VERBAND DER AUSLANDSBANKEN IN DEUTSCHLAND E. V. ASSOCIATION OF FOREIGN BANKS IN GERMANY

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1 VERBAND DER AUSLANDSBANKEN IN DEUTSCHLAND E. V. ASSOCIATION OF FOREIGN BANKS IN GERMANY INTERESSENVERTRETUNG AUSLÄNDISCHER BANKEN, KAPITALANLAGEGESELLSCHAFTEN, FINANZDIENSTLEISTUNGSINSTITUTE UND REPRÄSENTANZEN REPRESENTATION OF INTERESTS OF FOREIGN BANKS, INVESTMENT MANAGEMENT COMPANIES, FINANCIAL SERVICES INSTITUTIONS AND REPRESENTATIVE OFFICES Commission of the European Communities Avenue de Cortenbergh 107 B-1049 Brussel 14. November 2005\VA\Ma Green Paper on the Enhancement of the EU Framework for Investment Funds Dear Madam, dear Sir, The Association of Foreign Banks in Germany appreciates the opportunity to comment on the Green Paper on the Enhancement of the EU Framework for Investment Funds (SEC(2005) 947). We represent foreign banks, investment firms and investment management companies operating in Germany. Among our members, we have Kapitalanlagegesellschaften according to the German Investment Act, as well as foreign investment management companies within the meaning of the UCITS Directive, operating in Germany under the European passport. I. Preliminary Remarks One of the key questions on new regulation in the investment fund area is whether the investor would actually appreciate new regulatory features. We would like to stress that the UCITS Directive already provides for comprehensive and extensive regulation and investor protection. We have to bear in mind that these features of the investment fund are not for free. Compliance with regulatory requirements is causing expenses. Would investors really enjoy new regulation, should they have to pay additional fees for it? Or would they start feeling over-protected, thus directing their attention towards cheaper alternatives? The competitive situation of the UCITS fund is increasingly difficult. There is a clear trend that investors prefer investing in products with both favourable tax treatment and low inherent regulatory costs. Unfortunately, tax issues cannot be addressed by UCITS Directive implementation. But there is room for a discussion of regulatory costs, which have to be minimized to the necessary level. Therefore, amendments of the current framework for investment funds should not only focus on more investor protection. They should rather strictly focus on cost-effective investor protection. However, it is difficult to achieve cost-effectiveness by changing regulatory frameworks, because of the implementation costs which have to be outweighed by the respective benefits. Savignystrasse Frankfurt am Main Homepage Telefon 069/ Telefax 069/ verband@vab.de Konto Nr SEB AG Frankfurt am Main BLZ I:\O(Internationale Orga)\O550(EURichtlinien&VO)\O550T23(OGAW-UCITS)\O550T23N(Novellen)\O550T23N02(Grünbuch InvFonds)\Stell_Grünbuch Investmentfonds_ doc

2 Bearing this in mind, we would like to highlight the following points: The management company passport is one of the central issues for the further implementation of the UCITS Directive. It can provide great advantages for both industry and investors, especially in conjunction with cross-border fund mergers. See our answers to the questions Q2-Q4 and Q8. Any additional MiFID-like regulation for UCITS management companies should be tailor-made, bearing in mind that management companies distributing their funds are and directly compete with producers of financial instruments, not intermediaries. See question Q5. The extent to which there is direct competition between UCITS funds and certificates/structured bonds, is largely overestimated. Instead, UCITS funds and certificates/structured bonds compete like different asset classes. The competitiveness of UCITS should be enhanced by de-regulation measures, but not by prohibitive legislation against certificates/structured bonds. See question Q15. From the German point of view, a harmonisation in the private placement area would presumably cut down the freedoms that presently exist. See question Q18. II. Answers to the Green Paper Questions Question Q1: Will the above initiatives bring sufficient legal certainty to the implementation of the Directive? The work on the UCITS Directive s transitional provisions completed by CESR was important for the implementation of UCITS III by grandfathered funds. We welcome the EU Commission s intention to support the implementation of CESR s respective guidelines. We strongly support the Commission s intention to simplify the notification procedure for passporting funds. Both the industry and the investors will stand to gain from cost reductions. The notification procedure should not be used as a Trojan Horse for introducing supplementary host Member States supervision. In the long run, based on supervisory convergence in product regulation and a functioning management company passport, the aim should be to abolish all notification requirements for UCITS funds in the long run. It is true that the Commission s recommendations on the use of derivatives and the simplified prospectus have improved legal certainty in these areas. However, in our opinion, the simplified prospectus has not yet proven its effectiveness. We suggest to enter into an evaluation of the simplified prospectus. We agree with the Commission that the definition of eligible assets for UCITS is one of the important tasks in order to achieve legal certainty under UCITS III legislation. Question Q2: Are there any additional concerns relating to day-to-day implementation of the Directive which need to be tackled as a priority? We would strongly recommend that the implementation of the management company passport (dealt with in the Green Paper under ) is added to the priority list. It is one of the central achievements of UCITS III, but currently not at all implemented by supervisory authorities. The management company passport should cover UCITS of both the company and the contractual type to be launched cross-border. Day-to-day business is affected in one of the most central aspects: The location of legal entities. Currently, a lot of management companies establish additional entities abroad. These would be spare, if a functioning management company passport regime was installed. 2

3 Question Q3: Would an effective management company passport deliver significant additional economic advantages as opposed to delegation arrangements? Please indicate sources and likely scale of expected benefit. An effective management company passport would indeed deliver economic advantages. See above, question 2. Currently, the duplication of management companies in the country of origin and in other Member States is quite common. If additional entities could be spared, costs for personnel, administration, outsourcing and legal advice would obviously be reduced. Question Q4: Would the splitting of responsibility for the supervision of the management company and the fund across jurisdictions give rise to additional operational risks or supervisory concerns? Please describe sources of problem and steps that would have to be taken to manage such risks effectively. Firstly, we would like to stress that a split of responsibilities between two or even more supervisors is nothing new. We find similar arrangements in the Prospectus Directive that grants issuers a choice of the home Member State for various products that cover large parts of the securities market. In the case of supervised banks or investment firms, the supervisory competencies are split between supervision of the company and supervision of the prospectus (the product). The MiFID divides competencies between the home and the host Member State, along the lines of, broadly speaking, the supervision of the investment firm on the one hand, and its behaviour in the market on the other hand. The Banking Directive divides supervisory competencies in relation to institutions acting cross-border under the European Passport, between the home Member State and the host Member State (putting the emphasis on home Member State supervision). All these arrangements work out well in day-to-day business and supervision. As regards potential sources of problems, the experience of supervisors with the implementation of the before-mentioned Directives should be taken into account. It is not likely that additional supervisory concerns in the field of UCITS might exceed the problems dealt with by those other Directives. We think that a division of competencies between national supervisors would be feasible on the basis of the current Art b UCITS-Directive. CESR might work out the details. Question Q5: Will greater transparency, comparability and attention to investor needs in fund distribution materially enhance the functioning of European investment fund markets and the level of investor protection? Should this be a priority? This question is difficult to answer, not least because its form and content may indicate the existence of some quite common misunderstandings. It is true that transparency is in general useful for end-investors, especially in conjunction with a competitive environment on the sell-side. Both transparency as regards the features of products, and transparency as regards costs and fees, have to be mentioned in this respect. Fund investors might benefit from the publication of management and distribution fees and respective competition between investment managers. But considerations on cost-effectiveness apply also in this field of possible regulation. With regard to additional costs that may be produced by additional regulation, it might turn out that new regulation is only the second best way to enhance investor protection. Instead, already existing efficient market features have to be preserved and protected against negative side effects of new regulation. Bearing in mind that efficient civil law exists to protect investors interests, bad advice and/or false or misleading statements in prospectuses, marketing publications or contracts inevitably lead to civil actions 3

4 against the responsible firm. Thus, this is a source of operational risks, as well as the use of potentially misleading product labels. It is in the industry s own interest to avoid these risks, to have measures in place to avoid mis-selling or bad advice. We have to add that to date, funds are distributed by management companies themselves, by other third parties on the basis of advisory services, by so-called fund-supermarkets or direct brokers via internet, by internet brokers on an execution only - basis designed for experienced investors, or else even via a listing on an exchange. The competition makes distribution fees vary accordingly and remarkably: The same fund may be available for offering premiums ranging from 6 % to zero % of the share price. In this competitive surrounding, tailor-made distribution solutions for different groups of investors have developed, mostly on the basis of specific investors demands. In fact, end-investors have a choice between various distribution channels and may easily switch from one to the other, if they deem it adequate. Consequently, we have some doubts that the MiFID may unreflectedly be used as a toolbox for additional regulation on UCITS. The MiFID basically regulates intermediaries for financial instruments, while the UCITS Directive concerns the production and distribution of funds by UCITS companies. But in general, the UCITS industry does not act as intermediary. It has to compete with producers of financial instruments. Additional regulation from the intermediary area might lead to competitive disadvantages. The Green Paper (2.2.2.) lists some examples of possible transformation of MiFID rules to UCITS rules. We would like to comment on these as follows: Duties of care and risk warnings: The MiFID deals with wide-spread product categories of a different risk profile (e. g. government bonds versus OTC options and forwards), sometimes not even issued on the basis of prospectuses (e. g. derivative contracts), and with no inherent risk management. This is not at all the case with UCITS funds. These are largely standardised, having inherent risk barriers introduced by investment and issuer limits and restrictions to eligible assets. Risk management systems for derivatives are mandatory, and so is a volatility warning (Art. 24a (3) UCITS Directive). Both a prospectus and a simplified prospectus explain the product to investors. In the light of these features of the UCITS Directive it should be carefully evaluated, if and to what extent additional MiFID-oriented rules are necessary and proportionate, and if the investor might really gain from additional regulation. Management and disclosure of conflicts of interest: The UCITS Directive already provides for rules of conduct, although some of them are on a principle-based level. Interpretation guidelines for supervisors might prove to be necessary. But again, the application of MiFID rules might cause overregulation. It should be carefully considered which conflicts of interests could arise in the UCITS field, and how they might be addressed efficiently. Best execution: The distribution of UCITS funds by intermediaries is already regulated by MiFID. It should be carefully evaluated if the application of rules made for intermediaries of UCITS can have additional positive effects and will be proportionate. As we explained above, fund investors tend to choose distribution channels as a matter of how much advice they expect personally, and how much fees they want to pay for it. It would be impossible to describe in an abstract way what kind of execution by a UCITS company the investor would choose to be best. The Commission pointed out recently that best execution according to the MiFID is to be defined basically by costs and price. If the distribution of funds was judged exclusively on the basis of these parameters, advisory-based distribution channels currently appreciated by industry and investors might be in question. 4

5 Question Q6: Will clarification of conduct of business rules applying to firms which retail funds to investors contribute significantly to this objective? Should other steps (enhanced disclosure) be considered? See Question 5. Question Q7: Are there particular fund-specific issues that are not covered by ongoing work on detailed implementation of MiFID conduct of business rules? n. a. Question Q8: Is there a commercial or economic logic (net benefits) for cross-border fund mergers? Could those benefits be largely achieved by rationalisation within national borders? The logic for cross-border fund mergers is basically the same as for national fund mergers, especially as fund production in Europe is normally done in different jurisdictions. Unfortunately, we cannot contribute any data in this respect; but we rely on the discussions held with market participants which are emphasising the need for an acceptable framework for fund mergers both in supervisory and tax law. The issue will certainly become even more important when the European Passport for management companies is fully implemented. The management company passport would be a catalyst for fund mergers. So far, a lot of asset management groups have management companies in more than one Member State. Under a management passport, the need for such a multitude of management companies would disappear, and the question of mergers of already existing funds, managed today by different intragroup management companies, will have to be answered urgently then in order to explore the full benefit of the management company passport. Question Q9: Could the desired benefits be achieved by pooling? n. a. Question Q10: Is competition at the level of fund management and/or distribution sufficient to ensure that investors will benefit from greater efficiency? We believe that, as far as the German market is concerned, the answer would definitely be yes, because the market is highly competitive with a large number of domestic and foreign asset managers distributing their funds to German clients, using different and competing distribution channels with different fee and service characteristics (cf. Question 5). Question Q11: Which are the advantages and disadvantages (supervisory or commercial risks) stemming from the possibility to choose a depositary in another Member State? To what extent does delegation or other arrangements obviate the need for legislative action on these issues? n. a. 5

6 Question Q12: Do you think that on-going industry-driven standardisation will deliver fruit within reasonable time-frames? Is there any need for public sector involvement? We support the Commission s view that bearing in mind the efforts the industry is currently undertaking, it should do without additional regulatory measures for the time being. Question Q13: Does heavy reliance on formal investment limits represent a sustainable approach to delivering high levels of investor protection? The answer would be yes and no. Formal and rigid investment limits correspond to the fact that, in general, individual investment management contracts contain clauses on the assets being eligible for investment. Insofar, the contractual practise suggests that formal investment limits are valid and well functioning tools of investment strategy definition and investor protection. In the light of the new Basle Accord, however, it may be argued that the rigidity of investment limits is not up-to-date, as far as risk-based approaches are being introduced in the banking directive. Art. 22 (3) UCITS-Directive is an example of risk-based regulation in the field of UCITS. It might be useful to think of risk-based investment limits to be introduced in the context of Art. 19 and UCITS-Directive, in order to grant additional investment possibilities to investment managers using risk-based management approaches outside the field of derivatives. However, for small management companies and/or low risk fund management approaches the current investment limits framework should remain available as a basic, simple and effective regime. More sophisticated and costly risk-based investment limits on the basis of recognized risk measuring systems should be an opt-in possibility for UCITS for which this would be suitable. Question Q14: Do you think that safeguards at the level of the management company and depositary are sufficiently robust to address emerging risks in UCITS management and administration? What other measures for maintaining a high level of investor protection would you consider appropriate? We do not feel that the risk situation of UCITS management and administration has developed in a way that would not be properly addressed by already existing European level 1 legislation. The UCITS Directive provides for sufficient safeguards. Although these are principle-based, they might be developed in the supervisory convergence process. Consequently, we do not see the need for additional regulation as regards risk management. The fund industry value-chain is developing, but not to an extent that would be outside the scope of the existing European legal framework. Question Q15: Are there instances resulting in a distortion of investor s choice that call for particular attention from European and/or national policy-makers? There is a tendency among investment industry s associations and regulators to long for regulation with regard to structured products, i. e. certificates (sometimes even referred to with the term esotheric products ), which are currently increasing their market share. It is pointed out that the certificate industry gains assets under management to the detriment of the UCITS funds. But the extent to which there is direct competition between UCITS funds and certificates/structured bonds, is largely overestimated. Instead, UCITS funds and certificates/structured bonds compete like 6

7 different asset classes. The competitiveness of UCITS should be enhanced by de-regulation measures, but not by prohibitive legislation against certificates/structured bonds. There are several aspects we would like to point out in this respect: In general, funds and certificates/structured products are different asset classes, addressing different needs of investors. The majority of certificates/structured bonds does not offer investment opportunities that would be similar to UCITS funds and vice versa: ο A large part of the certificate/structured bond issues are designed for and bought by institutional investors. This is outside the scope of the UCITS Directive. Insurance undertakings and UCITS managers are important investors in certificates/structured bonds. ο Some of the certificates/structured bonds designed as so-called derivative securities are instruments of pure speculation, with a risk-return-profile comparable to options and/or futures or combinations of them. They are not at all created and bought for long-term investment. These products therefore compete with exchange-traded options and futures, but not with UCITS funds. As regards these certificates/structured bonds, there may be reasonable doubts if retail investors should really expose themselves to the risks of this kind of speculation. But basically it is not up to legislators and/or regulators to decide for them. ο A lot of certificates/structured bonds offer the opportunity to participate in specific simple investment strategies. E. g. discount certificates include a popular investment strategy: long stock + short call, made available in one financial instrument. These products are not comparable and do not compete with UCITS funds, because unlike these products, UCITS funds involve the delegation of discretionary asset management. ο The return of some certificates/structured bonds is linked to the performance of a managed portfolio. However, these certificates/structured bonds are generally not linked to UCITS funds or comparable portfolios, but to alternative investments, such as hedge fund strategies or private equity. So these kinds of investments would largely be outside the scope of the UCITS Directive. ο Competition exists between index tracking UCITS funds and so-called index certificates (structured bonds linked to a financial index). However, there are basic differences between them. The index tracking fund provides for safety in case of bankruptcy of the management company. But it is more expensive for investors because of the management fees and the risk of tracking errors, which both do not occur in the case of investments in index certificates. Every Euro can only be invested once. But the before-mentioned examples show that generally there is no more competition between certificates/structured bonds and UCITS funds than between UCITS funds and other kinds of direct investments, e. g. in government bonds, stocks, derivatives or a simple savings account. We believe that it would be wrong to try to enhance one asset classes competitiveness by mere prohibitive legislation against others. Instead, new regulation should focus on the flexibility and the effectiveness of the current UCITS framework itself. There is room for enhancing the UCITS funds competitiveness compared with other asset classes. The UCITS fund s regulation should be reconsidered in order to define de-regulation measures. Despite the differences between UCITS funds and certificates/structured bonds, there is a potential that the latter asset class becomes an alternative to UCITS for investors, should UCITS funds be too expensive due to more regulation. This has to be avoided, by minimizing regulatory costs for UCITS. 7

8 Question Q16: To what extent do problems of regulatory framework give rise to market access problems which might call for a common EU approach to a) private equity funds; b) hedge funds and funds of hedge funds? Firstly, we welcome that obviously the EU Commission speaks in favour of easy EU-wide market access for private equity and hedge fund products in the field of investment funds. As far as we know, in some of the Member States market access turns out to be very difficult. Even in Member States with a more liberal approach offerors of so-called alternative investments face some difficulties. Legal uncertainty arises e. g. because private equity funds and/or hedge funds are not clearly legally defined. Moreover, the supervisory and/or tax treatment might be unclear. However, the market access for hedge funds and funds of hedge funds in Germany is well defined and relatively liberal, though the requirements especially for tax purposes are far from easy to meet for foreign investment managers. Nevertheless it should be borne in mind that alternative investments exceed the UCITS fund brand. They also exceed the scope of the UCITS Directive, because private equity investments are illiquid and targeted to institutional investors, and hedge funds are and have to be unregulated. Therefore we wonder if an amendment of the UCITS Directive can be the appropriate way to introduce market access regulation for these types of investments. However, we would like to point out that the current discussion on level 2 might lead to a recognition of closed-end funds as eligible assets under UCITS III. Therefore, the Commission should consider that funds of (closed-end) private equity funds, funds of (closed-end) hedge funds, but also funds of (closedend) real estate funds might soon emerge under the current Directive, and might soon be distributed under the European Passport. Question Q17: Are there particular risks (from an investor protection or a market stability perspective) associated with the activities of either private equity or hedge funds which might warrant particular attention? As regards hedge funds, we would refer to the OECD study Hedge Funds, Highly Leveraged Investment Strategies and Financial Markets, in: Financial Market Trends (73), June 1999, page 27 ff., and the FSA s discussion paper Hedgefunds: A Discussion of Risk and Regulatory Engagement 1. Possible regulation in this respect should, however, be discussed on a global level because the hedge fund industry tends to avoid regulation by moving offshore. Apart from the risks decribed in the before-mentioned studies, particularly in Germany there is a discussion on risks for a suitable corporate governance arising from aggressive investors like private equity or hedge funds. Especially issuers tend to complain about undue influence that aggressive investors take, either by using their shareholder votes or through short selling techniques, to obtain shortterm return on their investment. They also point out that excessive securities lending makes it impossible for them to get to know who their shareholders are. In our opinion, the use of shareholder votes, short selling and securities lending are symptoms of a well functioning financial market. If those investors tend to use these tactics, then this is a clear indication that market inefficiencies occur that are worth being exploited. Our view is that investors by these means contribute to timely and fair market pricing. The influence exerted on corporate governance should be regarded as useful, but not undue, even if it contradicts the issuers managements plans in the short run

9 Question Q18: To what extent could a common private placement regime help to overcome barriers to cross-border offer of alternative investments to qualified investors? Can this clarification of marketing and sales process be implemented independently of flanking measures at the level of fund manager etc.? The current German framework for private placements is liberal. Both investors and offerors of alternative investments are used to cross border distribution by private placement. We have currently no information that the liberal German approach has led to problems, and therefore we do not feel that it might be necessary to consider an adaptation of the private placement framework, neither on the national German, nor on the European level. Instead, we fear that additional regulation, always subject to some sort of compromise, could lead to unnecessary restrictions, because regulators tend to underestimate even the qualified investors ability and will to protect themselves on their own against possible risks. However, we have no information to comment on the situation in other Member States. Maybe the introduction of a basic rule on EU level, stipulating that Member States would have to ensure market access for private placements of unregulated investment products under simplified conditions and without undue restrictions, could be useful. The details, however, should be defined by the Member States. Question Q19: Does the current product-based prescriptive UCITS law represent a viable longterm basis for a well-supervised and integrated European investment fund market? Under what conditions, or at what stage, should a move toward principle-driven, risk-based regulation be contemplated? We think that it is never too early to consider the new opportunities risk-based regulation might introduce for the fund industry. A principle-driven approach might lead to a supervision focussing on the risk management by the management companies, and not on rather formal investment limits for funds. This would provide for additional flexibility in product invention, which we deem helpful for the future competitiveness of investment funds in a developing financial market, especially with regard to MiFID regulated financial services and products (s. Q15). However, the role of depositary banks should be reconsidered. In a merely risk-based fund management approach, depositary banks might no longer be able (by technical means) to assess to what extent the fund management is in line with regulatory requirements. This is already the case with regard to the management of risks stemming from the use of derivatives in UCITS funds. Modern risk management requires processes and information technology which would be too costly for depositary banks to monitor. The plausibility of the parameters for a sophisticated risk-management system are not easily assessible either. In addition, details of the risk management might be regarded as professional secrets, as they vary from one company to the other and influence the risk-return profile of their investments. Given the introduction of risk-based regulation, the formerly product-based supervision would have to be changed in an investment company- or management company-based supervision because the appropriateness of risk-management systems can only be supervised at the company level. Consequently, the product passport would become spare, while the management company passport would become the central tool for cross-border business in the Internal Market. 9

10 If you have any questions, please do not hesitate to contact us. Kind regards, Jens Tolckmitt Wolfgang Vahldiek 10