THE ESTONIAN MINISTRY OF FINANCE

EUROPEAN COMMISSION INTERNAL MARKET AND SERVICES DG B-1049 BRUSSEL BELGIUM November, 15th, 2005 THE RESPONSE BY THE ESTONIAN MINISTRY OF FINANCE TO THE GREEN PAPER ON THE ENHANCEMENT OF THE EU FRAMEWORK FOR INVESTMENT FUNDS Q1: Will the above initiatives bring sufficient legal certainty to the implementation of the Directive? Q2: Are there additional concerns relating to day-to-day implementation of the Directive which need to be tackled as a priority? Estonia (EE): In general, as noted in the 2.1 of Green Paper, the initiative involving the enhancement of EU framework for investment funds (Green Paper) can bring sufficient legal certainty in the implementation of the UCITS Directive (85/611/EEC) in a short and medium term period. As every country has its national specificities, such as product characteristics, consumer preferences and market structures, also this can be the main obstacle and stumbling block on the way towards a creation of the Single Market in financial services. Therefore, the common interpretation by national supervisors should overrule the created hurdles for cross-border operators. Accordingly, CESR has already done quite much to clear some of the hurdles in connection with the accommodation of national concerns and specificities. This continuous process should facilitate the convergence of supervisory practices and the move towards more integrated Single Market in the asset management area. However, a certain inconsistency between CESR guidelines and UCITS Directive cannot be plausible in a long run. In certain aspects, the legal certainty may deepen as a result of holding them in abeyance and this in the end can only be solved through amendments of the existing EU legislation for investment funds 1. Nevertheless, in general we support the approach provided by CESR guidelines, which are likely to be relying more on the principles of how fund cross-border business is being conducted in practice. In a short term, the preference is for a concentration of efforts on a coordinated implementation and enforcement of the existing legislation. As the new Member Sates benefit fully from the single passport regime only just 1 st of May 2004, it is important that the existing rules are being put more into practice before further legislation is considered. 1 In some areas the juridical relationship between Directive 85/611/EEC and CESR s guidelines for supervisors remains largely unclear. For example Article 6b paragraph 5 of Directive clearly stipulates that the management company shall also be subject to the notification procedure where it entrusts a third party with the marketing of the units in a host Member State. However, CESR guidelines lays down on page 8 that only a product passport and no management company passport shall be required if a management company only wishes to distribute UCITS managed by itself in a host Member State. Ministry of Finance Suur-Ameerika 1, 15006 Tallinn ESTONIA, Reg. code 70000272 Phone: +372 611 3558 Fax: +372 696 6810 E-mail: info@fin.ee http://www.fin.ee

Therefore, at present the first priority is to make the most out of the existing framework by trying to hammer out common interpretations by clarifying the transitional provisions and definitions of the UCITS Directive. Accordingly from the industry s perspective, better coordination among national authorities, stricter enforcement and a more coherent implementation of European regulation should be the main target for the near future. 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. 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. EE: The latest amendments of UCITS Directive (amended with the Directive 2001/107/EC) introduced the passport regime of management companies, which allows them to provide their services in other Member States without the need for further authorization. This step should probably have brought management companies into line with the passport rights enjoyed by credit institutions, investment firms and insurance undertakings. But as many things in theory, it did not necessarily happen in practice. For example it is still not possible for a UCITS established in contractual form or as a unit trust to appoint a management company outside the Member State in which the UCITS is established (due to the fact that UCITS is to be established and is subject to home state legislation in the jurisdiction in which its management company has its registered office). Thus, these restrictions could place UCITS managers who provide portfolio management services at a disadvantage compared to their competitors in the EU financial sector. However, there is currently no empirical evidence that the effective management company passport can deliver significant additional economic advantages compared to delegation arrangements. Therefore, it is risky to split the responsibility for the supervision of the management company and the fund across jurisdictions as it may give rise to additional operational risks or supervisory concerns as remarked. But the question remains, how to achieve a better cross-border administrative rationalization and the consequent efficiency gains. Accordingly, besides the traditional outsourcing the new business models should be developed to achieve lower costs and greater global coverage and to find better solution for locating activities. Hence, analyzing the possibilities of how to gain more effective realization of management company passport and use outsourcing options (including offshoring risks) should remain as one of the priorities of regulators agendas. 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? EE: The greater transparency, comparability and attention to investor needs in fund distribution may materially enhance the functioning of European investment fund markets and also raise the level of investor protection. One of the means towards more European-wide transparency is certainly the creation of simplified prospectus. A simplified prospectus aims to provide the potential investor with clear, relevant and intelligible information on key features: the investment objective of the fund, fees, how it is invested and how the full prospectus and latest annual report may be obtained. Nevertheless, further analysis may be needed to understand how this measure has improved the transparency and comparability of UCITS so far. 2

Also, despite of the existence of simplified prospectus, the information standards can still vary between EU countries in respect of fund costs and performance due to different regulation and traditions. Furthermore, the compilation and information presentation of simplified prospectuses may vary a lot between different Members States and even in nationally by fund product providers. Furthermore, the way the fund product providers compile and present information in the simplified prospectuses can vary markedly between the Member States, as well at a single Member State level. This diversity may impede cross-border business from both the producer s and the consumer s side. Thus, a possible review of how the rules of simplified prospectus are stipulated in different Member States and further potential amendments in the Commission Recommendation 2004/384/EC could be useful. In principle, strengthening consumer confidence is certainly a key issue in cross-border marketing of investment funds. Confidence in trading between the different Member States is a prerequisite for a well functioning internal market. Only then will the consumers benefit from wider choice and better prices and in turn the firms from easier market access. From a consumer/investor s perspective, the consumer protection rules have to build up confidence and trust in the reliability of cross-border business. However, any extra legislation to strengthen the consumer protection needs a thoroughgoing analysis, whereas it is essential that the possible administrative costs are not transferred to end users, bringing along a price boost for retail customers. 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? EE: The variety of existing conduct of business rules among the Member States can indeed hinder the consumer s ability to orientate in different Member States markets. Probably there is a need for some common principles which clearly express investor rights and ensures their confidence. Therefore, in a sense of enhanced disclosure, the convergence of general principles might be needed. However, there is no need for uniform EU corporate governance rules, as well expressed in the Corporate Governance Action Plan. Otherwise, if it is not proved that the higher level of conduct of business rules would create a significant benefit for the investors, there is a danger that a possible over-regulation can have an undesirable effects for the end-users (in the sense of costs). In general, we believe that the industry should take the lead in developing high level principles in that respect and in ensuring that they principles are applied rigorously in due cooperation with the Commission and CESR. Yet, it is worth to keep in mind that self-regulation is justified only if the industry acts in conformity with it (therefore, a mechanism that guarantees that the rules are followed by all market players). If not, an appropriate regulatory intervention is still possibly needed. In addition, the current trend, as described in the Annex of the Green Paper, according to which a high proportion of the management fees are being left to distributors reflects the market power of distributors, which may erode the competitiveness of EU investment funds market. Thus, in order to achieve a more uniform European investment funds infrastructure more balanced distribution platforms may need to be developed. Also, developing further the electronic platforms may reduce the distribution costs and setting out common further technical rules can decrease operational risk. However, solutions for these obstacles mentioned in the current paragraph should mostly be left in the hands of market. Q7: Are there particular fund-specific issues that are not covered by ongoing work on detailed implementation of MiFID conduct of business rules? EE: At this stage, taking into consideration the occurred problems with the MiFID regulation being to some extent too detailed, we find that there should not be any additional measures with regards to fund-specific issues. 3

In addition, as it is considered in the background paper of UCITS Green Paper, the concrete implications of the relationship between UCITS-Directive and MiFID (with respect to the sales process) are not always easy to determine. Therefore, the raised questions on the interaction between both directives in a background paper need further clarification. As the possible improvements regarding the costtransparency of investment fund business may prove to be essential for the investors, standardized disclosures for the UCITS produced by fund managers and/or intermediaries on the level of MiFiD need an extra consideration. 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? Q9: Could the desired benefits be achieved through pooling? Q10: Is competition at the level of fund management and/or distribution sufficient to ensure that investors will benefit from greater efficiency? EE: As also noted in the different research papers, the number of investment funds per head of population is significantly higher in EU than in the U.S. This may raise the concerns on where do fund profitability going forward in European Single Market. So, the question whether the European industry is really able to sustain additional fund launches while certain investment sectors are already saturated with providers providing little differentiation, is largely justified. One of the means to deal with it is to merge small, uneconomic funds into larger funds and accordingly there might be commercial and economic benefits from cross-border fund mergers. At present, as already noted many times in the Green Paper and in the Background Paper, the crossborder mergers are hampered because of the existing merger regimes that only contemplate domestic mergers. Estonia, similarly to the most Member States, has also a domestic regime that allows for fund mergers. But as for the European industry, in order to gain full economies of scale, there needs to be a way of doing the same has to be a simplified way for cross-border mergers also between different jurisdictions. Given the national interests involved and the prospects for effective regulatory cooperation in such a complex area, the most effective solution in the long run may be the introduction of new European legislation allowing for cross-border mergers and also for pooling. So, we basically support this idea. To conclude, it is essential for the future development of the industry that investment funds are managed more efficiently, because the smaller funds have higher relative costs. Nevertheless, the further consolidation and cross-border mergers of investment funds must be industry driven and not forced by regulators, as the flexible legislation is only the effective mean to achieve this. Q11: Which are the advantages and disadvantages (supervisory or commercial risks) steaming 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? 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? EE: Firstly, we basically agree that the possibility to choose a depository in another Member State could offer potential for efficiency gains and it can reduce the prohibitive barriers to enter the market, as well as it reduces the costs for management companies and for investors and enhances the development of a cross-border investment fund business. Also the introduction of a passport for depositaries allowing them to provide their services across the border is one possible option to consider (e.g. establishing a new legal framework for depositories without changing the existing EU legislation of banks and investment firms). Currently, the custodians are already able to rely on an ISD passport in order to provide safekeeping and administration services under the ISD, which is one of the main task of a depositary. 4

However, at this point it is almost clear that the regulation on depositaries may differ between Member States and supervisory authorities could have difficulties conducting their according tasks in case the depositories can be chosen in other Member States. But a tighter depositary regime can bring along additional costs, which should be weighted against potential advantages, therefore the first step should be to examine further this area and define clearly the main responsibilities of depositary before starting considering for instance the passport-regulation in respect of depositaries. Nevertheless, one possible and efficient solution besides separate passport regime for depositaries is to enable for EU credit institutions established in another Member State to act as depositories of UCITS without stipulating any extra rules. This should be based mainly on a precondition that these institutions already have a Single Market passport regime (including capital requirements etc). This option can also be considered regarding the investment firms, however, as much lower capital requirements are currently applied to these institutions this area needs a further evaluation. The information on the Commission s initiative to reduce differences in national rules step-by-step and on the progress in regulators work to foster convergence in UCITS depositary rules (to be published in the year 2006) is crucial, in order to determine necessary action. To conclude, the on-going industry-driven standardisation can deliver fruit to some extent within reasonable time-period and the possible legislative action could be, as mentioned above, allowing EU credit institutions to be depositaries in another Member State (the same possibilities for investment firms need an additional analysis). Q13: Does heavy reliance on formal investment limits represent a sustainable approach to delivering high levels of investor protection? 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? Q15: Are there instances resulting in a distortion of investor s choice that call for particular attention from European and/or national policy-makers? EE: In general, currently established safeguards for investor protection seem to be at an appropriate level as there have not been any fraud cases with the UCITS recently (at least not in Estonia). However, if the current investment powers of UCITS are extended (for example, in relation to venture capital or real estate), above-mentioned levels might need an explicit analysis and a possible upgrade (for example higher capital requirements of management companies to cover operational risks and etc). Nevertheless, as the two quantitative and qualitative studies, i.e. Current trends in the European asset management industry and Potential cost savings in a fully integrated European investment funds market launched by the Commission, have not been completed yet, the further steps may be premature in a short-run. Concerning the other measures of importance with regard to strengthening investor confidence in domestic and also in cross border business, one option would be to set up an investor compensation scheme for UCITS as it already applies to management companies which provide investment services under the ISD. However, as there are always extra costs related with any compensation scheme, this area may need thorough analysis taking into account the size of the potential risk that needs to be insured. In addition to the compensation schemes, measures of industry self-regulation (such as codes of conducts) may help to strengthen investor confidence. Self-regulation can contain clear voluntarily binding commitments towards consumers. Nevertheless, there may be the need for some form of enforcement rules, perhaps through the introduction of a legal sanction for not honoring commitments contained in the codes. 5

There may be cases in which there is a distortion of the investor s choice deriving from more favorable regime of such products as unit-linked life insurance or certain structured products (for example pension funds). Though, the same business or the same functions may give rise to similar risks and therefore they should be basically subject to comparable regulatory treatment - regardless of the type of authorization under which the institution is conducting the business, or the precise classification of the end-product retailed to the end-consumer. Before any legislative steps are taken by the European or national policy-makers, a further analysis might be needed. In addition, there may be strong synergies between the regulation of funds and of pension fund management where the rules are laid down in more unified basis in both sectors. The asset management industry could be a source of fresh ideas for the new approaches towards regulation and integration of the pension fund and life insurance sectors. Q16: To what extent do problems of regulatory fragmentation 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? 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? EE: New products, such as structured hedge funds and capital-guarantee vehicles, will continue to develop to match the needs of the business environment. Moreover, probably the industry of alternative investment funds may grow even more by changing in order to meet the demands of a landscape of increased transparency and regulation. However, the fact that such products are not covered by EU legislation does not imply they are not regulated. On the contrary, many Member States have national based rules, but it is not the case with all the Member States (for example Estonia). Nevertheless, as these rules are not harmonized or coordinated, the private equity and venture capital industry may be subject to regulatory fragmentation that can create a legal uncertainty (e.g. nonrecognition of legal structures). As the absence of regulation may generate uncertainty and lack of trust within the industry, a common European approach to these funds can be considered, which is viable and effective enhancing thereby further integration of EU fund industry. Also, besides the private equity funds, hedge funds and funds of hedge funds, there are other fund vehicles like real estate funds in EU. Furthermore, compared to low equity returns, these alternative fund structures could provide a muchneeded alternative for investors seeking high levels of positive returns. Nevertheless, the possible risks might not be perceived, especially operational risk, which is often underestimated and not well understood and this will continue to be viewed as less important than investment risk. Therefore, the risks related with alternative investment schemes may need further analysis mainly in respect of retail investor protection. To conclude, for non-harmonized products, there may be a need for extension of EU framework enabling common passport regime also to these special type of investment funds, based on principles which are flexible enough to cope with the latest trends and innovation. However, this must be rather an option than an obligation for hedge funds and other non-harmonized products to come under the EU jurisdiction as they may wish to continue to provide their services outside the EU legal framework. Thus, there is no need to classify these special types of investment vehicles directly as UCITS funds, it rather needs further consideration, whether to apply the provisions of mutual recognition also to non- UCITS funds. Q18: To what extent could a common private placement regime help to overcome barriers to crossborder 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.? 6

EE: The common private placement regime for alternative investment funds may in principle help to overcome the barriers to cross-border offer, as currently the private-placed fund has to face different regimes in different Member States. At the same time indeed the range of the targets of private placement regime has to be determined, by defining the term private placement and the question of whether also the retail investors should be included or should the possible regime be applied only to qualified investors, is not yet answered. Although external equity capital is a source of financing for only a small number of those alternative funds, the rapid growth of them seems to give basis to start considering also the common private placement regime, as the fragmented European capital markets are not currently providing enough basis for such a rapid expansion of alternative investment schemes. Clarifying the marketing and sales process trough implementation of the flanking measures independently at the level of fund manager is one possible solution. Nevertheless, a further analysis in this field is probably needed. However, taking into consideration other issues to be solved, the abovementioned subject should not be a priority item. Q19: Does the current product-based prescriptive UCITS law represent a viable long-term 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? EE: The question whether there is a need for a new framework or is the existing framework sufficient, remains. Probably, some market players do not find that there is a need for any new, far-reaching, legislative initiatives for UCITS. However, in some areas the further legislation might be needed, among other things, to clarify the rules on eligible assets, to strengthen the management company regime and to facilitate cross-border fund mergers. Also, the introduction of a mutual recognition regime for venture capital funds, hedge funds and other special type of investment vehicles could facilitate crossborder fund business. But in moving forward, it should be easier to change the existing legislation rather than starting from scratch and building a new legislative framework. From this perspective there is no need for an Asset management directive I. Secondly, it is likely that the Lamfalussy approach needs to be applied to more areas of the Directive. Therefore, whatever the level of ambition, it is important that the occasion of any future recasting of UCITS legislation is used to give effect to the Lamfalussy mechanisms. This will offer the flexibility needed to cope with innovation in this fast-moving sector. In addition, one of the issues is also a global competitiveness as the attractiveness of the UCITS brand should be better exploited the concept of product regulation could be more widely exported as a basis for effective access to third country markets. To conclude, when starting to amend UCITS regulation, an appropriate balance between functional and product-based regulation must be find. And finally, the legislation cannot resolve everything, even if the greater flexibility is permitted by common EU legal framework. In general, in order to gain further integration of EU financial services, the industry must come up also with its own solutions, as the feasible EU legal regime is only a stimulator and appropriate means to achieve the common objectives. 7