Page 1 UCITS V and VI preparing for the new rules, and beyond Grania Baird, Partner, Farrer & Co LLP and Julia Hartley, Professional Support Lawyer, Farrer & Co LLP 1. Introduction On 28 August 2014, Directive 2014/91/EU on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS V) was published in the Official Journal of the EU 1. UCITS V aims to introduce a more coherent and consistent approach in relation to the protection for retail investors in collective investment schemes as there now is for professional investors in unregulated collective investment schemes following the implementation of the Alternative Investment Fund Managers Directive (2011/61/EU) (AIFMD). Under UCITS V a variety of corresponding measures are introduced relating to the depositary function, manager remuneration and sanctions, and amendments made to the existing regime in Directive 2009/65/EC (UCITS Directive) relating to access to telephone and data records. References in this briefing are to the consolidated text of the UCITS Directive as amended by UCITS V, as UCITS V is an amending Directive. UCITS V came into force on 17 September 2014 and member states have until 18 March 2016 to transpose it into national law. HM Treasury and the Financial Conduct Authority (FCA) will need to implement the requirements through legislation and amendments to the FCA Handbook. The European Securities and Markets Authority (ESMA) is in the process of providing technical advice on various delegated acts under UCITS V to the European Commission (known as the Level 2 implementing measures), including particulars of the depositary agreement, conditions for performing the depositary function, due diligence duties on the depositary, and further issues relating to lost financial instruments and liability. In November 2014, ESMA submitted its advice on the content of two of the delegated acts on depositaries, namely delegation and independence, which are discussed in more detail below. 2. UCITS V the key provisions The key provisions of UCITS V cover the following areas: the role, eligibility, responsibility and liability of depositaries in order to improve investor protection; how remuneration policies apply to key members of staff within UCITS managers so as to discourage excessive risk-taking; harmonisation of minimum administrative sanctions across the EU; and access to telephone and data records held by UCITS managers. 2.1 Depositary (Articles 22-24) UCITS have always needed a depositary; however, UCITS V introduces measures that will bring the regulation of the appointed depositary in line with the higher standard of liability requirements, if not beyond, those under AIFMD. Previously, although the high-level duties of the depositary were contained in the UCITS Directive, detailed obligations of the depositary had been left to be defined by member states, and UCITS V addresses this gap, and aims to harmonise the regulatory requirements placed on the depositary. 1 http://eur-lex.europa.eu/legal-content/en/txt/pdf/?uri=oj:jol_2014_257_r_0007&from=en
Page 2 2.1.1 Eligibility The eligibility to act as depositary has also been restricted to: a credit institution or investment firm, being entities that can meet certain capital and own funds requirements; and this must be independent of the management company so it can act solely in the interests of the investors in the UCITS. ESMA's November 2014 advice identified two areas of potential risk that may potentially jeopardise independence between the management company and the depositary, namely common management and cross-shareholdings, and made recommendations on how to address these: 2.1.2 Duties common management for example, no person to be a member of both management bodies; and cross-shareholdings the depositary should not have a direct or indirect holding of more than 10% of the shares or voting rights which enable it to exercise a significant influence over the management company or vice versa. ESMA also recommends that the management company puts in place a robust process for choosing the depositary, based on pre-defined objective criteria. Safekeeping: UCITS V specifies the requirement to appoint a single independent depositary who will be entrusted to safeguard all assets which, similarly to AIFMD assets, are categorised into two classes: "financial instruments", broadly those in Annex C of Directive 2004/39/EC (2014/65/EU) (MiFID II), which must be taken into safe-keeping and segregated in the depositaries books; and "other assets", for which the depositary has a less onerous role, mainly limited to verification and record-keeping. For UK UCITS this distinction is not of much practical significance since the FCA's Collective Investment Schemes Sourcebook (COLL) requires all assets to be under the depositary's control and custody, but the distinction may have relevance to other non-uk UCITS. However, this does have a bearing on liability, and is discussed further below. Cash-flow monitoring: A new obligation on depositaries, which reflects that imposed under AIFMD, is that of a cash-flow monitoring function, which includes checking that cash movements in a fund are monitored and booked correctly. Oversight: The depositary has an oversight function, as was the case under the UCITS Directive, making sure the UCITS fund is operated in accordance with the regulations of its constituting documents, such as the subscription and cancellation of units, and ensuring that income is applied correctly, and so on.
Page 3 Written agreement: The depositary must be appointed under a written contract, the detail of what the contract must contain is expected to be similar to that required for alternative investment fund managers (AIFMs) under AIFMD, and it is expected that the detail will be published later this year in the Level 2 implementing measures. 2.1.3 Delegation Following AIFMD, UCITS V places limitations on the ability of the depositary to delegate, and includes rules regarding permitted delegation. In particular, the depositary is not permitted to delegate its oversight and cash-flow monitoring obligations. The custody and safekeeping functions may be delegated but only if: the tasks are not delegated with the intention of avoiding the requirements laid down in the UCITS Directive; the depositary can demonstrate that there is an objective reason for the delegation; and the depositary has exercised all due skill care and diligence in the selection and appointment of the third party and continues to do so during the periodic review and ongoing monitoring. The delegate must at all times during the performance of the functions delegated to it: have structures and expertise that are adequate and proportionate to the nature and complexity of the assets which have been entrusted to it; for custody tasks be subject to: (i) effective prudential regulation, including minimum capital requirements, and supervision in the jurisdiction concerned; and (ii) an external periodic audit to ensure that the financial instruments are in its possession; segregate the assets of the clients of the depositary from its own assets and from the assets of the depositary in such a way that they can, at any time, be clearly identified as belonging to clients of a particular depositary; take all necessary steps to ensure that in the event of its insolvency, assets of a UCITS held by it in custody are unavailable for distribution among, or realisation for the benefit of, its creditors; and comply with those conditions imposed on the depositary itself, i.e. its appointment is evidenced by a written contract; it complies with the safekeeping requirements for financial instruments and other assets (as above); it is under the same obligations as on the depositary not to reuse the assets held in custody for its own account; and must be independent of the management company. Where the law of a third country requires that certain financial instruments be held in custody by a local entity and no local entities satisfy the delegation requirements regarding effective prudential regulation, the depositary may delegate its functions to such a local entity only to the extent required by the law of that third country, only for as long as there are no local entities that satisfy the delegation requirements, and only where: the investors of the UCITS have been duly informed; and the investment company has instructed the depositary to delegate custody to such a local entity. ESMA published advice in November 2014 on the third party insolvency protections that are required when delegating safe-keeping. These contain measures, arrangements and tasks for the third party to whom custody is delegated. For example, sub-custodians outside the UK must obtain independent legal advice to verify that applicable insolvency laws in that jurisdiction recognise the segregation of assets from third party's assets and depositary's assets and that segregated assets do not form part of the third party's estate in case of insolvency. Whether within the EU or not, the sub-custodian must adequately inform the depositary about the applicable rules and conditions on the relevant insolvency regime to which assets are linked.
Page 4 2.1.4 Liability One of the most contentious proposals has been the detail surrounding the role and liability of depositaries in UCITS V, and the extent to which a depositary should be liable for assets held in custody and their liability when they appoint a third-party sub-custodian. These liability provisions go much further than those of AIFMD: 2 under AIFMD the depositary has the ability to discharge liability by meeting the specified delegation criteria or under the express terms of its written contract with the sub-custodian, whilst UCITS V explicitly prevents the depositary from excluding or limiting its liability by agreement; AIFMD allows for the depositary to discharge its liability when safekeeping by a local entity is required under local law, whereas this is not available to the depositary under UCITS V, even when placed under the same local law delegation requirement; liability to the investors of the AIF may be invoked directly or indirectly, depending on the legal nature of the relationship between the depositary, AIFM and investors. Investors in a UCITS may invoke liability of the depositary directly or indirectly provided that this does not lead to a duplication of redress or to unequal treatment of investors. UCITS V replaces the existing liability standard of "unjustifiable failure to perform its obligations or its improper performance of them", as this was interpreted differently by member states, which meant discrepancies in investor protection across Europe. Essentially, UCITS V implements a 'strict liability' regime whereby the depositary must return lost instruments at its own cost, and without the ability to discharge liability on having delegated to a subcustodian. The depositary is liable to the UCITS and its investors: for loss of financial instruments by a depositary or its delegate; for loss caused by its negligence or intentional failure to fulfil its obligations under UCITS V; in the event of loss, to return equivalent financial instruments without delay. A depositary will not be liable if it can prove that the loss arose as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary. 2.2 Remuneration (Article 14) Under UCITS V, management companies are required to establish and apply remuneration policies and practices that are consistent with and promote sound and effective risk management, and do not encourage risk taking that is inconsistent with the risk profiles of the UCITS it manages. Again, these are intended to be closely aligned with those applicable to fund managers under AIFMD. These policies are to apply to staff whose professional activities have a material impact on risk profiles of the management company or UCITS which they manage. These will be senior managers, risk-takers, those fulfilling control functions, and employees receiving remuneration within the same bracket of senior managers or risktakers. Where remuneration is performance-related, the total must be based on a combination of the assessment of the performance of the individual, the business unit or UCITS, and the overall results of the management company. 2 See Art. 21 AIFMD / Art. 24 UCITS
Page 5 Fixed and variable components must be appropriately balanced with the fixed component representing a high enough proportion of the total remuneration to allow a flexible policy on the variable remuneration (including the possibility of paying no variable remuneration), with the variable element split between 50% in units of the managed UCITS and 40% deferred for a minimum of three years. There are various requirements as to how details of the remuneration policy must be disclosed in the UCITS prospectus, annual report, and the key investor information document (KIID). 2.3 Sanctions (Article 99) UCITS V aims to tackle the different approaches to sanctioning across the EU by introducing a range of administrative sanctions and measures and minimum list of sanctioning criteria. This harmonises minimum administrative sanctions with maximum penalties of 5 million (or 10% of annual turnover) for a company or 5 million for individuals (together with the possibility of bans and/or criminal sanctions). In the UK the FCA has many of the powers envisaged under the directive so little impact from this harmonisation is expected. 2.4 Access to phone and data records (Article 98) The relevant competent authority for the member state in question will be able to require existing recordings of telephone conversations or other data traffic records held by a UCITS, management companies, investment companies or depositaries from a telecommunications operator, where there is a reasonable suspicion of an infringement of the UCITS Directive, and where such records may be relevant to an investigation into any infringements. 3. Practical steps Depositary agreements will need to be repapered to reflect the new regime, and in particular authorised unit trusts will need a depositary agreement for the first time, the terms of which will need to be negotiated. These agreements, together with any sub-custody agreements, will also need to be examined, and potentially renegotiated, to be in line with the new liability provisions. This is particularly relevant when it comes to the delegation issue, as it may not be possible for the liability risk to be put on any sub-custodian. As many of the changes follow those introduced in AIFMD in order to align the two regimes, it is hoped that these issues have been dealt with in many similar fund arrangements, and so the expertise to effect changes in the UCITS regime may now be more readily available. Fund documentation such as UCITS fund prospectuses will need to be reviewed and updated to reflect the expanded depositary role and the remuneration rules; and any KIID will need to be amended to include the required remuneration statement. UCITS managers will also need to consider their remuneration policy, and whether existing arrangements meet the requirements or expose any gaps that will need to be addressed. This may also impact on the employment contracts and incentive programmes that are currently in place. Fund structures may also need to be carefully examined to allow for the new rules on variable remuneration for the requirement of payment in units in the UCITS fund. 4. What's next - UCITS VI? In July 2012, the European Commission set out areas of proposed reform to the UCITS regime in a consultation, which was issued shortly after the legislative proposals for UCITS V, had been published. The main objective under UCITS VI was to find the best possible way to protect the confidence of investors, and promote UCITS as best form of fund legislation in and outside Europe. In a speech given by Steven Maijoor (chair of ESMA) in November 2014, he confirmed that the most pressing proposals are being addressed by other measures, for example, the European Commission has proposed a new regulation to address the issue of redemption pressure in money market funds. As a result, although there are proposals in relation to money market funds and long-term investment funds, it looks like UCITS VI is out in the long grass for now.
Page 6 If you require further information on anything covered in this briefing please contact Grania Baird (grania.baird@farrer.co.uk; 020 3375 7443), or Julia Hartley (julia.hartley@farrer.co.uk; 020 3375 7551), or your usual contact at the firm on 020 3375 7000. Further information can also be found on the Commercial page on our website. This publication is a general summary of the law. circumstances. It should not replace legal advice tailored to your specific Farrer & Co LLP, January 2015