In July 2012, the EU Commission (the "Commission") released a proposal on the revision of the Undertaking for Collective Investment in Transferable Securities ("UCITS") regime in respect of depositary functions, remuneration policies and sanctions relating to UCITS ("UCITS V").
The proposed amendments to the existing UCITS regime aim to address lessons learned from the financial crises, most notably in connection with the Madoff incident which highlighted a number of issues relating to inconsistency between member states of the EU ("Member States") in applying the provisions of the UCITS directive. The principal aim of the reform is to create uniform market conditions across the EU, thereby increasing investor protection and investor confidence and safeguarding the integrity of the UCITS market and brand worldwide.
UCITS V focuses on three main areas; namely (i) clarification of the UCITS depositary's functions and liability in circumstances where assets are lost in custody, (ii) rules governing remuneration policies which UCITS will be obliged to introduce and (iii) the harmonisation of the minimum administrative sanctions regime across Member States.
We examine each of these areas in greater detail below.
The core function of the depositary is the protection of the investors in the relevant fund structure. Accordingly, UCITS V addresses eligibility criteria applicable to depositaries, circumstances in which delegation is permitted and the liability of such entities to the underlying investors.
While the existing UCITS framework requires that depositaries must be institutions which are subject to prudential regulation and on-going supervision, each Member State can determine which categories of institutions shall be eligible to act as depositories to UCITS funds.
This has led to legal uncertainty and inconsistency amongst Member States, which in turn leads to different levels of investor protection.
The Commission has sought to address the legal uncertainty this flexibility has created by setting out an exhaustive list of entities which are eligible to act as depositories of UCITS funds. The Commission has recommended in its proposal that only (i) credit institutions and (ii) MiFID investment firms that provide safekeeping and administration services authorised and regulated within the EU may act as depositories, with grandfathering provisions proposed for existing depositaries of UCITS in order to give them an opportunity to convert themselves into eligible entities. The Commission noted in this regard that each of these categories of depositories will provide sufficient guarantees in terms of prudential regulation, capital requirements and effective supervision.
It is noteworthy that while the Alternative Investment Fund Managers Directive (the "AIFM Directive") provides that a third category (namely other entities which are subject to prudential regulation and ongoing supervision) could be eligible to act as depository of alternative investment funds, this third category has not been included in UCITS V.
Because the AIFM Directive cross-refers to the provisions of the UCITS directive which are being amended, this may result in the eligibility criteria for depositories of non-UCITS funds being indirectly restricted. The one concern is therefore that this provision will reduce competition in the market place which may not be of benefit to investors. Consequently there is merit in the above referenced third category being included in the finalised proposal.
Given that UCITS may now invest in an increasingly complex array of financial instruments and in many markets outside of the EU, fund managers now often require depositaries to appoint sub-custodians in third country markets. However, as seen from the Madoff and Lehman cases, the use of local sub-custody networks can pose considerable risks to a UCITS.
To this end, UCITS V provides that a...