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Brown Brothers Harriman Investor Services Limited
OEICs/UTs Update - Special Edition; July 2000

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UCITS Directive

Revised versions of both Proposals have been issued by the European Commission. In some respects these differ significantly from the original and we have summarised below the changes we have identified as being of particular interest.

Proposal 1, which extends the range of instruments in which a UCITS can invest.

Securities lending transactions should only be carried out on part of the portfolio and on a temporary basis - this contrasts with the current position under the FSA regulations where there are no limits on the amount of the scheme property which can be subject to securities lending.

The limit for investment in a single security of an index fund to be increased to 20% - the 10% limit retained for non-index UCITS, effectively making index funds a separate category of fund.

UCITS should be specifically permitted to invest, as part of their general investment policy and/or for hedging purposes, in standardised and over-the-counter (OTC) derivatives. The maximum amount of exposure created by investment in OTC derivatives is limited to 30% of the scheme property. This is a complete change to the current position where derivatives may only be acquired for efficient portfolio management purposes, not as an investment in their own right. UCITS which invest in derivatives must provide details in the prospectus and appropriate risk warnings. In several instances reference is made to "part of" the general investment policy including investment in derivatives, no limit is defined but the implication is that investment entirely in derivatives is not permitted.

One of the restrictions in relation to derivatives is the following "When the underlying of a financial derivative instrument consists of instruments for which the Directive sets quantitative limits the underlying must be taken into account in the calculation of such limits. When a transferable security embeds a derivative the latter must be taken into account when complying with the requirements of this Article". It is possible that this will prevent investment in a debenture, such as was recently the case with Vodafone, to increase exposure to a stock in an index tracking fund where that stock is, under the new rules, more than 20% of the index.

Funds of funds will be permitted, which will allow investment in both UCITS and non-UCITS. The investment in non-UCITS will be limited to 30% of the scheme property. Investment in other fund of funds will not be permitted. The limit for investment in another UCITs or non-UCITs fund is 10% of the scheme property although member states may raise the limit to a maximum of 20%.

Whilst the Proposal emphasises effective independence between the management company and depositary it does allow both the management company and the depositary to belong to the same economic group or for either to be in a position to exercise a significant influence over the other, in these circumstances it goes on to say "it is necessary to undertake all measures assuring the independence between the two entities".

The definition of "transferable securities" has been extended to include money market instruments normally dealt in on regulated markets within Article 19(1)(a), (b) or (c). Subject to certain constraints money market instruments other than those dealt in on a regulated market are also permitted.

Investment is permitted in deposits with credit institutions provided those deposits are repayable on demand or have the right to be withdrawn and mature in no more than 12 months. There are additional constraints if the registered office of the appropriate institution is not in a member state.

Because additional categories of investment are permitted the investment limits rules have also been extended as follows:

A UCITS may invest no more than 5% of its assets in each of the following instruments issued by or made with the same body or to which the same body is the counter-party:
- transferable securities
- money market instruments
- deposits
- OTC financial derivative instruments

As at present member states may raise the 5% limit to a maximum of 10% subject to all investments in excess of 5% with the same body not exceeding 40% of the value of the scheme property. In addition a further limit has been introduced whereby member states may allow investments in different instruments with the same body/counter-party up to a limit of 15% (for example 9% in a transferable security and 5% in a deposit). Companies within the same group are regarded as a single body for the purpose of calculating the limits.

Proposal 2, authorisation, regulation and granting of a passport to management companies and providing for a simplified prospectus.

The initial capital requirement for a management company is raised from Euro 50,000 to Euro 125,000. One of the reasons given for this is the likelihood of more extensive use of OTC derivatives, which require more sophisticated means of risk-management and valuation. The newly introduced ongoing capital requirements are triggered only by UCITS' portfolios investing in instruments other than transferable securities.

Simplified prospectus - the aim is maximum harmonisation and therefore the required contents have been fully described, member states are not permitted to ask for further documents or items to be added. The intention is that the simplified prospectus should be designed to be investor friendly, giving key information about the UCITS in a clear and easily understandable way.

Investor Guarantee Schemes - this is on hold as the Commission does not consider it is yet in a position to propose the introduction of compensation arrangements for unit holders of UCITS. The Commission will consider the possibility of proposing appropriate legislative measures in the future.

Management Company Authorisation - the company will be able to manage the assets of investment companies incorporated in member states other than its home member state as well as distributing units of schemes set up in its home member state and undertaking related functions. In order to prevent supervisory arbitrage there will be a requirement that for authorisation a UCITS should not be prevented in any legal way from being marketed in its home member state.

Delegation - "Member States permitting such delegations shall ensure that the management company to which they granted an authorisation does not delegate globally its functions to one or more third parties, so as to become an empty entity…..".

Activities of a management company - Member States may permit management companies to also manage other portfolios of investments, including those owned by institutional investors such as pension funds and private clients. They will also be able to provide related investment advice and safekeeping and administration in relation to units of collective investment undertakings which are managed by the management company.

Conflicts of Interest - There is a prohibition on "the core function of investment management being given to the depositary and to persons having qualifying holdings in the management company's or the depositary's capital or to any other person whose interests may conflict with those of the management company or the Unitholders". This is interesting as it implies that the depositary may have a conflict of interest with the Unitholders whereas the FSA rules clearly state that the depositary must act in the interest of shareholders, the trustee of unit trusts has always had the obligation to act in the interest of unitholders. Further, the present FSA rules provide that "Where there are no directors the depositary's powers are extended, temporarily, to enable it to manage the scheme property".

The timetable for implementation of both Proposals is presently that no later than 30th June, 2002 member states shall adopt the laws, regulations and administrative provisions necessary for them to comply and that the provisions shall enter into force no later than 31st December 2002.

The material in these communications is intended as a brief overview of current issues under discussion or consultation and points of interest. BBH provides the enclosed information as a compilation of industry sources. It has not been independently verified and is inherently subject to change. This information is not offered as financial, investment, tax or legal advice nor should it be construed as a recommendation to invest or not to invest in any country, whether covered or not. The services of an appropriate professional should be sought in connection with such matters. BBH does not make any representation or warranty as to the accuracy or completeness of the information provided. Accordingly, BBH shall not be liable for any inaccurate or incomplete information.

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Brown Brothers Harriman Investor Services Limited OEICs/UTs Update - Special Edition; July 2000

Brown Brothers Harriman Investor Services Limited
OEICs/UTs Update - Special Edition; July 2000