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The Bank of New York Trust and Depositary Co. Ltd
Fund Focus NEWSLETTER
Summer 2006
20 June 2006
A Newsletter produced by The Bank of New York Trust and Depositary Co. Ltd
© 2006 The Bank of New York Company, Inc. All rights reserved

'Climate, Service and Partnership'

Foreword

General Regulatory Round-Up

Unbundling and Soft Commissions

Investment Trusts

Single and Dual Pricing for Authorised Funds

Hedge Funds

Investment Strategies -General Principles

CESR's Final advice to the European Commission on the eligible assets of UCITS

The Negotiability of Transferable Securities

The Eligibility of Money Market Instruments

The Eligibility of Derivative Instruments on Financial Indices

The Industry View - The Investment Management Association

Conclusion

Sharegift - When an idea is a really good idea........

Crossword Competition Winner

Foreword

Welcome to the Summer edition of FUND FOCUS. In this issue we have three guest writers.

The first guest article is written by Aedana Ward on Hedge Funds. This is a perennially topical subject particularly with the FSA now proposing to allow retail investors access to a fund of hedge funds. Aedana Ward is a Tax Director at Deloitte and she is responsible for Deloitte's delivery of tax services to Hedge Funds.

The second guest article is written by Charlotte Hill, a partner at Stephenson Harwood who undertakes a detailed and interesting examination of CESR's paper on eligible assets.

Last but not least is a guest article by Anne McMeehan of Cauldron Consulting on Giftshare, which has the laudable goal of achieving a diversity of charitable giving, reflecting the widest possible spectrum of UK charities.

A regulatory roundup on matters such as Dual Pricing, Unbundling of Commissions and Investment Trusts together with the announcement of the winner of the previous edition's crossword competition completes this edition.

I hope you enjoy reading the articles.

David E. L. England
Chief Executive Officer

General Regulatory Round-Up

Unbundling and Soft Commissions

The FSA's proposed new rules on unbundling equity commissions are being threatened to some degree by MiFID. The European internal markets commissioner, Charlie McCreevy, intends to push for maximum harmonisation on the implementation of MiFID within the financial services sector across Europe. The new FSA proposals are super equivalent to MiFID, and therein lies the problem. The final feedback paper on CP05/13 was originally expected in March 2006 but has now been delayed until the summer.

"Although Article Four of the Directive (MiFID) does permit member states to introduce additional regulations this should only be in 'exceptional cases where such requirements are objectively justified and proportionate'. The FSA have therefore got some convincing to do."

Regarding the proposed rules themselves, it is expected that they could have some or all of the following impact on the investment industry, although to a significant degree much of the impact will depend upon the attitude of the 'professional appointee' or trustee appointed for the purpose of reviewing the information provided.

· Managers will absorb the value of soft commissions into their fees

· More deals done with funds at keener or lower commission levels and consequently concentration of dealings with fewer large investment houses offering the keenest rates for execution

· Increase in commission sharing arrangements with the potential of part of the commission being paid direct to research houses

· Reduction in the availability of sell side research departments

· Increase in the availability of buy side research departments

Investment Trusts

The FSA has decided against further regulation of investment trusts enacted in a similar vein to that which applies to CISs, although they have said that investors should be warned that they will not be covered by the Financial Ombudsman Service and Financial Service Compensation Scheme. The forthcoming review of the listing rules and the changes in respect of corporate governance recommended by the Association of Investments Trust Companies (AITC) are deemed by the FSA to provide an adequate level of oversight for present circumstances.

Single and Dual Pricing for Authorised Funds

The new Collective Investment Schemes Sourcebook (COLL) was introduced on the basis that all funds will operate on a single-pricing basis only. During the consultation phase for COLL, the FSA effectively deferred their decision on the future of dual-pricing for AUTs. This allowed some firms to continue using the dual pricing arrangements permitted by CIS until February 2007 when COLL becomes mandatory. The FSA had always promised to issue a further consultation paper on the future of dual pricing. With the market timing issues hitting the headlines about 2 years ago, particularly in the US, there seemed to be even more reason to consider the on-going future of dual pricing.

The Consultation Paper makes the following proposals:

· Dual-pricing to remain for AUTs and also to be introduced for ICVCs

· The choice of pricing will be at the discretion of the Authorised Fund Manager (AFM)

· Fund prospectus to state whether it is single or dual priced fund with a suitable explanation of the term

· Definitions are to be altered to refer instead to "dual priced authorised fund" and "single-priced authorised fund"

· An umbrella structure can consist of both dual-priced and single-priced sub-funds

· Share classes within a sub-fund should be priced using one method

· A change in the pricing basis (from single to dual pricing or vice versa) should be considered a significant change, requiring at least 60 days' notice to investors under the new COLL sourcebook

· No changes are proposed in relation to qualified investor schemes (QIS) other than deleting the requirement to notify prices to the Depositary

The FSA has said that it has completed a full analysis on the two methods of pricing and has concluded that they can co-exist with each other. It has found no evidence that either type of pricing method involves a bias or is being exploited to the disadvantage of the consumer. The FSA also states that a cost/benefit analysis has indicated that there was not enough beneficial evidence to support a prescriptive change to single-pricing for all authorised funds. Additionally within the consultation paper the FSA asks for views on two matters:

Firstly, the FSA feels that for dual-priced funds there is a lack in transparency which investors might find confusing and feel therefore that there may be merit in changing the way in which prices and initial charges are expressed. This will provide consistency between single and dual priced funds.

Secondly, COLL regulations (as did the CIS sourcebook) require the AFM to treat each different class of units separately when creating and cancelling units. This often results in units of one class being created while units in another class are being cancelled. The FSA has asked for initial views on the feasibility of netting off different share classes for box management purposes.

Hedge Funds

by Aedana Ward of Deloitte & Touche LLP

Increased demand for access to hedging strategies to diversify risk from traditional asset classes has engendered much interest of late particularly from the life and pension scheme sector, and more recently from the traditional asset management sector wishing to hedge their existing portfolio risk. The new pensions regime is likely to fuel this interest as pension scheme assets are expected to swell with many savers availing themselves of the increased contribution limits.

This in turn has led to some interesting developments within the hedge fund industry, resulting in renewed focus on achieving absolute returns by developing investment opportunities linked to more innovative asset classes. The preponderance of players in the "traditional end" of the alternative market has fuelled a move towards more alternative facets of the market in the relentless pursuit of returns.

"The challenge for hedge fund managers in attracting investment is to offer investment structures which do not carry unnecessary tax risk or unacceptable levels of uncertainty of tax treatment for the investor."

This has led to some debate in recent months around the interpretation of some of the tax rules applicable to UK investment managers in general. This in particular is what constitutes an investment transaction for the purposes of the rules applicable to hedge fund managers.

Investment Strategies - General Principles

If any of the proposed activities on behalf of a hedge fund could be regarded as trading activities, the manager will need to demonstrate that it meets the conditions set out in the Investment Manager Exemption (IME) in Schedule 26 FA 2003. This will ensure that its activities on behalf of the fund do not give rise to a UK tax exposure. However the IME only applies to certain transactions, not all transactions may benefit from the exemption. It is therefore important for managers considering innovative strategies that they address whether their particular strategy may benefit from the exemption.

It is useful to state the general principles with regards to the transactions which benefit from the IME in order to explore the potential impact of these rules for more innovative investment strategies.

Assuming that other aspects of the IME have been met, the key question is whether the transactions fall within the definition of investment transaction in The Financial Act 2003.

Para 3 Sched 26 Finance Act 2003 states that an investment transaction means:

· Transactions in shares, stock, futures contracts, options contracts or securities of any descriptions but not futures contracts or options contracts relating to land

· Transactions consisting of the buying or selling of foreign currency or the placing of money at interest

· Such other transactions as the treasury may by regulation designate

A second legislative provision is also relevant to the definition of investment transaction. Statutory Instrument 2003/2173 extends the definition of investment transaction. The Statutory Instrument provides that a transaction which otherwise does not fall within Para 3 Schedule 26 Finance Act 2003 falls within that paragraph where its terms provide that:

· After setting off their obligations to each other under the contracts, a cash payment is to be made by one party to the other in respect of the excess, if any

· Each party is liable to make to the other party one or more cash payments in respect of that parties obligations to the other under that contract

· Do not provide for the delivery of any property other than currency

The Statutory Instrument is intended to include cash settled transactions within the scope of investment transactions for the purposes of the application of the IME. It is worth noting however that the Statutory Instrument specifically excludes contracts relating to land, insurance or capital redemption business form the above provisions. Therefore lending to acquire property could be excluded from the scope of the IME.

In addition to the above definitions of investment transaction the Statement of Practice SP 01/01 sets out the types of transactions which are generally speaking covered by the IME - it also excludes some transactions from the "protection" of the IME. The Statement of

Practice does not have the same legislative standing as the provisions mentioned above but is currently the only form of guidance available on the interpretation of the rules. SP 01/01 comments that:

The IME provisions are restricted to transactions in shares, stock, commercial paper and warrants, futures including forward contracts, options contracts or securities of any description (but not futures contracts or options contracts relating to land although such contracts involving indices of land may qualify), interest rate swaps, equity swaps, currency swaps and commodity and commodity index swaps (but not transactions in physical commodities, including gold, nor warrants on the London Metal Exchange which give the holder title to the metal).

As can be seen from the above provisions a number of transactions are specifically excluded from the scope of the exemption, for example transactions relating to land and transactions involving physical delivery of commodities.

There are, however, a number of areas where there is still a degree of uncertainty as to whether the exemption is applicable. For example, the legislation does not elaborate to any significant degree on the definition of a security for the purposes of the exemption and this has cast a degree of uncertainty over precisely what types of transactions are covered by "transactions in securities". In particular, guidance and clarity is needed in relation to a number of transactions which are increasingly attracting interest on the part of hedge fund managers, namely property derivatives, commodity related products for example energy trading, loan origination, and acquisition of a receivable stream. This is not an exhaustive list and it is likely, as markets and strategies evolve, that we will see more innovation in terms of asset classes.

"While the industry awaits further guidance from HMRC on this topic we recommend that hedge fund managers consider any form of innovation to their investment strategy carefully to ensure that they do not inadvertently cause any undue tax risk for their hedge fund operations."

Aedana Ward is a Tax Director at Deloitte and is responsible for the Deloitte's delivery of tax services to Hedge Funds.

CESR's Final Advice to the European Commission on the Eligible Assets of UCITS

by Charlotte Hill, Partner, Stephenson Harwood

Following two rounds of consultations on the topic in 2005, the Committee of European Securities Regulators ("CESR") published its final advice to the European Commission regarding clarification of definitions concerning eligible assets for investments of UCITS on 26 January 2006. As with the first consultation, there was a very large response to the second consultation and CESR received almost 50 responses, mostly from asset managers and their associations. The advice addresses three principal issues: the negotiability of transferable securities, the eligibility of money market instruments, and the eligibility of derivative instruments on financial indices.

The Negotiability of Transferable Securities

In responding to the second consultation paper, a large number of respondents queried the proposed requirement that "the security must be freely negotiable on the capital markets". They pointed out that this requirement appeared to preclude investment in (for example) private placements. CESR responded to this and in its final advice, has deleted the reference to "freely" and to "on the capital markets", so the requirement is now that "the security must be negotiable". CESR concluded that a UCITS may invest in "not freely

negotiable" transferable securities, provided that it is aware of the existence of limitations to their transferability and notwithstanding that it would be able to redeem units at the request of the unitholders. In addition, CESR has clarified that where a security is listed, a presumption of negotiability applies. However, as with the presumption of liquidity, it is not guaranteed - for example, in the case where there are specific restrictions on the transferability of the security (that is, the presence of a lock-in clause or of a clause submitting the transfer of a share to the agreement of the other shareholders).

CESR comments that "transferable securities" might encompass a range of products with different features, such as shares, bonds, certain structured financial instruments, other types of financial innovations or certain closed-ended funds. Nevertheless, in all these cases the UCITS must be able to fulfil obligations imposed by the UCITS Directive, such as portfolio liquidity.

The purpose of the requirement for portfolio liquidity is to ensure that the UCITS will be readily able to meet foreseeable demands from investors to redeem their investment at a fair value, as required by the UCITS Directive. In order to meet this obligation, UCITS funds are required to maintain an appropriate degree of liquidity. For example, a daily dealing UCITS would need to maintain a different liquidity profile compared to a UCITS that deals less frequently.

Different investment instruments have different levels of liquidity, for example, some company shares are more liquid than others. CESR comments, "the fact of admission to trading on a regulated market for a transferable security provides a presumption of liquidity, but does not guarantee it". The result of this is that UCITS are able to rely on that presumption in making investment decisions unless they are or should be aware of circumstances that indicate that a particular transferable security is not liquid.

So what must a UCITS do in order to assess whether an individual transferable security is sufficiently liquid for a portfolio? CESR's view is that the need for instrument liquidity is related to Article 37 of the UCITS Directive, which requires that a UCITS "must re-purchase or redeem its units at the request of any unitholder". There must therefore be adequate prospective liquidity so that the UCITS is reasonably satisfied that this obligation will be met.

A portfolio may consist of securities, some of which may be

more liquid than others and the overall portfolio liquidity is created from the sum of the liquidities of the underlying financial instruments.

"It is permitted for a UCITS to buy or hold transferable securities of varying liquidities. However, where the portfolio contains a significant number of less liquid securities, the UCITS "must keep the situation under appropriate review".

The Eligibility of Money Market Instruments

Some respondents to the second consultation paper were concerned that the wording of CESR's recommendations could rule out certain types of money market instruments, such as certificates of deposit, which would not be able to fulfil the draft requirements. CESR took notice of these points and its final advice makes a distinction between different types of issues. The information requirements have been relaxed for certain types of issuers and issues, for example, when the issuer is an establishment subject to prudential supervision.

The Eligibility of Derivative Instruments on Financial Indices

CESR had shown little movement on the question of hedge fund indices in the second consultation paper. However, a very large number of respondents lobbied hard and there was some optimism that CESR would change its mind and reconsider its position and allow derivatives on financial indices based on non-eligible assets. CESR states that in its view, in addition to indices based on financial derivatives on commodities, as suggested in the second consultation paper, indices on property may be eligible provided they comply with the appropriate criteria. For example, that the index is sufficiently diversified and that it represents an adequate benchmark for the market to which it refers. On the question of hedge fund indices however, CESR remained completely unmoved. It stated, "given the complexities of hedge fund indices and the fact that they are still developing, CESR cannot recommend, at this stage, allowing hedge fund indices to be considered as financial indices for the eligibility of UCITS". However, it states that it is monitoring the issue and is gaining additional experience, after which it may reconsider its position, which it aims to do by October 2006.

"In the intervening period, CESR members are obliged to agree not to authorise setting up new UCITS with such investment policies."

This is a position likely to affect all EU regulators, including those whose current interpretations of the UCITS legislation permit investment in hedge fund indices. It is also a particularly frustrating position, considering that CESR has suggested that indices on property may be eligible, provided that the index is sufficiently diversified and represents an adequate benchmark for the market to which it refers - something of interest to those wishing to promote property funds on a pan-European basis.

"Considerable lobbying will be necessary if CESR is to change its views on hedge fund indices by October."

The Industry View - The Investment Management Association

In a press release dated 31 January 2006, the Investment Management Association ("IMA") stated that it was "pleased with CESR's final advice on assets in which funds can invest". It commented that significant progress had been made since the first consultation paper and that CESR appeared to have listened to the industry's concerns and had removed the overly restrictive aspects of the original proposals.

"Sheila Nicoll, Deputy Chief Executive of the IMA, stated in the press release 'CESR's final advice on the issue of eligible assets is a significant step forward on the way to creating a single market for asset management'."

Conclusion

In its final advice on assets in which funds can invest, CESR has moved some way from its proposals in its first consultation paper. The final proposals have, in general, met with industry approval.

"However, the issue of the hedge fund indices not being considered as financial indices for the eligibility of UCITS remains outstanding and will affect a large number of players in the market."

Although hedge fund indices are not viewed as eligible, indices on property may be, provided that the index is sufficiently diversified and represents an adequate benchmark for the market to which it refers. It seems likely that the issue will be revisited before the end of this year, and those who would like to see hedge fund indices being included as financial indices for the eligibility of UCITS should lobby hard to change CESR's current position.

Article by Charlotte Hill, Partner, Stephenson Harwood. Charlotte has recently joined Stephenson Harwood from CMS Cameron McKenna LLP to bolster the Fund Management Team.

Sharegift - When an idea is a really good idea

by Anne McMeehan of Cauldron Consulting

The best ideas are often incredibly simple. Surprisingly though, this is not always a helpful characteristic.

An employee who comes across an apparently simple and better way of doing something may nevertheless be reluctant to tell their boss. The impediment is the often unwarranted assumption that their solution must be fundamentally flawed. Similarly, if the boss is exposed for having failed to spot a 'no-brainer', then who looks the idiot? In both cases, there is a high probability that the simple solution will be forgotten.

Suspicion too, can be a highly effective disabler. 'It can't possibly be that simple! What's the catch?' And finally, disdain, often the most powerful setback to a simple solution. 'I'm far too busy dealing with more important issues; we'll get round to it some other time.'

A truly simple idea exists that could easily be successfully implemented across the funds industry. Some companies have already taken it up, for what this idea lacks in brilliance, it certainly makes up for in sound common sense. For it costs nothing, yet can save time, effort and money. Did I hear you say, 'What's the catch?' The answer to that question is - none.

Firms are frequently obliged to administer unclaimed client money balances or small holdings of units or shares which are often wholly uneconomic to manage. (The experience of many listed companies, with shareholder registers burdened with a long tail of tiny holdings, is directly comparable. In many instances, the proceeds that would be raised from the sale of these individual accounts would be insufficient to pay for the charges incurred in the process.)

These unheeded balances, small compensation payments, even unwanted investments are often something that their 'owners' would rather be rid of. Yet as long as these holdings exist, the manager is obliged to administer them. There is a solution however - a simple one, that costs neither management companies nor individual owners a single penny to put in place.

ShareGift was formed in 1996, specifically to accept donations of small shareholdings. These are then aggregated and sold, the proceeds going to charity. So far, ShareGift has donated some £8 million to over 1,000 different charities.

Many companies have already arranged to include provisions in the terms and conditions of their ISAs and regular savings plans permitting small distributions, tax credits, accruing after plans have been closed, to be paid to charity. Some investors even prefer to use this method of charitable giving - donating shareholdings rather than an amount of money. Many of the UK's largest listed companies refer to ShareGift in their Company Reports and other shareholder communications, specifically to draw attention to this helpful 'house-keeping' service.

Across the financial services arena lie many 'wasted' assets, collectively worth many millions of pounds. Yet before ShareGift, there was no simple way of disposing of these nuisance holdings. For many shareholders, companies, investment managers, probate solicitors alike, the headache continues. This does not need to be the case.

ShareGift, a charity in its own right, re-registers donated holdings into ShareGift's name and collects them until there are sufficient in any given company to sell. Shares are sold through Killik & Co, who waive all charges, (as do ShareGift's global custodians, OMX Securities) and charitable donations are then made from the proceeds.

"The sole aim is to realise the value of the assets as soon as possible. No investment view is taken of the holdings."

The distribution policy for the funds created by the sale of the assets is based upon consideration of charities and areas of charitable work which have been suggested by the donors and other supporters.

"This results in a diversity of charitable giving, reflecting the widest possible spectrum of UK charities - from major household names to tiny local initiatives. The objective is to attract odd lot shareholders, not to deter them because they find the policy for giving unacceptable."

ShareGift works closely with registrar groups, solicitors, stockbrokers, accountants and financial advisers, also providing solutions for odd lots in investment banks' error accounts.

It may well be that this is the first that you personally have heard of ShareGift. Its potential relevance to your business, your clients, you know better than anybody else. It represents a solution to a number of problems. It's your idea now - freely given. Please don't forget it.

ShareGift, 5 Lower Grosvenor Place, London SW1 0EJ Tel: 020 7337 0501 www.ShareGift.org

ShareGift (The Orr Mackintosh Foundation) is a company limited by guarantee registered in England No. 3150478 and a registered charity no. 1052686.

Crossword Competition

The crossword competition in the last issue was won by Paul Roman, the compliance officer at Singer and Friedlander. David England presented Paul with his prize of a bottle of Veuve Clicquot Champagne.

The Bank of New York Trust and Depositary Co. Ltd One Canada Square London, E14 5AL www.bankofny.com

In the United Kingdom, this document is approved by The Bank of New York, London Branch, One Canada Square, London, E14 5AL, authorised and regulated by the Financial Services Authority.

To protect the confidential and proprietary information included in this material, it may not be disclosed or provided to any third party without the prior written consent of The Bank of New York. The information included in this material is provided for general information purposes only and does not constitute legal or professional advice. Neither The Bank of New York nor any of its affiliates accept any liability or responsibility for any losses arising or resulting from any reliance on information included in this material. This limitation of liability applies to all claims and losses of any kind, including (without limitation) loss of profits, business, revenue, goodwill or anticipated saving; and/or consequential or indirect loss..

Contents

The Bank of New York Trust and Depositary Co. Ltd Fund Focus NEWSLETTER Summer 2006 20 June 2006 A Newsletter produced by The Bank of New York Trust and Depositary Co. Ltd © 2006 The Bank of New York Company, Inc. All rights reserved

The Bank of New York Trust and Depositary Co. Ltd
Fund Focus NEWSLETTER
Summer 2006
20 June 2006
A Newsletter produced by The Bank of New York Trust and Depositary Co. Ltd
© 2006 The Bank of New York Company, Inc. All rights reserved