Contents > Trustees & Depositaries > CTCL Citicorp Trustee Company ... > CTCL Insight 0412
Page last published: 5 October 2005

Fiduciary Services
Citigroup® Global Transaction Services
Insight; December 2004

CitiGroup home page

Citibank N.A. London Branch is authorised and regulated by the Financial Services Authority.

Darren Burrows	020 7500 8847	Steve Clark	020 7500 6351
Iain Lyall	020 7500 8356	Ken Getty	020 7500 8834
Dave Morrison	020 7500 8021	Michael Riordan	020 7500 8303
Bronwyn Wright	00 353 1622 2791

Contents

Introduction

Anti-Money Laundering

Price Errors: A Cross-Jurisdictional Comparison

The Role of the Trustee/Depository vis-a-vis the Prime Broker

Country Profile: Poland

Companies (Auditing & Accounting) Act 2003

Financial Derivative Instruments – The Role of the Fiduciary

Contact Details

Introduction

Bronwyn Wright

Bronwyn Wright is European Head of Fiduciary Relationships for London, Luxembourg, Ireland, Germany, Jersey, and Head of Fiduciary Services for Citibank International plc, Ireland Branch. She has extensive knowledge of regulatory requirements and best market practices in Asian, European and Offshore Centres. She has recently co-authored the diploma in Mutual Funds and gives lectures in the certificate and diploma in Mutual Funds. In addition, Bronwyn chairs the Dublin Funds Industry Association Trustee Committee. She is a graduate of University College Dublin, holding a degree in Economics and Politics and a Masters in Economics.

The European Mutual Fund environment continues to grow exponentially with promoters establishing regulated funds in less well-established European countries following the expansion of the EU. Hedge Funds in Germany occupy the daily agenda for Prime Brokers with at least two funds approved by the BaFin. Continuous focus and consideration is given to fund restructures in at least one or multiple jurisdictions and how efficiencies can be gained through pooling or maintaining the tax transparency of multiple pension funds through an Irish-regulated Common Contractual Fund. In addition, UK promoters are considering the benefits of COLL which allows greater investment strategy and limits for sophisticated investors. It is anticipated that the establishment of these vehicles will occur Quarter 1 2005, following recognition that these funds should be taxed as collective investment schemes, as opposed to Companies or Private Trusts which carry a higher tax rate.

Given a promoter can have multiple funds in multiple European centres, we can no longer look at one jurisdiction and focus our energies exclusively on the development of that market. To grow as service providers and promoters we must be cognisant of all European mutual fund centres, the growth, direction, development, similarities, differences, opportunities and potential threats each one offers. The market and regulatory change over the last 12 months has been phenomenal, in key areas such as the role of the Trustee/Depositary vis-a-vis the Prime Broker, Financial Derivative Instruments and the Irish Companies Auditing and Accounting Act 2003. In addition, established practices in areas such as the correction and resolution of price errors and the approach adopted by service providers to fulfil anti-money laundering requirements must also be considered.

One aspect of regulated Hedge Funds that always merits consideration is the role of the Trustee/Depository vis-a-vis the Prime Broker and how the regulatory responsibility, liability and practical aspects are similar and/or different from one European regulatory jurisdiction to the next. Effectively the Prime Broker is performing roles traditionally performed in the established mutual funds industry by a global custodian. Given the above, we must consider how the trustee/depositary can fulfil its regulatory responsibilities if it has no control or safe custody of the fund assets via its parent organisation.

One of the main opportunities arising from the implementation of the UCITS III Product Directive is the ability for UCITS to invest in Financial Derivative Instruments (FDIs) as part of the investment strategy of a fund. However, differences have arisen between the jurisdictions in relation to the role of the fiduciary in monitoring FDI risk management processes.

The Companies (Auditing and Accounting) Act 2003 has been described as arguably the most important piece of legislation affecting the accountancy profession in Ireland and heralds a new era of corporate governance for Irish companies.

All mutual funds regardless of the simplicity, complexity, technology capability and resources associated with them may have price errors. The rectification, resolution, compensation levels and communication with local regulators differ across Europe.

The snapshot above demonstrates that the mutual fund environment is growing rapidly from a regulatory and market-driven perspective. To grow and be competitive we must act as Europeans and keep abreast of this change thus allowing us to understand, and develop with this rapidly-expanding business.

Bronwyn Wright

Anti-Money Laundering

Significant effort has been made internationally by both regulators and financial institutions in recent years to counter the risk of money laundering. However, despite these efforts, money laundering remains a constant concern for financial service providers. Recent high profile cases involving substantial sanctions have re-emphasised the importance of anti-money laundering (AML) in the financial services sector. These cases have been costly to the institutions involved in terms of reputational damage, fines and the costs of conducting detailed reviews of internal controls and procedures.

Overview

Two initiatives have taken place over the last 15 years to provide a more unified international approach to anti-money laundering. The objectives of these initiatives are to make it more difficult for criminals to launder money and also to facilitate the tracing of funds where it is suspected that they may have derived from criminal activities. Firstly, an OECD sponsored body, i.e. the Financial Action Task Force (FATF), was set up in 1989 to develop and promote policies, both at national and international levels, to combat money laundering. Secondly, the EU Council issued a directive (91/308/EEC) requiring member states to implement measures to prevent money laundering.

Impact on Mutual Funds

As a significant product provider within financial services, the mutual fund sector is open to the risk of criminals laundering money through investment into and out of funds. It is therefore imperative that the various service providers to funds are aware of their responsibilities in relation to anti-money laundering. In this regard, some differences do arise between jurisdictions.

Irish Position

In Ireland, the EU Directive on anti-money laundering was implemented by the Criminal Justice Act 1994. In addition to the Act, Guidance Notes have been issued by the Financial Services Regulator and various financial services industry bodies. The Act imposes obligations on financial services providers, i.e. Designated Bodies, to take appropriate measures to prevent and assist in the detection of money laundering.

In respect of mutual funds, the Act defines the following as Designated Bodies:

Persons who carry out the safekeeping and administration of securities, i.e. fund trustees/custodians

UCITS and Non-UCITS Investment Companies

Management Companies for UCITS and Non UCITS Unit Trusts

In respect of Investment Companies and Unit Trusts, normal industry practice is that anti-money laundering (AML) responsibilities imposed on the fund are delegated to the fund administrator.

Under the terms of the Act the following procedures must be implemented by all Designated Bodies:

Know your customer/record-retention procedures

Internal reporting procedures by appointing a money laundering reporting officer who acts as a central contact for the receipt of suspicious transactions reports and then forwards information to law enforcement agencies

Training of all employees in respect of anti-money laundering

Both the administrator and fiduciary are responsible for ensuring that the above AML procedures are adhered to by regulated mutual funds.

UK Position

In the UK, money laundering rules are specified in the Financial Services Authority (FSA) Money Laundering Sourcebook. The basic anti-money laundering requirements are similar to those specified above for Ireland, i.e. know your customer/record-retention, reporting procedures and training.

In the UK the authorised fund manager (AFM) holds responsibility for ensuring a fund complies with the rules specified in the FSA Sourcebook. However, the position regarding the responsibility of the fiduciary is somewhat different to Ireland. The fiduciary association in the UK, i.e. the Depositary and Trustee Association (DATA), issued a research paper on the subject in February 2002 stating 'at most depositaries/trustees should satisfy themselves that AFMs have money laundering procedures and controls in place and the AFM ensures that they are adhered to'.

As a significant product provider within financial services, the mutual fund sector is open to the risk of criminals laundering money through investment in and out of funds. It is therefore imperative that service providers across all jurisdictions are aware of their anti-money laundering responsibilities.

In addition, the fiduciary has to consider its role in respect of its responsibility as registrar. Current thinking on this area is that the money laundering rules do not impact on this. Money laundering rules for regulated firms extend to verification of identity and address, and know your customer which encompasses the source of funds and the purpose of the account.

The regulations indicate that the registrar has responsibility only to ensure that the information included on the register is complete. The requirements do not extend to verification/accuracy.

Another area where the fiduciary needs to be mindful is where it becomes aware of AML deficiencies at an AFM. In these circumstances, the question arises as to whether the depositary should continue to pay out distribution/cancellation monies to investors and whether the depositary should advise the FSA of the matter.

Luxembourg Position

In Luxembourg, the concept of money laundering was introduced by the law of 7 July 1989. Further to this, the law of 5 April 1993 imposed obligations on financial institutions to combat money laundering. Institut Monétaire Luxembourgeois (LMI) circular 94/112 provides detailed guidance to relevant financial professionals on how to implement these obligations. The obligations are similar to Ireland and the UK.

As previously stated, AML responsibility rests with relevant financial professionals to include both undertakings for collective investments 'UCIs' and the central administrator. One area Luxembourg differs from other jurisdictions in relation to AML stems from the fact the administrator and the fiduciary are usually part of the same legal entity. Therefore, the issue of what responsibilities are held separately by the fiduciary does not arise. AML is the responsibility of the relevant financial professional which comprises both the administrator and fiduciary.

USA Patriot Act of 2001

In addition to regulations resulting from EU and Financial Action Task Force (FATF) policies, recent developments in anti-money laundering have been driven by the US and specifically by the US Patriot Act of 2001, a piece of legislation implemented on 26 October 2001 following the tragic events of 11 September 2001. The main provisions of the Patriot Act are as follows:

Applies anti-money laundering provisions to all terrorist assets, including legally obtained funds, if intended for use in planning, committing or concealing a terrorist act.

Mandates all financial institutions have anti-money laundering programmes.

Prohibits US financial institutions from providing US correspondent banking services to foreign shell banks, directly or indirectly.

Targets foreign jurisdictions with legal and regulatory structures that may create a high risk of money laundering.

Mandates new enhanced due diligence procedures, particularly for private banking and correspondent banking relationships.

Broadens the ability of the US Government to seize assets held in a foreign bank.

Facilitates the exchange of information relating to terrorism and money laundering among financial institutions, their regulators and law enforcement authorities.

The Act also specifies that information relating to foreign bank records must be provided to the US Government within seven days of being requested. Failure to comply may result in termination of an account within 10 days' notice from the Government. A penalty of US$10,000 per day applies for failure to close an account.

Conclusion

Although anti-money laundering measures do not differ between the major European jurisdictions, there are differences in respect of what exactly the fiduciary is responsible for. In Ireland, the fiduciary holds direct anti-money laundering responsibility as a designated body. In the UK, the fiduciary's responsibility appears limited to oversight of the AFM. In Luxembourg, the fiduciary holds no separate responsibility.

Although anti-money laundering measures themselves may not differ, the responsibilities of mutual fund service providers vary between jurisdictions and it is therefore important that European fund operators and providers recognise this.

Price Errors: A Cross-Jurisdictional Comparison

A price error can be defined as one or more errors in the computation of the net asset value (NAV), which, when considered cumulatively, result in a difference between the originally computed NAV and the correct NAV of at least 0.01% per share/unit. The 'per share price error' is the difference between the originally computed per share NAV and the amount that would have been computed had no error occurred.

An error can arise on an individual shareholder basis or on a fund-wide basis. The 'pricing error period' comprises those days during which the error existed. NAV computation errors can arise as a result of an error made by one or more service providers to a mutual fund. Although service providers are cognisant of providing a premier service, the Trustee, Administrator, Transfer Agent and/or the Investment Manager all contribute to the calculation process of a NAV, and therefore can contribute to the production of an inaccurate NAV. Such factors or circumstances may be put down to inadequate control procedures, management deficiencies, failings or shortcomings in computer systems, accounting systems or non-compliance with the valuation rules laid down in the fund's constitutional documents or prospectus.

Common sources of price errors are the incorrect accrual of income to a fund in the form of dividends or interest, inaccurate or lack of fee and expenses accruals or the lack thereof, inaccurate accounting of trades or unit/share deals and incorrect pricing of assets in the computation of a NAV.

It is accepted practice in most mutual fund centres to recognise only those computation errors with a material impact on the NAV, and which, expressed in a percentage of the NAV, exceed a certain threshold referred to as the materiality threshold. The regulator in Luxembourg and the United Kingdom defines the materiality threshold for price errors. The Dublin Funds Industry defines the materiality threshold for price errors. There is no formal regulatory or industry guidance on price errors in Jersey, although the Jersey Financial Services Commission (JFSC) regards the UK regulator, the Financial Services Authority (FSA) guidelines as a prudent approach to price errors.

The materiality thresholds differ across European mutual fund centres. This is demonstrated in the proceeding chart.

Jurisdiction	Materiality
Ireland	50bps
United Kingdom	50bps
Luxembourg	Cash Funds-25bps Bond/Mixed Fund-50bps Equity/Other Fund-100bps
Jersey	50bps

The materiality concept does not entail the obligation upon promoters to apply the tolerance limits to NAV errors; they can adopt lower thresholds or even a zero tolerance policy. It is common practice in mutual fund centres for promoters to negotiate a lower materiality level with the service providers to the mutual fund. The rationale for this decision should be documented and signed by authorised signatures of the fund.

The fiduciary entity, acting in the interests of the investors in a mutual fund, has discretion in all matters concerning price errors such as their correction and compensation. As a result, the Fiduciary has the ability to reduce the materiality level on a case-by-case basis if there is evidence the party responsible for the error did not have sufficient controls or procedures in place.

It is important to note not all NAV computational errors are classified as price errors. A NAV is deemed to be correct when the computation rules laid down in the fund's constitutive documents and prospectus have been strictly and consistently applied on the basis of the latest information available. The later receipt of new information would not be considered an error and would form part of the risk accepted by an investor when choosing to invest in a mutual fund. It is recognised that the quality of information necessary to formulate pricing in certain funds such as emerging markets or derivatives funds may not be as timely, reliable or predictable as in the case of a developed market fund and thus is more prone to initial estimates changing based on information received following a valuation point.

In Luxembourg all material price errors must be immediately notified to the regulator, Commission de Surveillance du Secteur Financier (CSSF). A brief pre-notification upon discovery is required, followed by a full Remedial Action Plan (RAP) and auditor's report once the remedial action has been brought to closure.

The fiduciary entity, acting in the interests of the investors in a mutual fund has discretion in all matters concerning price errors, such as their correction and compensation. As a result, the Fiduciary has the ability to reduce the materiality level on a case-by-case basis if there is evidence the party responsible for the error did not have sufficient controls or procedures in place.

Similarly in the United Kingdom the regulator, the FSA, requires notification on a quarterly basis of all material price errors and notification immediately of all material price errors that do not require compensation.

The Jersey regulator (JFSC) requires to be notified of material price errors requiring compensation once they are resolved, on all open-ended funds.

There is no requirement to advise the regulator in Ireland, the Irish Financial Services Regulatory Authority (IFSRA) of price errors; however the fiduciary is required to log all price errors that can be subject to review by IFSRA at any time.

It is a matter for a mutual fund's appointed fiduciary to ensure the proper resolution of price errors. Corrective or remedial action taken for price errors can differ across European Jurisdictions. All corrective or remedial action, however, must be in the interest of the investors in the mutual fund.

The Fund Administrator is required to quantify the financial impact of any price error. A price error should not be reviewed in isolation, but all concurrent/parallel price errors must be considered to determine the aggregate financial impact. Price errors can result in losses or gains to both the fund and/or to existing and new investors. The fiduciary is required to review the analysis completed by the Administrator. Coupled with the fiduciary review, an external auditor is required to review the analysis in Luxembourg.

When compensation amounts have been determined and agreed, compensation must be paid to the relevant parties without delay. Where an investor has benefited as a result of an error, it is not practical or in some cases legally permissible for the Fund Manager/ Administrator to seek recovery of the monies from the investor. Where the fund has benefited from an error, the fund should recognise and retain such profit.

It is market practice to apply de minimis rules to losses and thus compensation amounts due to individual investors whereby funds may refrain from the payment of compensation to individual investors below certain levels. Setting de minimis avoids the frustration of investors receiving modest amounts of compensation that would be nullified by bank charges and other expenses. Please see the current market practice in 4 European jurisdictions in relation to de minimis in the proceeding chart.

Jurisdiction	Retail Investors	Institutional Investors	Fund
Ireland	€50	€500	None applies
United Kingdom	£10	£10	None applies
Luxembourg	Set on a fund by fund basis	-	None applies
Jersey			None applies

It is imperative that once a price error is rectified the party responsible for the error ensure that sufficient controls and procedures are put in place to avoid recurrence. These remedial measures are subject to the review of the fiduciary in all jurisdictions and the Regulator and auditor in some jurisdictions.

Although there are clearly differences in materiality thresholds and de minimis levels of price errors in European mutual fund centres, the approach adopted by four of the largest mutual fund centres in Europe is basically the same. All centres require the error to be quantified, compensation to be paid to the fund or investors where above a certain threshold and de minimis compensation and remedial measures to ensure the error does not re-occur. This approach is ultimately in place to protect the interests of investors. The fiduciary has the overriding responsibility to ensure that all price errors are corrected in line with local regulatory requirements and market practice. The fiduciary also has absolute discretion over all actions completed on a price errors.

Although there are clearly differences in materiality thresholds and the de minimis levels of price errors in European mutual fund centres, the approach adopted by four of the largest centres in applying remedial action is largely the same.

The Role of the Trustee/Depository vis-a-vis the Prime Broker

The European-regulated mutual fund area has seen significant change during 2004, resulting in Germany opening its borders to Hedge Funds as a result of legislation that came into force in January 2004, coupled with tax changes being implemented which remove significant barriers to investment in foreign Hedge Funds by German tax resident investors. In addition, Ireland has continued to grow exponentially as a service provider to regulated and unregulated Hedge Funds, with Luxembourg gaining momentum following a Circular introduced by the local regulator December 2002.

The role of the Prime Broker

One aspect of regulated Hedge Funds that always merits consideration is the role of the Trustee/ Depository vis-a-vis the Prime Broker and how the regulatory responsibility, liability and practical aspects are similar and/or different from one European regulatory jurisdiction to the next. To fully understand the role and responsibility assumed by Trustee/ Depository we must first consider what is a Prime Broker and the functions it performs.

The purpose of a Prime Broker

The Prime Broker is an integral part in supporting the operations of a Hedge Fund. Prime Brokers provide clearing, custody, margin financing, report and stock lending services to Hedge Funds in one single service. In providing a custody service for Hedge Fund assets and dealing in trades, the Prime Broker is performing roles traditionally performed in the established mutual funds industry by a global custodian. Prime Brokers give Hedge Funds the access to financing and stock loan that would otherwise be limited on a direct basis, thus enabling the Hedge Funds to pursue its chosen investment strategy employing the use of leverage and short selling, two of the key characteristics of the Hedge Fund.

The role of the Prime Broker

Clearing and custody

This core service provided by the Prime Broker is post trade, therefore, the Hedge Fund retains the ability to execute trades with the Prime Broker's own broker or with another firm. The Hedge Fund is the contracting party with the executing broker, the Prime Broker is necessary for the settlement process. Following the execution of a trade, the Hedge Fund and the executing broker advise the Prime Broker of the trade details. If the details match, the Prime Broker will settle the trade and safekeep the fund asset. Another key role of the Prime Broker is to act as global custodian for Hedge Funds' securities. Traditionally the Trustee/Depository, which has responsibility for the safekeeping of the fund assets, delegates this function to its parent organisation that has a global custodian function. Furthermore, this decision is made by the Trustee/Depository.

The Prime Broker is appointed as a global custodian to allow it to conduct securities lending and financing. However, the key driver is the ability and expertise of the Prime Broker's technology and operating systems that can facilitate the reporting and tracking of either securities borrowed or short positions resulting from the sale of borrowed securities.

Margin financing

The Prime Broker provides leverage to a Hedge Fund by lending cash to enable the fund to purchase assets. This process is very transparent as when the Hedge Fund buys or sells assets, cash is debited/credited from/to the Prime Brokerage accounts.

Security lending

Short positions are a key component of a Hedge Funds trading strategy. However, prior to executing a short sale the Hedge Fund will liaise with the securities lending desk to obtain the stock. Once the Hedge Fund sells the asset (which the Prime Broker delivers) resulting in a short position, the Hedge Fund will purchase assets in the market which the Prime Broker will receive which will close the short position.

Collateral

The Hedge Fund assets held by the Prime Broker as custodian also act as collateral for the borrowing and security lending obligations undertaken by the Hedge Fund. The level of borrowing that the Prime Broker is prepared to extend to the Hedge Fund will depend on the level of collateral held by the Prime Broker. The Prime Broker will attribute its own value to the collateral for the purpose of determining how much it is prepared to lend to the Hedge Fund. This value is always at a discount to the current market price. This allows the Prime Broker to protect itself against a fall in the value of the securities in the event it has to utilise some for the instruments in the Hedge Fund. The difference between the market value and discount value taken by the Prime Broker is referred to as a 'haircut'.

There are two ways a Prime Broker can ensure it has recourse to the assets of the Hedge Fund by:

Taking a charge over the Hedge Fund assets if the Prime Broker reserves the right to enforce its charge and liquidate the Hedge Fund or,

Taking a title to the Hedge Fund's assets if the Hedge Fund assets are the property of the Prime Broker. In this instance, the Hedge Fund has a contractual right against the Prime Broker for the return of equivalent assets. The principal difference between title and charge is that where the assets are subject to charge, they are safe-custodied by the Prime Broker but the Prime Broker has no recourse or right to the assets and they are likely to be secure in the event of a Prime Broker's insolvency. When a Prime Broker takes title, the Hedge Fund assets become the property of the Prime Broker.

The regulatory responsibilities of the Trustee/Depository

Regardless of European regulatory jurisdiction where a Hedge Fund is authorised, one of the principal responsibilities of the Trustee/Depository is the safekeeping and control of the fund assets, even if it is a Hedge Fund, thus protecting the shareholders' interest. This regulatory responsibility has been the subject of much discussion between regulators, lawyers, trustee, depositaries and Prime Brokers. How can the Trustee/Depository fulfil its regulatory responsibilities if it has no control or safe custody of the fund assets via its parent organisations?

Local regulators must be satisfied the Trustee/Depository can still discharge such obligations even with the appointment of the Prime Broker, as it is essentially replacing its own global sub-custody network. The question arises whether the Prime Broker falls within the Trustee/Depositary's sub-custody network. Furthermore, local legislation in some European jurisdictions states the Trustee/Depositary must exercise due care and diligence in choosing and appointing a third party as a safe-keeping agent so as to ensure that the third party has and retains the expertise, competence and standing appropriate to discharge the necessary responsibilities. From a German and Irish regulatory perspective the BaFin (German regulator) and IFSRA (Irish regulator) advise that as the Hedge Funds assets are held by the Prime Broker, the Prime Broker must be treated as part of the Trustee/Depositary sub-custody network, thus imposing the obligations mentioned heretofore.

Local regulators require the Trustee/Depository to maintain appropriate internal control systems to ensure that records ideally identify the nature and amount of all assets under custody, the ownership of each asset and where documents of title are located. In addition, even though the Prime Broker holds the fund assets, the Hedge Fund assets must be held in the name of the Trustee/Depository fund, and must be available to the fund in the event of insolvency of the trustee/custodian or its sub-custodian. This point has raised concern if the Prime Broker takes title over the hedge assets.

Practical Considerations of the Trustee/Depository

The Hedge Fund promoter usually advises the Trustee/Depository of the Prime Broker it wishes to engage. In this context, the Trustee/Depository is appointing a sub-custodian that it has limited involvement with in the decision. From a fund documentation perspective each individual Prime Broker has its own 'standard document' that it wishes to sign with the Trustee/Depository. When compared to all other regulated mutual funds, the Trustee/Depository chooses and appoints its sub-custodian and provides a standard sub-custody agreement to its agent, rather than the agent providing its agreement to the Trustee/Depositary.

To date, IFSRA requires the Irish Trustee to appoint the Prime Broker as its sub-custodian. The appropriate sub-custody agreement is signed between both parties and submitted to IFSRA for approval prior to launch of the Hedge Fund. In addition, the Irish Trustee assumes liability for the sub-custodian on an ongoing basis. With respect to the BaFin a similar document is required between both parties (Depositary and Prime Broker) which is also signed by the KAG as the fund cash accounts are in the name of the KAG. In this instance the Depositary Bank assumes liability for the sub-custodian, i.e. The Prime Broker on an on-going basis.

It is also worth noting, that a further structure has been approved by the BaFin. The KAG appoints the Prime Broker and the Depositary Bank consents to the appointment. This document is signed by all three parties. The KAG assumes responsibility for the actions of the Prime Broker and the Depositary Bank is responsible for the selection and on-going monitoring of the Prime Broker, however it is worth noting the German Investment Act states that the Depositary Bank has full liability for the Prime Broker and the safekeeping of the Hedge Fund assets. The question arises in the event this structure is signed by all parties is, will the legislation supercede the contract and will the Depositary Bank be held responsible for the actions of the Prime Broker even though the KAG contractually assumed this responsibility?

Conclusion

As the European-regulated Hedge Fund market accounts for approximately 10% of assets under management, and additional European countries introduce legislation for such funds, the role of the Prime Broker, Trustee/Depository, regulatory and practical considerations associated with these entities are an evolving and developing process. It is an area that continues to absorb and challenge the minds of regulators, Prime Brokers and Trustee/Depositories on an on-going basis. However it is developing and it is only a matter of time before Hedge Funds will be established and operating seamlessly like traditional long only funds.

The regulatory responsibility of the fiduciary in safekeeping the assets of a regulated hedge fund has been the subject of much discussion between regulators, lawyers, trustees, depositaries and prime brokers. Local regulators must be satisfied the Trustee/Depositary can still discharge its obligations by the appointment of a Prime Broker instead of a global sub-custodian.

Country Profile: Poland

Although Poland is often politically categorised as being an Eastern European country, its actual geographic location is very much in the centre of Europe. The past millennium has seen the name Poland being applied to a shifting territorial base, from the 16th century where it was the second largest European state behind Russia, to periods where there was no separate Polish state at all. Poland now stands as the 9th largest country in Europe and joined with 9 other Central European and Mediterranean countries to form part of an enlarged European

History

From the rule of Duke Mieszko I in the late 10th Century through to the present day, Poland has had a particularly long and varied history. Its unification as a nation in the 11th Century was relatively short lived and was divided into principalities again until reunification in the 14th Century. Poland became a powerhouse of Europe in the 16th Century, extending its borders from the Baltic to the Black Sea, however in the 17th and 18th Centuries Poland came under attack from all sides and was eventually divided up in a series of three partitions by Austria, Russia and Prussia. Despite two uprisings in the 19th Century, Poland was continually occupied until the end of World War I when independence was finally seized. Following World War II, Poland suffered from economic hardship and political oppression as the communists gained power. A number of popular protests in the 1980s led to the establishment of Solidarity and eventually the Communist party was disbanded, allowing democratic elections to be held. In the 1990s. Despite great instability, Poland's economy was transformed into one of the most robust in Central Europe, thus paving the way for admission into the EU in 2004.

Economy

The transition from a command or socialist economy to a market economy has been driven by the Polish government's policy of economic liberalisation and the success in achieving this and attracting foreign investment emphasises Poland's prominence amongst other transition economies. However, there are a number of challenges that face Poland, particularly unemployment which currently stands in excess of 18%, one of the highest levels in the European Union. Of those employed, there is significant pressure on salaries to increase, with wage inflation in the mining, steel, oil and food processing sectors potentially increasing several dozen percent, which may rein in some of the anticipated growth in the economy.

Poland (and Warsaw particularly) is quickly establishing itself as a prime centre for outsourcing, due largely to the favourable climate for business, the improving state-private relations and relatively inexpensive workforce. There are areas that will need to be addressed however to ensure Warsaw remains an outsourcing centre of choice, such as the transportation system, the quality of living in general and most importantly the telecommunications infrastructure.

Stock Exchange

The Warsaw Stock Exchange (WSE) operates based on the Law on Public Trading in Securities 1997, under the supervision of the Polish Securities and Exchange Commission. The WSE began activity in its present form in 1991, starting from the very beginning with electronic paperless trading. WARSET, the WSE's electronic order-driven system, is based on two trading platforms – continuous trading and two fixed-price sessions. A company can only be traded in one system and its liquidity level is the ultimate criterion for deciding which system that should be.

Market liquidity in WARSET is the responsibility of issuers and market makers. In addition, trading information is available to each market participant on a real time basis, this being distributed electronically via Reuters and Bloomberg from the WSE - the sole source.

Instruments Traded

Equities – Ordinary equities listed on the WSE are bearer instruments and exist only in book entry form. Local custodians and brokers who maintain securities accounts on investors' behalf are responsible for recording ownership. The admission to public trading for shares of companies via the primary market is largely conducted by IPO, whereas secondary trading takes place on both the WSE and Central Table of Offers (CeTO), the only official OTC market. Subscription Rights and PDAs (new shares subscribed via public offer) can both be traded on the WSE.

Treasury Bills – (T-Bills) are traded on the inter-bank (OTC) market as well as on the ERSPW electronic trading platform. The State Treasury will issue these instruments with regular maturities of 13, 26, 39 and 52 weeks or occasionally with maturities on a case-by-case basis. They are issued in book entry form and held on the Central Register (CRBS) at the National Bank of Poland (NBP), mainly through local banks and other direct participants.

Government Bonds – All types of Treasury bonds are in book entry form, with the most common (those with 5 and 10 year maturities) traded between international investors. The NBP will sell these bonds at face value plus accrued interest or at a discount through Treasury Securities Dealers. Secondary trading generally takes place on the more liquid EPSPW and OTC market, however there is some activity on the WSE-launched platform (RPS) but volume is hampered by the lack of liquidity.

Derivatives – Futures contracts on the WIG20, TechWIG and MIDWIG Indices, on stocks of ten companies and on the USD and Euro, together with European and American style warrants on indices and futures contracts are all traded in the continuous trading system. European-style options can also be traded on the WIG20 index.

Currency Market and FX Controls

Following the implementation of the FX Law in October 2002, full convertibility of the Polish Zloty was granted for non-Polish resident investors based in the European Union (EU), European Economic Area (EEA) and the Organisation for Economic Cooperation and Development (OECD) countries. For non-Polish residents based in non-EU, EEA or OECD countries some controls remain in force, although certain activities can be performed by obtaining a permit from the National Bank of Poland.

Market Indices

Name	Composition
WIG Index	Total return index weighted by market capitalisation
WIG-20	20 largest and most liquid companies listed on the WSE
MIDWIG	Next 40 largest and most liquid companies listed on the WSE
WIRR	Companies listed on the parallel market
TechWIG	Companies from the SiTech segment created by the WSE
NIF Index	14 National Investment Funds

The main WIG Index is a total return index which includes dividends and pre-emptive (subscription) rights. It includes all companies listed on the main market except foreign companies and investment funds. The WIG-20 and MIDWIG indices comprise of the top 20 and up to the next 40 largest and most liquid WSE listed companies respectively, and the TechWIG includes companies companies from the IT and Telecom sectors, regardless of quotation market.

The performance of the above indices over the last 3 years has been relatively impressive when compared to some of the larger world indices. The WIG index, for example has posted a 3-year return of 100.97%*, compared with 8.58%* for the S&P500 and 6.25%* for the FTSE All-Share over the same period. The WIG-20 has also out-performed the DOW Jones and FTSE-100 by over 43%* and 55%* respectively over the same 3-year period. The relative performance of the WSE when compared with the 9 other accession countries on the same basis on the other hand reveals an under-performance against the likes of the Estonian, Czech Republic, Slovenian, Slovakian and Hungarian Stock Exchanges.

* Based on index performance over a 3-year period from 19 October 2001 to 15 October 2004, with gross dividends re-invested. Source: Bloomberg

Market Regulation

The legislative framework for exchange operations is provided by a number of rules and statutes. The General Meeting, consisting of representatives from the State Treasury, WSE shareholders, banks and brokerage houses, is the highest decision-making body and has the ability to effect updated legislation and appoint members to the Supervisory Board. These 12 appointed members are responsible for controlling the operation of the exchange, admitting securities for trading, granting and recalling stock exchange membership. Finally, a management board consisting of 5 members co-ordinates the day-to-day operations of the WSE.

Investing in Poland

If you wish to discuss the eligibility of Poland as an investment market in your collective investment schemes, or would like further detailed information on the Polish market, please contact your Citigroup European Fiduciary Relationship Manager.

Official Name: The Republic of Poland

Capital: Warsaw

Population: 38.6 million (UN, 2003)

Local Currency: Polish Zloty

Exchange Rate: 1€ = 4.38

Primary Stock Exchange: Gielda Papierow Wartosciowych w Warszawie SA (Warsaw Stock Exchange)

Market Cap: PLN 428.1 Billion (€97.7 Billion)

Firms Listing Equity on WSE: 204

Indices: Warsaw Stock Exchange Index (WIG); WIG-20; MIDWIG; WIRR; TechWIG; NIF Index

Settlement Cycle: T+3 for Equities
T+2 for T-Bonds (WSE)
T+1 for T-Bonds (Off Market) and T-Bills

Companies (Auditing & Accounting) Act 2003

The Companies (Auditing & Accounting) Act 2003 (the Act) has been the subject of much recent discussion in Ireland, both in the media and the accountancy profession. It has been described by some commentators as arguably the most important piece of Irish legislation affecting the accountancy profession in Ireland. It heralds a new era for corporate governance for Irish companies.

Background

In 1999, the Public Accounts Committee in Ireland issued a report in respect of widespread non-compliance with legislation relating to Deposit Interest Retention Tax (DIRT). As a result of this report and other high-profile scandals, the Irish Government appointed a Review Group on auditing. The Review Group's terms of reference included an examination of the role of the external auditor in ensuring compliance by companies with their statutory obligations. Many of the provisions of the Act reflect the recommendations of the Review Group.

Main Provisions of the Act

The four main provisions of the Act are as follows:

1. The establishment of a new supervisory authority, i.e. the Irish Auditing and Supervisory Authority, which will supervise the regulation of the Irish accountancy profession by the various professional bodies. In addition, the new authority has responsibility for reviewing the financial statements of all public companies and certain private companies.

2. The requirement for directors of certain companies to sign compliance statements confirming the company has internal financial and other procedures in place to ensure compliance with its relevant obligations.

3. The requirement for all public companies and certain private companies to establish an audit committee.

4. The establishment in law of the role and composition of the audit committee.

The Irish Auditing and Supervisory Authority (the Authority)

The Authority has now been established and the Chief Executive Designate has been appointed. The membership of the Authority comprises representatives of the Prescribed Accountancy Bodies 'PABs' and designated organisations such as IBEC, the Irish Congress of Trade Unions, the Pensions Board, the Irish Revenue Commissioners and the Irish Law Society.

The objectives of the Authority are to supervise the regulation of PABs, promote high standards in the accountancy profession and monitor the financial statements of certain companies.

The main functions of the Authority in relation to the supervision of PABs are as follows:

To grant recognition to various accountancy bodies.

To approve and request changes to the constitutions of PABs.

To supervise how PABs monitor and discipline their members.

To investigate breaches of standards by members of PABs.

The Authority is also responsible for reviewing the financial statements of all public companies and large private companies, i.e. companies with turnover in excess of EUR50million and balance sheet in excess of EUR25million. In this regard, the Act has recognised in law accounting standards such as FRS and specifies that the financial statements must state whether the statements comply with the standards. If there are any departures from these standards the reasons for such departure must be detailed in the financial statements.

In respect of the review of the financial statements, the process of the Authority is as follows:

The Authority notifies the directors of doubt over compliance with regulation and standards.

The directors must either justify the financial statements or revise them.

If the Authority is not satisfied with the response of the directors, it may apply to the High Court.

The High Court may demand the revision of the financial statements.

The Companies (Auditing & Accounting) Act 2003 imposes wide-ranging obligations on many Irish-based companies and significantly increases the responsibility of directors. The Director's Compliance Statement for example places a requirement on all directors to comment whether they are of the opinion that they used "all reasonable endeavours" to ensure that the company was compliant with its obligations in the relevant year.

Compliance Statements

This requirement applies to all public companies, whether listed or not, and private companies with turnover in excess of EUR15.2million or assets in excess of EUR7.6million.

In effect there are two compliance statements which must be signed by the directors, i.e. the Compliance Policy Statement which is required every three years and the Annual Compliance Statement. Both statements are required in respect of compliance with 'relevant obligations' which is defined as including the following:

All company law.

All taxation law.

Any other enactments which may materially affect the company's financial statements.

The three-yearly Compliance Policy Statement details the policies in place regarding compliance with relevant obligations and describes the internal financial and other procedures in place to ensure compliance. The Annual Compliance Statement confirms whether or not the internal financial and other procedures were in place during the year and confirms whether or not the directors have reviewed their effectiveness.

In addition to the provision of the compliance statements, the external auditors must undertake an annual review of the directors' statements and report on whether both are 'fair and reasonable'.

Both the directors' compliance statements and their review by the external auditors are currently the subject of much discussion with a proposed implementation date of financial statements with a financial year commencing on or after 1 July 2005. Draft guidance has been issued by both the Office of the Director of Corporate Enforcement and the Auditing Practices Board. Feedback has been provided by the accountancy profession on the draft guidance.

It is important to note that the Act allows for the exemption of mutual fund companies from the requirement for directors' compliance statements and it is anticipated that this exemption will be utilised by the Irish authorities.

Audit Committees

The Act requires that all public companies and certain private companies must establish an audit committee. This requirement applies to all public companies, whether listed or not, and private companies with turnover in excess of EUR50million and balance sheet in excess of EUR25million. Private companies may elect to opt out of this requirement, however, such an opt out must be fully explained in the annual financial statements.

The Act requires that the committee must consist of at least two directors and may not include the chairman of the board. In addition, the committee may not include an employee in the last five years. The terms of reference of the committee must be written, presented at the company's AGM and specify how the committee will discharge its specific responsibilities.

In addition, the Act establishes in law the functions of the audit committee as follows:

To recommend to the board for approval the annual financial statements and the compliance statements detailed above.

To determine whether the financial statements comply with the Companies Act and are true and fair.

To recommend to shareholders the appointment of the external auditor.

To monitor the performance and independence of the external auditor.

To recommend the awarding of non-audit work to the external auditor.

To ensure the company has appropriate internal audit.

Conclusion

The Act is one of the most significant bodies of corporate governance legislation implemented to date in Ireland. Its implications for Irish registered companies outweigh the implications imposed on US companies by the Sarbanes-Oxley Act. Many of the Act's provisions are still under discussion, in particular, the requirement for directors' compliance statements. This requirement places onerous responsibilities on companies that are impacted.

The implications of the Act on Irish-registered companies outweigh those imposed on US companies by Sarbanes-Oxley. Many of the Act's provisions are still under discussion, in particular the requirement for directors' compliance statements which places onerous responsibilities on company directors.

Financial Derivative Instruments – The Role of the Fiduciary

One of the main opportunities arising from the implementation of the UCITS III Product Directive is the ability for UCITS to invest in Financial Derivative Instruments (FDIs) as part of the investment strategy of a fund. Prior to UCITS III, FDIs could only be utilised for Efficient Portfolio Management purposes.

However, in order to protect the interests of investors, the Directive requires the establishment of risk management processes to mitigate the risks associated with FDIs. In addition, a fund's exposure to FDIs cannot exceed its total net assets. Two methods are allowable in calculating a fund's exposure, i.e. the Commitment Approach and the Value as Risk Approach.

Ireland, Luxembourg and the UK have adopted a consistent approach in relation to the extension of FDIs as allowable investment strategies. However, differences have arisen between the jurisdictions in relation to the role of the Fiduciary in monitoring FDI risk management processes.

Irish Position

In Ireland, the Regulator has issued guidance which imposes reporting and procedural requirements on UCITS investing in FDIs. Inter alia, the guidance requires that a UCITS employs a risk management process to monitor and measure the risks associated with FDIs. However, the role of the Fiduciary in assessing the adequacy of a risk management process has not been prescribed by the Regulator. Instead, the local industry body, i.e. the Dublin Funds Industry Association (DFIA) has issued guidance on the matter.

The DFIA guidance emphasises that ultimately it is the responsibility of the Directors or Manager of a UCITS to ensure that a fund has an adequate risk management process. The Fiduciary's role is one of oversight. This stems from its regulatory duty to report annually to investors on whether the fund has been managed in accordance with the UCITS Regulations. To fulfil this role, the guidance suggests the following:

At the time of a fund being launched, the Fiduciary checks that the Manager has submitted a risk management process to the Regulator. If a risk management process is not submitted, the fiduciary should check the prospectus states the fund does not intend to utilise FDIs.

The Fiduciary reviews the risk management process being submitted by the fund to the Regulator to ensure it is consistent with the fund prospectus.

The Fiduciary ensure that the UCITS has submitted its annual risk management process report to the Regulator.

That FDI positions are included in the Manager's procedures for monitoring investment restrictions and that these are included in the Fiduciary's review.

The Fiduciary obtain a copy of the board's periodic FDI risk report.

UK Position

In the UK, guidelines on risk management processes have been issued by the industry bodies representing depositaries, i.e. the Depositary and Trustee Association (DATA) fund managers and futures & options practitioners. These guidelines are very prescriptive and have been approved by the UK Regulator. As DATA is a party to the guidelines, depositaries in the UK are responsible for ensuring that the detailed processes specified in the guidelines are adhered to by the Manager.

An overview of the detailed processes is as follows:

1. Categories of Risk

The fund manager must analyse risks within a UCITS and document how the FDI strategy will impact such risks. The guidelines require the manager to consider the following risks: market risk; credit risk; operational risk; legal and documentation risk; cash flow risk; basis risk; regulatory risk; and reputational risk.

2. Appropriate Supervisory Structure

The fund manager must have a supervisory structure appropriate to the complexity and sophistication of the FDI strategy utilised. The guidelines require the structure applies some or all of the following processes:

Nomination of a committee of senior individuals with responsibility for FDIs

Committee to be made formally responsible to the board

Internal audit to evaluate FDI controls

Role of external audit to be assessed

Remuneration policies to be reviewed; and

Notification of FSA with details of risk management process.

3. Independent Framework of Internal Controls

The guidelines specify the manager's system of internal controls must contain the following components: competence; appropriateness; responsibility; segregation; processes; procedures; monitoring; limit-setting; independent price verification; stress testing & scenario analysis; and reporting.

4. New Derivative Strategy or Instruments

The guidelines state prior to the introduction of new FDI strategies or instruments, the manager must provide the committee with a detailed report. One of the report requirements is to confirm the opinion of the depositary has been sought prior to the introduction of the new strategy/instrument. This results in the depositary having responsibility for reviewing all manager proposals regarding changes to its FDI strategy prior to implementation.

The impact of the above is that the depositary is required to review the minutiae of the manager's FDI strategy to ensure that it adheres to the guidelines and also to review all changes to FDI strategy proposed by the manager.

Luxembourg Position

In Luxembourg, the risk management process requirements enacted in regulation are similar to Ireland and the UK. However, neither the Regulator nor the industry has issued any guidance on the risk management process or the approach to be adopted by the fiduciary in monitoring the process. It is expected that the industry representative body, i.e. Association Luxembourgeoise des Fonds d'Investissement (ALFI) will issue a paper on the subject shortly.

Conclusion

The approach to be adopted by the fiduciary in monitoring FDI risk management processes differs across the major European jurisdictions. In Ireland, the role of the fiduciary concentrates on ensuring the manager has produced a risk management process in accordance with the prospectus, and submitted to the Regulator. In the UK, the role of the fiduciary is more onerous. The fiduciary must review the risk management process in detail to ensure it adheres to the detailed guidance issued by the industry. In addition, the fiduciary in the UK must provide an opinion on new FDI strategies and instruments. In Luxembourg, detailed guidance is yet to be issued.

United Kingdom
Citicorp Trustee Company Ltd
Citigroup Centre
Canada Square
Canary Wharf
London E14 5LB
United Kingdom

Luxembourg
Citibank (Luxembourg) SA
58 Boulevard Grand Duchesse Charlotte
L-1330
Luxembourg

Ireland
Citibank Intl plc Ireland Branch
1 North Wall Quay
Dublin 1
Ireland

Contact Details

Sean Quinn

European Head of Fiduciary Services
sean.quinn@citigroup.com
Tel: +44 (0)20 7500 5619
Fax: +44 (0)20 7500 5835
London

Bronwyn Wright

European Head of Fiduciary Relationships
bronwyn.wright@citigroup.com
Tel: +353 1 622 2791
Fax: +353 1 622 6691
Dublin

David Morrison

Fiduciary Relationship Manager
david.m.morrison@citigroup.com
Tel: +44 (0)20 7500 8021
Fax: +44 (0)20 7508 0363
London

Iain Lyall

Fiduciary Relationship Manager
ian.lyall@citigroup.com
Tel: +44 (0)20 7500 8356
Fax: +44 (0)20 7508 0363
London

Francis Pedrini

Fiduciary Relationship Manager
francis.pedrini@citigroup.com
Tel: +352 45 1414 228
Fax: +352 45 1414 253
Luxembourg

Daniel Mente

Fiduciary Relationship Manager
daniel.mente@citigroup.com
Tel: +352 45 1414 492
Fax: +352 45 1414 253
Luxembourg

Nicola Byrne

Fiduciary Relationship Manager
nicola.byrne@citigroup.com
Tel: +353 1 622 1056
Fax: +353 1 622 6691
Dublin

Francine Bailey

Fiduciary Relationship Manager
francine.bailey@citigroup.com
Tel: +44 (0)20 7500 8580
Tel: +44 (0)20 7508 0363
London

Citigroup® Global Transaction Services is a leading provider of cash management, trade, securities and fund services to financial institutions, corporate clients and public sector entities around the world. With a global network spanning 90 countries, we are uniquely qualified to service clients with local and cross-border interests and provide integrated reporting and management.

Citigroup® Global Transaction Services helps clients address strategic issues such as working capital and liquidity management, treasury integration, trade finance and other trade services, custody, clearing, fund administration, securities financing, depositary receipts, and agency and fiduciary programs. Our global platform is unique in the industry for its reach, interoperability and flexibility. It provides clients with timely, accurate information and dynamic, web-based tools to effectively manage their securities portfolios, financial positions, working capital and supply chains around the world. Combined with a worldwide network of dedicated and experienced transaction services professionals, Citigroup is well suited to serve clients anywhere they do business.

This document is solely for information and Citibank will not be responsible for updating any information contained herein. It is not intended to provide specific advice on any other matter. If advice is required you should consult your own advisors, legal or otherwise. No responsibility for any loss occasioned as a result of using this document is accepted. Under no circumstances is it to be considered an offer to sell or a solicitation to buy any investment or product.

Contents

Fiduciary Services Citigroup® Global Transaction Services Insight; December 2004

Fiduciary Services
Citigroup® Global Transaction Services
Insight; December 2004