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Citicorp Trustee Company Limited; August 2002
NEWS & VIEWS

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Welcome to the third edition of News & Views for 2002

This issue of News & Views covers the following industry matters:

We wish to take this opportunity to remind readers of the change to our registered office to Citigroup Centre, Canada Square, Canary Wharf, London E14 5LB effective from 1st July 2002. This change will impact more upon those readers who are clients of CTCL in so much that the revised information will be used to update scheme documents and in the case of an ICVC, the ACD will need to advise the FSA of the change.

This issue of News & Views covers the following industry matters:

· UCITS III (also see Citibank MARKETview circular attached)

· UCITS III - UK perspective

· Limited Issue Funds

· Guaranteed and Capital Protected Funds

· Single Pricing

· Highlights of the Sandler Report

UCITS III

The UCITS Directive is intended to make funds more attractive to investors, without compromising investor protection and in doing so adopt a unified approach across Europe.

The Directive has two main parts; the 'Provider Directive' and the 'Product Directive'.

The Provider Directive

There are three main provisions relating to:

· A European passport for management companies to operate throughout the EU

· The regulation of those management companies

· The requirement for a simplified prospectus for funds.

Passport

The aim is to enable management companies authorised to operate in their home country to carry out the same services in other EU jurisdictions, either by providing cross border services or by establishing a branch in another EU country.

Regulation

With the new Directive in place it will be possible for Member States to expand the range of permissible services for management companies whilst at the same time tightening the regulatory and supervisory requirements. The management company must now meet stricter capital adequacy requirements.

Prospectus

In addition to a full prospectus made available free of charge, on request, managers must publish a simplified prospectus which is clear and concise and more 'investor friendly' and for use in all Member States where the fund is marketed.

The Product Directive

The main proposal is to expand the range of assets in which a UCITS scheme may invest, and to expand the range of funds which are UCITS qualifying to include money market funds and fund of funds.

Attached is a MARKETview circular issued by Citibank explaining the changes within UCITS III in more detail.

Please contact 3d should you require this circular

UCITS III - The UK PERSPECTIVE

The proposals inherent in UCITS III form part of the FSA's Consultation Paper 135. This section looks at some of the main proposals in CP135.

The FSA have said that the main thrust of their approach to the Product Directive is to maintain the maximum flexibility permitted by the rules, where possible to have less prescription within the rules, and to avoid, if possible, rules that exceed the requirements of the Product Directive. They also intend to allow maximum use of any transitional provisions.

Timetable for implementation

The investment issues in the first amendment directive are to be implemented by Member States by 13th August 2003 with an effective date of application of no later than 13th February 2004. A five-year transitional period is also allowed from the date of adoption.

The FSA hope to give UK firms a 'head start' over european competitors through early implementation. The proposed effective dates for UK implementation are as follows:

· For new schemes authorised after 13th August 2003 - the new rules must be applied as from 13th August 2003

· For new securities schemes authorised between 13th February and 12th August 2003 - the new rules must be applied as from 13th February 2004

· For existing securities schemes as at 13th February 2002 - the new rules must be applied as from 13th February 2007.

In all of the above scenarios a fund may adopt the new rules ahead of the date when adoption becomes mandatory.

While we welcome the fact that it is intended to make full use of the transitional arrangements, it does mean that we will be faced with a situation where two sets of rules would be operating in parallel, particularly in respect of Chapter 5 of the CIS Sourcebook. A management group may of course be able to mitigate against any such 'dual running' effect through early adoption of the new rules for existing funds. For trustees and depositaries the period of 'dual running' is likely to be much longer as it is dependent upon the rate at which AFMs switch to the new rules.

New fund category

The new directive paves the way for the FSA to propose the establishment of a new category of fund to be known as the mixed fund category. This new category will amalgamate the existing categories for securities funds, warrant funds, funds of funds, futures and option funds and money market funds, all of which will be UCITS qualifying under the new Directive.

The non-UCITS qualifying funds are Geared Futures and Options Funds, Property Funds and Pension Feeder Funds and these will remain as three individual categories of fund.

Index Funds

The directive allows the size of a holding in one issuer to be increased to 20% of the NAV of the fund, and even up to 35% of the NAV of the fund in exceptional markets. However before a fund may take advantage of this relaxation there are key criteria that must be met:

· The fund must replicate an index in its composition (not merely replicate the performance of an index)

· The index must be a recognised industry benchmark and not merely a specially designed or 'boutique' type index

· The index must be sufficiently diversified

· The index must be published in an appropriate place and manner.

The FSA have said that they will test whether the index being replicated meets the above criteria at the time of authorisation of the fund.

Nevertheless we can foresee a potential issue in whenever the circumstances surrounding an index changes at some point in the future e.g. the constituents change, countries are deleted (or added), the method of publication changes, etc. Unless it is the intention of the FSA to embark upon a continuous review process regarding the 'appropriateness of indices' for replicating, then there is potential for disagreement between the scheme operator and trustee/depositary as to whether the index being replicated still meets all the relevant criteria.

Derivative Use

The FSA has indicated that the EPM rules (as presently apply) including the requirement for individual cover for transactions may no longer be relevant. This is because there is a new requirement in the Directive that a UCITS operator must have a risk management process in respect of the scheme's position in derivatives and a further requirement for increased disclosure by the scheme operator on the scheme's use of derivatives. There remains considerable uncertainty at present as to what form this risk management process will take and as to what exactly are the respective responsibilities of the fund operator and the trustee/depositary in relation to it.

The FSA have said that the new rules will not impose a requirement to 'look through' index derivatives to the underlying investments and apply the investment rules, provided the index derivative is based on an industry recognised benchmark and therefore is an approved index.

Article 24a - Disclosure Issues.

The Directive provides for greater disclosure to investors and where applicable a prominent statement of high volatility and prominent and detailed statements on the use of derivatives. Disclosures on index replication are also required where appropriate. The risk management process should also be available on request.

LIMITED ISSUE FUNDS

The FSA have rejected the idea of having a separate fund category for Limited Issue Funds. This they believe to be incompatible with their proposals for implementing the Product Directive which involve the reduction of the number of fund categories by the creation of a new mixed fund category (see above).

It is proposed that all categories of funds, whether or not UCITS qualifying, (but excepting feeder funds) will be permitted to limit their size through restrictions on the issue of shares/units. Feeder funds are to be excepted because of the often contractual nature of regular savings into these funds.

The creation of a Limited Issue Fund will be achieved through the issue of a limited issue share/unit class. All classes of units/shares in a Limited Issue Fund must be restricted and the regulations will be drafted to prevent a limited issue class and a non-limited issue class to co-exist within the same fund or same sub-fund.

The limitation may be effected by restrictions in monetary value or timeframe or by number of units/shares in issue, either at the fund level or sub-fund level where an umbrella structure is used.

Where an umbrella structure is used there will be a requirement to always have at least two non-limited sub-funds within the umbrella so as to ensure that the switching rights of investors are not compromised.

Guaranteed and Protected Funds

The protection of the investor's capital can be achieved in one of two ways:

Guaranteed

Only when a fund is offering a legally enforceable guarantee by a regulated third party (not AFM or Depositary) will it be able to use the term 'guaranteed' in the title. The restriction on the depositary from acting as a guarantor applies only to funds for which it currently occupies that role, and does not extend to any associated company of the depositary who would independently meet the requirements for acting as guarantor.

The guarantor should be responsible for underwriting both the market risk and any specific risks attaching to the fund that may be the cause of an investment shortfall at a given date. All investors in the fund should be covered by the guarantee.

Capital Protected

The plan is for any protection of capital to be provided from within the fund itself through the use of an appropriate investment strategy involving derivatives. The degree of protection will be wholly dependent upon delivery of that strategy.

In this scenario, the name of the fund may include the term 'capital protected' or similar and again all investors in the fund must be covered by the 'protection'.

SINGLE PRICING

Readers will be aware that single pricing is compulsory for OEICs and voluntary for unit trusts. The notion of compulsory single pricing for AUTs has been put on 'hold' by the FSA until the industry has experienced swinging single pricing for at least 12 months. The FSA proposes to consider the matter further in 2004.

Prior to 1 August 2002, there was only the 'dilution levy' method that allowed the costs of dealing in the underlying securities of a fund to be recouped from investors in a fund that is single priced. On that date the new single pricing rules which introduce the 'swinging price' method came into effect.

The new rules also bring into effect new disclosure requirements for all methods of single pricing.

Having reviewed both the dilution levy method and the swinging single pricing method (also known as the dilution adjustment method) the FSA have concluded that both are reasonable methods of recovering the costs of dealing in investments from transacting investors. Therefore, the FSA have said that AFMs should be allowed to adopt either method as they wish.

AFMs who want to adopt the new swinging single price method immediately will feel the impact of the new rules first as they will have to update the scheme documents immediately.

Those managers that currently use the dilution levy method of single pricing, even if they do not intend to change this mechanism, will also be impacted by the new disclosure rules on single pricing which are designed to aid transparency and avoid investor confusion.

The requirements involve disclosure of high level information on costs and the operation of dilution policy within the key features document with more detailed information in the prospectus. This change to the original proposals in CP131 is wholly consistent with the approach taken by Sandler in respect of a simplified key features document - see below.

AFMs not intending to change their method of single pricing, will need to amend their key features documents to reflect the new requirements by 1st February 2003 at the latest. They will also have to update the prospectus at the next revision date or by 1st February 2003 at the latest.

The FSA have made one further change to the original proposals in CP131 in that they have tightened the restrictions surrounding the decision on whether to 'swing' the price or not.

During the consultation process many respondents had expressed disappointment that the FSA had not decided upon one method of single pricing. That and the fact that there were to be three methods of pricing available (one traditional method for unit trusts and two methods for ICVCs) would, they said, only increase confusion over pricing in the minds of investors. The FSA has rejected that line of reasoning and have said they are not presently aware of any confusion among investors in that regard presently, despite the fact that foreign funds marketed in the UK have several different approaches to pricing.

Additionally the FSA has said that their research indicated that pricing mechanism was not a major factor of consideration for investors when dealing in collective investment schemes.

Methods of Single Pricing

There is no obligation imposed by the CIS Sourcebook on the AFM to make any type of dilution adjustment.

However having set out the policy on fund dilution within the KFD and the prospectus, and in accordance with that policy, when making a decision on whether or not to apply an adjustment or levy an AFM should also take account of:

a) the trend within the fund towards expansion or contraction

b) the transactions to be made at the particular valuation point.

Dilution Levy Method

Role of Trustee/Depositary

The trustee/depositary is not required to agree with any decision the AFM takes when considering whether a dilution levy should be applied at all, or deciding at what level a dilution levy should be imposed or how it should be calculated. Their involvement is to ensure that where an AFM does charge a dilution levy it is charged in accordance with the regulations and the AFM's stated dilution levy policy, and that the application of that policy is consistent and that the calculation is fair and reasonable to all investors. The trustee/depositary is also charged with ensuring that the AFM takes all relevant matters into account when arriving at his decision. The trustee/depositary being responsible for the assets of the fund will also want to ensure that any such dilution levies charged are promptly paid over to the fund.

Swinging Single Price method
(or Dilution Adjustment method)

Role of Trustee/Depositary

The role includes the responsibilities listed above for the dilution levy method. In addition the new rules appear to place additional emphasis on the trustee/depositary policing the decision on whether to swing or not and to ensure that the AFM is making his decision based on genuine fund dilution concerns.

The FSA have put in place strict regulations surrounding the decision on whether to 'swing' the price or not.

AFMs, when considering whether or not to swing a price, are prohibited by regulation from basing their decision on, or allowing their decision to be influenced by, their current box position and their potential to make profits or avoid losses on that position. Trustees/depositaries are tasked by regulation to ensure that the AFMs adhere to this rule.

Where an AFM intends to make aggressive use of the swing mechanism, this will invariably mean that the AFM will have to provide a written daily rationale of their decision to the trustee/depositary.

Where an AFM and depositary agree a more mechanical approach to price adjustments that can not be influenced by the manager then there is not such a need for 'evidencing' or rationale for price swings.

Swinging Single Pricing in Operation

Having taken the decision to apply a dilution adjustment then the AFM must, with reference to the valuation point.

a) where issues exceed redemptions make any dilution adjustment upwards and the adjustment must not exceed the AFM's reasonable estimate of the difference between the price which would have been applied if no adjustment was made and the total of the scheme property using the best offer price available in the market for the underlying securities plus dealing costs, and

b) where redemptions exceed issues any dilution adjustment must be downwards and must not exceed the AFM's reasonable estimate of the difference between the price which would have been applied if no adjustment was made and the total value of the scheme property using the best bid price available in the market for the underlying securities less dealing costs.

SANDLER REPORT (Highlights)

Sandler's remit included the identification of competitive forces and incentives driving the UK retail savings market and to suggest policy responses to ensure consumers are well served.

The IMA have welcomed the Sandler report, and in particular:

· The move toward a more level playing field between life and mutual fund products

· The emphasis on simplicity and transparency.

· Greater separation between cost of advice and the cost of the product

· A renewed focus on consumer education

· Adviser qualifications to be more focused on investment matters.

· Simplification of key features documents.

The FSA have said that they are happy with the general direction of the report's recommendations and will be consulting with the Treasury in September 2002 on the best way of taking the recommendations forward.

The report has highlighted several areas where the retail savings industry could be improved either by industry players' or by government intervention.

The main areas of concern to Sandler are:

· The difficulty consumers have deciding which product suits their needs most

· The fact that consumers are likely to choose managed products and pay more for a service when they are not best placed to compare the merits of various alternative products

· The complexity of the charging structures of the products and of the cost of advice when sought

· The perception that commission driven selling leads to advisers' recommending one provider's products in preference to another provider's product

· The complexities of the tax treatment of various products, which may require a consumer to seek specific advice.

Sandler's recommendations linked to these concerns are:

· Greater availability of stakeholder and CAT standard products with reasonable exit terms

· Restricting the cost of advice to a fee based relationship between the consumer and adviser

· Future government legislation steering away from tax incentives for specific savings products

· Simplified key features documents.

The material in this communication is for information purposes only. At the time of publication, this information was believed to be accurate, but neither Citibank nor Citicorp Trustee Company Limited makes any representation or warranty to any person as to the accuracy or completeness of the material contained herein. The material contained herein does not constitute in any way investment or legal advice or a recommendation reference or endorsement by Citibank or Citicorp Trustee Company Limited or any person or entity named herein.

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Citicorp Trustee Company Limited; August 2002 NEWS & VIEWS

Citicorp Trustee Company Limited; August 2002
NEWS & VIEWS