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Citicorp Trustee Company Limited
September 2003

CTCL home page

Since its inception in 1987, Citicorp Trustee Company Ltd (CTCL) has grown to become the 3rd largest supplier of Trustee and Depositary services to authorised funds in the UK with more than 300 authorised unit trusts and umbrella sub funds under its fiduciary care and total assets of over £40 billion. Our 14 client management groups include some of the largest and most respected names in the UK retail funds industry. CTCL also forms an important part of Citigroup's European fund activities with Trustee, Depositary, fund accounting and other associated services offered in Dublin, Luxembourg, the Channel Islands and a number of mainland European centres.

CTCL is a member of the Depositary and Trustee Association (DATA), our industry body and is an active participant with our Chief Executive, Sean Quinn, the current DATA chairman.

Through publications such as News & Views, individual client presentations, industry round tables, and DATA, CTCL seeks to add value through comment on future regulatory change, but also through the establishment of industry best practice and interpretation in areas where regulation is not prescriptive, or allows a degree of discretion.

In recent years, CTCL staff have gained a wealth of experience through a variety of fund reconstruction exercises such as Unit Trust and OEIC mergers and Unit Trust to OEIC conversions. Any one of our team will be happy to discuss any plans of your own, your views on the contents of this publication or any other technical query you may have and can arrange individual discussions through to formal staff presentations on a variety of technical matters if desired. Please also contact us should there be a specific matter you feel would be a useful inclusion in future publications.

Citicorp Trustee Company Limited, Lewisham House, 25 Molesworth Street, London SE13 7EX is a subsidiary of Citibank N.A. and is regulated by FSA.. Registered in England No. 235914. Registered Office: Citigroup Centre, Canada Square, Canary Wharf, London E14 5LB. Ultimately owned by Citigroup Inc, New York, USA.

If you would like to discuss any matter contained in this newsletter in greater detail, please call:

Steve James	020 7500 8309	Dave Morrison	020 7500 8021
Paul Robertson	020 7500 8580	Steve Clark	020 7500 6351
Darren Burrows	020 7500 8847	Marilyn Fernanades	020 7500 7024
Iain Lyall	020 7500 8356	Ken Getty	020 7500 8834
Mick Lintunen	020 7500 8303

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

CP 185 - The CIS Sourcebook - A new approach

The EU Savings Directive

UCITS III Derivative Risk Management Process

OEICs - Corporate Housekeeping

The new SORP for Authorised Funds

IAS - General Corporate Accounting Issues - Potential Relevance to Schemes (Guest article by David Barnes and Jamie Partridge of Deloitte & Touche)

CP 176 - Unbundling: a better deal for the investor?

SDRT and OEIC Mergers

Problems for Managers of Funds of Funds-HN24

CP 185 - The CIS Sourcebook - A new approach

May 21st 2003 saw the release of Consultation Paper 185, the FSA's long awaited discussion of its proposals to overhaul the regulation governing the running of authorised collective investment schemes in the UK. Since N2, the CIS Sourcebook has undergone a number of changes and revisions, particularly in relation to Single Pricing following CP131, and the changes required to implement the UCITS Product Amending Directive set out in CP135. It is however generally accepted that the Sourcebook is overly prescriptive in places and in general need of a more fundamental revision to reflect the changing nature of the UK savings market and to facilitate the creation of more bespoke savings products and thus encourage Fund Managers to domicile products in the UK.

CTCL encourages all operators of UK schemes to read the proposals in detail and for its own part has joined the DATA working groups assessing the impact of the proposed changes. The consultation period ends in October and in future additions of News & Views we will look to discuss specific proposals in more detail. We will also look to discuss with our clients their own views and move forward to assessing the impact on practice and procedural changes which will be required in our clients' and our own operations as we move towards the proposed implementation date of February 2004 with transitional provisions through to 2007.

The current rules are highly prescriptive. They also provide the same level of protection for all consumers - whether retail or non-retail. This often results in share class constructions where retail and non-retail investors sit side by side, not always comfortably. Indeed many of the reviews on other matters such as (swinging) single pricing were partly driven by the need to provide safeguards covering the competing interests of the larger versus the smaller investor.

While some of the existing CIS Sourcebook material is required to implement existing legislation, much is not. In addition to the required "baseline material" prescription has been built up over the years by the FSA and their predecessors. The FSA now propose a "lighter touch" regime of regulation which will give flexibility to fund operators through the definition of fund characteristics within fund documentation rather than a one size fits all generic regulatory standard.

The FSA have stated that the broad objectives of their review were to:

construct a regime of product regulation for CISs that delivers appropriate protection for investors and promotes confidence in authorised CIS products, whilst recognising that consumers are different in terms of their experience and expertise;

remove, wherever appropriate, prescriptive material in the current rules, so as to provide a more flexible framework within which operators can provide CIS products to meet a variety of consumer needs.

The new draft sourcebook has been written with key foundations in mind -

Regulation of Operators

Custody and Oversight

Pricing & Dealing Controls

Appropriate Investments

Investor Engagement & Notification

Through these foundations, many of the key characteristics of the sourcebook remain. There are however a number of key changes suggested and these are discussed briefly below:

Establishment of a regime for non-retail funds -A new regulatory regime is to be established divided primarily into two tiers - retail funds and non retail funds. The proposal is for there to be separate regulation of non-retail funds with less extensive prescriptive regulation, relying more on the general principle of the foundation protections. Non-retail funds would only be open to investors of a certain level of sophistication equivalent to market counterparties and intermediate customers as defined in the COB Sourcebook. Rather than specific investment rules, only a general obligation to appropriately spread risk will exist. Derivative exposure and borrowing to 100% of the fund's NAV would also be permissible. Finally, changes to the role of the Depositary are suggested together with the introduction of a third functionary to each scheme with limited responsibility for oversight of the ACD. The result is to reduce the fiduciary duties of the Depositary.

The continued consolidation of authorised fund categories which started with the introduction of the UCITS compliant "mixed fund" through to the introduction of a "non-UCITS mixed fund" which would replace the current range of non-UCITS fund categories and allow the operation of a wide variety of schemes including property.

A review of scheme governance arrangements concluding that the current model works well for retail funds, but with a different view being taken for non-retail.

Increased reliance on scheme documentation to define the characteristics and running of individual funds with the suggestion that standard model documents will be created to ease the administrative burden of this approach.

To review the need for investor approval so that only significant changes to a fund require their approval. A balance will be attempted to ensure that approval and notification rules remain consistent with the principles of investor protection.

Allow limiting of redemptions for non-UCITS funds in certain instances on the assumption of appropriate investor disclosure. Redemption opportunities could be as infrequent as once every six months with appropriate controls. In addition, deferred redemption provisions may be permitted to allow operators to deal with large or continual requests for redemptions in an orderly manner.

Harmonisation of certain rules for AUTs and OEICs which include allowing classes of units within an AUT (other than income and accumulation), the introduction of performance fees and a wider interpretation of fees chargeable to an AUT.

The proposal that investors receive a report which is more focused on investment progress than accounting information in a short form format.

Amendments to property fund investment restrictions to increase their investor appeal, including the removal of the current 80% immovables limit, reducing property spread requirements and relaxations in the requirements relating to independent valuation.

Removal of the current 2 hour box notification window in favour of a general commitment for AFMs to deal fairly between themselves and customers. In addition it is proposed to give operators more flexibility in deciding the dealing cut-off time in an attempt to avoid the need to estimate creation and cancellation figures before fund prices are established.

Allow fair value pricing and remove much of the prescription regarding the appropriate market price which should be assigned to investments. This approach will be particularly useful for funds where the underlying exchange is closed at the fund's valuation point. Operators will be permitted to assign reasonable prices based on subsequent global market movements and hence protect against fund arbitrage which is becoming an increasing problem.

Relaxation of price publication guidance to reflect today's technology and investor communication methods. Prices would need only to be published "appropriately".

The complete text of the new draft sourcebook is contained within the consultation paper and is intended to follow the life cycle of the fund with the intention of making it clearer and more navigable. The existing sourcebook will not disappear, but will be renamed the "Interim CIS Sourcebook (ICIS). In most cases funds will be able to continue under the current sourcebook until 12th February 2007 in an attempt to mirror the transitional arrangements following the UCITS Product Amending Directive. Until 2007, operators will therefore have the potential to run funds under 3 separate investment & borrowing regimes.

Interim CIS Sourcebook (pre UCITS amendments) - ICIS 5A Interim CIS Sourcebook (post UCITS amendments) - ICIS 5 New CIS Sourcebook - CIS 5

The potential for confusion and error is obvious as are the additional costs and time which will be incurred by all operators. CTCL is particularly concerned in relation to operators who propose fund reconstructions through this transition period as in most cases they will invalidate transitionary concessions and force a move to the latter versions of the Sourcebook almost immediately. We would urge those with immediate plans, particularly for changes prior to the implementation of the new Sourcebook in February 2004 to discuss their particular situation with us. The challenges facing all operators as a result of CP185 are not insignificant, but CTCL generally welcomes the changes suggested by the FSA.

The EU Savings Directive

The Directive, the final text of which was published on 26th June 2003, aims to ensure EU residents cannot avoid or evade tax in their home member state through not declaring income received from investments in another member state. To achieve its objective the Directive requires a system of automatic exchange of tax-relevant information on interest income earned by individuals who are resident in other EU countries. Luxembourg, Austria and Belgium are, however, to be allowed to levy a withholding tax over a transitional period.

It is by no means clear that the Directive will even come into force; its proposed effective date of 1 January 2005 is dependent upon the overseas dependent territories of EU States (including Channel Islands, Isle of Man and some Caribbean islands) agreeing to either automatic exchange of information or to a transitional withholding tax scheme on the same basis as Luxembourg, Austria and Belgium. It also depends on "equivalent measures" being agreed by the Swiss Confederation, Liechtenstein, San Marino, Monaco and Andorra. The European Council will decide unanimously by 30 June 2004 whether or not these conditions have been met. If they have been, the Directive will become effective on 1st January 2005.

Managers cannot, however, have the luxury of waiting until June 2004 to commence preparations for the implementation of the new regime as a significant amount of work is required to be performed before the Directive comes into force. It is clear from the text of the Directive and from the UK Inland Revenue's Discussion Papers (including Discussion Paper 7 in respect of Collective Investment Schemes and the Regulatory Impact Assessment paper) that the Directive will necessitate significant changes both to Managers' systems and to their procedures for gathering customer documentation. Also, it will be necessary for Managers to perform an extensive review of current client documentation.

Whilst many issues need to be clarified before the task of system enhancements can be commenced, some of the developments likely to be required are summarised below.

Investment Monitoring Systems Development

In respect of CIS, the relevant interest payments are "periodic" and "rolled-up" income payments made by "bond funds." Periodic income refers to distributions; the rolled-up income refers to income included in the proceeds of the sale or redemption of units.

'Bond funds' are funds with over a set percentage invested in "debt claims." In respect of "periodic income payments", bond funds are those with more than 15% of the fund invested in debt claims; for, rolled-up income payments, bond funds are those with more than 40% of the fund invested in debt claims (the limit will be reduced to 25% from 1 January 2011).

Investment monitoring systems are, therefore, going to need to be able to identify the percentage of "debt claims" held in funds. However, this may be no easy matter as it is unclear what constitutes a debt claim; in particular Article 15 of the Directive states that "debt claims" do not include debt first issued before, and for which there have been no issues after, 1 March 2002. Will Managers be able to extract this information themselves or will additional data feeds need to be requested from vendors? Will vendors be able to provide such information in a user-friendly format?

It does appear likely that Managers will be able to rely on the fund's investment policy, as set out in the prospectus, as opposed to having to looking at the actual composition of the fund's assets. Nevertheless, Managers will need to have the functionality to consider the composition of the portfolio - if only to be able to ensure and demonstrate compliance with the stated investment policy.

Whilst the Directive does not distinguish between single funds and 'umbrella funds', the Revenue discussion paper makes clear that the Government intends that the scheme will treat each sub-fund of an umbrella fund as if it were a fund in its own right, as is the case currently in UK tax law. This is undoubtedly a welcome move.

Dealing and Registration Systems Development

The Directive requires automatic reporting of the following details:

the identity and residence of the beneficial owner of the payment

the name and address of the paying agent

the account number of the beneficial owner,

details of the interest payment or identification of the debt giving rise to interest

Identity and Residence of the Beneficial Owner

For clients taken on before 1 January 04, Managers need to establish the client's name, address and residence by using the information at his disposal. At minimum, financial institutions will have to go through their existing client documentation, identify the investor's country of residence and ensure that that information is captured in the back office systems so as to enable the reporting requirements to be met.

For clients taken on after 1 January 04, Managers need to establish the client's name, address and tax ID by reference to that person's passport, ID card or other official document. If no tax ID is identifiable, then the client's date and place of birth per their passport or ID needs to be recorded. The individual's residence must be established from passport or ID unless there is a tax residence certificate issued by a third country. To capture this data, Managers may have to revise their current application forms and will have to ensure that the appropriate systems developments are performed to enable the reporting requirements to be met.

Details of the Interest Payment

Whilst the Directive offers the choice of reporting either the interest element in the income payment or the whole income payment, the Government proposes to require reports under the scheme of the whole amount of an income payment or of the full amount of the sale proceeds of units in the fund.

Reporting Format

The Inland Revenue intend to build on the current reporting arrangements in place under sections 17 and 18 of the Taxes Management Act 1970, requiring Managers to modify their current systems to add the information solely required by the Directive. Therefore, the current sections 17 and 18 reports will need to be expanded to require disclosure of country of residence, date of birth, place of birth, tax identification number as well as an "income code" to differentiate between different categories of interest.

Prospectus Updates

The Prospectus will also need to be updated to reflect the new taxation arrangements and also to disclose the fund's investment policy in respect of whether or not it intends to have more or less than 15% and 40% of the fund respectively invested in negotiable debt securities. Also, client application forms may also need to be redesigned to capture the additional client data now required.

Conclusion

Even though it is by no means clear that the Directive will come into force on 1 January 2005, Managers need to start thinking about the impact of the Directive immediately. At the very least, Managers need to scope-out the extent of work required and ensure that budgets, resources and time are available for completion of any necessary customer documentation projects and systems enhancements.

In planning the work required, Managers should also have one eye on the future. The logical next steps would seem to be for the Directive to be extended to cover dividend income and indeed any other type of taxable income and also for bilateral exchange of information agreements to be agreed with other countries outside the EU.

Whilst the Inland Revenue has taken the preliminary view that a competition assessment is not required, Managers should also consider how the Directive alters the competitive landscape. Will the Directive provide a fairer platform for UK financial institutions to compete for EU customers or will it lead to a further flight of capital by private individuals in the 12 information sharing member countries to other territories? The agreement doesn't tackle the ease with which EU nationals can open and operate bank accounts outside the EU.

The Inland Revenue has requested feedback by 22 August 2003. The IMA has asked its members for feedback by the 1st August so that this can be collated and passed on to the Inland Revenue.

UCITS III Derivative Risk Management Process

Implementation of CP135 (the FSA's interpretation of UCITS III) offers an alternative to the established efficient portfolio management (EPM) regime for AIFs. Provided there is a clear statement in the prospectus describing the extent to which the facility may be exercised, a scheme within the new environment may use derivatives as an integral part of an ongoing investment strategy (there is no longer the restriction to temporary transitional, hedge or arbitrage strategies).

There remains the requirement to 'cover' underlying asset 'exposure' arising from derivatives within the scheme. However, the need to assign 'appropriate' assets for this purpose has been moderated to an aggregated 'global' need for 'adequacy' - assessment will reflect issues such as asset price correlation and holding liquidity. Exposure is redefined as the aggregated direct and contingent obligation to other parties (beyond the control of the scheme manager) including any forward (or futures) transactions or the selling (or writing) of options. Notably, buying of an option or warrant only exposes the initial outlay / premium (and not the underlying asset value, though such indirect investment is to be calculated and aggregated for investment spread limit monitoring).

Similarly, short-selling is disallowed where obligations to deliver cannot be met (CIS 5.2.24); short option positions may be permissible, though (CIS 5.2.22(5)) disallows any transaction with the intended effect of creating the potential for uncovered sales. There is a concession in this respect to derivatives of relevant indices (CIS 5.2.33).

A Manager's Risk Management Process should be commensurate with the complexity of the investments and strategies employed for a scheme and should be detailed to the FSA. As part of our duty of oversight, CTCL is required to review the operation of and determine an opinion as to the suitability of such processes and systems to be employed, in advance of their implementation. The range of techniques and strategies to be employed in schemes will be relevant and are likely to have a significant influence on a scheme's risk rating. It is relevant to note here that there is a recently released (joint IMA, FOA, DATA) industry document 'Risk Management Process: Guidelines For UCITS Managers' that may serve as a reference document. This document has received support from the FSA and can be found on the DATA and IMA websites.

To enable the Depositary to assess the adequacy of cover and compatibility with the wider investment objective of the fund we believe that it would not be desirable to continue with the current EPM arrangements, i.e. on a transaction by transaction basis, and rather we therefore propose that we will request an explanation for a transaction if it is not immediately obvious to us on the basis of previous fund activity. In other words, on a technique by technique basis.

CTCL will continue to adopt a pragmatic approach to our monitoring of derivative investment within our schemes. We also expect that this new flexibility for scheme investment will perhaps lead to a fundamental and broad review of portfolio management techniques within AIFs

OEICs - Corporate Housekeeping

A number of our clients have converted their unit trust ranges into OEICs during the last couple of years and this process has led to some general questions concerning corporate governance and the roles of the respective parties. Some of the questions and our responses are reproduced below for your information.

What is the role of the Company itself as a corporate entity?

The Company is a separate legal entity, but it is essentially a vehicle for collective investment and beyond that its role is in practice very limited. The Depositary is appointed to hold the property of the Company, and the ACD is appointed to operate the Company. There are certain requirements that the Company must fulfil to become authorised. For example, the Instrument of Incorporation must comply fully with the requirements of the Open-Ended Investment Companies Regulations 2001 (the "OEIC Regulations") and the Collective Investment Schemes Sourcebook of the Financial Services Authority (the "CIS Sourcebook"). The Company may execute documents and, at a minimum will enter into agreements with its Depositary and ACD.

When does the Company have to hold its AGM?

Under Regulation 37 of the OEIC Regulations, the Company is required to hold an annual general meeting ("AGM"). It should be noted that if the Company holds its AGM within 18 months of the date of its incorporation, (important distinction from the date of its launch - if a new OEIC) it does not need to hold any other AGM in the first two years after its incorporation. After this, not more than 15 months should elapse between the date of one AGM and the following one.

What matters should the AGM cover?

The OEIC Regulations set out a number of matters that must be considered at the AGM. These include the appointment of any subsequent directors (including a new ACD), which require ratification by a shareholder's resolution at the next AGM following appointment. A copy of any director's service contract (including the ACD Agreement) must be available for inspection at the AGM and the ACD must also lay copies of the annual report before the Company at its AGM. The auditors of the Company should be appointed at the AGM and their remuneration fixed (the first auditors hold office until the first AGM, at which time their appointment may be approved/ratified). There is nothing in the OEIC Regulations or the CIS Sourcebook to prevent other matters being considered by the AGM, although there are no further statutory requirements as to what should be considered. CTCL will attend every AGM and all other shareholder meetings including those called under the circumstances below to oversee the interests of shareholders.

What are the other occasions on which the Company might need to hold formal meetings?

In addition, the CIS Sourcebook sets out a number of occasions on which it will be necessary to call a shareholder's meeting (or sub-fund or class meeting where appropriate) - see below.

The ACD may convene a general meeting of shareholders at any time (subject to the requirements for notice of meetings set out in Regulation 11.2.3 of the CIS Sourcebook).

The ACD must also convene a meeting no later than 8 weeks after the receipt of a requisition for a meeting signed by shareholders who at the date of the requisition are registered as holders of shares representing not less than one tenth in value of all the shares in issue at that date.

Changes to the Instrument of Incorporation

Under Regulation 21 of the OEIC Regulations, any change to the Instrument of Incorporation of the Company should be notified to the FSA. It will also be necessary in a number of cases to call a meeting of shareholders to sanction the change. Subject to certain exclusions, the occasions when changes can be made without a shareholders' meeting are set out in Regulation 11.4.4(4) of the CIS Sourcebook and include changes to implement any change in the law, a change in the name of the Company and a change to remove obsolete provisions from the Instrument. There is also a provision allowing a change to be made without notice if, in the opinion of the ACD, it would not involve any holder or potential holder in any material prejudice. In other cases a shareholders' meeting will be required.

Changes to the Prospectus

These are required to be notified to the Financial Services Authority (the "FSA") if they are deemed to be "significant". Under Regulation 3.4.2 of the CIS Sourcebook, certain changes to the Prospectus of the Company will also have to be approved by an extraordinary resolution of shareholders. These include changes to the investment and borrowing powers of the Company, changes to increase the ACD's maximum rate of remuneration, changes to payments made to the ACD, unless they are of minimum significance, changes to the payments authorised to be made out of scheme property and amendments to the dilution policy.

A Scheme of Arrangement

This will be entered into where it is proposed that the property of the Company is to become the property of another regulated collective investment scheme. The proposal must not be implemented without the sanction of an extraordinary resolution of shareholders in the Company. Similarly, if it is proposed that the Company should receive property from another regulated collective investment scheme pursuant to a scheme of arrangement, the proposal must not be implemented without an extraordinary resolution of shareholders being passed, unless the proposal is not likely to result in any material prejudice to existing shareholders, is consistent with the investment objectives of the Company and could be achieved without a breach of Chapter 5 (or Chapter 5A, as applicable) of the CIS Sourcebook.

What are the primary roles and responsibilities of the ACD?

Under Regulation 7.3.1(2) of the CIS Sourcebook, the ACD must carry out such functions as are necessary in order to ensure compliance with the rules in the CIS Sourcebook that impose obligations on the Company or the ACD. Although Regulation 7.3.1(3) provides some examples of the duties that will be imposed on the ACD, it does not restrict Regulation 7.3.1(2).

Matters that are the responsibility of the ACD include ensuring that the scheme property is invested in accordance with the investment objectives of the Company, taking all reasonable steps to ensure that the shares in the Company are priced in accordance with the provisions of Chapter 4 of the CIS Sourcebook and taking any steps to correct incorrect pricing and arranging any reimbursements or payments that must be made to rectify such errors.

The Key Features Document of the Company should be drawn up in accordance with the relevant rules and its contents should be reviewed regularly to ensure continuing compliance with these rules.

Preparation of the annual and interim report and accounts is also the responsibility of the ACD and should be prepared as set out in the SORP.

However, outside the specific duties set out in the CIS Sourcebook, the ACD should always keep in mind the general obligation on it to ensure compliance of both itself and the Company with the provisions of the CIS Sourcebook and the OEIC Regulations 2001.

On which occasions should the ACD hold formal board/director meetings to minute decisions in relation to the Company?

There is no requirement as to when the ACD should minute decisions it makes. However, a sensible approach should be taken in the light of the general record keeping requirements imposed on the ACD. These are that the ACD must make and retain such accounting and other records as are necessary to enable the Company to comply with the OEIC Regulations and the provisions of the CIS Sourcebook and to demonstrate at any time that such compliance has been achieved. These records must be available for inspection by the Depositary on our compliance monitoring visits.

The new Statement of Recommended Practice (SORP) for Authorised Funds

As readers will be aware it has been three years since the OEIC SORP was produced and the Authorised Unit Trust SORP has not been reviewed for almost seven years. Therefore, the Accounting Standards Board (ASB) has authorised the IMA to form and oversee a working group of interested parties with the aim of producing and issuing an updated SORP for the Authorised Funds Industry. In this regard the IMA have recently issued an exposure draft of the new SORP for the Authorised Funds Industry inviting comments from the industry by 18th August.

In summary;

the new SORP combines the two existing SORPs into one;

it is expected that the CIS Sourcebook will be updated to require adherence to the new SORP when issued;

the proposal (and current timetable) is that funds with accounting periods beginning on or after 1 October 2003 will adopt the new SORP;

the draft exposure suggests updates to disclosure requirements on the use of derivatives - to reflect the wider use of derivatives now possible under the amending UCITS Product Directive; the draft exposure suggests that the accounting treatment of income on debt securities issued at a premium be brought into line with the treatment of income on debt securities issued at a discount;.

the earlier concession allowing the continued amortisation of initial set up cost (appropriate where amortisation had already commenced) - is to be withdrawn;

guidance is given on the accounting treatment surrounding 'guarantees' on 'guaranteed' funds and

clarity is improved in the following areas - special dividends, contingent liabilities, discounted securities, zero dividend preference shares, FRS16, allocation of derivative income between capital and income.

It should be noted that with effect from 1 January 2005 EU Regulation requires all listed companies to prepare their accounts in accordance with international accounting and reporting standards. However, as it is still unclear whether and to what extent this will apply to other entities, the draft SORP has not been drawn up in accordance with International Accounting Standards (IAS). This is because the draft SORP cannot pre-empt accounting standards but this is not seen as a major problem given that the IMA have given a commitment to make regular reviews of the SORP going forward. Nevertheless readers may be interested in the following article about IAS kindly provided by Davis Barnes and Jamie Partridge of Deloitte & Touche which highlights changes that they believe may be on the horizon in respect of accounting for Authorised Investment Funds.

IAS - General Corporate Accounting Issues - Potential Relevance to Schemes

(Guest article by David Barnes and Jamie Partridge, Deloitte & Touche)

2005 is likely to bring the biggest one-off change in accounting requirements. From 1 January 2005, consolidated financial statements of all companies listed in the EU must be prepared under International Accounting Standards ('IAS'). Those affected will need to prepare 2004 comparatives under IAS, bringing the impact of IAS even closer. Furthermore, from 2005 all UK companies, or unlisted groups, will have the option of preparing accounts under IAS or UK GAAP from 2005.

Mandatory application of IAS does not extend beyond consolidated accounts of listed companies. But, as the UK Accounting Standards Board has signalled its intent to converge UK GAAP with IAS, and with similar debates occurring in other European countries (and even the US), it seems certain that investment funds will be affected.

IAS has been chosen by the EU as a means of eradicating differences in financial statements prepared in different jurisdictions, facilitating cross-border investment and increasing transparency in the capital markets. Though IAS is only currently applicable to certain companies it is probable that many pan-European fund providers will chose to adopt IAS to facilitate international comparability and enhance cross border marketing of their funds.

The International Accounting Standards Board ('IASB'), the standard setting body, was established in April 2001 and replaces the old International Accounting Standards Committee. The IASB consists of twelve full-time and two part-time members with a range of back-grounds, including auditors, financial statement preparers and users. Their initial goal is to gain acceptance of IAS by multinational companies for cross border capital raising while the overall aim is to have all large businesses worldwide preparing financial statements under a common set of global accounting standards.

At the moment there are 41 international accounting standards, though not all of these will have an effect on the fund management sector. Specific examples of significant changes arising from IAS and which will affect investment funds include:

All investments must be designated Available for Sale, Held for Trading, Originated Loans and Receivables or Held to Maturity with a different accounting treatment applying to each category of investment. The categorisation of all financial instruments will need to be considered individually.

Investments will be valued on a bid basis, rather than at mid market as is currently the case.

Embedded derivatives - a derivative that is embedded within a host instrument must be accounted for separately under IAS 39 if its economic characteristics and risks are not closely related to those of its host. Many convertible bonds have embedded derivatives, so it is not necessarily only exotic investments that are affected by this requirement.

Hedge accounting criteria will be more stringent. Formal hedging documentation of inception of the hedge will increase the cost of compliance.

Changes to the format of the primary statements for company reporting - the P&L account (or, for many funds, the statement of total return) will be replaced by the Income Statement. The Statement of Total Recognised Gains & Losses will be lost with the items that previously flowed through this now going to either the Income Statement or to equity.

Many financial instruments, such as preference shares, will be treated as debt rather than equity, potentially impacting gearing and reserves.

Dividends, or distributions, declared post year-end can no longer be accounted for in the previous financial period. This increases the need for effective dividend planning.

The impact on investment funds will primarily depend on the structure (e.g. life, open, closed etc.) and the financial instruments held. The change in investment valuation from mid to bid will mean a decrease in the net asset value of the fund and the increased requirement to present fair values of many financial assets and liabilities, especially derivatives, will mean increased volatility. Management will also need to consider whether, if IAS is used for financial reporting, pricing continues to be performed under UK GAAP. It will be important to manage investor expectations through this process, ensuring the customer understands the changes.

IAS is likely to increase volatility in financial statements. More items will be fairly valued with gains or losses going through the Income Statement. Effective management will be essential throughout any IAS transition. Management needs to consider the impact of IAS on earnings, the cost of compliance and transitional issues such as managing operation risk, systems requirements and relationships with stakeholders.

The changes necessary will impact systems, operations, staff remuneration, investor relations and banking relationships. Management can begin to understand the impact on their business through high-level impact analysis, followed strategic assessment and implementation but these processes are time consuming and with barely 18 months remaining, the time to consider these is now.

David Barnes is a senior partner in Deloitte & Touche Investment Management Group based in London. E-mail: djbarnes@deloitte.co.uk Tel: 0207 303 2888

Jamie Partridge is a manager in Deloitte & Touche based in Glasgow and specialises in providing services to the investment management industry. E-mail: jpartridge@deloitte.co.uk Tel: 0141 314 5956

If you have any comments or questions in respect of this article or would like any further information on IAS please contact David or Jamie.

CP 176 - Unbundling: a better deal for the investor?

In publishing CP176 - Bundled Brokerage and Soft Commission Agreements, the FSA declared that:

"Our proposals will benefit consumers by ensuring that Fund Managers acting on their behalf have stronger incentives to obtain value for money, and to put in place dealing arrangements that clearly operate in the best interests of retail as well as institutional funds."

Since the release of CP176, a multitude of articles have appeared concerning the potential impact of the proposals on Fund Managers. This article, however, considers the impact on investors and, in particular, whether, as claimed by the FSA, the proposals will benefit the investors in the funds.

Three possible benefits to the investors are considered below:

1) A reduction in the types of fees charged to the funds.

The FSA has described the current fee structure whereby additional services such as research and market technology are bundled with dealing costs and charged to the funds as "a system in which costs are opaque and accountability to fund management customers is deficient."

These additional bundled costs (approximated by the FSA at c. £0.9bn per annum) are currently a real cost to the funds and, therefore, to the investors as they impact on investment returns. However, it would surely be naïve to predict that these proposals will lead to investors saving £0.9bn per annum. It is unlikely that once these bundled costs have been identified and costed, that Managers will suffer all of these costs themselves and, therefore, the argument that improved investment returns for the funds will then ensue from the lower costs, may be weakened.

What perhaps is more likely is that, whilst the opaque may be replaced with transparency, Managers may, through shareholders' meetings, obtain the required permissions from shareholders to pass on some of the costs to the funds, possibly including research and market technology. Although the FSA are contemplating proposing that market technology costs should no longer be able to be supplied under soft commission arrangements, it is not being suggested that such incurred costs will not be allowed to be charged to ICVCs.

In this respect, one implication of CP176 may be to hasten the move by Managers to convert from unit trusts to ICVC's in order to take advantage of the more flexible regulatory provisions as to which costs can be borne by the fund.

2) Improved research leading to better investment decisions and improved fund performance

The argument proceeds that once Managers cost out exactly how much of the bundled costs relate to research, they will consider whether those costs represent good value for money, will no longer pay for poorer quality research and will instead look to high quality research including from those smaller specialist research houses which currently find it difficult to compete on a level playing field.

It seems a natural consequence of the above that, in addition to leading to improved competition, that after analysing research costs, Managers would seek out higher quality research that will in turn lead to improved investment decisions and fund performance.

However, there is an unsettling assumption, inherent within the above proposition, that much of the research currently being provided by the investment banks is of little value and would not be paid for if those costs were not bundled as at present with dealing costs.

3) More competitive trade execution prices

Having split out the cost of dealing from other services, it is reasonable to expect that Managers will make appropriate comparisons of dealing costs within the industry and then migrate to those brokers who can provide them with the lowest dealing costs. Generally this is going to be to the larger investment banks who are able to take greatest advantage of economies of scale.

However, in this respect, the possibility of cost savings rests on the assumption that brokers margins can be squeezed yet further than they are at present.

Conclusion

The opaqueness of softing arrangements and bundled commissions within the industry has led to a suspicion that the underlying customers are being disadvantaged by the current regime through an element of double charging for research and other non-dealing services provided by brokers. It is recognised that greater transparency will bring some benefits to investors; i.e. better quality research and likely lower dealing costs as greater transparency will encourage more scrutiny and comparison with subsequent migration to those brokers with the lowest dealing costs and the research houses with the highest quality research. Nevertheless the overall cost savings to the fund and therefore investors may not be as high as envisaged by the FSA because it is possible that AFMs may try to pass on some of the unbundled costs to the fund.

The industry has until Friday 10th October 2003 to respond to CP176, further to which a second consultation paper is expected to be published in quarter 4 2003 setting out proposed changes to the FSA Handbook.

SDRT and OEIC Mergers

The IMA has recently stated that it has received confirmation from the Inland Revenue that it is content to regard mergers of single OEICs and mergers of OEIC subfunds as transactions that do not give rise to a charge to SDRT under section 87 Finance Act 1986.

Readers will be aware that an exemption is already in place in respect of AUT mergers into an OEIC and for the conversion of an AUT into an OEIC. Readers will also be aware that the Save and Prosper ruling that disallowed the SDRT charge was primarily concerned with a mergers of AUTs. The industry therefore leaned to the view that if AUT mergers were exempt from SDRT so should OEIC mergers, however the Inland Revenue previously had not subscribed to that view as it believed that there were enough differences between AUTs and OEICs to prevent the Save and Prosper case forming a precedent for OEIC mergers.

The Inland Revenue's change in stance follows recent legal advice received by it which indicated that it's pobability of success in any litigation challenging SDRT liability on OEIC mergers would not be sufficient to justify proceeding. However, the IMA are continuing to seek a statutory footing for this relief and managers would still be well advised to seek legal advice in respect to mergers of OEICs, and reorganisations generally as the legal advice received by the Revenue was based on the facts of the Save and Prosper decision and the particular case opined on.

CTCL are seeking more extensive and detailed legal advice in respect of the liability to SDRT in the various different OEIC reorganisation or merger scenarios that may arise. Managers who would like to discuss their own reorganisation plans and the potential SDRT liability should contact Steve James of CTCL on 020 7500 8309.

Problems for Managers of Funds of Funds-HN24

One of the miscellaneous FSA Handbook amendments detailed in the recently issued Handbook Notice 24 (HN24), threatened to have an important impact on the management of Funds of Funds Schemes. It appeared that after 1 September 2003 a fund of funds may not be able to invest in both a CIS5A securities scheme and a new CIS5 mixed fund scheme.

In order to maintain product distinctiveness a fund of funds has, through regulation, been restricted to investing in 'target' funds which all fit into the same fund category. This regulation within the CIS Sourcebook has been 'updated' to include the new UCITS III category of mixed fund (CIS 5) as another one of the fund categories that a fund of funds can invest in. However, as before target funds can still only be selected from one category. The only exception to the rule is that money funds may be combined with any other category if desired.

At face value this presents a problem for a fund of funds investing in old style CIS 5A securities schemes whenever any of their target funds convert into a mixed fund. i.e. a new category of funds, as two categories of funds (with the exception of money market funds) can not be held within a fund of funds. Furthermore it will be difficult to monitor target funds to discover their intentions in respect of UCITS III conversion.

However, we understand that the FSA has acknowledged unintended consequences of the amendment as drafted and are looking to find a solution which, when found, is likely to be released through the IMA. Furthermore our understanding is that the FSA will not expect Managers to implement an on-going process to monitor target funds to determine which investment category they belong to i.e. UCITS mixed fund or CIS 5A securities fund.

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.

Contents

Citicorp Trustee Company Limited September 2003

Citicorp Trustee Company Limited
September 2003