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Citicorp Trustee Company Limited; December 2003

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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	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
Dave Morrison	020 7500 8021

Contents

Time Zone Arbitrage

Late Day Trading

Multi Manager Funds

Impact of the UCITS III management directive on the UK fund management industry

Sean Quinn
Managing Director
Citicorp Trustee Company Limited

Welcome to the December edition of the Citigroup Trustee Company Limited (CTCL) News & Views. 2003 has been another busy year for us at CTCL and the industry itself. Unit Trust to OEIC conversions continued apace, and in February a cross over point was reached when, for the first time, more than half of the funds in our care were OEICs. This trend has continued and that figure now stands at 70%. In total, CTCL has now been involved with the conversion of over 200 Unit Trusts since 1998.

2003 also brought with it an increased activity in fund mergers reflecting the trends of fund range and management company consolidation. This trend looks set to continue into 2004 with CTCL working with a number of our clients in relation to mergers and the consolidation of ranges through the introduction of Multi Manager products. CTCL has developed a number of guides and presentations relating to merger and conversion activity. Please feel free to contact any one of our team should you wish to involve us in your future plans.

This was also the year that "CP 185 - The CIS Sourcebook - A new Approach", hit all our desks, billed as the most substantial overhaul of fund regulation for many years, a fact that is certainly hard to deny. CTCL, along with other practioners have broadly welcomed the proposed changes and opportunities they potentially create, particularly in relation to non-retail funds. Our industry body, the Depositary and Trustee Association (DATA), has reviewed the proposals in great detail. So much so, that at our annual dinner last month, it was commented that DATA's response was actually longer than the Consultation Paper itself!

While in agreement with the majority of suggested changes, CTCL retains two key concerns which have been communicated to the FSA; firstly, the proposals to create a new functionary in relation to non-retail funds, namely, the "oversight" function. CTCL strongly believes that the specific permissions to act as Trustee or Depositary together with significant capital requirements are key to investor protection. The proposed rule changes introduce a super equivalence in relation to the second fiduciary role between current providers such as CTCL and other regulated firms. This together with dramatically reduced (although yet to be fully defined) responsibilities of oversight cannot, in our view, benefit the protection offered to investors. We have therefore sought clarification from the FSA on this point. Irrespective of this discussion, CTCL plans to offer the oversight function for the new non-retail funds regime as it becomes fully defined.

The second concern relates to the recent industry issue of "Spitzer". The UK industry, regulator and press are now asking the awkward question - "has it, or could it happen here?" A number of articles around this subject are included in this edition. The general industry consensus in answering that question seems to be that whilst it may be happening, compared to the US, there are barriers preventing such widespread abuse; these barriers include, for example, bid / offer spreads on unit trusts, dilution provisions for single priced OEICs and the 2 hour box notification window. Only time will tell if these assumptions are correct.

However, CP 185, which has at its core the admirable aim of simplifying the CIS Sourcebook and replacing prescription with principle, is proposing the removal of the 2 hour requirement (one of the key controls in the prevention of market timing / arbitrage abuse of funds) and its replacement with a commitment to treat customers fairly and equally. CTCL has responded to the FSA consultation by requesting that the 2 hour window for Unit Trusts remain and also that a corresponding provision be formally imposed in relation to OEICs as an added protection.

In addition to the articles on potential abuses within mutual funds, this edition of News & Views also includes a timely article on multi-manager funds and an article on the Management Directive which has been provided by Tim Herrington and Jeremy Stevenson of Clifford Chance.

I hope you find this quarter's News & Views interesting. Should you wish to make suggestions for future content or know anyone who would like to receive a copy then please let us know by telephoning one of the numbers on the last page.

TIME ZONE ARBITRAGE

"Scope for market timing operations always exists where a fund is invested in markets that are closed at the valuation point. Although market timing is not illegal it can dilute the fund values to the detriment of investors."

The above words are those of the FSA, provided as an explanatory cover note to a questionnaire it has sent to some FSA regulated fund managers enquiring about their dealings with and their susceptibility to market-timers. This is the FSA's initial reaction to the reported abuses which are currently being investigated by Elliot Spitzer, Attorney General of New York.

In order to gauge the extent to which there is a risk in the UK and to identify which funds are most at risk it is worth looking at the key features of these practices.

Is the market closed at the time the UK fund is being valued?

Firstly, market timing is going to be relevant to funds invested in overseas markets which are closed at the time the UK fund is being valued; for example, a UK regulated US Growth Fund being valued at 12pm GMT. The US stocks in that fund are being valued at the closing price in the US, some fifteen hours or so before the UK valuation takes place. Therefore, any news that was released in respect of those US stocks after the US market closed will not have been factored into the price at which the UK fund is being valued. The investor who knows what stocks are being held in the portfolio and who watches for news on those stocks can make a reasoned decision as to how the price of the stocks and hence the fund are going to be priced the following day. Therefore, for example, if they believe the value of the stocks and therefore the fund are going to increase, the investor can buy into the fund at a price that has not factored in the good news and then next day can sell out at the increased priced if the market has not moved downwards.

When are company announcements made in the overseas market?

It follows on from the above that the international funds most susceptible are those, like the US, in which, company announcements are made after the market closes. Funds invested in other markets (such as the UK), in which company announcements are made at opening, or throughout the day, are not exposed to the same level of threat from market timers.

By way of example, if a "bellwether" stock such as IBM was due to report earnings at the end of the day, the results announced are likely to have a significant impact on market sentiment in the US the next morning and possibly also on markets around the globe. To have access to this type of information and still be in a position to deal in funds which have been priced based on the price of stocks prior to release of that information is a clear advantage.

What is the spread on the fund price?

In order for market timing practices to succeed, investors need to be able to come in and out of funds quickly and cheaply. The obvious point to make, therefore, is that single priced funds will be much more attractive than dual priced funds as they have no spread. The absence of spread in the price means that there is no need for the market-timer to restrict their activities to funds invested in equities listed or in stocks on the world's largest and most liquid markets in order for this practice to be worthwhile.

In dual priced funds, the bid / offer spread of the fund is in effect a hurdle rate which the investor must be able to exceed if he is to benefit from market timing practices. Therefore, those funds with the lowest spreads will be much more attractive to the market timers. Funds investing in equities listed on the world's largest and most liquid markets will typically have the lowest spreads and are therefore more susceptible to the market timers.

What is the policy on dilution?

The statement that single priced funds will be much more attractive than dual priced funds is subject to the caveat that in order to best be able to profit, the market timer will need to avoid incurring a dilution levy or adjustment. Therefore, a single-priced fund which imposes a dilution adjustment each day, depending on whether there is net level of creations or cancellations, will be a much less attractive target (in effect it is dual priced) than the fund which does not apply a levy or adjustment or only does so in extreme circumstances which the market-timer can reasonably expect to avoid.

What are the initial dealing costs?

Again, in order for market timing to be worthwhile for the investors, the return obtainable from the practice must exceed the costs incurred in the dealing activity. Therefore, the funds most at risk will be those which have either low initial fees or in which the manager routinely waives or reduces the initial fee payable by large investors who could possibly seek to take advantage of market timing.

The FSA's approach

As stated above, market timing depends on investors being able to come in and out of funds in large volumes and at short notice. This coming in and out of the funds in large volumes is going to manifest itself in high levels of both sales and redemptions – a curiously high level given that the fund is probably relatively stable if invested in equities listed on the world's largest and most liquid markets.

In its questionnaire, the FSA has gone further than simply identifying the causes of the problem (although it has also identified International Equity funds as being those most at risk), and is attempting to identify actual cases of market timing by looking at the above symptoms of the problem. They have, therefore, asked managers to disclose the level of sales and redemptions in their five biggest international equity funds since the start of this year. The firms are also expected to disclose sales and redemptions worth more than £100,000 in all their funds, including the names of clients. As a benchmark, it is worth noting that a recent Financial Times article identified that there are 29 global and international funds that last year had both sales and redemptions of more than 100 per cent of the fund's total assets.

Fair value pricing

One aspect of CP185 which does mitigate against the risk of market-timing abuses is the introduction of the scope for fair value pricing. Explicit guidance from the FSA is awaited in respect of how and when managers will be able to apply indexation or other techniques when pricing funds where the underlying stocks trade on markets which are closed at the valuation point. It will be interesting to see whether, in light of the attention currently being paid to market timing activities, managers will in some circumstances be specifically required to fair value price as opposed to simply having the option to do so.

The Impact on Managers

Given that there is a risk of such abuse in the UK, there is an onus on AFMs to develop (where they do not already exist) controls, systems, tests and monitoring procedures that are designed to identify and act against market abuses of this nature, to protect existing investors within funds and to ensure compliance with the regulations. The reviews which managers will have had to perform in order to respond to the FSA's questionnaire will provide a useful basis to develop from.

Managers who facilitate market-timing practices should also beware of the recent activism shown by investors in the US who have reportedly turned away from funds managed by a number of those managers who have been named by Spitzer in the course of his investigations.

Conclusion

Whilst this practice is not illegal, in the post-Enron world of higher standards of integrity the spotlight has now fallen squarely on market timing and the moral case against it. The practice is objectionable because it offers the potential to short term traders of funds at the expense of the long term investor. The cost to long term investors across the globe has recently been estimated at $5bn per year.

In our role as depositary, CTCL will be discussing with managers the controls and monitoring processes that form current industry best practice and which are being employed to minimize the susceptibility of funds to market timing activities.

We will also continue to call, independently and through DATA, for changes to the regulations to clarify the responsibilities of the manager and the Trustee / Depositary in respect of trading designed to take advantage of market timing and also for clarification of the circumstances in which the manager becomes obliged to fair value account for the assets within the fund.

LATE DAY TRADING

It is has been alleged that some hedge funds in the US have been able to trade in mutual funds after their valuation point and after the market close, but by obtaining the fund price already determined rather than taking the forward price to the next valuation point. This practice enables the hedge funds to exploit market information not known at the valuation point. The belief is that this practice is carried out with the collusion of fund managers, who in return may earn 'soft' fees at the expense of smaller, long-term investors who suffer dilution within the fund.

There are a number of similarities with the issue of market timing discussed in the previous article –both practices have been highlighted through the investigations by Elliot Spitzer into mutual funds and both rely on investors being able to come in and out of funds quickly and cheaply in large volumes. There is, however, a crucial difference. Whilst market timing activity is not illegal on either side of the Atlantic, late day trading is illegal in the US and, in the UK, these practices would fall foul of the CIS regulations.

Could it happen in the UK?

As in the previous article, it is again worth attempting to identify those funds which are most at risk and, as with market timing, the first comments that can be made are that the spread in the fund price, the policy on dilution and the initial fees charged are all key issues in considering whether a fund offers an opportunity for this type of abuse. However, to understand the substance of the issue, it is perhaps worth looking at a number of different scenarios comparing the US market and the UK market.

A US mutual fund investing in US stocks

One of the key features of the US market which facilitates late-day trading is that, whilst the fund is valued at 4pm at the close of the market, after the market close there may be a number of company announcements in respect of the stocks in which the fund is invested. The late-day trader can therefore assess the impact this news is going to have on the price of the fund. If he believes the fund value will go up, he can buy into the fund at the unadjusted price and if he feels the fund will decrease in value he can sell out of the fund at the unadjusted price.

A UK regulated fund investing in UK stocks or in markets which are open at the valuation point

Whilst, unlike in the US, company announcements are made during the day, the scope for late day trading remains as most funds value between 10 am and 2pm, typically at 12pm. The late day trader can therefore take advantage of news that emerges in the market after the valuation point. However, one of the key features of the UK market is the requirement to notify the Trustee of any creations or cancellations within two hours of the valuation point; this effectively reduces any opportunity for abuse against the fund to a maximum of two hours. Of course, there would still be scope for abuse in respect of any units or shares held in the manager's box – a manager could theoretically be prepared to offer up shares held in his box to a late day trader late-day in return for the expectation of winning further business; this too would undoubtedly fall foul of the regulations.

A UK regulated fund investing in stocks in markets which are closed at the valuation point

It follows from the above that in many cases there will be little incentive for late day trading in funds which invest in markets which are closed both at the fund's valuation point and at the point when notifications of creations and cancellations are made to the Trustee. Take for example a UK fund which invests in US equities. If the fund is priced at 12pm and details of creations and cancellations are advised to the Trustee by 2pm, then late-day trades would only be of advantage to the late day trader if there were any emerging news in the US between 5am and 7am EST. However, whilst late-day trading may not be such a risk in these funds, the risk of market-timing remains, as discussed in the previous article.

The FSA's Approach

In the week before the news of the Spitzer investigations emerged, the FSA sent a questionnaire to some management groups which examines a number of aspects of how managers performed the valuation of funds. Whilst it is unclear whether the timing of this questionnaire was simply coincidence, it is likely that the FSA will be able to use the responses in order to gauge the susceptibility of the UK market and of particular management groups and funds to late-day trading activity. The questionnaire also considers whether the pricing and transfer agency roles are performed in-house or by third party administrators –presumably with the implication that the managers most at risk are those who perform all activities in-house, as otherwise they require the collusion of third parties in facilitating late-day trading activity.

Regulatory change

As stated above, one of key protections in the UK market against late-day trading is the two-hour notification requirement for creations and cancellations. It is very important to note, therefore, that this rule actually only applies to Unit Trusts. There is no such requirement in respect of ICVCs and it is the Depositaries themselves who are currently requesting that managers comply with a two-hour window notification period in respect of ICVCs. With hindsight, it seems unfortunate that the draft regulations in CP185 actually remove the two hour window in respect of Unit Trusts in order to bring Unit Trusts into line with ICVCs where the two hour window does not apply.

Another proposal within CP185 which arguably weakens the current regime and introduces greater risk of such abuses happening within UK regulated funds is the proposal which expressly permits AFM to take into account sales and redemptions after the valuation point.

The Impact on Managers

Whilst the incentives and profit potential from such abusive strategies are much higher in the US as a consequence of the way the US market functions, there is indeed some potential for late trading and market timing in the UK, albeit that it is currently confined to a two-hour window.

Given that there is a risk of such abuse in the UK, as with market-timing, there is an onus on AFMs to develop (where they do not already exist) controls, systems, tests and monitoring procedures that are designed to identify and act against market abuses of this nature and to protect existing investors within funds and to ensure compliance with the regulations.

Conclusion

It is apparent that while the FSA is attempting to reduce the level of prescription in regulation, there are certain circumstances where the majority of investors would benefit from the opposite approach, something that Spitzer is beginning to highlight. CTCL has raised this subject with the FSA both independently and through DATA, our industry body, to ensure that the ramifications of these changes are fully understood.

MULTI MANAGER FUNDS

Multi Manager funds are becoming increasingly popular, scarcely now does a weekend pass without press comment of some description. Indeed within our client base we now have 13 unit trusts and 28 OEICs established for this purpose.

In this article we consider the respective structures of the two variations of Multi Manager Funds available – the Fund of Funds and the Manager of Manager schemes. We also review some of the practical issues which the ACD will have to consider in deciding upon whether to launch a Fund of Funds or Manager of Manager schemes.

What are Multi-Manager funds?

Multi Manager funds are an investment vehicle set up for the purpose of investing in other collective investment schemes. There are two different varieties of multi-manager funds – the well known Funds of Funds variety and the less well known Manager of Managers schemes. The common feature of both schemes is that they are attractive to the investor who wishes to gain exposure in a single CIS product to the expertise of more than one fund manager. An overview of each is set out below.

Overview of Fund of Funds Structure

Funds of Funds invest directly in UK-registered unit trusts or OEICs. Whilst for securities schemes there is a restriction that not more than 5% in value of the scheme property is to consist of transferable securities which are units in collective investment schemes, there is no such restrictions for Funds of Funds. For these the scheme property must generally only consist of units in regulated collective investment schemes, although not more than 20% in value of the scheme property should consist of units in any one regulated collective investment scheme.

Overview of Manager of Managers scheme

Rather than buying commercially available ready made unit trusts and OEICs as is the way with Fund of Funds, Manager of Managers funds employ specialist investment firms to run bespoke segments of a fund.

Each sub-fund may have any number of Investment Managers each working to the same overall investment mandate and with each being allocated new creation monies according to a predetermined ratio e.g. 40% to Investment Manager A 25% to Investment Manager B and 35% to Investment Manager C. The managers of each portion of the assets could be exclusively externally appointed or could be a mixture of internal and external management.

ACD's Considerations

Below we identified a number of matters that an ACD would need to consider when deciding on whether to launch a Fund of Funds or a Manager of Manager Fund.

Regulatory regime

Fund of Funds can be established as CIS 5A Non-UCITs Fund of Funds or CIS 5 UCITs Mixed Funds. A number of groups have elected to set up as CIS 5A Non-UCITs Fund of Funds in preference to CIS 5 UCITs Mixed funds to take advantage of the wider investment and borrowing powers which are outlined later in this article.

As Manager of Manager schemes invest mainly in transferable securities as opposed to collective investment schemes it is most likely that these will be established as CIS 5 UCITs mixed funds.

Fund of Funds - Structure

Investors' Recognition and Understanding of the products

Private investors arguably have a better understanding of Fund of Funds as the underlying unit trusts or OEICs can be easily identified and they may recognise their "star" fund managers from articles they read in the press. Manager of Manager schemes are on the other hand an altogether more difficult concept to explain to retail investors.

Complexities in establishing the fund

From the Product Provider's view there is less due diligence required on behalf of the Fund of Fund schemes as the prime consideration is to select an appropriate fund in which to invest. This is in contrast to Manager of Manager schemes in respect of which the ACD must perform appropriate due diligence on each fund manager or fund management company being delegated to manage a pool of assets. This would include consideration of, for example, the financial stability and future revenue growth of the selected investment management house as these would be factors in retaining high profile managers and talented staff in the longer term and hence the ability of the appointed manager to meet long term investment performance objectives.

The added complexity involved necessarily means that where the ACD of a Manager of Managers scheme wants access to new products or exposures, the ACD has to go through the complex process of appointing another fund manager and allocating a portion of the fund to that manager to manage. By contrast, Funds of Funds managers have immediate access to new products or those which are relatively unknown and they can invest immediately in another already established CIS.

Dealing with Fund Manager Defection

Multi Manager Schemes are popular with some investors as they can be used as a means of overcoming the growing number of star fund manager defections. This can be achieved in the Funds of Funds variety by the manager simply selling the fund managed by the defecting manager and switching into the fund that the star manager moves to. This switch can often be made with little or no initial charge. This compares to the altogether more complex situation that would confront the Manager of Manager's fund where the arrangement with the outgoing fund manager's firm will need to be terminated and a new external manager will need to be appointed.

Changing the Fund Manager

If, for example, performance deteriorates and it becomes necessary to change exposure within a fund, then in the case of a Fund of Funds this can be done quite simply by selling one of the CIS currently held in the Fund of Funds and purchasing another CIS instead; you move from investing in a fund managed by one manager to investing in a fund managed by another manager. This can be done immediately and should only take a couple of days to complete.

In a Manager of Managers structure, however, the manager responsible for a particular region or sector may need to be removed and another manager appointed. As seen above this can be complex and take some time to complete. On the other hand, a benefit of the Manager of Managers structure is that the underlying investments remain the property of the fund itself; it should therefore be possible for asset re-allocation costs to be kept to a minimum even if the investment performance deteriorates.

Risk Management

In a Manager of Managers scheme, as the underlying investments remain the property of the fund itself, the Manager can monitor the performance of individual stocks very closely. It is sometimes argued that Manager of Manager schemes are best placed to control risk as they can enter into detailed legal agreements with investment firms on how a segment of the portfolio is to be run.

Whilst the Fund of Funds manager has no control over individual stock selection or performance monitoring, supporters of Fund of Funds often argue that Manager of Managers schemes can be constrained by strictly laid down internal risk profiles and consequently closely follow indices movements.

Costs

It is generally accepted that Manager of Manager funds are cheaper than Fund of Funds. In a Manager of Managers Fund, each of the managers will be paid an AMC in respect of the portion of the fund assets with which they are entrusted. However, in respect of Fund of Funds there are two levels of charges – the Fund of Funds manager charges an AMC as does the manager of each of the CIS invested in by the Fund of Funds.

This dual level of charging is also made clear in Fitzrovia's publication of Total Expense Ratios (TER). In this, the IMA recognised measurement of charges, the Fund of Funds' TER currently reflects the total operating costs only of the scheme itself. For example, if the Fund of Funds management charge is 1% and there are no other higher level charges and all other expenses including the AMC of the underlying funds are 0.48%, then the TER will be shown as 1% as this is what was actually charged to the "top level" of the Fund of Funds in the last financial year.

	Manager of Manager	Fund of Funds
Restriction	CIS 5 UCITS	CIS 5A FoF	CIS 5 UCITS	CP 185 non UCITs
	Mixed Fund	(non UCITS)	Mixed Fund	Mixed Fund
Max % in Collective Investment Scheme (CIS) allowable	100%	100%	100%	100%
Max % in non UCITS CIS	30%	100%	30%	100%
Max % of fund in 1 underlying CIS scheme	20%	20%	20%	20%
Max % of shares in issue of underlying funds	25%	100%	25%	100%
Requirement for geographic or economic remit of underlying funds	None	None	None	None

Investment Restrictions Monitoring

Above is a summary of the investment and borrowing powers of Manager of Manager Funds and of Fund of Funds.

Whilst it is quite straightforward to monitor to ensure that the investment restrictions are being met in the case of Fund of Funds, Manager of Managers funds provide greater challenges. For example, if you have a Sub Fund which is split into three investment pools managed by three external managers, there could be a situation where different managers buy the same stock line on behalf of the same Sub Fund.

For rules based on the NAV, problems can be overcome by requiring each pool to be in compliance. For example, if the managers of each of the three pools ensure that no more than 5% of the NAV is invested in any security then by definition the entire Sub Fund will be in compliance. However, this is far from perfect as, for example, if one manager chooses not to invest in one stock at all, a restrictive pool-based monitoring approach would not allow the manager of another pool to take advantage of the investment powers of the Sub Fund as a whole.

The concentration limits also pose a problem. For example, pool A holds company XYZ A shares to the extent of 18% of the issued share capital of the company, 2.6% of the NAV, and pool B could hold 3% of the issued share capital 0.4% of the NAV; at sub-fund level there would be a breach of the 20% concentration rule applicable to OEICs but not the 10% spread rules.

A challenge which, therefore, faces Manager of Manager schemes is the need to develop a compliance monitoring system which is able to monitor both at the various pool levels and also collectively at the sub-fund level. For our part, CTCL have adapted our IDEE investment restrictions monitoring system for this purpose and would be happy to discuss the development challenges with any interested parties.

A final twist

To complicate the above discussion somewhat, it should be noted that it is common for a Fund of Funds umbrella to overlay the Manager of Managers structure. This is illustrated in the diagram below.

This structure is appropriate because it allows the investor to select a fund within the Fund of Funds umbrella tailored to specific needs such as retirement planning but with exposure to a range of external managers via the underlying Manager of Managers OEIC.

If you have any questions in respect of Multi–Manager funds or would like to discuss your own proposals with CTCL, then please contact Iain Lyall (020 7500 8356) who will be pleased to assist you.

Next quarter we will be publishing a related article on the practical aspects to consider when implementing Multi-Manager funds. The article is written by Ellen Verth from Consult Evolve who is an independent consultant.

Manager of Managers – Structure

IMPACT OF THE UCITS III MANAGEMENT DIRECTIVE ON THE UK FUND MANAGEMENT INDUSTRY

As the dust begins to settle following the introduction of the detailed regulations and guidance required to implement the UCITS Management Directive throughout Europe, UK fund managers would be forgiven for wondering how exactly the directive will benefit them in the future. While there are certainly issues with its uniform implementation across the European Union, it is not all bad news write Tim Herrington and Jeremy Stevenson from Clifford Chance LLP in London.

With the publication in August of its Policy Statement providing feedback on CP 163, entitled "The UCITS Management Directive - Implementing the UCITS Amending Directive (2001/107/EC)" (the Policy Statement), the FSA has set out how it intends to implement the "passport" and financial resources aspects of the Management Directive. The third aspect of the Management Directive in relation to simplified prospectuses is being addressed as part of another consultation, CP 170 "Informing Consumers: Product Disclosure at the Point of Sale".

Publication of the Policy Statement represents the introduction into UK law of the second amending directive that together with the "Product Directive" implemented in November 2002 comprise the UCITS III reforms to the UCITS Directive. The changes described in the Policy Statement will take effect on 13 February 2004 in line with the timetable prescribed in the Management Directive.

The UK industry's two main competitors, Ireland and Luxembourg, have also passed the requirements of the Management Directive into local law. While there was limited scope for individual Member States to diverge from the text of the directive it is apparent that some Member States, including Ireland and Luxembourg, have interpreted certain aspects of the directive quite differently, especially in relation to cross border fund establishment, transition periods and financial resources requirements. The differences between Luxembourg, Ireland and the UK are, as one would expect, less marked than with other jurisdictions but differences still remain. The impact of these differences on the UK industry and the broad aims of the Management Directive are discussed below.

Brief Refresher on the Management Directive

While most readers are no doubt familiar with the content and purposes of the Management Directive, it is worth remembering that both the Product Directive and Management Directive are a result of the EU Financial Services Action Plan which has as its ultimate aim the creation of a fully harmonised single European financial market by 2005. Agreement on the directives took many years of delicate negotiations and reflects a finely balanced compromise.

The key aspects of the Management Directive are:

granting of a "passport" to management companies similar to that currently afforded to investment firms under the Investment Services Directive (ISD) to allow them to provide certain cross border services across the EEA. The intention is for the home state authorisation of a management company to be extended to and be effective in all other Member States;

extending the permitted activities of management companies to include management of not only UCITS, but also other types of investment funds and segregated or managed accounts and ancillary activities like custody of interests in collective investment schemes, administration and investment advice;

limiting the ability of a management company to delegate its functions to ensure that it maintains the ability to control and supervise any delegates;

applying financial resource requirements and conduct of business rules to the management company along with risk management and regulatory reporting requirements; and

introducing a requirement for a simplified prospectus to be provided to investors prior to a sale. A full prospectus should be available free of charge if requested. (This aspect of the Management Directive is not considered in any further detail in this article).

Implementation of the Management Directive in the United Kingdom

The Policy Statement sets out how the FSA and HM Treasury intend to implement the Management Directive in the UK. It follows consultation with the industry as part of CP 163 and thankfully some of the more aggressive elements of CP 163 have been removed. That said, the FSA still intends to apply requirements over and above those contained in the Management Directive on the basis that such requirements are justified in the interests of consumer protection.

Application

The Policy Statement provides that the Management Directive will apply to the manager of an authorised unit trust (AUT) and the authorised corporate director (ACD) of an investment company with variable capital (ICVC) in the UK.

The application of the rules to the manager of an AUT is not controversial and reflects the existing definition in the UCITS Directive. The treatment of an ACD as a management company, while broadly accepted by the industry, will cause some difficulties for those ACDs currently operating under an ISD passport. The activities allowed under an existing ISD passport are broader than those that will be permitted under a UCITS passport. For example, an ISD passport allows an ACD to receive and transmit orders and to execute orders on a cross border basis. The Management Directive does not refer to these activities directly and it is not clear whether they are covered by the "marketing" function within the permitted activity of collective portfolio management. A firm is obliged to surrender its ISD passport from 13 February 2004 if it wants to take advantage of the new UCITS arrangements.

In other jurisdictions the rules implementing the Management Directive have had to take account of self-managed investment companies (i.e those without a regulated investment manager acting in an ACD capacity) such as the self managed SICAV in Luxembourg, usually by restricting the directive's application to such entities. These types of funds are not currently available in the UK. (The FSA in CP185 entitled "The CIS Sourcebook - A new approach" is currently consulting on whether or not the UK should allow a self-managed ICVC to be established).

Financial Resources

The Policy Statement also sets out the FSA's approach to financial resources for a management company. The FSA has retreated from its original definition of "fixed overheads" for the purposes of the financial resources calculation - this would have required the industry to maintain an estimated additional £270m in capital. As they stand, the revised prudential rules still place a burden on UK fund managers in excess of the minimum required by the Management Directive (and the regulators in other European jurisdictions). The FSA believes this "super-equivalence" and the corresponding competitive disadvantage to the UK fund industry is justified to ensure the interests of consumers are protected. The additional requirements on UK fund managers are:

deduction of illiquid assets when calculating financial resources; and

a cumulative approach to setting risk-based capital requirements.

Transitional Period

In relation to transitional periods, the Policy Statement reverses the position in CP163 and provides UK fund managers with the full transitional period through to 13 February 2007 - provided they don't seek to take advantage of any of the new entitlements introduced by the Management Directive. Importantly, ACD's operating under an ISD passport can continue to so do until the end of the transition period provided they do not perform any of the new activities allowed by the Management Directive and further, that the extent of their activities performed under the ISD passport does not exceed the scope of those permitted by the UCITS passport. If they cannot meet these conditions then they will need to surrender their ISD passport and operate under the UCITS passport from 13 February 2004.

UK fund managers will be able to use the UCITS passport granted by the Management Directive to market existing UCITS funds authorised before 13 February 2002 into other Member States, even though such funds may not have been updated to reflect the Product Directive. All fund managers and UCITS funds, regardless of when authorised, will need to comply with UCITS III from 13 February 2007.

Cross Border Fund Management

The FSA intends that UK managers should have full access to Article 6 of the Management Directive and be able to manage investment companies throughout the EEA once authorised in the UK and correspondingly, for EEA managers to be able to rely on the directive to manage UK based funds. In order for the latter to happen the FSA will amend the CIS Rulebook and HM Treasury will amend the OEIC Regulations to make it clear that an ACD of an ICVC can be an EEA management company - previously it had to be a UK entity - although a management company acting as an ACD must still comply with all of the UK rules related to such a role, including the CIS Rules.

The FSA note in the Policy Statement that its liberal view of the passport provided by the Management Directive is not shared by all Member States. We will discuss this in more detail below.

Other than those issues highlighted above, the amendments provided for in the Policy Statement reflect the minimum requirements of the Management Directive.

Implementation of the Management Directive in Luxembourg and Ireland

Both Luxembourg and Ireland have introduced the Management Directive into local law and have provided guidance to their local industry. It is therefore possible to compare how they have treated certain issues like cross-border fund management into their jurisdiction, financial resources and transitional periods.

Transitional Periods

The transitional periods for managers in the UK, Luxembourg and Ireland are broadly the same.

Fund managers authorised before 13 February 2004 in Luxembourg who manage UCITS funds authorised under the original directive have the full transition period to 13 February 2007. Management companies authorised before 13 February 2004 which manage UCITS III funds will have the ability to rely on the transition period.

In Ireland, management companies also have until 13 February 2007 to comply with the new rules in the Management Directive, including where they are managing UCITS III funds.

Financial Resources

The UK rules as set out in the Policy Statement appear to put the UK at a competitive disadvantage. Both Luxembourg and Ireland appear to have restricted their resource requirements to the minimum levels set out in the Management Directive or other European capital adequacy requirements. In the interests of consumer protection, the FSA have insisted on retaining the "super-equivalence" rules as discussed above. However, the FSA believes that these requirements on their own are unlikely to provide a material competitive disadvantage for the UK industry.

Cross-Border Fund Management

One of the key attractions of the new Management Directive was the removal of barriers to an authorised fund manager in one Member State acting as manager to an investment company domiciled in another, that is, to a fund in corporate form such as an ICVC or a SICAV. The FSA has embraced this aspect of the Management Directive and EEA authorised managers can act as an ACD of an ICVC whether or not they establish a branch in the UK.

However, as alluded to by the FSA in the Policy Statement, not all Member States have taken this approach. In particular, Ireland has stated that non-Irish managers cannot act as manager or ACD to Irish UCITS funds (or, for that matter, manager to Irish non-UCITS retail funds). The position in Luxembourg is not clear, although it appears from a recent circular that a manager of a Luxembourg UCITS must have a branch in Luxembourg to receive recognition and further, that the central administration of the management company must be in Luxembourg. These requirements will severely limit any cross-border services into Luxembourg.

Of those countries to have enacted the Management Directive and which have local UCITS funds, only Spain, the UK and Belgium have stated that EEA-authorised firms can manage their local investment companies, although a number of jurisdictions remain undecided and may follow their lead.

The fact the some Member States have not enacted the cross border elements of the directive severely limits the ability of the Management Directive to remove barriers to a single market for financial services. It must be questionable whether Luxembourg and Ireland (and the other countries who have taken a similar position) are in fact implementing the directive correctly. The issue is of such seriousness that it is to be reviewed by the UCITS Contact Committee (or the Committee of European Securities Regulators, once it takes over supervision of UCITS - see below).

So, where does that leave the UK industry? UK fund managers will now be subject to competition from EEA-authorised managers while their competitors retain the benefit of a protected domestic industry. There is no required reciprocity in the FSA rules - an Irish manager is entitled to manage a UK ICVC, but the opposite will not apply. Irish based managers will be able to offer their services further than their UK counterparts. More importantly though, large European fund managers will not be able to realise the economies of scale promised by the Management Directive. Group structures will need to retain UK, Irish and Luxembourg authorised subsidiaries rather than centralising management within one entity.

Interestingly, the Irish funds industry itself is not happy with the approach of its regulator. The issues raised by the Irish regulator and others reflect an uneasiness with the regulation of funds and that of the manager being split, as well as perceived problems with a foreign manager adequately monitoring central administration in the domicile of the fund.

Other Issues Impacting on the UK Fund Industry

Change of EU Supervisory Bodies

The Committee of European Securities Regulators (CESR) is to take over the role performed by the UCITS Contact Committee at some point next year. CESR recently published a consultation document to ensure the European funds industry supported its appointment. The change of supervisory bodies reflects changes brought about by the Management Directive, specifically the extension of permitted activities for an authorised fund manager which accords with the activities allowed under the Investment Services Directive. In its consultation paper CESR state that ensuring harmonised implementation of the UCITS Directive in relation to the scope of the passport of asset management companies is an "area of possible intervention and priority". At least there is recognition at an EU level that a failure to allow cross border management of funds represents a loss of one of the key objectives of the directive and the Financial Services Action Plan.

Corporate Governance

Even the UCITS universe is not immune to the increased attention and exposure being given to corporate governance around the globe. In a recent speech by the Director General of Internal Markets at the EU specific reference was made to corporate governance issues in the context of the Management Directive.

The Director General cited the fit and proper tests for management companies and the rules of conduct (including the need to avoid conflicts of interest) as important elements of corporate governance. These issues are of course already covered in great detail in the FSA Handbook. Of more relevance to the UK industry was the Director General's stated desire to harmonise the conduct of business and internal organisation rules for management companies across the EU.

So, is the UK still the best place to establish a fund management business?

Nothing in the Management Directive has fundamentally altered the UK's leading position within the European fund industry as a location for asset managers of UCITS funds to be based. Those areas of "super-equivalence" over the requirements of the Management Directive are not of such materiality to affect a decision as to whether to establish or retain a business here. Importantly for the UK, nothing in the directive will impact on the amount of human capital, know-how and support for the industry found within the UK. In many respects the Management Directive raises the standards elsewhere in Europe to those of the UK.

The only caveat to this is that the UK industry could potentially be adversely affected by the inconsistent application of the cross border management rules. Managers with UK and either Ireland or Luxembourg domiciled funds may elect to set up in one of the other locations and manage their UK funds from offshore. That said, any manager with funds in all three locations (or other Member States) will be unable to achieve the same level of benefit from managing outside the UK and would be likely to choose the most appropriate jurisdiction for other commercial reasons, such as those listed above for the UK.

But is the Management Directive positive for the UK industry?

The answer to this is "yes, but not as much as it could be". Let us not forget that the Management Directive expands the permitted activities of an authorised UCITS manager to management of other types of funds and of segregated accounts as well as allowing a host of ancillary services including advice.

Furthermore, where applicable, those services can be provided on a cross border basis. This should enable existing businesses to develop additional revenue streams or reduce dependencies on third parties.

The key issue for the UK industry is the differing approach taken by Member States to cross border management of local vehicles. If this impediment was lifted then one could see UK fund managers being able to expand their product offering and more importantly, especially for the larger fund managers, rationalising their operations with associated cost savings and efficiency improvements. Obviously any decision to rationalise operations also turns on issues like tax and human resources, but for the regulatory obstacles to be removed would represent a significant improvement for the industry.

Tim Herrington is Senior Partner (tel +44 (0)207 006 1201) and Jeremy Stevenson is a Senior Associate (tel: +44 (0)207 006 4516) in the Global Asset Management Group at Clifford Chance LLP in London. The authors would like to thank Matthew Huggett (tel +44 (0)207 006 1626), Senior Associate in the Global Asset Management Group, for his assistance in the preparation of this article.

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.