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Page last published: 21 October 2009

Fiduciary Services
Citicorp Trustee Company Limited
Informal Compliance; June 2004
Citigroup® Global Transaction Services

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Citicorp Trustee Company Limited 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:

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

Contents

An Overview of COLL (the new Handbook)

Property Funds

Unbundling and Soft Commissions

Best Execution

Standardisation of the Depositary Role

Eligible Markets and the new EU Member States

An Update on the Savings Directive

Sean Quinn
Managing Director
Citicorp Trustee Company Limited

Welcome to the June edition of Citicorp Trustee Company's (CTCL) News & Views.

The last few months have, of course, been spent digesting the new regulations and related issues faced by the CIS industry. We now have the new COLL handbook which gives a more sensible and flexible approach to today's CIS environment and CTCL welcomes the opportunities it provides for managers and the opportunity it offers for improved investor choice.

We are particularly pleased with the new environment for property schemes and also with the regime introduced for the Qualified Investor Schemes (QIS); the QIS rules support the need for the professional fiduciary and they start to differentiate the needs and necessary investor protection required for retail and institutional products. However, it is worth remembering that whilst COLL has now been released, the environment for property funds generally will remain unclear until the Treasury concludes its consultation and review in respect of Property Investment Funds (Pifs) - more of this enclosed. Equally, whilst the QIS regulations have been released, the tax environment for their operation has not yet been agreed with the Inland Revenue.

All the positive 'pats on the back' following the launch of COLL cannot disguise the fact that the UK industry is woefully small compared with its equivalent European CIS markets and rivals. Much more than better regulation will be needed to address this widening gap. Many new funds are still not being launched in the UK but have drifted to the offshore centres where the regulations and infrastructure can still more easily meet the needs of product managers for flexible regulations and supporting infrastructure.

A particularly good example of a similar European market which is adapting to the need to compete with offshore centres is Germany. In Germany, regulations which traditionally have made the UK look 'flexible and user friendly' have been replaced as of 1st January this year with new regulations allowing, amongst other changes, hedge funds for institutional funds and even fund of hedge funds for the German retail market. It is too early to say if this will be successful but it provides an interesting example for the UK industry to observe from a traditionally very conservative regulatory environment.

With 10 new countries having joined in May, the UK industry will be pushed even harder to change more rapidly to deal with and take its fair proportion of the investment opportunities in these growing new European Union economies.

On a positive note, the European Commission are considering how to standardise the depositary function within the EU. This is very welcome - all major UK managers have themselves, or are part of groups which have, funds domiciled in multiple European locations and the standardisation of the depositary role is essential to facilitate obstacle-free cross-border operation of investment funds so that both investors and the industry get the full benefits of the UCITS Product and Management Directives already in place. More on this issue is included inside this publication. We hope you find this edition interesting and we welcome your ideas and feedback on the current and previous editions of 'News and Views'. So please don't hesitate to provide comments and suggestions to your CTCL contacts or to myself.

An Overview of COLL (The New Handbook)

On 23rd March 2004, the FSA issued Policy Statement 04/7 which introduced the new Collective Investment Scheme Handbook (COLL), the most fundamental change ever in the regulation of authorised funds. The objective of the new Handbook is to provide a modernised and less prescriptive regime offering more flexibility and opportunity for improved investor choice.

In this article we provide a brief overview of the new Handbook. You should, however, contact us if you would like further information on any of the issues discussed. CTCL has already commenced the process of engaging with managers in respect of the new Handbook, a process which has included presenting on a number of the key issues within COLL, including Fair Value Pricing, Qualified Investor Schemes, property-based Funds under COLL, performance-related fees and the new dealing arrangements.

CTCL would be pleased to meet you to discuss your own requirements in respect of the Handbook.

Application and Transitional Arrangements

In CP 185, it was proposed that, after release of the COLL handbook, all new funds would have to be authorised as COLL funds and that all existing authorised funds would have to convert to COLL by February 2007. This has been relaxed in the final COLL provisions which provide that:

From 1st April 2004, Managers are able to establish new funds under COLL. However, until February 2007, Managers can elect to launch funds under the CIS regulations if this is deemed to be easier for administrative and costs reasons.

Funds authorised under CIS (both CIS 5 and 5A) must convert to COLL by February 2007, but can do so at any time before then.

Types of Funds

COLL provides for three new types of funds, which will be the only fund types in place after the expiry of the transitional arrangements in 2007. These fund types are:

COLL Retail UCITS funds

COLL Retail Non-UCITS funds

COLL Qualified Investor Schemes

Each of these is examined in more detail below. Additionally, on the centre pages, there are some summary diagrams and charts in respect of COLL which we hope you will find useful.

COLL Retail UCITS Funds

COLL Retail UCITS funds are intended essentially to replace the existing CIS 5A Securities funds and Warrant funds and the CIS 5 UCITS III Mixed Funds. The key features of the new funds are set out below:

Harmonisation of Rules for Unit Trusts and ICVCs

All proposals in relation to the harmonisation of Authorised Unit Trusts with ICVCs have been implemented, including allowing unit classes beyond income and accumulation units, the box management process and aligning fees and expenses. Two areas where differences remain are in respect of dual pricing (discussed below) and AGMs. Whilst ICVCs must have an annual general meeting on account of their corporate structure, there is no such requirement for unit trusts - a real cost saving.

Dual Pricing

Whilst the COLL handbook has been written with reference exclusively to single pricing, the transitional rules provide that existing dual-priced unit trusts may continue to use the dual-pricing system should they decide to convert to COLL. Furthermore, whilst not provided for in COLL, we understand that new unit trusts established under CIS and indeed those established under COLL will be allowed to use dual pricing, for the time being at least.

In the Policy Statement accompanying the new handbook the FSA explain that dual pricing has been retained for unit trusts at least until the industry has sufficient experience of "swinging pricing" to make a decision on whether to make single pricing compulsory. Therefore, the transitional rule above may well need to be extended beyond 2007 or, indeed, dual pricing may need to be brought into the new COLL handbook.

Box Management

Against the backdrop of Spitzer, it was difficult to see how the FSA could proceed with the plans set out in CP185 to dispense with the 2-hour rule and, therefore, it is perhaps unsurprising that in COLL the FSA has laid out a compromise option.

The CIS handbook provides that for unit trusts the instruction to create or cancel units must be given by the AFM to the Trustee within two hours. No similar rule was in place as regards ICVCs but Managers and Depositaries had in practice operated a 2-hour rule for ICVCs as for unit trusts.

In COLL, the FSA introduces a new compromise provision that applies equally to unit trusts and ICVCs. Firstly it recognises that because the Manager normally controls the issue, cancellation, sale and redemption of units, it occupies a position that could, without appropriate controls, involve a conflict of interest between itself and its clients. On account of this, in all cases, the Manager will have to provide the notification of the creations and cancellations to the trustee or depositary.

However, the regulations provide that the timeframe for making the notification should be agreed between the trustee and the depositary having regard to the scope for a potential conflict of interest, although in all cases it needs to be within 24 hours. The FSA give further guidance:

"Where a Manager operates a box with the principal aim of making a profit, the time period should be short (for example, two hours); otherwise a longer period (for example, up to the next valuation point but in all cases within 24 hours) may be acceptable."

Dealing Provisions

Whilst limited-issue provisions have been available to CIS funds since November 2002, COLL funds will also be able to take advantage of new provisions for deferred redemptions and also for dealing cut-off points (the provisions for limited redemptions apply only to the non-UCITS funds). Whilst, aspects of their operation remains unclear, particularly as regards having differing rules for different unit/share classes, these regulations provide Managers with a most useful cocktail of provisions for meeting their dealing obligations and their obligations to issue and redeem shares.

CTCL have conducted detailed analysis of the new dealing provisions. Please contact us if you would like to discuss these further.

Investment and Borrowing Rules

For the most part the investment and borrowing powers for the COLL Retail UCITS funds are identical to those for the Mixed Funds under CIS 5. This can be seen in the summary comparative analysis of borrowing powers set out on the centre pages of this publication.

Fair Value Pricing

As expected, COLL includes provisions for fair value pricing including a requirement that where the Manager has reasonable grounds to believe that the most recent price available does not reflect the Manager's best estimate of the value of a security at the valuation point, then the Manager should value the investment at a price which, in its opinion, reflects a fair and reasonable price of that investment - the fair value price.

There is little additional guidance provided by the FSA within COLL regarding fair value pricing. However, the FSA are working with the IMA and DATA to produce a joint industry code for the application of fair value pricing.

In COLL, the FSA have sought to allay certain fears by confirming that properly-applied FVP will not, if subsequent information indicates that the price should have been different, be treated as a pricing error. Of course, if any potential pricing error does occur that will require consideration of whether that has occurred in spite of fair value pricing being applied correctly or because it has been applied incorrectly.

Fair value pricing will be considered in a separate article in the next edition of News & Views.

Performance Fees

COLL specifically provides that for Manager's periodic charge or for the payment out of the scheme property to the investment adviser, the prospectus may provide for performance fees so long as that is not unfair to any unitholders. As with fair value pricing, in the absence of any guidance in COLL, it is likely that the IMA will seek to identify a number of standard methods for calculating performance fees as otherwise they may cause a great deal of confusion for unitholders and administrators alike.

Investor Information

Short-form accounts

COLL provides that a Manager must produce a short report as well as the long form of accounts. A short report must be produced for each sub-fund and must include all significant information which would enable unitholders to make an informed judgement on the activities of the sub-fund during the period.

This will include:

A brief assessment of the sub-fund's risk profile

A review of the sub-fund's investment activities and performance during the period

A performance record to enable the unitholder to put into context the investment performance of the scheme (although this does not have to be the prescriptive five-year review required in long-form report and accounts)

Sufficient information to enable the unitholder to form a view on where the portfolio is invested at the end of the period and the extent to which that has changed over the period.

The FSA is working with the IMA on the development of a best practice model for short reports that will enhance their consistency and comparability. Amongst the various matters that need not be included in the short report are the full accounts and the reports of the depositary and of the auditor.

Prospectus

Prospectus need no longer disclose the maximum rates of remuneration to be paid to the AFM or associates out of the scheme property. The FSA do not feel that such maxima provide an effective tool in controlling costs.

Simplified Prospectus

Against the backdrop of the above, it is worth remembering that the FSA have still not brought forward their proposals for introduction of a simplified prospectus. Readers will remember that the simplified prospectus is a replacement for the key features document, not for the prospectus. The FSA have indicated that they expect the simplified prospectus provisions to have been introduced by September 2004.

Changes

COLL introduces a new framework for considering changes to the prospectus. The existing material vs. immaterial changes framework is replaced by fundamental, significant and notifiable changes, with only fundamental changes requiring the approval of unitholders.

Undoubtedly, certain changes which under the CIS regime are material, and therefore require unitholder approval, will under the COLL regime be significant changes as opposed to fundamental and will, therefore, not require unit holder approval. An example may well be a new payment to the AFM out of the scheme property.

Managers should also bear in mind this new approach when planning to convert to COLL. For example, if a Manager wished to change an investment objective, and that change would be material under CIS but only significant under COLL, and if the Manager also wished to move from CIS to COLL, then if the objective is changed after the conversion as opposed to before, this could alleviate the need to obtain unit holder approval for the COLL conversion or for the subsequent change in investment objective.

A summary of the COLL rules in respect of changes, together with some guidance as to what would constitute a fundamental, a significant or a notifiable change, is set out in the centre pages of this newsletter.

Retail Non-UCITS Funds

Retail Non-UCITS funds differ from Retail UCITS funds in that they need not comply with the UCITS directive and secondly in that they cannot be passported. However, as it is intended that these funds can still be promoted to retail investors, the FSA has taken the view that they should have broadly similar rules governing them as the Retail UCITS funds. There are, however, some significant differences as identified below:

Investment and Borrowing Powers Differences

Article 1 of the UCITS directive itself requires there to be a difference between the investment and borrowing powers permitted to a UCITS fund and those available to a non-UCITS fund. The key differences that the FSA has provided for when compared to Retail UCITS funds include:

Investments in gold and property and a wider range of non-UCITS CISs

Up to 20% in unapproved securities compared to 10%

Up to 20% in unregulated CIS (not allowed for UCITS funds)

Up to 35% in any one CIS

Removal of the concentration rules

The 10% borrowing can be on a permanent rather than on a temporary basis.

This will allow Managers to launch "mixed funds" in a similar way to those allowable following the implementation of CP135. For example, a single fund could consist of investments in securities, gold and property where other more stringent rules such as the temporary borrowing requirements of UCITS retail funds would not apply.

Dealing Powers Differences

The non-UCITS funds have the same powers as for UCITS funds as regards limited issue, deferred redemption and cutoff points for dealing applications. These non-UCITS funds are also able to make use of limited redemption arrangements and, where they do so, they are able to take advantage of wider provisions in respect of cut-off points.

Retail Non-UCITS Property Funds

In order to demonstrate the potential for retail non-UCITS funds under COLL, it is perhaps useful to compare the possibilities for property funds under CIS 5A and under COLL respectively.

Firstly, the Manager would enjoy the wider range of investment and borrowing powers provided for in COLL which, as particularly relates to property, include:

50% in vacant, non-income producing or development property

100% in a property (previously 80%)

Mortgages up to 100% can be secured (previously 50%) on properties to the value of 20% NAV (previously 15%)

Grant options on an immovable so long as value of immovable is up to 20% of property in fund

Property index-based derivatives permitted

Borrowing up to 10% on a permanent basis.

Secondly, the Manager can then take advantage of the more flexible dealing rules, and in particular limited redemption and cut-off, as considered below:

Limited Redemption

COLL provides that Retail Non-UCITS funds that invest substantially in approved immovables or whose investment objectives are to provide a specified level of return may provide for limited redemption arrangements appropriate to its aims and objectives, in any case at least once in every six months.

Cut-off

COLL also states that where limited redemptions arrangements are being operated, the cut-off point may reflect the expected length of time required to undertake transactions in the underlying investment provided the 185-day limit is complied with.

Therefore, for example, within the context of a Retail Non-UCITS fund the objective of which is to invest in property, as it may reasonably take three months or more to undertake transactions in the underlying assets (the immovable property), a Manager could reasonably only allow redemptions once every three months and further provide that all dealing applications need to be received by a cut-off point three months before that valuation point.

This would provide the Manager with a lot of flexibility in planning for redemptions and, therefore, the Manager would not have to retain the same levels of liquidity within the fund as is currently required with CIS 5A property funds to enable the Manager to meet redemptions as and when they occur.

Qualified Investor Schemes (QIS)

New institutional funds can now be launched in the UK for the first time and have been named "Qualified Investor Schemes (QIS)." These are not aimed at the retail investor and investing is restricted to institutional and expert investors, jointly termed "sophisticated investors." These schemes can be promoted to sophisticated investors on the same terms as unregulated collective investment schemes.

On account of the sophistication of the investor base, the new rulebook provides for a less-prescriptive regime for these funds. Indeed, these funds are not dealt with in the generality of the handbook but rather have their own chapter within COLL - Chapter 8 - which deals with matters such as investor relations, dealing arrangements and investment and borrowing powers.

Throughout Chapter 8, the focus is on disclosing within the prospectus the details of how the fund is going to operate, rather than prescribing in the regulations how the fund must operate. Among the key features of these new funds are:

A QIS can invest in a wider range of investments, including real estate, precious metals (gold, silver and platinum) and commodity contracts traded on recognised investment exchanges

Rather than specifying spread limits for particular asset types, the FSA have simply required that the means of risk spreading should be disclosed in the prospectus;

Investee Collective Investment Schemes must be prohibited from investing more than 15% of their value in other schemes. This ensures consistency with the FSA's rules on cross-holdings between investment trusts

No maximum period is provided for limited redemptions, although the fund should not lose its character of being open-ended. Further, the provisions in respect of limited redemptions should be consistent with "the reasonable expectations of the target investor group and the particular investment objectives of the scheme"

A QIS can borrow up to 100% of its NAV

The prospectus of a QIS must be offered to all prospective investors before conclusion of the unit purchase

Annual and half-yearly reports need only be available on request as opposed to being dispatched to investors as a matter of course.

Role of the Depositary

CP 185 considered whether in respect of QIS the current role of the depositary (providing safe custody of scheme assets and oversight of certain aspects of scheme operation) could be split, with the suggestion that only safe custody would have to be undertaken by the Depositary.

The FSA however have maintained the current oversight structure pending "further work" in this area having received representation from the industry that the current structure worked effectively and that the appointment of a suitable third party to oversee the Manager instead of the depositary could instead dilute the high standard of care and expertise enjoyed by investors who also have the benefits of a fee structure based upon the economies of scale.

Scope for Hedge Funds

When the FSA recently consulted on hedge funds, it concluded that they should not be available for the retail market. This policy remained unchanged within the COLL Handbook. However, the regulations for the new QIS schemes, and in particular the widening of the investment and borrowing powers to enable short selling and covered gearing (100%) will allow for some features of hedge funds to be employed within these schemes.

At a general level, QIS should provide a more-flexible fund option for Managers and investors. In particular, these types of funds may be of benefit to Life and Pension scheme investors.

However, the appeal of QISs to Managers and to investors will largely depend on the tax treatment applied to these funds. It is unclear what tax regime the Inland Revenue will seek to apply to such funds or, indeed, when the Revenue will bring forth their tax proposals for COLL authorised funds.

Property Investment Funds (Pifs) and the impact on regulated CIS.

Gordon Brown announced in the March budget a consultation on promoting more flexible investment in property. The main suggestion proposed is the introduction of Property Investment Funds (Pifs). These schemes would pool money to buy residential and, possibly, commercial property which would then be let to tenants to provide investors with a regular income.

The timing would appear to be good; property has consistently outperformed the FTSE All Share Index and, the continuing popularity of buy-to-let properties indicates a high level of interest amongst retail investors keen to obtain exposure to the property market (notwithstanding the risk of increasing interest rates).

However, it is still unclear where these Pifs will fit into the current landscape for property funds and for property-related investment. Moreover, it is unclear whether the arrival of Pifs will overshadow the recent developments in respect of retail property funds which have come about in the long-awaited introduction of the new sourcebook for collective investment schemes (COLL) which was launched by the FSA at the end of March 2004.

In this article, we set out an overview of the current regulatory landscape for property collective investment schemes before then considering the key features of the proposed Pifs including a review of their possible impact on the fund management industry.

Current Regulatory Landscape

All of the currently-existing property funds which are Authorised Collective Investment Schemes (as opposed to Investment Trusts) are established under the CIS 5A regulations; these are retail non-UCITS schemes. The new Collective Investment Schemes sourcebook (COLL), launched in March 2004, also provides for two new types of property funds to be established - COLL Retail Non-UCITS Schemes and COLL Qualified Investor Schemes - although no such schemes have yet been launched. A number of the features of these three scheme types are considered below.

CIS 5A Retail Non-UCITS Schemes

I&B, Pricing and Dealing regulations set out in CIS Handbook

Between 20% and 80% of NAV to be invested in approved immovables

Not more than 25% of NAV in approved immovables which are unoccupied or non-income producing

Fund may borrow up to 10% of NAV on a temporary basis.

COLL Retail Non-UCITS Schemes

I&B, Pricing and Dealing regulations set out in COLL Handbook

Up to 100% in immovable property

Borrowing up to 10% on a permanent basis

50% in vacant or development property

Can be sold to retail investors

Can hold most other types of securities and derivatives

COLL Qualified Investor Schemes

Restricted by terms of prospectus, not by regulations

Invest up to 100% in immovables

Borrow up to 100% on a permanent basis and can short sell securities

Cannot be sold to retail investors

Clarification on tax treatment required

Can invest in commodities and precious metals

As regards funds intended for retail investors, the extended investment and borrowing powers of the new COLL scheme will offer much greater investment potential to Managers than the CIS 5A funds. COLL funds also have the advantage of providing greater flexibility in respect of dealing arrangements; AFMs will be able to employ such techniques as cut-off points for receipt of dealing applications and will also be able to provide for limited redemptions - this, together with the wider investment and borrowing powers, will assist AFMs in dealing with investor redemptions without having to sell the underlying property investments in the scheme at short notice.

It is against this background that we need to consider the possible introduction of Pifs.

Overview of COLL

The Regulatory Landscape for Authorised Funds after the Introduction of COLL

* These funds can no longer be launched but existing funds can convert to CIS UCITS III Mixed funds or to COLL funds at any time and must do so by 13th February 2007.

** These funds can still be launched but can convert to COLL funds at any time and must convert to COLL funds by 13th February 2007.

*** Conversion to QIS only if all investors in the converting scheme qualify to be investors in the QIS.

Summary of Investment & Borrowing Powers

* investee scheme must have terms which prohibit more than 5% in value of scheme property consisting of units in CIS.

** investee scheme must have terms which prohibit more than 10% in value of scheme property consisting of units in CIS.

*** investee scheme must have terms which prohibit more than 15% in value of scheme property consisting of units in CIS.

* Certificates representing certain securities are to be treated as equivalent to the underlying security.

COLL Approvals and Notifications Requirements

NB: The above examples are for guidance only and are extracted from the FSA COLL Handbook.
The Authorised Fund Manager will need to determine in each case whether the change is fundamental, significant or notifiable.

Background to Pifs

The launch of the consultation on Pifs follows a review of housing supply by Kate Barker, a former member of the Bank of England's monetary policy committee. She concluded that Britain must build at least another 70,000 homes a year to reduce house-price inflation and make property more affordable to first time buyers.

She also noted the limited role played by investment funds in the residential property market in the UK, in contrast to the situation in the US, France and Canada and noted that this was contributing to a widening gap between housing supply and demand. She suggested that a new style of property fund would provide an extra source of demand for rented properties encouraging developers to supply more homes.

The broad principle is to create an investment vehicle that provides a liquid market in property investment that is widely accessible by the private investor. The Pif is based on the American model, the Real Estate Investment Trust (REIT). In the United States, the total return on REITs was over 16% per annum over the past five years.

At the moment there are only a handful of CIS funds that invest in residential property but they have, in practice usually been available only to wealthy individuals. No new COLL funds have yet been launched. Some investment has also been made via limited partnerships (LPs) but again this option is only available to wealthy individuals; amounts invested in property LPs have risen from £2 bn in 1997 to £15 bn in 2002.

Therefore, most small investors who want exposure to property returns have typically turned to the buy-to-let market where 70% of the private rented stock is owned and managed by landlords with only a handful of properties each. This is a particularly high risk way for investors to access this market, as they are not very well diversified. In addition, most buy-to-let investors are more likely to buy a second-hand property so the investment funds provide no incentives for house builders to supply additional homes. It simply results in the price of second-hand homes continuing to rise.

Proposed Characteristics of the new Pifs

The following are the key potential characteristics of the proposed Pifs:

The funds would not have to pay tax on any rental income as long as it was substantially distributed to investors. They would also be exempt from capital-gains tax (CGT) on profits from property sales

Investors would still be subject to both income tax and CGT (unless the funds could be held within an ISA)

Pifs could be restricted to a borrowing limit of 50% of their assets. This is lower than the 85% an individual investor can generally borrow on a buy-to-let property. However, the effect of this is that the fund will have less exposure to interest rate changes. The individual investor's risk level therefore is reduced twice. He will have less exposure to a fund (because he is one of many) which has less exposure still to interest rate changes (because 50% is the borrowing limit). This will have a stabilising effect given the prevalence of variable rate mortgages in the UK (even for buy-to-let)

The minimum investment could be much lower than that required to purchase a buy-to-let investment (at the moment this works out at an average of £30,000) making it easier for small investors to take part.

The funds could also invest in commercial property, including shops, offices and industrial premises.

Open ended or closed ended

One of the most important decisions the government has to take is whether to make these funds closed ended listed companies like investment trusts or open-ended companies like authorised unit trusts (AUTs) and ICVCs. The government has suggested that making the new vehicles closed ended listed companies would have the following benefits:

Widest possible access to the public

High level of market scrutiny

Requirement to adhere to the listing rules

A listed Pif would be likely to trade close to its net asset value (unlike current property companies)

Investors can withdraw their investment by selling shares. The price obtained reflects market sentiment but does not require the Pif to sell underlying assets.

However, the possibility of making Pifs open-ended vehicles has not been ruled out in the consultation and there are advantages with this option also:

Although listed companies like investment trusts have existed for some time, they have not historically attracted the same level of interest from the public as open-ended AUTs and OEICs

AUTs and OEICs publish prices on a daily basis and these prices are widely available to investors.

Perhaps, the most significant disadvantage of the open-ended structure is that a reserve of cash or other liquidity has to be kept to meet redemptions or else property may need to be sold to repay investors exiting the fund. Although, as noted above, the more flexible investment and borrowing powers and, in particular, the dealing rules introduced in COLL for the retail non-UCITS funds will assist AFMs in dealing with investor redemptions in those open-ended schemes; Pifs may have similar arrangements in place.

Effect on Authorised Collective Investment Schemes

In the retail environment, it is certainly possible that the attractiveness to retail investors of the COLL Retail Non-UCITS schemes as a vehicle for property investment (and therefore their attractiveness to Managers as a product-offering) may be affected by the launch of Pifs.

The key factors will be:

Whether Pifs will be able to invest in commercial as well as residential property (this will affect the comparative diversification and yield of the funds)

Whether or not they will be open ended or close ended.

However, the most significant issue will no doubt be the ISA-eligibility of Pifs. Whilst the consultation document is silent on the question of ISA eligibility, if Pifs enjoy PEP/ISA eligibility, then this would surely place Pifs at an enormous competitive advantage over the authorised collective schemes which would not be PEP/ISA eligible.

On the other hand, if the consultation determines that an open-ended structure is appropriate for Pifs, then perhaps the Chancellor's objectives could best be achieved by utilising the currently-available COLL retail non-UCITS structure. This would avoid the need to launch a new product and, of course, it could be provided, if desired, that such funds should enjoy ISA-eligibility.

Whilst much of the above is still conjecture, what is certain is that COLL property funds enjoy one great advantage over Pifs in that they can already be launched today. It is not yet clear if Pifs will be introduced and what the final product will look like. Further, given that the consultation period for the Treasury's proposals on Pifs ends on 16th July 2004 after which time the regulations will have to be drafted and introduced, including in respect of the tax status, it is unlikely that we will see any Pif funds launched for over a year.

Effect on the Fund Management Industry Generally

Given the amount of money invested in buy-to-let properties in the UK, the effect on fund management revenue could be significant if Pifs take off. It will obviously depend on the amount of existing buy-to-lets that are acquired by Pifs and the extent to which any new monies are invested in Pifs.

Many countries that have adopted such property vehicles have imposed a conversion charge where existing buy-to-let properties are acquired by Pifs. This is likely to be imposed by the UK government to ensure that there is no overall cost to the taxpayer from any conversions.

For example, in France, to obtain Pif equivalent status, a conversion charge equal to 16.5% of unrealised capital gains on eligible assets to be transferred is imposed. This represents a 50% discount on the tax that would be payable on realised capital gains and it is payable in 4 equal annual instalments to lessen the cash flow impacts on investors who are converting. Different methods are applied in the US. Whichever method the Chancellor opts for he will have to ensure that existing buy-to-let investors are not prevented by one-off taxation consequences from otherwise converting to Pifs.

Much will also depend on the investor's risk profile. The more entrepreneurial investor will most likely continue with buy-to-let because they value the control exercised over their investment. Rather than paying a fund manager (and probably a property manager) for their time and effort, they prefer to use their own time to deliver investment returns. More passive investors who have neither the time nor the risk appetite for buy-to-let will be attracted to the Pif option.

Finally, it will also depend on the size of the investor. Small investors have previously been unable to invest in buy-to-let because of the large initial outlay. The minimum subscription of Pifs may be low enough to encourage these investors.

If the bulk of the funds come from current investors who are dissatisfied with returns on bonds or equities, the effect on the fund management industry could be neutral at best. Only if this results in the subscription of completely new funds (i.e. held up to now in property or cash) will there be a fillip for fund-management revenues.

CTCL has a dedicated property funds unit and we would be delighted to meet with Managers to discuss the opportunities for property funds under the new COLL handbook or your existing plans in this regard.

Unbundling and Soft Commissions - FSA Policy Statement 04 /13

In April 2003, the FSA published Consultation Paper CP 176 - Bundled brokerage and soft commission arrangements in which it stated its concerns that fund managers who use bundled and soft commission arrangements face conflicts of interest in their relationship with brokers and are not directly accountable to their clients for expenditure on bundled and softed items.

To address this, the FSA proposed two measures in CP 176:

Limiting the range of goods and services that could be purchased with commission

Requiring fund managers to value the goods and services that could still be softed or bundled, and to rebate an equivalent amount to their customers' funds ('the rebate proposal').

Responses and Feedback to CP 176

The FSA received nearly 150 responses to CP 176 and it is perhaps no surprise that fund managers were generally hostile to the proposal in CP 176 that they should make rebates to customers' funds. In particular, they suggested that the cost impact would affect the competitiveness of UK funds and could lead to a possible shift of fund management business to overseas jurisdictions.

In light of this feedback, the FSA appointed Deloitte to carry out further research. Deloitte's report on the matter indicates that the CP 176 proposals would not have a significant impact on the competitiveness of the UK fund management industry as a whole, although noting that between 2.0% and 5.5% of funds under management could be affected, principally small- and medium-sized fund managers. Deloitte also predicted that implementation of both proposals could deliver net savings to clients' funds (through reduced consumption of bundled services and through lower commission costs) of up to £288.4m. This is a significant figure but has to be seen in the context of the £250 billion plus of UK funds under management.

The Way Forward

Against the background of the responses received, in the May Policy Report in respect of feedback on CP 176 the FSA have held back at this stage from pushing forward with their proposals for regulatory reform and have opted instead to give the industry the opportunity to deliver a suitable response. In this regard, PS 04/13 makes particular reference to the proposed system of "comparative disclosure" suggested in the consultation response from the IMA.

In adopting this stance, the FSA are adopting an "evolutionary approach" to unbundling. This starts with brokers pricing the execution and research elements of bundled payments separately, followed by fund managers providing effective disclosure and making effective and efficient purchasing decisions.

The FSA will assess the industry's progress towards development of a workable and adequate disclosure regime at the end of 2004. As a yardstick, the FSA say that "It is important that through improved disclosure, institutional customers such as pension fund trustees get the information they need to put pressure on their managers, as appropriate, over the control of costs." In PS 04/13, they are quite explicit in warning that if they judge that disclosure is not going to support their desired outcomes that they will then reconsider implementation of the rebate proposal set out in CP 176.

As a final note on this issue, readers should be aware that the FSA are proposing to limit the availability of bundling and softing arrangements to the provision of investment research only. The scope of investment research will be defined by the FSA over the coming months.

Governance Arrangements - "An Investors' Champion."

The FSA state that by itself disclosure is unlikely to be an effective solution for investors in retail funds because of the investors' relative lack of knowledge and bargaining power. The possible solution which the FSA has in mind is for strengthened corporate governance of retail funds to "sharpen the accountability of fund managers."

In particular, in PS 04/13, the FSA refer to the possible development of an "investors' champion", to receive and assess disclosures from the fund manager on behalf of the fund's investors as a whole and to engage with the fund manager in challenging costs where the need arises.

Obviously the solution may well entail enhancing the role of the trustee and depositary in exercising oversight of the fund manager's control of dealing and commission costs. However, the FSA have also stated their intention to consider the solutions used in other types of retail managed fund, such as investment trusts and the funds of life assurers.

Best Execution

The FSA recently (5th April 2004) fined Morgan Grenfell & Co Limited, for failing to act in its customer's best interests and failing to manage conflicts of interests. The customer was a Fund Manager. The FSA found that Morgan Grenfell commenced proprietary trading in certain of the constituent securities of a client's programme trade, prior to its award, based on limited information provided to enable the firm to quote for that business. Morgan Grenfell failed either to inform the customer in advance that it might trade in the component securities based upon the information supplied or to ensure that its participation in the market did not cause the customer to suffer a disadvantage.

The client was a fund manager dealing on behalf of various funds and the proprietary trading resulted in the funds paying more for the programme trade than they would otherwise have done. The ultimate losers were, therefore, the underlying investors in the relevant funds.

Implications for fund managers

The above case re-emphasises that fund managers must be vigilant when executing trades through brokers to ensure that they are getting best execution.

In light of this case, managers may wish to reconsider the suitability and reach of their current processes in place for checking the prices that are paid for purchases (and received from disposals) and for identifying any unusual price movements between the placing and execution of an order. Managers may also wish to consider asking brokers to disclose any proprietary trades they have made in the stocks being dealt.

Standardisation of Depositary Role Across Europe

The UCITS depositary is the third fundamental pillar of the UCITS' framework (the fund and its manager being the first two), which was set up by Directive 85/611/EEC. Within the context of the estimated 550 UCITS depositaries across the 25 current EU countries involving the safeguarding of assets worth four thousand billion euros, the European Commission have stated that they intend to spend the next two years reviewing the differing roles of the Depositary across individual EU Member States. The goal is to move toward standardisation of the depositary function within the whole of the EU at the end of this period.

Standardisation of the role of the Depositary is to be achieved through increased legislation where appropriate to supplement current EU legislation that so far contains few principles and duties for Depositaries. In this existing scenario the problem has been that, when Member States have imported those few European rules for Depositaries into national law, Member States have often added a broader and differing list of tasks and organisational rules. In addition there are differing responsibilities of Auditors in relation to investment funds between Member States and the apparent merging, blurring, or overlap of the functions and responsibilities of Auditors and Depositaries when comparing these roles from Member State to Member State. The Commission has said it will aim to work with national regulators in reducing the differences. Currently, the UK would feature at the end of the spectrum where the role of the depositary is most demanding whereas Luxembourg would feature at the end of the spectrum where the role of the depositary was least demanding; Ireland would sit somewhere in the middle.

The European Commission is of the view that standardisation of the depositary role is essential to facilitate obstacle-free operation of cross-border investment funds, so that both investors and the industry get the full benefits of the UCITS Product and Management Directives already in place.

Some of the issues which the Commission will no doubt wish to address include:

Prevention of conflicts of interests - ensuring that the interests of investors, depositaries and fund managers have a high degree of correlation and consistency in all Member States

Clarifying depositaries' liability - to ensure a high and consistent level of investor protection throughout the EU through convergence of depositaries' obligations, duties and liability in respect of safeguarding of assets

Convergence of national prudential requirements - to ensure that the levels of entry into the market for depositaries are the same in all Member States

Enhancing transparency of costs and improving investor and public information - to ensure that the same levels of disclosure on Depositary services and hence to help to create a level playing field amongst Depositaries across Member States.

Before appointing depositaries based in other Member States, domestic fund managers will want clarity on all the above matters, perhaps particularly in respect of the liability of and resources available to depositaries.

At a corporate level Citigroup has already embarked upon the review of depositary functions, procedures and operations across all the European jurisdictions in which it currently offers Depositary services. Consequently it will be no surprise that Citigroup and its individual depositary companies all welcome and fully support what the European Commission is hoping to achieve in this vital area of investor protection.

Eligible Markets and the New EU Member States - Update

With effect from 1st May 2004 Cyprus, the Czech Republic, Estonia, Latvia, Lithuania, Hungary, Malta, Poland, Slovenia and the Slovak Republic all ascended to membership of the European Economic Area (EEA) through the enlargement of the European Union.

Prior to their ascension, Managers were expected to perform some due diligence of these markets and to consult with the Trustee/Depositary before deciding on their eligibility. It would appear that this level of due diligence may no longer be required as by virtue of their new membership of the EU, the CIS Sourcebook rules requires that the new countries should be treated on the same level as the older EU countries when it comes to assessing eligibility and the requirement for due diligence.

Readers will recall that in the last edition of News and Views, we said that CTCL raised this issue at DATA with a view to approaching the FSA to clarify the requirement for due diligence on some or all of these countries, whilst expressing concerns over operational issues within some of the new markets.

The FSA have now responded to DATA to say that they are constrained by the requirements of Article 19(1) of the UCITS Directive as to what constitutes an eligible market under CIS 5.2.12R. However, they have further said that where a Trustee or Depositary has concerns on the operational practices of any of the new markets then these should be made known to fund managers to avoid situations where dis-investment is necessary and thereby causing an adverse impact on a fund.

An Update on the Savings Directive

Whilst Managers will already have taken steps such as the revision of client documentation and systems development in preparation for the introduction of the Savings Directive, it may come as a surprise to some to learn that the final decision has yet to be made on whether the Directive will come into force or not on 1st January 2005. That decision will not be taken until EU Finance Ministers assemble in June 2004. If Finance Ministers decide that the Directive is not ready for full implementation, they are likely to set a new effective date for implementation.

As many readers will know, the Directive provides for member states to report interest income to account holders' home tax authorities. The Directive, thereby aims to ensure that EU residents cannot avoid tax in their home state by not declaring income received in another member state. Therefore, it requires automatic exchange of information and that information to be collected by "paying agents."

However, it has always been intended that the introduction of the Directive would depend on the EU's success in "encouraging" countries outside the EU, like Switzerland, Liechtenstein, Monaco, Andorra and San Marino, to impose "equivalent" measures. The June meeting of Finance Ministers will decide whether sufficient progress has been made.

In this regard, a significant leap forward occurred on 19th May when Switzerland and the EU formally agreed a series of treaties that should pave the way for the implementation in Switzerland of the Savings Tax directive. However, there are still several obvious potential stumbling blocks.

Firstly, the deal with Switzerland has not yet been signed; that is planned for August - after the June vote. Also, it is unclear whether or not the necessary legislative reform can be introduced in Switzerland by 1st January 2005 - that was admitted by Swiss President Joseph Deiss at a Brussels press conference immediately after the deal was agreed on 19th May. The issue will become even more acute if it becomes likely that the introduction of arrangements in Switzerland will be dependent upon the Swiss government winning a national referendum on the issue.

The greatest problem, however, is that the plans require the unanimous support of all 15 EU Finance Ministers. Any one country which is dissatisfied with the arrangements agreed with the Swiss could therefore scupper the plans. In this regard it is known, for example, that Luxembourg is already concerned at the inclusion in the Swiss agreement of an exemption in respect of providing information to other governments on people suspected of tax evasion on the basis that that is not a crime in Switzerland.

On the other hand, and adopting a more positive outlook, the fact that the Swiss have now agreed a deal with the EU will put additional pressures on the other countries such as Liechtenstein, Monaco, Andorra and San Marino to do the same and this will surely provide encouragement to the EU Finance Ministers at their June meeting.

And finally …

In a separate development, at the beginning of May, the ECOFIN Council stated that they expect the Directive to apply to the ten accession states which became member states of the European Union on 1st May 2004 as it does to existing Member States; we understand that this will take the form of exchange of information as opposed to withholding tax arrangements such as those which are being permitted to Austria, Belgium and Luxembourg for a transitional period.

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

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Informal Compliance; June 2004
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