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Page last published: 25 October 2005

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Citicorp Trustee Company Limited
Informal Compliance; 4 August 2005

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United Kingdom

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

Luxembourg

Citibank International Plc (Luxembourg Branch)
58 Boulevard Grande Duchesse Charlotte
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Ireland

Citibank International plc Ireland Branch
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Contact details

Sean Quinn European Head of Fiduciary Services sean.quinn@citigroup.com Tel: +44 (0)20 7500 5619 Fax: +44 (0)20 7500 5835	Stefano Pierantozzi Head of European Fund Compliance stefano.pierantozzi@citigroup.com Tel: +44 (0)20 7508 6651 London	Adam Willis Compliance Resource adam.willis@citigroup.com London
Darren Burrows Head of UK Funds Compliance darren.burrows@citigroup.com Tel: +44 (0)207 500 8847 Fax: +44 (0)207 508 0363 London	Cian O’Callaghan Compliance and Technical Manager cian.ocallaghan@citigroup.com Tel: +44 (0)207 500 8834 Fax: +44 (0)207 508 0363 London

· FSA update on CIS Issues

· Passporting of Management Services – Where Now?

· Registration and Distribution of UCITS within Member States

· Dual Pricing – Beyond 2007

· New Landscape – Corporate Governance in the Funds Industry

· Other Matters

· News & Views – Next Edition

Sean Quinn
Managing Director
Citicorp Trustee Company Limited

Welcome to the August 2005 edition of News & Views. The first half of 2005 has certainly been interesting and challenging; much time has been spent with managers discussing their plans for the year ahead and the opportunities provided by COLL and UCITS III (issues which again feature heavily in this edition of News & Views). The second half of the year will no doubt provide equal interest and challenge as we see managers’ plans starting to be implemented. We look forward to working with all our management groups in this regard.

In early May, I attended the CESR open-hearing on the definition of eligible securities that was held in Paris. CESR is considering the extent to which UCITS funds should be able to achieve indirect exposure to asset classes such as hedge funds, commodities and real property (to which direct exposure is not permissible) through investment in, for example, closed-ended funds or financial derivatives.

This throws up a number of competing issues. On the one hand, there is the need to ensure that UCITS continues to meet the hallmark of being a retail product, and that it continues to warrant and achieve the confidence of retail investors. On the other hand, there is the need to have in place an environment in which product development opportunities are created and seized. For example, as we discussed in our March edition of News & Views, it seems possible for UCITS funds to track hedge fund indices through the use of total return swaps. It is important that this CESR consultation reaches appropriate conclusions on whether such investment strategies are to have a place within UCITS funds.

Where UCITS III should be providing managers with real benefits and opportunities in terms of product development, is in respect of cross-border fund management. However, there have been disappointing developments in this regard in the last quarter.

Firstly, it was particularly disappointing to read the recent comments of CESR that it had not been the intention of member states to allow foreign management companies to set up investment companies in their jurisdictions. This would effectively seem to killoff (for now) the management passport in its current form. It denies managers the ability to realise the economies of scale promised by the management companies Directive, as they will need to retain UK, Irish and Luxembourg authorised subsidiaries rather than centralising management within one entity in one jurisdiction.

Also, the joint IMA/EFAMA paper on “A Harmonised, Simplified Approach to UCITS Registration” made gloomy reading in its conclusion that the process of requiring funds to register in the different member states in which they are to be distributed is a source of market failure, since it represents a barrier to entry by foreign fund providers. The report identifies that, in some cases, it is as burdensome and time-consuming to register a UCITS fund within the European Economic Area (EEA) as it is to register it in countries outside the EEA, such as Switzerland and Hong Kong. Also, the report provides evidence that it can be cheaper to register a UCITS fund for distribution in Switzerland than to register it within many EEA countries including Belgium, France, Germany and Italy.

Closer to home, the issue of COLL conversions is firmly on managers’ agendas. In this edition of News & Views, we are pleased to include an article on COLL, written by Will Davis and Wayne Lottering of the Financial Services Authority (FSA). The article explores a range of the issues that are emerging as managers increasingly consider their moves to COLL.

We are also grateful to David Logan of Deloitte who has contributed an article on the latest developments in corporate governance in the US and UK and the effects these will have on the administration of funds – and indeed on the role and responsibilities of depositaries.

Collective Investment Schemes (CIS) – An FSA Update

A year into the new COLL regime, Wayne Lottering and Will Davis of the FSA's CIS team examine the emerging practical and technical issues for conversions from CIS and new scheme launches.

Wayne Lottering

Wayne Lottering is the manager of the Collective Investment Scheme (CIS) team within the FSA's Individuals, CIS and Mutuals Department.

His team is responsible for the authorisation and revocation of all regulated collective investment schemes in the UK; as well any changes to existing schemes. He is also responsible for the recognition of UCITS-qualifying schemes. Previously, he was also responsible for registration functions for mutual societies such as industrials and provident societies.

Wayne has been involved in financial services for over 20 years, having originally qualified as a chartered insurer. He has worked for a number of financial services companies, including Save & Prosper/Flemings. Before joining the Individuals, CIS and Mutuals Department he spent three years working within the FSA's supervision area, focusing on IMRO firms.

Will Davis

Will Davis is the authorised funds expert at the FSA, having previously been responsible for policy formulation and drafting of COLL and CIS. Prior to this he was involved in legal and policy issues on investment management generally. He is a solicitor with a background in investment management/funds matters.

Introduction

As the clock ticks down to the COLL conversion longstop of February 2007, there has inevitably been a certain wait-and-see attitude given uncertainties over tax and the UCITS issues that are still being clarified through CESR. To date, only some 6% of authorised funds have converted to COLL. This article looks at the issues around conversion, including some interesting boundary issues as to what may be possible under COLL.

Conversion mechanism

At its simplest, this involves the submission to the FSA of the election to convert, the fee, and revised scheme documentation. Extending scheme powers to take advantage of wider COLL powers adds in the investor approval/notification dimension. If a big bang approach is taken to moving to UCITS III and possible fund restructuring at the same time, complexity increases substantially. It is worth noting that the COLL election should specify a firm date for the conversion and not be conditional (e.g. on the outcome of a shareholder resolution).

European issues for UCITS

CESR has a mandate to put forward proposals as to how the UCITS transitional provisions in the UCITS amending directives should be applied and defining in more detail what are the eligible assets for UCITS.

Transitional provisions

· The CESR guidelines address the position of UCITS engaged in cross-border passporting. The key impact will be on umbrella funds authorised before 13/2/02 which have added a sub-fund since that date – the umbrella fund must convert to UCITS III by 31/12/05 (instead of the 13/2/07 date originally specified in the UCITS III Directive).

· UCITS III passporting out from the UK will need to obtain an attestation from the FSA that they have an appropriate derivative risk management process in place.

· All passporting funds (UCITS I or III) must offer a simplified prospectus to prospective investors by 30/9/05. That said, the FSA's rules on the simplified prospectus are likely to require the provision of the simplified prospectus to investors rather than its mere offering.

Definitions of eligible assets for UCITS

CESR published its consultation paper on 18 March 2005. It raises the following main areas of concern:

· Transferable securities – the approach proposed appears to require extra diligence by the authorised fund manager (AFM) in evaluating whether an instrument is a transferable security. This is over and above the traditional criteria of admission to/dealing on a relevant market and includes the manager looking at criteria such as liquidity, availability of reliable valuations and information, the transferability and the ability to assess the risk of the security on an ongoing basis. In relation to closed-ended funds, as well as the above factors, there should be consideration of the risks of any cross-holdings in other closed-ended funds, as well as there being investor protection safeguards.

· Derivatives – CESR members are divided as to whether it is necessary to look through to the underlying of a derivative on a financial index. Without the look-through (which is not required by the text of the UCITS III Directive) there is the possibility of exposure to alternative asset classes, e.g. using a derivative on a hedge fund index. Firms wishing to launch this type of product as a UCITS should consider carefully the risk that the final UCITS interpretation is adverse – something that could require them to wind it up.

Topical and technical issues

Derivatives

Handbook Notice 40 sets out rule changes to CIS and COLL reflecting the European Commission recommendation on the use of financial derivative instruments in UCITS. Short selling is now allowed – subject to criteria of liquidity. Also, there is the ability to manage OTC counterparty exposure limits by taking collateral to net off the exposure. This could offer considerable efficiencies in the structuring and investment management of schemes, as a scheme could effectively hold just one OTC position with a single counterparty.

Property

For Non-UCITS Retail Schemes (NURSEs) we have clarified that the 10% limit on general borrowing is separate from, and additional to, the limits on mortgages over immovables. We are also seeing a variety of structures being proposed for holding immovables for tax and transferability reasons. These vehicles should be no more than a transparent holding shell and the underlying immovables should be dealt with as if held directly (e.g. application of valuation rules).

Performance fees

These can exist in many forms and the recent IMA/DATA/Fitzrovia technical discussion paper provides a useful examination. Our particular concerns are on the fairness of a methodology both as between the manager and investors and different investors and we would urge managers to discuss their proposals with us prior to submission of an application. We are also concerned that particular emphasis should be placed on producing a clear and relatively simple explanation in the prospectus of the operation of the fee, including appropriate worked examples of different scenarios. We will carefully review the clarity of this prospectus material so the submission to us should be well crafted.

Cherry picking

Recent developments have further extended the ability to use COLL powers in CIS schemes:

· Dual pricing – Whilst the COLL rules do not allow a new COLL scheme to be set up using dual pricing, we consider further the issue of pricing methodologies. We recognise it may be appropriate to allow a new COLL scheme to dual price. Accordingly, a number of firms have successfully applied for and have been granted rules waivers (COLL 4.2.5(16)(a)) enabling them to operate dual pricing in a new COLL scheme.

· More flexible price publication – Handbook Notice 41 allows CIS schemes to publish their prices in an appropriate manner, rather than having to be in a national newspaper. This may have particular cost saving implications for managers close to renewing their annual price publication contracts.

Dispensing with AGMs

The Open-Ended Investment Company Regulations 2005 allow an OEIC to dispense with the need to hold future AGMs on having given 60 day’s notice to its investors. Adopting COLL powers may require a shareholder meeting and a resolution so this is a consideration in deciding at what point to dispense with the AGM.

Risk spreading in QIS

As there are no quantitative limits in the COLL rules it is worth pointing out that a single asset scheme (even though the underlying may adequately spread risk) will not be acceptable for a QIS owing to the consequences for the scheme if that single asset were to become illiquid.

Deferred redemption – QIS

We will look at proposals on a case by case basis in deciding what is an acceptable deferral timeframe. Regard will be had to the normal dealing frequency in assessing whether the duration of a deferral provision is reasonable.

Traffic lights system for scheme changes

Classifying the impact of a change to a scheme and how to action it is for the AFM to decide on reasonable grounds based on its perceived impact and using the guidance in COLL 4.3. It is not for the FSA to take that decision, but for the AFM (if necessary in discussion with the depositary) to take a pragmatic and reasonable view. A particular type of change may not always fall within the same category, as the same change may have a different impact on investors in different schemes. Accordingly, the FSA will not be producing a hard and fast list of how particular changes should be classified. That said, we note that there has been some debate over how a removal of a maximum charge should be classified. Generally, we would view this as no more than a significant change as the key impact is what is actually being charged and how this is modified (significant change mechanism).

Switching between scheme types

This should be possible, in principle, subject to certain safeguards, except that a UCITS is prohibited (COLL 3.2.8 and the UCITS Directive) from changing to another scheme type. Therefore, a NURSE could convert to a QIS, provided the necessary investor approvals are obtained and all the investors into the QIS qualify as "sophisticated" and are, therefore, eligible for this type of scheme. Moving from a QIS to a NURSE or a NURSE to a UCITS will result in a more restricted scheme for which the necessary investor approvals must be sought.

Taxation

The FSA is not responsible for tax matters and introduced the new scheme types in COLL on the basis of the FSA's objectives in the Financial Services and Markets Act 2000 – primarily, innovation, competition and investor protection.

We welcome the recent Budget statement clarifying the tax treatment of COLL funds, as the lack of certainty on treatment had hindered the launch of COLL funds, especially the QIS. It is encouraging to see that QIS funds are not carved out from the general tax treatment for authorised funds and that retail funds, which do not limit redemption or promise a "cash-like" return, will be ISA-eligible; although the exact timeframe for the eligibility of NURSEs is not clear. Other uncertainty remains as to how a substantial ownership test might be applied to disqualify a fund from authorised scheme tax treatment. However, the Budget wording appears more flexible than the 10% ownership disqualification previously mooted. Further proposals will be developed by the Revenue in due course.

Practically speaking

Although a basic conversion to COLL could be very straightforward, there is likely to be much to consider in terms of extension of powers and internal housekeeping on fund ranges. Firms should allow adequate time to obtain consents and prepare revised documentation to a good standard. We are not, in principle, here to check in detail proposals and documentation, but where there are difficult or novel issues, please contact us to discuss these issues if it is not possible to resolve them through discussions with other parties.

Contact details

All scheme alterations, conversions and new schemes should be dealt with through the CIS Authorisations team at the FSA. Please note that Jeff Thomas is the new head of CIS Authorisations at the FSA as Kevin Tomlin has moved on to pastures new.

Passporting of Management Services – Where Now?

UCITS III consisted of the Management Company Directive and the Product Directive. Central to the Management Company Directive (and to the goal of EU harmonisation) was the opportunity for the passporting of management services across Europe which would, in theory, allow a management company established in one member state to manage a fund authorised in another member state.

However, in its recently published transitional provisions, CESR has stated that a UCITS in the form of an open-ended investment company (e.g. OEIC or SICAV) may not designate a management company in a different jurisdiction. It is fair to say that those who have followed this issue over the last few years may be surprised at CESR’s assessment that it had not been the intention of the European Commission to allow cross-border provision of investment management services to UCITS.

Of course, both the Product Directive and the Management Company 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. The apparent failure to allow cross-border management of funds represents a loss of one of the key objectives of the Management Company Directive and the Financial Services Action Plan. From one perspective, the reason for this failure would seem to be a lack of political will amongst member states to introduce fully the provisions of the Management Company Directive in this respect. However, CESR also notes the ambiguity of Article 3 of the amended 85/611/EEC Directive which states that “a UCITS shall be deemed to be situated in the member state in which the investment company or the management company of the unit trust has its registered office”.

Certainly, from a UK perspective, the FSA formed the view that managers should be able to manage investment companies throughout the EEA once authorised in one member state. Indeed, the CIS Rulebook and OEIC Regulations were amended to make it clear that an Authorised Corporate Director (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.

From a UK perspective, against the background of CESR’s comments, it may be that any European managers currently passporting into the UK will lose their authorisation to do so and the rulebook and OEIC regulations may now again need to be amended.

In truth, however, it was clear from the time that the Management Company Directive was implemented that there were two opposing school of thoughts as regards its purpose. Whilst some jurisdictions such as Spain and Belgium did also adopt the UK approach, both Luxembourg and Dublin, the UK’s two main competitors, adopted a more restrictive approach to the passporting of management services.

Ireland provided that non-Irish managers could not act as manager to Irish UCITS retail funds. Whilst Luxembourg regulations did seem to admit to the possibility of a management passport, the fact that a manager of a Luxembourg UCITS must have a branch in Luxembourg and that the central administration of the management company must be in Luxembourg, entirely limited the scope for such passporting.

If one particular criticism can be made of the FSA it is perhaps that it proceeded to implement the Management Company Directive in the way that it did, when it was already clear that its liberal view of the passport provided by the Management Company Directive was not shared by all member states. This one-sided implementation meant that since implementation, UK managers have been subject to competition from EEA-authorised managers while their competitors retain the benefit of a protected domestic industry.

Other aspects of Management Directive

Whilst the pan-European passport did seem to be the central plank of the Management Company Directive there are, of course, other elements of the Directive. Its objectives of achieving consistency across Europe in these other aspects remain intact. These aspects include:

· 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

· 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 (super-equivalent requirements introduced in the UK)

· Introducing a requirement for a simplified prospectus.

Conclusion

Agreement on the Management Company Directive took many years of delicate negotiation to achieve and promised to be a major step on the road to fully harmonised cross-border investment management. It is hugely disappointing that the finely balanced compromise, which seemed to have been reached, appears to have been undermined by a combination of lack of political will to introduce what had been agreed and by the inconsistencies or ambiguities in the text of the UCITS Directive.

Disappointingly, for the time being at least, large European fund managers will not be able to realise the economies of scale promised by the Management Company Directive and will need to retain UK, Irish and Luxembourg authorised subsidiaries rather than centralising management within one entity. On a positive note, CESR has asked that the European Commission includes this issue of the Management Company Passport in its forthcoming UCITS review later in 2005.

Registration and Distribution of UCITS within Member States

The April 2005 joint IMA/EFAMA (European Fund and Asset Management Association) paper on “A Harmonised, Simplified Approach to UCITS Registration” (the “Report”) concluded that the “registration process itself is a source of market failure, since it represents a barrier to entry by foreign fund providers.”

Whilst in the previous article, we considered the UCITS passport for management companies, in this article we look at the UCITS passport for funds and the ability for managers to market the units of a fund authorised in one EEA state within other member states and, in particular, the problems caused by the registration process.

In addition to the management passport, UCITS funds also have a fund passport. The purpose of the funds passport is to allow a UCITS fund authorised in its home member state to market its units in other member states without seeking individual authorisation in those host states. Notwithstanding this passport, the UCITS Directive requires UCITS to register with the regulators in those host member states where they wish to market their units.

The purpose of the registration requirement is to ensure that the host state regulators are aware of the UCITS funds that are being promoted to members of the public within their jurisdictions. It also enables those regulators to understand the marketing plans of the fund providers. It follows that the host state regulators’ ability to refuse to allow a UCITS fund to register is limited to general provisions, such as the marketing and distribution arrangements. Once the UCITS fund has been duly authorised by the home state regulator, the host state regulator cannot deny registration on the basis of its belief that the fund should not have been so authorised by the home state regulator.

However, it is clear that different standards and practices have come to exist in the different member states, so much so that the complexity and the cost involved in the registration process potentially undermines the concept of the UCITS fund’s passport and creates a barrier to cross-border fund distribution. More concerning still, the Report speaks of “a growing sense … that the process can be used by host state authorities to re-assess the initial authorisation of the fund.”

The differences that have emerged between the member states involve such matters as:

· whether registration needs to be done at the umbrella level, sub-fund level or share class level (and the basis on which the costs of such registration are charged)

· in reference to the above, whether all share classes need to be registered or only those which are to be marketed to the public

· whether or not an attestation is required from the home state regulator

· whether the regulator needs to be kept notified of all distributors of the UCITS funds

· translation requirements for documents. Most member states require local translations of documents (Norway, Sweden and Luxembourg accept English versions for all documents)

· which documents need to be filed. In addition to the updated prospectus, annual report and accounts and half-year reports, France and Germany, for example, require as follows

· France – certification, signed by two directors, of the accuracy of the information contained in the prospectus, a representation agent confirmation letter and an updated French addendum to the prospectus highlighting special French requirements;

· Germany – a letter signed by a director confirming that the documentation is in line with German regulations, a letter from the German paying agent confirming its role, a letter from the information agent confirming its role and proof of payment of the initial fee.

In terms of time delays, the Report identifies that the average timeframe for registering a UCITS fund which has been authorised in another member state is approximately eight weeks, although climbing to up to 16 weeks in Italy and Spain. The report also identifies multi-country registrations taking up to seven months.

In terms of regulatory cost, the report identifies a real divergence between different member states. For example, an umbrella with 50 sub-funds would cost only €2,701 to register in the UK, compared with €122,012 in France and €62,971 in Germany. Anecdotal evidence detailed in the Report includes the fact that these regulatory costs, for example, account for approximately one-third of the costs involved in the registration process (other costs being legal costs etc in drawing up the fund documentation).

However, the Report would seem to go a step further than just calling for consistency and standardisation in respect of these matters. It appears to question the need for a registration process at all, stating that it offers very “little justification in terms of investor protection.” In this regard, the Report identifies the fact that it is increasingly rare for the fund providers to be themselves involved in selling directly to members of the public in the member states and that it is in increasingly common for this marketing role to be performed by the local fund supermarkets and distributors (in some countries, funds can only be marketed through a local distributor).

The point being made is this: given that the apparent justification of the registration requirements is to allow host regulators to understand the marketing plans of the fund providers, in the context of the increasing role of the fund distributors it is difficult to see what real benefits are being achieved through the registration process.

Conclusion

Even assuming that a registration process needs to be maintained, there is clearly much scope for introducing consistency and standardisation of approach across Europe. This is particularly important now, at a time when managers are looking more than ever at the potential opportunities made available for cross-border distribution of funds.

Against this background, it is to be welcomed that the Heinemann Report and the report of the Commission’s Expert Group on Asset Management reaffirmed the need to simplify the registration process. Further comfort can be taken from the fact that CESR has identified simplification of the registration process as one of its priorities in the area of investment management and included it in its published mandate of priority issues for its Expert Group on Investment Management.

Dual Pricing – beyond 2007

Currently, collective investment schemes are either dual priced – with investors’ purchases at offer price (e.g. 102 pence) and redemptions at bid price (e.g. 98 pence) – or they are single priced with all dealing happening at a single price, generally mid price (e.g. 100 pence).

However, the COLL Sourcebook provides that authorised funds should be single-priced. Moreover, these new regulations simply do not provide for the possibility of dual pricing of funds. Whilst COLL Transitional Provision 8 allows existing CIS funds converting to COLL to continue to operate dual pricing, this expires in February 2007. In addition, any new funds launched under COLL have to single-price unless they successfully apply for a waiver to allow them to dual-price. The waiver will only be granted where it would be unduly burdensome to require the manager to single price the fund.

The consequence of the above is that it has been assumed that, unless the FSA make any further provisions to the contrary, dual-pricing will disappear by February 2007. By that date, funds will have to have moved to single-pricing. This is obviously an important issue for managers and one on which they have a right to expect clarity, not least so that they can commence their planning for any needed conversion to single-pricing and do so in the context of their other product development plans. These include, of course, the wider elements of COLL conversion.

However, there have been some positive developments in this regard in recent months. These suggest that dual-pricing may indeed be granted a life-line beyond 2007 or, at least, and perhaps more importantly, that there will be clarity in respect of this matter sooner rather than later.

The FSA has indicated that it will soon start looking into this issue and, most importantly, that before any decision is taken to make single-pricing compulsory, it will have to be able to justify this approach on the basis of a cost-benefit analysis. In addition, it has stated that it will give at least 12 months notice of any such decision to make single-pricing compulsory. This, in turn, may require the extension of the current transitional provisions beyond February 2007.

These indications from the FSA are to be welcomed. They do, however, sit uneasily with the drafting of COLL, whereby the only option open to funds post-February 2007 is to single-price. Given that situation, it would seem that any decision by the FSA to introduce dual pricing under COLL would also require a consultation process (although almost certainly not a cost-benefit analysis). If time does not allow such consideration before February 2007, it looks as if the matter will be dealt with, if need be, by way of the extension of the current transitional provisions.

Given then that there is no certainty over the future of dual-pricing, the FSA has also been encouraged to reconsider its current waiver process. In particular, it has been urged to consider whether or not waivers to allow managers to continue to dual-price should, in the interim, be granted as a formality, rather than requiring managers to set out the justifications for this, as they are currently required to do. This would avoid the current delays caused by this process.

It is to be hoped that we do indeed see progress on this matter soon. When considering the justifications for the on-going existence of dual-pricing and for requiring a move to single pricing, the FSA will be guided by certain principles including:

· Simplicity (easy for consumers to understand)

· Transparency (showing charges and duties separately from the price)

· Fairness (for consumers); and

· Competitiveness of UK products and firms.

Interestingly, there is a large section of informed opinion that believes that the future of dual pricing is largely secure on the basis that a move to require single-pricing simply will not pass the cost-benefit analysis to which the FSA has committed itself. While this may well prove to be case, it may be that a number of more limited changes are introduced having regard to the above principles, particularly those of simplicity, transparency and fairness.

As regards simplicity, an investor with a range of investments may currently have exposure to dual-priced funds, single-priced funds applying a swing, other single-priced funds applying a levy and others applying neither a swing nor a levy. Also, it is more than likely that, where there is more than one fund applying a swing or more than one applying a levy, the circumstances and methodology for applying the swing or levy differ from one fund to the next. This is certainly not “simple” and it is very questionable whether this variety and complexity contributes positively to the understanding of investors.

In terms of contract note disclosures, different levels of transparency also prevail – depending on whether the fund is dual-priced or single-priced with a levy or adjustment. For single-priced funds applying a dilution levy the mid-price is shown on the contract note and any dilution levy to cover the spread on the underlying investments or in respect of dealing costs is disclosed separately. This compares with dual-priced and swinging-priced funds (single-price but with dilution adjustment) where the spread and dealing costs are included within the unit prices and so are less transparent. Against the back-drop of such matters as the Treating Customers Fairly initiative and the work being completed on corporate governance, it may be felt that now is the right to time to insist that the dealing costs are disclosed separately on the face of the contract note whatever pricing methodology is being used.

As regards fairness, there have, of course, been academic arguments since the introduction of dilution adjustments and levies as to the respective fairness of each. Dilution adjustments can be criticised for applying to all investors equally whether or not their particular deals are causing dilution. One investor can end up suffering a dilution adjustment because of the dealing activity of another. There is also the issue that on occasion investors purchasing units may be able to do so at bid whilst those redeeming may have to do so at offer – depending on which way the swing is being applied on any day.

As regards dilution levies, there are also various objections that can be raised, in particular, the fact that typically only large deals will attract the levy even although a series of smaller deals by investors may have the same cumulative dilutive effect. However, perhaps the greatest objections in terms of fairness relate to the arguable lack of simplicity and fairness.

Competitiveness is also worth considering. The question here is whether the industry would be more competitive in Europe if the FSA were to be more prescriptive on the issue of pricing – for example, by insisting on single-pricing with dilution levy as the only pricing method available to managers. A uniform single-pricing approach may have the advantage of being closer to continental models and, therefore, more readily understandable by investors across Europe than, for example, dual-priced funds. However, given the limited passporting that actually occurs at present, it would seem inappropriate for the FSA to use this as the basis for requiring single-pricing rather than dual-pricing and it would be unlikely that a cost-benefit analysis would succeed on this basis.

On a final thought, if the FSA does move to protect the long-term future of dual-pricing, then one wonders how long it will be before we have the first conversions back from single pricing to dual pricing. Managers may perhaps consider doing so for a number of reasons; including:

· To achieve consistency (for example, where they have other funds continuing to dual-price)

· Because they feel that the bid-offer spread approach is more understandable to investors and a more effective way of combating dilution and market timing activities than their single pricing and dilution methodologies

· Because of the ability to generate box profits through the cancellation and creation of units through the box at bid and offer prices respectively.

It is important that we have clarity of the future of dual-pricing beyond 2007 sooner rather than later. It is to be hoped that the debate on the matter gets underway in earnest in the coming months.

Adjusting to a New Landscape – Corporate Governance in the Funds Industry

Both the closed and open ended fund industries are the subject of increasing regulation. The intensifying focus on corporate governance in the US and UK will have profound effects on the administration of funds. David Logan reviews recent developments and their implications.

Corporate governance has been, and continues to be, a hot topic for businesses and their professional advisers – a topic that moves further up the agenda every year. The closed-ended fund sector is no exception. There have been several developments in closed-ended fund corporate governance, as onshore closed-ended funds – generally investment trusts – continue to see changes enforced by the rules of the UK Listing Authority.

There may also be changes ahead for the open ended fund industry. There have been a number of developments in the US and, as it appears that regulatory dialogue between the US and UK is improving, these may have some impact on the UK fund industry in the future.

Additionally, the FSA has stated its intention, as set out in Policy Statement (PS) 04/23, to examine the governance arrangements of both open and closed end funds, as a potential means of sharpening fund manager accountability. Meanwhile, the Investment Management Association (IMA) has also undertaken a significant amount of work in respect of fund governance over the past few months.

This article explores these recent developments, considers how they will affect the industry and looks ahead to how this agenda is likely to develop over the coming months.

Corporate governance in the closed-ended funds industry

UK closed-ended funds have been subject to many developments in the last year or so. However, many of these are only now having an impact on their public and governance reporting.

The first changes were the rules arising from the FSA’s Consultation Paper (CP) 164 – involving the limits on cross holdings, requirements for enhanced portfolio disclosures and directorship limits and, particularly, the annual re-election of fund management representatives to the boards of investment trusts. One point that is causing boards some practical concern, mainly as regards the process required to support the disclosures, is the requirement that the board confirms that the ‘continuing appointment of the investment manager on the terms agreed is in the best interests of shareholders’ in their annual accounts. In particular, management engagement committees of many investment trusts have had to consider the evidence they require to support this assertion.

Secondly, listed companies are required to report under the revised combined code, incorporating the Higgs and Smith guidance, for accounting periods ending on or after 31 October 2004. Some of the issues arising from this requirement for investment companies concern how a non-executive board evaluates its effectiveness, and the requirement for audit committees to include membership with ‘recent financial experience’. Again, both are practical issues which in most cases will require board action.

Thirdly, sitting alongside the combined code is the Association of Investment Trust Companies (AITC) code on corporate governance. Increasingly, AITC members are making reference to the AITC code in their corporate governance disclosures, especially as it helps them to report upon the unique circumstances of investment trusts in comparison to other listed companies, and helps justify potential areas of non-compliance with the combined code. These include the potential absence of an internal audit function and the more limited role of senior independent directors when compared with many other companies.

Finally, there is the Treasury Consultation on Regulation of Investment Trusts, which was published in November 2004. We anticipate that this consultation will be the last document with significant regulatory impact arising from the split capital investment trust crisis. This consultation broadly considers the potential to regulate investment trusts in a similar manner as CIS.

Corporate governance in the mutual funds industry

It is fair to say there is no common best practice approach to open ended fund corporate governance across Europe, though good practice is often defined in individual jurisdictions. As a whole, therefore, Europe does not currently hold out a model of mutual fund governance that is likely to influence significantly UK thinking.

However, in the US, the outcome of New York’s Attorney General Eliot Spitzer’s review of the market timing and late trading scandals, culminating in 51 enforcement actions and penalties of $730m levied on the industry, has provoked a governance backlash.

The SEC has introduced certain new exemptive rules regarding potentially serious conflicts of interest between a fund and its manager. Without these exemptions, certain transactions would be prohibited by the Investment Companies Act.

The new exemptive rules essentially represent an enhancement of those previously in place which focused on the judgement and scrutiny of certain transactions by the independent directors of a mutual fund.

Specifically, the new exemptions require:

· Each mutual fund board to have an independent chairman, independent of the advisory organisation, to run board meetings and set out a framework of conduct for the board

· A requirement that 75% of a mutual fund board should be comprised of independent directors, rather than directors linked to the fund manager who have traditionally dominated mutual fund boards

· A requirement for all investment advisers (mutual fund managers) to adopt a code of ethics, addressing conflicts of interest that arise from personal trading by advisory personnel.

There is also an implication that the fund board may wish to review its adviser’s code of ethics and the limits that it places on advisory personnel and, particularly, how those help protect the interests of investors.

There are also changes to compliance arrangements including a new US requirement to appoint a chief compliance officer, who is answerable to the fund board, as well as the adviser, in respect of mutual fund compliance.

Finally, new reporting requirements have been introduced, to provide greater transparency to investors. These include:

· Enhanced disclosures in relation to market timing

· Disclosures regarding the use of fair value pricing

· Greater granularity of mutual fund expense reporting in annual reports

· Improved disclosure regarding the fund manager’s potential conflicts of interest, and

· A discussion of the matters that the board took into account in determining whether to extend or renew a management contract.

The UK environment for fund governance

The FSA indicated in Policy Statement 04/23 that it would review fund governance in the UK, both for open-ended and closed-ended funds.

The FSA also indicated that it would defer that review until the completion of the Investment Management Association’s (IMA) study of fund governance. The IMA’s review is now complete and a consultation draft of its report on the governance arrangement of UK authorised collective investment schemes was issued at the tail end of 2004, with the final report issued in March 2005. The drivers for the IMA review were several and included:

· The increasing demand for disclosure information by institutional clients, particularly in areas such as transaction costs

· The changes in the US mutual fund industry detailed above

· Structural changes in the UK funds industry, and

· The FSA’s move away from rule-based regulation of CIS towards principle-based regulation with the introductions of the new COLL sourcebook.

The core objective of the review was to maintain and improve consumer confidence in the CIS industry, with any recommendations avoiding unnecessary cost.

One of the key points arising from the review concerns the oversight role of the depositary, an element not included in many overseas fund structures. The IMA believes that the depositary provides a well resourced, active oversight mechanism that is arguably stronger in many ways than an independent board of directors.

The depositary:

· Is authorised by the FSA

· Has direct responsibility for the assets of the collective investment scheme

· Tends to oversee a range of funds and can identify good industry practice

· Carries out regular on-site reviews of the manager, and

· Has an obligation at all times to act in the best interests of investors.

These factors create a persuasive argument as to why the UK fund structure already has a strong level of governance control, so long as the arrangements function as intended. As a result, the IMA review found no need for fundamental change regarding fund oversight in the UK.

It did make 23 specific recommendations, covering a variety of topics, many of which can be grouped into two main areas: improving disclosure and refining and enhancing the role of the depositary, to ensure that the

Improving disclosure

Where there is a change of depositary, the IMA recommends that the reasons for that change, together with any wider arrangements to which the depositary is party, are disclosed in the fund’s next report and accounts. Additionally, where the change in depositary takes place part way through an accounting period, it is recommended that both the incoming and outgoing depositary provide a report for inclusion in the report and accounts.

Recommendation 8 of the IMA’s report concerns costs disclosure and suggests that a manager provide the depositary with information similar to that which it would provide to institutional clients under the IMA’s Pension Fund Disclosure Code (PFDC). This would require generic narrative disclosure regarding the manager’s approach to issues such as best execution, broker selection and transaction cost analysis, with the objective of assisting the client, or in this case, the depositary, to monitor and compare all costs incurred in management activities.

There are suggested additional disclosures to the annual report and accounts of a CIS to provide gross, rather than net, sales and purchases information and to analyse commissions, taxes and other charges on trades. Furthermore, it is suggested that transaction volumes by top ten counterparties, including details of fees incurred by counterparty and whether any counterparty is related to the manager or depositary, should also be disclosed.

On box trading, the report recommends that the manager includes in its prospectus a clear statement of its policy on box management, indicating whether the box is utilised for more than administrative convenience – for example, as a means of taking significant speculative positions. In addition, it is also recommended that the box profits earned by the manager should be disclosed in the fund accounts.

Finally, additional disclosure is recommended in respect of total expense ratios (TERs). The IMA recommends that, in line with the EC’s simplified prospectus directive recommendations, the TER be disclosed in the annual report and accounts of a CIS as meaningful information to unitholders.

Refining and enhancing the role of the depositary

The IMA has recommended that, prior to approving a change in depositary, the FSA obtain a statement from the outgoing depositary indicating whether there are any circumstances it needs to be aware of.

Secondly, in line with the disclosure requirements regarding box management, the IMA recommends that the depositary review the manager’s use of the box and confirm in the depositary’s report in the Fund’s annual report and accounts that it is in line with the prospectus.

Again, in line with the manager’s disclosure recommendations, the depositary should oversee the manager’s PFDC Level One disclosures and ensure that adequate supporting controls and processes are in place.

Finally, the IMA also recommends that the depositary oversees the appropriateness of the manager’s decision whether to apply a dilution levy in respect of individual transactions.

Next steps

We believe it probable that the FSA will react positively to the IMA consultation, particularly given that it has involved significant industry input. Accordingly, it is possible that many parts of the IMA’s recommendations will be accepted and implemented.

Clearly, there are a number of changes required for this to happen (to FSA Rules, to industry practice and to the Statement of Recommended Practice governing the accounts of CIS) and these will take time. It will be interesting to see the extent to which the industry picks up the key requirements and chooses voluntarily to adopt the key recommendations prior to any formal rule issuance.

Assuming that these recommendations are adopted and become common practice in the open-ended fund sector, a question arises in respect of the dichoomy with the information enclosed in the closed-ended and fund sector. Potentially, many of the proposals, particularly in respect of disclosure, would be applicable to closed-ended fund investors. To couple these disclosures with the board independence framework already in place could serve to create greater clarity in the closed-ended fund sector of the market as well.

Other Matters

Removal of OEIC AGM and the need to re-appoint the scheme auditor

Since 6th April and the coming into force of the Open-Ended Investment Companies (Amendment) Regulations 2005, the manager is now able to dispense with the requirement to hold an AGM. This can be achieved by giving the shareholders 60 days notice of their intention to do so.

A side-effect of this approach, however, and one that managers should be aware of, is that on the removal of the need to hold AGMs, any auditor appointed ceases to hold office and therefore will need to be reappointed immediately.

CIS to COLL – derivatives and risk management processes

Managers currently using derivatives as per the Efficient Portfolio Management (EPM) provisions under CIS 5A, and looking to convert to COLL, will be required under UCITS III to introduce a risk management process for derivatives. This applies even where the manager does not take advantage of any of the wider investment and borrowing and derivatives usage powers.

This means, in particular, that the manager will have to construct a formal risk management process that is appropriate to the complexity and sophistication of derivatives usage within the UCITS III fund. Notwithstanding the limitation of derivatives usage to EPM, the manager will need to formally disclose to the FSA:

· The methods for estimating risks in derivatives transactions

· The types of derivatives to be used within the scheme

· The underlying risks inherent in those derivatives

· Any relevant quantitative limits that are applied.

Managers will also need to be able to provide to unitholders, upon request, information supplementary to that contained in the prospectus of that scheme in relation to:

· The quantitative limits applying to the risk management of that scheme

· The methods used in relation to the above; and

· Any recent development of the risk and yields of the main categories of investment.

Changes to the Instrument of Incorporation

For many managers, the conversion to COLL will largely be a “paper” exercise. They will simply move from authorisation under CIS to authorisation under COLL without taking advantage of any of the wider powers available and, therefore, without unitholder approval being sought.

For ICVC managers it is worth bearing in mind that this approach may in itself restrict the ability to launch future sub-funds under the same ICVC umbrellas. The point here is that before a future sub-fund could be launched that did take advantage of the wider UCITS III powers, the Instrument of Incorporation will also need to be changed to permit the sub-funds to have these wider powers.

Interestingly, in this regard, one large UK fund manager recently moved to change the instrument to allow for future sub-funds to take the wider UCITS III powers and obtained unitholder approval for this from the investors in the current sub-funds even although those sub-funds were not themselves taking advantage of the wider powers available under UCITS III.

News & Views – Next Edition

In our next edition of News & Views, we will review three key issues of interest to managers as they look ahead and consider their funds’ conversion to COLL. These issues are:

· COLL conversions – to vote or not to vote.
As the months go by and we progress along the path to February 2007, managers are increasingly looking at their plans for COLL conversion. While the package of product changes that managers seek to select from the COLL menu differs from one manager to the next, the question remains largely unchanged – is a unitholder vote required? In this article, we will consider the various options available to managers under COLL and consider whether adoption of the various options requires unitholder approval under the FSA’s traffic light system for fundamental, significant and notifiable events.

· Derivative strategies
Following on from the above topic, we will consider the various derivatives strategies that are now being utilised (or the potential utilisation being mooted) within the context of UCITS funds. We consider which strategies can be achieved under the EPM regime and which require the funds to first convert to UCITS III.

· Box management – the future
In this article, we will look at the trends that are emerging in respect of box management. At a time when the key objective of many managers is to reduce the amount of their capital that is tied up in their box, other managers are again focusing on the box as a valuable revenue stream. We will consider the competing motivations behind these approaches and also look at the opportunities now available to managers under COLL in respect of both these approaches. We also will consider how the FSA’s governance review may, in due course, impact upon the box management process and a manager’s strategies.

Contents

Citigroup® Global Transaction Services Fiduciary Services Citicorp Trustee Company Limited Informal Compliance; 4 August 2005 CTCL home page

Citigroup® Global Transaction Services
Fiduciary Services
Citicorp Trustee Company Limited
Informal Compliance; 4 August 2005

CTCL home page