Contents > Citigroup® Global Transaction ...
Page last published: 23 April 2010

Citigroup® Global Transaction Services
Fiduciary Services
news&views; May 2006
Weaving through the MiFID Maze; Microfinance funds in Luxembourg

CTCL home page

Across Europe

· All you (possibly) wanted to know about MiFID

· Feedback to the EU Green Paper published by the European Commission

· CESR's Final Advice on Eligible Assets for UCITS

· Updates from IOSCO

· Summary of the Statement of Recommended Practice (SORP)

Luxembourg

· Developments in Luxembourg Real Estate Funds

· Microfinance funds: Mixing financial profit with social good

Ireland

· Property Funds in Ireland - Regulation and Additional Challenges

· An Update on UCITS III Management Company in Ireland

Germany

· Two years of German Investment Act: Results and possible future development in the German hedge fund market

Contacts

Welcome to the first edition of News & Views of 2006. Not surprisingly, as we head into the second quarter, regulatory issues are moving apace.

In recent months, several interesting updates have emerged from Europe. We have documented the salient ones here and they include recent MiFID developments, the establishment of a formal mediation mechanism to resolve disputes between European regulators on matters concerning the implementation of UCITS and the draft regulation on eligible assets for UCITS published by the European Commission.

In our February 2005 edition of News & Views, we stated with reference to the EC Recommendation 2004/303/EC on the use of financial derivative instruments for UCITS that "…as future regulations increasingly become influenced by Brussels, the attention and the lobbying efforts of the investment fund industry will shift from national regulators to EU institutions and the CESR…". This trend has gained momentum and once MiFID is implemented in 2007, the only piece of the jigsaw that will arguably be missing, is the establishment of a single European financial market with one, pan-European regulator. Despite CESR's coordination efforts, the process may not be properly completed until there is a central authority responsible not only for the creation of regulation, but also for its enforcement.

On the UCITS side, the impressive amount of work carried out by CESR in 2005, and other initiatives underway (mainly, the European Commission's Green Paper and the establishment of the expert group on investment fund market efficiency), will deliver most of the expected results by the end of this year. This should be reflective of CESR's "evolutionary approach" to UCITS - ie no revamping of the UCITS legislation in the medium to short-term.

On the non-UCITS side, there is still much to be discussed. The investment fund industry has shown a growing interest in the alternative investment market which has so far never been properly exploited. IOSCO's report on the regulatory environment for hedge funds has rightly underlined the fact that, as of today, the concept of "hedge fund" has not been defined in any of the major investment fund markets. If a single or harmonised approach has to be taken at European level on hedge funds (single and fund of funds) for instance, then the first step would be to provide for a single definition of what a hedge fund may be. Similar initiatives will probably have to be taken to define other alternative investments such as private equity funds, venture capital funds, property funds and microfinance funds.

With reference to Citigroup Fiduciary Services' core markets, we would like to draw your attention to the following regional issues. In the United Kingdom, we have seen the relaxation in March of this year of a number of proposals to the proposed real estate investment trusts structure ('REITS'). REITs will be introduced in January 2007 and will have two major selling points - they are on-shore and will have all of the qualities of property companies whilst paying less tax. REITS are becoming well established throughout the world. In the US, for example, the industry is worth in excess of $360bn and growth has been evidenced in Australia, Japan and France in particular. Also in March, we have seen the publication by the FSA of two important Feedback Statements on hedge funds and wider-range retail investment products. The hedge fund paper looks at issues raised in an earlier Discussion Paper (DP05/4) and centres around whether the FSA was correct in its assessment of the risks posed by the hedge fund phenomenon and which of the potential risk mitigation actions outlined require further review.

Obviously, the FSA is eager to ensure that the UK remains an attractive market place for hedge fund managers.

In relation to the Feedback Paper on investment products, again, risk identification and mitigation are central tenets of the FSA's objectives. It intends to reinforce its existing consumer information and awareness-investing proportionately is a key objective it wishes to get across to consumers.

The FSA also wishes to look at the question of 'product provider responsibility' as part of its established intention to treat customers fairly. Finally, it is proposed that the range of Non-UCITS Retail Schemes (NURSs) be extended to include unregulated schemes. This raises obvious concerns in terms of risk.

Turning to Germany (where, incidentally, REITS should be introduced later this year) we have provided an analysis of the discussions currently under way which aim to improve the existing provisions of the German Investment Act which mainly focus on the hedge funds' framework.

In Ireland, there is also growing interest in the property fund industry. The Dublin Funds Industry Association (DFIA) is currently in discussions with the Financial Regulator to devise a more robust framework for this investment vehicle. We comment in this edition on the Financial Regulator's publication of draft guidance notes on UCITS III Management Company, including suggestions for possible improvements.

Concerning Luxembourg, we would like to thank Michael Hornsby and Jose Maria Ortiz respectively from Ernst & Young for contributing their article on property funds. Finally, we are pleased to provide you with an interesting analysis of the Microfinance business, and its implications for the investment fund industry - good returns for a good cause!

Sean Quinn
European Head of Fiduciary Services

news & views contributors

Luxembourg:

Ireland

Stefano Pierantozzi
Head of European Fiduciary Oversight & Research
stefano.pierantozzi@citigroup.com
tel: +44 (0)207 508 6651
tel: +352 451 414 370

Cian O'Callaghan
Fiduciary Oversight & Research
cian.ocallaghan@citigroup.com
tel: +44 (0)207 500 8834

Adam Willis
Fiduciary Oversight & Research
adam.willis@citigroup.com
tel: +44 (0)207 500 8303

Stephen Clark
Fiduciary Oversight & Research
stephen.clark@citigroup.com
tel: +44 (0)207 500 6351

Davide Tassi
European Fiduciary Officer - Alternative Investments
davide.tassi@citigroup.com
tel: +44 (0)207 508 1133

Mathilde Cottard
GTS Analyst

Patrick Watelet
Head of Fund Compliance & Fiduciary Oversight
patrick.watelet@citigroup.com
tel: +352 451 414 231

Ulrich Witt
Fund Compliance & Fiduciary Oversight
ulrich.witt@citigroup.com
tel: +352 451 414 520

Michael Hornsby and Jose Ortiz
Ernst & Young Luxembourg

Andrew Farrell
Head of Fiduciary Oversight & Research
andrew.farrell@citigroup.com
tel: +353 1 622 6206

Luis Caso
Fiduciary Oversight & Research
luis.caso@citigroup.com
tel: +353 1 622 1052

Michelle Duffy
Fiduciary Oversight & Research
michelle.duffy@citigroup.com
tel: +353 1 622 6159

Ingrid Byrne
Fiduciary Oversight & Research
ingrid.byrne@citigroup.com
tel: +353 1 622 6264

Germany

Marco Sperlich
Fiduciary Oversight & Research
marco.sperlich@citigroup.com
tel: +49 69 1366 1179

All you (possibly) wanted to know about MiFID

In recent months there has been much discussion around the Markets in Financial Instruments Directive ("MiFID", also known as "Investment Services Directive 2" - "ISD2"). But MiFID is only a part, even if large, of an overall plan aimed at establishing an integrated and homogeneous financial services market in the European Union. Now that the European Commission has issued the draft implementing measures on MiFID, it is the right time to review how it all started, the state of play now, and what the future will bring us.

Those who have not heard about MiFID before, please raise a hand. We are rather confident that few, if any, of our readers, are raising their hands above their desks at this very moment, but if we were to ask about the origin of MiFID, what created the Committee of European Securities Supervisors ('CESR'), or what is the difference between "Level 2" and "Level 3", the results would not be necessarily equally comforting.

However, MiFID is one of the topics of the day, and will eventually bring impressive changes to the way financial services are sold across the European Union. Additionally, CESR and IOSCO (the "International Organisation of Securities Supervisors") have produced much documentation and research during the last two years which very few of us have had the chance or the time to review in their entirety, to see how all the pieces fit together.

The Financial Services Action Plan

On 11 May 1999, the European Union published a small document of approximately 30 pages, entitled: "Financial Services: Implementing the Framework for Financial Markets: Action Plan". The Financial Services Action Plan ("FSAP") was the result of long discussions begun the year before. Without going into excessive detail, the FSAP was conceived for the purpose of ensuring a "rapid progress towards a single financial market".

The FSAP identified measures to be put in place to improve the single market in financial services, stressing that "several proposals of immediate and significant relevance to the functioning of the EU financial markets have fallen victim to protracted political deadlock".

So, it was really a rescue plan rather than a simple action plan.

The real plan actually consisted of a simple table of actions, prioritised on the basis of their relevance/urgency:

· Priority 1 actions: actions calling for immediate attention, crucial for the realisation of the full benefits of the Euro and ensuring the competitiveness of the European Union's financial services sector and industry, while safeguarding consumers' interests

· Priority 2 actions: important for the functioning of the single market for financial services, to be put in place by either amending existing legislation or adapting present structures to meet new challenges

· Priority 3 actions: where a clear and general consensus exists that new work should be set in hand with a view to finalising a coherent policy by the end of the euro-transitional period To put matters into perspective, of the 43 actions identified, 20 were Priority 1, these including "Political agreement on the proposed directive on UCITS", and "Amendment of the money-laundering directive".

The committee of wise men (Lamfalussy report)

One year later, at the Lisbon European Council held in March 2000, the heads of state or government of Member States emphasised the need to accelerate the completion of the internal market in financial services, and to implement the FSAP by the year 2005. To meet this objective, changes were clearly required in the EU legislative process which had to be made more flexible, effective and transparent.

For these reasons, on 17 July 2000 the EU Economic and Finance Ministers (ECOFIN) mandated a "committee of wise men" with the task of designing a more effective approach towards the transposition and implementation of EU securities regulations. The committee, chaired by Baron Lamfalussy, delivered its final report on 15 February 2001 (the "Lamfalussy report").

Besides making a series of recommendations, the report defined a four-level approach to regulatory reforms, as follows:

· Level 1: framework principles to be decided by normal EU legislative procedures

· Level 2: implementation of framework principles through the creation of two new committees to assist the European Commission in determining how to implement details of the Level 1 framework. Those new committees would be a Securities' Committee ("ESC") and a Securities Regulators Committee ("ESCR", now "CESR")

· Level 3: enhanced co-operation and networking among EU securities regulators to ensure consistent and equivalent transposition of Level 1 and Level 2 legislation (common implementing standards)

· Level 4: strengthened enforcement, notably with more vigorous action by the European Commission to enforce Community law, underpinned by enhanced cooperation between Member States, their regulators, and the private sector

As at today, Levels 1, 2 and 3 of the Lamfalussy approach have all been applied. Level 4 remains untested.

Lamfalussy directives and MiFID timetable

Following the Lamfalussy approach, European directives fall into two categories: "Level 1 legislation" which set out framework principles and "Level 2 legislation" which set out the implementing measures that allow those framework principles to be put into practice. There are currently four Level 1 directives and three Level 2 implementing directives, as follows:

· Market abuse directive (2003/6/EC) and

1. Implementing directive 2003/124/EC (Level 2)

2. Implementing directive 2003/125/EC (Level 2)

3. Implementing directive 2004/72/EC (Level 2)

· Prospectus directive (2003/71/EC)

· MiFID (2004/39/EC)

· Transparency directive (2004/109/EC)

The transposition deadline has not yet expired with the exception of the MiFID and the transparency directives.

In this respect, it should be remembered that while the initial MiFID transposition deadline was two years following its publication (so, the initial deadline was 30 April 2006), the European Commission decided to postpone it by six months, until 30 October 2006, and to give six additional months to "firms and markets" to adapt themselves to the new requirements (ie, until 30 April 2007).

Following the completion of CESR's consultation process on MiFID implementing measures, and on the basis of the technical advice so received, on 6 February 2006 the European Commission published a draft implementing directive, and a draft implementing regulation (Level 2 measures). The draft implementing directive postpones the process again (31 January 2007 for transposition into national law, and 1 November 2007 for enforcement).

What MiFID is really about

MiFID covers a wide range of subjects which should be treated separately in order to provide a complete overview.

The main goals of MiFID can be identified as follows, on the basis of the same directive's text:

· Provide for the degree of harmonisation needed to offer investors a high level of protection and to allow investment firms to provide services throughout the EU, being a single market, on the basis of home country supervision

· Due to the increased dependence of investors on personal recommendations, include the provision of investment advice as an investment service requiring authorisation

· Expand the list of financial instruments to include certain commodity derivatives and other exotic instruments

· Establish a comprehensive regulatory regime to ensure a high quality of execution

The areas covered by MiFID can be identified as follows:

· Conditions and procedures for authorisation

· Organisational requirements

· Conduct of business

· Client order handling rules, and client classification

· Best execution, transparency

· Passporting rules

· Regulatory enforcement and co-operation between member states

· Information Technology and operations

· Equities trading, market structure

For the purpose of this article, we will mainly focus upon "authorisation and operating conditions for investment firms" (Title II of the directive).

As far as investment firms are concerned, MiFID deals with: conditions and procedures for authorisation, operating conditions and rights of investment firms.

Conditions and procedures for authorisation

In terms of authorisation process, we find the new wording provided in terms of passporting services interesting. While in the previous Investment Services Directive Member States had to "ensure that investment services could be provided on the basis of a European passport", MiFID simply (and strongly) states that "the authorisation [given by the home state authority] shall be valid for the entire Community and shall allow an investment firm to provide the services or perform the activities for which it has been authorised, throughout the Community, either through the establishment of a branch or the free provision of services".

The draft implementing directive postpones the process again (31 January 2007 for transposition into national law, and 1st November 2007 for enforcement)

Apart from dealing with capital requirements, management's threshold competency and reputation and identity of the principal shareholders, MiFID introduces stricter requirements in terms of internal organisation and controls (article 13).

· Investment firms are required to establish "adequate policies and procedures sufficient to ensure compliance of the firm including its managers, employees and tied agents [...] as well as appropriate rules governing personal transactions by such persons", and to maintain and operate "effective organisational and administrative arrangements [...] to prevent conflicts of interest"

· Investment firms are also required to ensure business continuity ("continuity and regularity in the performance of investment services and activities"), review the performance of third-party service providers as well as the outsourcing arrangements ("outsourcing of important operational functions may not be undertaken in such a way as to impair materially the quality of its internal control and the ability of the supervisor to monitor the firm's compliance with all obligations")

· Adequate record-keeping arrangements and sound administrative controls for administrative and accounting functions, as well as an effective risk assessment framework, are also requirements under MiFID

· MiFID also imposes adequate safekeeping arrangements, segregation of client accounts, and arrangements to safeguard clients' rights in case of the investment firm's insolvency

· Finally, and probably crucially for an effective functioning of the passporting rights, the host state authority can, in the case of investment firms' branches, "enforce the obligation" to comply with the rules set down in MiFID in respect of clients or potential clients, with regard to transactions undertaken by the branch

Article 14 and 15 of MiFID deal with the trading process and finalisation of transactions in a Multilateral Trading Facility ("MTF"), and relationships with third (non-EU) countries. We will not focus on these areas in this article.

Operating conditions

· Investment firms must "take all reasonable steps to identify conflicts of interest" between themselves (including their managers, employees, agent) and their clients, or between their clients. In those cases where organisational or administrative arrangements established by the investment firms are not sufficient to reasonably ensure that clients' interests are not damaged, the investment firm has an obligation to disclose the nature and sources of conflict to the client

· Conduct of business is one of the key areas upon which MiFID focuses its attention. When providing its services, an investment firm must "act honestly, fairly and professionally in accordance with the best interests of its clients", and comply in particular with seven basic principles (Art. 19, paragraphs 2 to 8):

1 Information provided to clients, including marketing information, must be fair, clear and not misleading.

2 Provide clients with appropriate, comprehensive information on: the investment firm and its services, the financial instruments and investment strategies proposed, the execution venues, and costs and associated charges. The information "may be provided" in a standardised format.

3 The investment firm must obtain the necessary information on the client's knowledge and experience, his financial situation and investment objectives, when providing investment advice or portfolio management, for the purpose of recommending to the client "suitable financial instruments".

4 Comparable obligations apply also in case of services other than investment advice or portfolio management, to enable the investment firm to assess if the investment service or product envisaged is appropriate for the client. If the product or service is not deemed appropriate, the investment firm must issue a warning to the client, which may be provided in a standardised format. A similar procedure shall apply in those cases where the client does not produce the information required to allow the investment firm to assess the client's personal situation

5 In the case of UCITS distribution, as well as in general for all those investment services consisting only of execution and/or transmission of client orders, and under some clearly-identified circumstances (Art. 19 paragraph 6), the investment firm can provide its services without the need to obtain detailed client information.

6 The investment firm must establish a record including the documents agreed between the investment firm and the client which set out the rights and duties of the parties.

7 The investment firm is required to provide the clients with "adequate reports on the services provided", including associated costs for any transaction or service.

8 None of the above obligations will have to be complied with if the investment service offered by the investment firm is part of a financial product subject to other EC legislation or European common standards provisions, relating to credit institutions and consumer credit with respect to risk assessment of clients and/or information requirements.

· MiFID also imposes new obligations in terms of best execution ("obligation to execute orders on terms most favourable to the client"). In this case, too, the generic obligation is based upon a number of key principles

Investment firms must take "all reasonable steps to obtain, when executing orders, the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order". This should not contrast with the obligation to execute specific instructions from the client.

To meet these requirements, investment firms must implement an effective compliance program and a formal "order execution policy". Such a policy must include, for each class of financial instruments, information on the venues where the investment firm executes clients' orders, and the factors (which will obviously be influenced by best execution requirements) applied to choose the execution venue.

MiFID requires the order execution policy to be disclosed to clients and Member States are required to impose investment firms obtaining prior consent of their clients to the execution policy. This assumes particular relevance in those cases where client orders may be placed outside regulated markets.

The monitoring of compliance with the order execution policy will have to be performed on a regular basis to identify and correct any weakness. Any subsequent change to the order execution policy will have to be notified to clients. Additionally, investment firms will be required to be able to demonstrate to their clients, at their request, that they have executed their orders in accordance with the policy. This implies that more robust audit trails and record-keeping procedures may have to be put in place in the near future.

· Along with best execution rules, MiFID imposes some minimum client order handling rules, to allow for the execution of comparable client orders in accordance with the time of their reception. The investment firm's internal procedures and arrangements must provide for prompt, fair and expeditious execution of orders

· As far as the provision of services through other investment firms and the appointment of tied agents are concerned (articles 20 and 23 respectively), there are a couple of issues that are worth noting. When an investment firm receives an instruction to perform a service on behalf of a client, through the intermediation of another investment firm, the responsibility for collecting and transmitting client information lies on the intermediating firm. Even if under some circumstances UCITS distribution may be exempt from client information requirements, promoters distributing their UCITS on a cross-border basis will be happy to know that they are allowed to rely fully on their (independent) distribution network

This will not be the case for tied agents, however MiFID states that where an investment firm decides to appoint a tied agent it remains "fully and unconditionally responsible" for any action or omission on the part of the tied agent when acting on behalf of the investment firm.

· Investment firms will be allowed not to comply with most of the obligations so far defined, in the case of transactions executed with eligible counterparties which include, inter alia, other investment firms, credit institutions, insurance companies, UCITS and UCITS management companies. Entities recognised as eligible counterparties will still have ability to ask to be treated, on a general or trade-by-trade basis, as a normal client

· With regard to "market transparency and integrity" (Articles 25 to 30), MiFID establishes minimum regulatory reporting requirements and record keeping requirements for transactions in financial instruments admitted to trading on regulated markets. Particular requirements will apply to MTFs ("Multilateral Trading Facilities") and to systematic internalisers in shares

In addition to the above regulatory reporting requirements, investment firms concluding transactions in shares admitted to trading on a regulated market, concluded outside a regulated market or MTF, must make public the volume and price of the shares involved, and the time of the transaction, on a real-time basis or as soon as possible.

Investment firms rights

One of MiFID's goals is to put a stop to those regulatory or legal practices preventing investment firms from taking full advantage of their passporting rights.

As far as the freedom to provide services is concerned, Article 31 of MiFID clearly states that "Member States shall not impose any additional requirements" on those investment firms authorised by the competent authority in another Member State, willing to provide their investment services under the regime of free provision of services.

The same applies in the case of the establishments of a branch. In this case, however, the host Member State authorities shall assume responsibility for ensuring that the services provided by the branch within its territory comply with MiFID's marketing, best execution and market transparency rules. Hopefully, implementing rules will provide enhanced clarity on the extent of these rules.

MiFID requires the order execution policy to be disclosed to clients

Assessing MiFID's impact

MiFID is a Level 1 directive, which means only Level 2 and Level 3 (implementation and transposition) measures will really clarify its impact. Some observations can be made anyway on its likely impact.

Level 2 and Level 3 measures, because of the Lamfalussy process, are the result of a compromise between the views of different Member States and their respective regulators. In this respect, MiFID should bring changes to any regulatory environment, regardless of its complexity or structure. In some cases changes may be almost purely cosmetic or limited to regulatory jargon, but it is very unlikely for any regulatory framework to remain unchanged. Changes will be more drastic for those regulatory environments that are still relatively underdeveloped, but this does not necessarily mean that MiFID compliance costs will be lower, for example, in the UK rather than in a new accessing country with a less-developed regulatory environment. Actually, it could well be the contrary.

As CESR to a great extent will be "defining" implementing measures, one of MiFID's effects (and of the Lamfalussy approach in general) will be that rules-writing will no longer be a matter of national approach or point of view. This is consistent with the FSAP's goal to establish common rules for a single financial market.

The draft implementing measures published by the European Commission on 6 February 2006 consist of a draft Level 2 directive and a draft Level 2 regulation. Along with these drafts, the European Commission has also published some background notes, which will help in driving MiFID's implementation process.

These measures will certainly ignite additional discussions amongst industry players. Until consensus is reached by the European institutions on a final version of the draft implementing measures, we do not propose to enter into a detailed analysis of them. Having stated this, we do not foresee major changes between the draft measures and their final version, so we strongly advise that, if you have not have done so already, you consider these documents and start making an impact analysis.

Final thoughts

So, which are the main areas of interest for the investment fund industry? Well, to use the UK Financial Services Authority's ("FSA") words, "MiFID will only partially affect the UCITS landscape given the carve-outs possible in the current text. However, generic portfolio management, provision of investment advice and custody will need to be compliant with the provisions of the directive - amongst other things, it affects organisational requirements, client agreements, assessing suitability and appropriateness of services for specific clients, providing best execution".

It should also be remembered that the European Commission's Green Paper on the enhancement of the EU framework for investment funds regards MiFID as a "useful toolbox to clarify all duties of care, risk warnings or other obligations that an investment firm owes to a client considering an investment in UCITS". In the same Green Paper, the European Commission proposes a timetable of actions aiming at enhancing the UCITS framework, which includes an "assessment of the articulation between UCITS and MiFID" to be completed in early 2006.

While waiting for the result of this assessment and a final version of the draft Level 2 implementing measures, we would like you to consider the following aspects:

· MiFID is not about collective investments: Article 2 of the Directive (Exemptions) states that "[this Directive shall not apply to] collective investment undertakings and pension funds whether coordinated at Community level or not and the depositaries and managers of such undertakings"

· Article 24 of MiFID defines "UCITS and their management companies" as "eligible counterparties". By way of exclusion, non-UCITS funds, which are mostly sold through private placement to professional investors, could benefit from additional protection compared with UCITS products, which are retail-oriented

· If, as suggested in the already-mentioned Green Paper, MiFID will also "serve as a basis to improve transparency of the distribution process via its rules on management and disclosure of conflict of interest and on best execution", the impact on the distribution chain could be even wider than currently expected

· Article 3 of MiFID (Optional exemptions) states that Member States may choose not to apply the requirements of the Directive to persons that "are not allowed to provide any investment service except the reception and transmission of orders in [...] units in collective investment undertakings"

As usual, we will keep you updated on future developments, so keep on reading News & Views and, if you have questions, please feel free to contact us.

Feedback to the EU Green Paper published by the European Commission

Following the publication of its "Green Paper on the enhancement of the EU framework for investment funds", the EC has received a number of written responses, including the one submitted by Citigroup's European Fiduciary Services. On 13 February 2006, the European Commission has issued a "Feedback Statement" paper.

Having received more than one hundred responses from fund industry players, it is not surprising that it took so long for the EC to produce a synopsis of the participants' points of view.

Also, it is interesting to note that responses were not always aligned, showing that while there is a general industry point of view on some issues, other issues are more contentious. Without entering into excessive details (the Feedback Statement is available on the European Commission's website), we would like to draw your attention to a few key issues.

It looks like an amendment to the Directive is considered necessary by the fund industry

UCITS III implementation

More than 60 percent of the respondents support the view that the notification procedure for Undertakings for Collective Investment in Transferable Securities ('UCITS') should be simplified as a matter of priority. While this feedback strongly supports the work recently performed by the Committee of European Securities Regulator ("CESR") for the purpose of streamlining the notification procedure, it is also true that CESR's activity is limited within the scope of the current UCITS III Directive wording. Following this consultation, it looks like an amendment to the Directive is considered necessary by the fund industry.

Similarly, most of the respondents (about 70 percent) suggested that the simplified prospectus, as currently implemented, does not meet its objectives of providing a useful information tool to investors.

Passporting services: management company and depositary

Even if the management company's and depositary's passports are discussed in separate sections of the Feedback Statement, we think it's interesting to note that the fund industry's view on both issues is not clear cut, with those who do not recommend a complete application of the right of free provision of services being in the majority.

An effective passport would allow a management company or a depositary domiciled in one Member State to provide services to a UCITS fund domiciled in another Member State, on the basis of the management company's or depositary's home Member State authorisation, without the need to have a physical presence in the UCITS' domicile state.

As far as the management company passport is concerned, most respondents argued that this possibility would raise concerns as far as investors' protection and effectiveness of supervision are concerned. Additionally, the split of supervision between the UCITS and the management company would increase legal and regulatory uncertainty, increase organisational complexity, and eventually increase risks for the final investors.

Little support was shown for the introduction of a depositary's passport, as respondents considered that the diversity of roles and functions of depositaries in different Member States, and the difficulties in harmonising these functions, would increase organisational complexity and cause additional concerns and disputes between supervisors, in the case of contrast between Home State and Host State regulations.

The main reasons for allowing the passporting of depositaries' services, ie cost efficiency and increased expertise and specialisation, do not seem to overcome the concerns raised so far, so it is very unlikely that the EC will decide to push in that direction. In addition, it is worth noting that respondents also suggested that if the management company passport option were pushed forward, it would be advisable to keep the depositary located in the UCITS' home state.

Mergers and pooling

In general terms, both cross-border fund mergers and cross-border pooling are seen by respondents as effective mechanisms to improve the cost-efficiency of the investment fund industry.

Pooling seems to be generally more supported than fund mergers and, in particular, the master-feeder structure appears preferred to virtual pooling techniques; master-feeder structures are considered more transparent, easier to supervise and less complex from an operational and organisational point of view.

Cross-border fund mergers are generally seen as economies of scale generators, but very little quantitative evidence was provided to support this view.

Alternative investments

Part of the debate has been around whether or not investment into property should be falling under the definition of "alternative". While there is widespread recognition that hedge funds (single or funds of funds), private equity and venture capital funds fall within this area, property funds remain in a limbo between the mainstream UCITS funds and more exotic products.

In terms of property funds, some industry players strongly suggested the creation of harmonised open-ended property funds available to retail investors, either extending the eligible asset classes for UCITS, or establishing a separate regime for open-ended property funds.

Most respondents agree that a common EU approach to alternative investments is required, but there are considerable divergences as to what such an approach should represent.

A large majority supports the introduction of a "common private placement regime" to facilitate cross-border offering of alternative investments to "qualified investors" only. There is also some support, to a lesser extent, for product harmonisation for alternative investments in general.

Other topics

Industry standardisation (industry or regulatory driven), investor protection, and competition from substitute products were also subject to discussion.

While we recommend you to read the Feedback Statement in its entirety, there are two particular comments we would like to make. One is that the investment fund industry has identified some weaknesses in the current framework. However there is no agreement as to what actions need to be put in place to eliminate these weaknesses. Secondly, these supposed areas for improvement sometimes seem to conflict with each other, showing that there is not a clearly identified way forward for the European fund industry. Hopefully the recent establishment of European expert working groups will help to define priorities and long-term strategies better.

CESR's Final Advice on Eligible Assets for UCITS

In the last edition of News & Views we provided you with comments and analysis on the consultation process established by the Committee of European Securities Regulators (CESR) to advise the European Commission (EC) on the definition of eligible assets for investment of Undertaking for Collective Investments in Transferable Securities (UCITS). The consultation process was completed in January, with the publication of CESR's final advice.

Much has been said and written in the last months on CESR's consultation on eligible assets, by us and other fund industry players, so the contents of this final advice should not come as a surprise to those who have followed the process. Having also attended the

CESR open hearings in Paris on this subject, we had already understood that CESR's position was to clarify, rather than to open the floodgates to new investment strategies or products - in line, we think it's fair to say, with the mission of UCITS products which is to provide a safe, risk-mitigating investment vehicle for retail investors.

What's new in the final advice

CESR's press release accompanying the publication of the final advice provides a good résumé of the main amendments to the last published draft advice. CESR highlights the areas upon which most of the discussions had focused during the last open hearing, and the progress made after the publication of the last draft:

· Negotiability of transferable securities: the suggested requirement that a security "must be freely negotiable on the capital markets" has been amended, and references to "freely" and "on the capital markets" deleted. Also clarification has been made to the terms of negotiability and liquidity for listed securities

· Eligibility of money market instruments: information requirements have been relaxed for certain types of issuers/issues, for example, when the issuer is an establishment subject to prudential supervision

· Eligibility of derivative instruments on financial indices: CESR's view is to extend eligibility not only to indices based on financial derivatives on commodities, but also to indices on properties, provided they are sufficiently diversified and represent an adequate benchmark for the market to which they refer

Hedge fund indices will remain in a limbo, but will be monitored by CESR. Their eligibility will be re-assessed in October 2006 but for the time being, CESR members will not authorise setting up new UCITS whose investment policies allow hedge fund indices.

The consultation process

We think it is useful at this stage to re-cap how the consultation started, progressed and what its impact will be in the coming months.

In October 2004, the EC mandated CESR to submit advice on the definitions pertaining to eligible assets that are contained in the UCITS Directive, with the purpose of ensuring a more consistent implementation of European legislation.

Following a call of evidence published at the end of 2004, CESR published its first draft advice on 17 March 2005.

After an open hearing held by CESR in May 2005, and in consideration of the number of answers received, CESR requested the EC to postpone the deadline for the issue of its final advice, and started a second consultation process by issuing its second draft advice and starting a new consultation on 20 October of the same year.

Having gathered all the responses to this second consultation process, and in consideration of the discussions held during the second open hearing organised on 7 November 2005, the final advice was issued on 26 January 2006.

Next steps

Even if the UCITS Directive has not been established under the framework of the Lamfalussy approach, CESR has applied to this consultation process a Lamfalussy-style approach, making a clear distinction, in its final advice, between "Level 2 advices" and "Level 3 guidelines". Such distinction is key, since while Level 2 advice requires implementation (hopefully, without material amendments) through a Directive or a Regulation, Level 3 guidelines provide for common (not binding) standards and practices for implementation at Member State legal or regulatory level.

The original timetable proposed by the EC for the clarification of definitions concerning eligible assets for UCITS considered April 2006 as the deadline for the conclusion of the process, as follows:

· October 2005: Technical advice from CESR

· December 2005: Publication of a working document on possible Comitology instrument on the EC website

· December 2005: EC's proposal for Comitology instrument sent to the European Securities Committee (ESC) and the European Parliament

· April 2006: Formal adoption by the EC

Upon CESR's request, the EC agreed to postpone the deadline for CESR's advice to mid January 2006. This has obviously impacted on the entire process which will be coming to a conclusion later than initially planned -but still during the course of 2006.

On 15 March 2006, the European Commission published a Working Document (ESC/13/2006) and a Background Note (ESC/14/2006) on "elements for a possible Commission Regulation on the clarification of definitions under the UCITS Directive".

According to the Background Note, "the Commission services envisage bringing forward this draft implementing measure in the form of a regulation. The nature of this exercise is confined to the clarification of the reading of existing provisions of the Directive. This lends itself to a regulation. The technical and detailed provisions of this implementing measure are capable of direct application to all UCITS, without the need for national transposition. In addition, it is desirable to avoid both potential for divergences in transposition of these provisions and unproductive extension of delays before the measures take effect".

Conclusion

The main goals of the consultation were to provide advice to the EC and establish a common understanding and definition of eligible assets for UCITS across the industry and Member States regulators. These goals have been achieved, even if the results may not satisfy all industry players, most of whom may have been expecting groundbreaking changes or initiatives.

The work performed on eligible assets should be not seen as a one-off exercise, and it is clear that going forward, CESR will take more and more of a lead in this respect. This is clear from CESR's own words, as it states in terms of eligibility of derivative instruments on hedge fund indices, that it is "monitoring the issue and is willing to reconsider its position by October 2006, after gaining sufficient experience".

Another element of interest can be found in the European Commission's decision to implement CESR's advice by means of a Regulation, instead of a Directive. The EC has taken this stance to avoid delays and interpretative divergences, but this approach has the added effect of moving the rules-writing activity away from Member States' regulatory authorities.

There is little doubt that in the coming months, there will be more to discuss as far as UCITS are concerned - watch this space!

Updates from IOSCO

In recent months, the International Organisation of Securities Commissions (IOSCO) has published a series of very interesting papers concerning the investment fund industry. Their main features are reported below.

The last few months have been a very productive period for IOSCO. For the investment fund industry, we think it's particularly important to report the main features of the following publications.

Paper on best practices standards on anti market timing and associated issues

In October 2005 the IOSCO technical committee published its final report on best practices standards on anti-market timing and associated issues for undertakings for collective investment ("UCIs").

The report describes market timing and associated issues, and their detrimental effect on UCIs and, ultimately, their investors, and seeks to identify best practice tools available for UCI operators to deter market timing. At the same time, IOSCO states that UCI operators have an obligation to employ these tools, and regulators "should seek to meet these standards when dealing with issues raised by market timing".

First standard: act in the interest of investors

Each UCI operator should be capable of demonstrating that:

· It treats investors fairly

· One group of investors is not favoured over others

· It manages conflict of interest between itself and the investors

· It makes full and fair disclosure to investors of policies that deal with conflicts

Second standard: operations and disclosure in respect of market timing and late trading must be consistent with the first standard

IOSCO is of the opinion that the specific tools to be used by UCI operators to monitor, detect, prevent and deter market timing and late timing practices should not be mandated, but rather it is up to the UCI operator to establish a suitable internal control environment.

However, UCI operators should analyse the impact of market timing and late trading practices, and take appropriate action to prevent such issues from occurring.

For this purpose, IOSCO recommends that UCI operators have a compliance programme in place to ensure the first standard is met, and suggests some additional processes which may be considered in establishing control mechanisms to detect market timing and late trading:

· Monitor trading patterns on the basis of parameters such as deal size, number and frequency

· Monitor the UCI's assets to determine if they present opportunities for time zone arbitrage

· On the basis of risks identified and their likely impact, take measures to prevent market timing or mitigate its effects

· Monitor valuation methodologies to ensure that the UCI's net asset value is accurate

· Ban late trading, to avoid any collusion between the UCI operator or its agent and an investor

· Evaluate the risk of late trading within the intermediary arrangements relating to the transmission of purchase and redemption requests

· Apply fair value methodologies when required, and if allowed by the local regulations

· Ensure the UCI operator has a right to inspect the records of the distributor in respect of identification and management of the risk of market timing - in particular in those cases where distributors aggregate subscription and redemption orders

· Implement compliance programmes, including written procedures and policies designed to monitor, detect and deter market timing as well as late trading

· Appoint a designated senior person responsible for the compliance oversight

· Use disclosure as a tool to inform investors of potential conflicts of interest and the actions taken to avoid those and treat investors fairly

Third standard: the regulatory regime should allow UCI operators appropriate flexibility in addressing the risk of detriment to investors arising from market timing

As stated above, IOSCO's expectations are that regulators should seek to meet some common regulatory standards. Those include taking a risk-based approach on UCI operators' monitoring to ensure benefits for the investors are proportionate with the costs of enforcing regulations. Also, UCI operators should be allowed a certain degree of flexibility in choosing the appropriate tools for complying with the regulations.

What is described above demonstrates a certain flexibility in IOSCO's approach. However, where there is a failure to meet the first standard, IOSCO's view is that should market timing and associate issues cause the UCI or a group of investors a loss, or should the UCI suffer dilution, the UCI operator's duty should be to compensate the investors and/or the UCI.

Additional options suggested to the regulators are to allow forward pricing and to restrict the time opportunity window between cut off time and NAV calculation time.

The exercise of discretion in the management of the risk of market timing should be subject to independent oversight to address the potential conflict of interest between the UCI operator and the investors.

Paper on anti money laundering guidance

In October 2005, IOSCO also published its final report on anti-money laundering ("AML") guidance for UCIs. In consideration of the fact that UCIs can be established under different legal forms, depending on the country of domicile, AML arrangements may be different from UCI to UCI. However, IOSCO has identified some key rules, which should apply under any circumstances.

Every UCI should develop and implement a written programme designed to prevent it from being used for money laundering and terrorist financing

As a starting point, every UCI should develop and implement a written programme designed to prevent it from being used for money laundering and terrorist financing. The programme should be approved in writing by the UCI's directors (or equivalent senior individuals, depending on the UCI's structure).

An appropriate AML programme should be based on the following foundations: a) robust written policies and procedures; b) regular and tailored employees' training; c) independent audit of the AML program; d) compliance management at adequately senior level and e) establishment of interdependencies with other group entities when the UCI is part of a wider financial services group.

Client verification and verification procedures

A UCI should apply client verification procedures on a risk basis if the criteria for risk determination are properly established and justified vis-à-vis the UCI's regulator.

In determining its procedural best practices, IOSCO identifies the following key elements to be taken into consideration:

a Responsibility for client identification and verification falls on the UCI. The UCI's directors or the UCI's authorised manager or equivalent should adopt a written policy describing in general terms the processes that the UCI will follow.

b Verification of investors' identity and of the beneficial owners (this latter, to a reasonable and practicable extent), may be determined on a risk basis depending on the type of investor, business relationship or transaction. The verification should provide a reasonable basis for the UCI to believe that the true identity of the investor is adequately known. The UCI may rely on documents as well as on non-documentary methods, or a combination of both, to establish investors' identity. IOSCO further details a list of documents required for personal or corporate investors.

c Investors should be identified before or during the opening of an account, to make sure that risks are properly managed. In this respect, it is however essential not to interrupt the normal conduct of business. The UCI should be ready to stop a transaction being executed, or terminating a relationship if required, along with reporting any suspicious activity to the applicable law enforcement agencies.

d IOSCO also suggests some "potential low-risk situations", in which simplified verification procedures can be applied.

Potential low risk situations

Considering how UCIs are usually distributed, we think it appropriate to focus in more detail on these low risk situations. This is also IOSCO's point of view, as their analysis covers a good part of its report.

IOSCO identifies eight situations where some form of simplified identification procedures can be applied. It should be remembered that IOSCO is not a regulator, and as such can define only best practices or business standards. Ultimately, the point of view of the UCI regulator will be the one that matters.

1 Bunched orders through omnibus accounts from market intermediaries: if the intermediary is a financial institution based in a country with adequate anti-money laundering standards, has in place an anti-money laundering programme, is subject to regulatory supervision and has measures in place to comply with supervisory requirements. In this case, identification can be limited to the market intermediary and does not extend to the underlying investors.

2 UCIs and funds of funds investing in UCIs: the same criteria as defined above apply. Under such circumstances, the UCI should be considered as the investor, and there is no need to verify the identity of any shareholder or unitholder of the investing UCI.

3 Investors introduced by group affiliates: if a client has already undergone client identification and in general, know your customer procedures while opening an account with an affiliated bank or financial intermediary, the UCI could apply more relaxed identification procedures. It should be considered, however, that this approach is valid only where the financial group of which the distributor and the UCI are part, has an anti-money laundering programme applicable to all the entities within the group.

4 Pension plans/superannuation schemes: due to their nature and the way contributions are paid to the scheme (often with employee contributions paid out of the salary), UCIs should consider investments made by pension plans/ superannuation schemes as low-risk from an anti-money laundering or terrorist financing perspective. The UCI should make sure that the pension plan/superannuation scheme is "genuine", but not treat the participants as its investors for client identification purposes.

5 Insurance products: the same criteria as those identified under point 1) above (bulk orders from market intermediaries) apply.

6 New investments in UCIs in the same UCI complex: in some jurisdictions, sub-funds within the same umbrella fund may engage in cross-investment. Also, investments may be made between funds which are not under the same umbrella structure, but which are affiliates of the same financial group. Under these circumstances, simplified procedures should be applied as under 3) above.

7 Public companies: in the case of listed companies, or subsidiaries of listed companies, it is IOSCO's opinion that there is no need to identify any shareholder, participant or unitholder of the company.

8 Low-risk products: where the UCI does not allow any cash withdrawal, third party payments (in or out of the fund) or payments (in or out of the fund) from/to accounts based in countries where no adequate anti-money laundering framework exist, the UCI itself may be considered as a low-risk product. IOSCO identifies additional control measures which may help considering the concerned UCI as a low risk product from an anti-money laundering perspective.

The UCI should not be sanctioned for failure of the relied-upon financial institution to fulfil adequately its responsibilities

Delegation of client anti money-laundering due diligence procedures

In some jurisdictions, a UCI may sub-contract its client due diligence procedures to a third party, usually a financial institution or a service provider such as a registrar or distributor.

IOSCO identifies some key factors to be considered when delegating or sub-contracting client due diligence:

· A contractual agreement must be in place, specifically allocating duties. Reference should be made to IOSCO's principles on outsourcing

· The UCI should be satisfied that any further sub-delegation is made to a sub-contractor with adequate expertise and staff

· The UCI must ensure that 'know your customer' procedures comply with the legislation in place where the UCI is established

· Law enforcement authorities in the country where the UCI is established must be allowed access to evidence of client identity identification, even where this is held abroad

· Suspicious transactions must be reported in the country where the UCI is established

Under certain jurisdictions, the UCI may rely upon a distributor, or an intermediary (in any case, usually a financial institution), to perform customer identification procedures. Regulatory requirements generally impose two criteria to be met:

· The UCI must be able to provide all the client documentation upon request and without delay

· The UCI must satisfy itself that the introducer is subject to appropriate anti-money laundering legislation, has in place an anti-money laundering programme, is supervised and has measures to comply with its regulatory obligations

In IOSCO's words, "if the basis for reliance on a third party is reasonable, and other jurisdiction-specific criteria permitting reliance are met, the UCI should not be sanctioned for failure of the relied-upon financial institution to fulfil adequately its responsibilities".

Consultation report on the regulatory environment for hedge funds

IOSCO's technical committee started investigating the regulatory environment for hedge funds in 1999 by conducting a survey amongst its members. This initial survey was updated in 2001, and in 2003 a report entitled "Regulatory and investor protection issues arising from the participation by retail investors in (funds of) hedge funds" was published.

In February 2005 IOSCO's standing committee on investment funds was mandated the task of mapping the regulatory environment across IOSCO members' jurisdictions to assess any regulatory reform having occurred in recent years relevant to the hedge fund business. The results of this exercise have been published in March 2006 in a consultation report entitled "The regulatory environment for hedge funds: a survey and comparison"

The consultation report is based upon the results of a survey conducted on the basis of a questionnaire addressing, amongst other things: strategies, definitions, registration, disclosure, advertising, reporting, examination and disciplinary actions.

IOSCO's opinion is that there are four significant conclusions to be drawn on the basis of the responses received:

· None of the responding members (which include, inter alia, the United States, the United Kingdom, Luxembourg, Ireland, France and Germany) has adopted a formal, legal definition of "hedge fund"

None of the responding members has adopted a formal, legal definition of "hedge fund"

· Hedge fund advisers (persons or entities managing a specific portion of the hedge fund's assets) are regulated in most of the responding jurisdictions

· Few jurisdictions report "any significant retailisation" of hedge funds at this point in time, but some regulators anticipate that this is changing or may change in the future

· There have been some incidents of fraud relating to hedge funds in the responding jurisdictions. In addition, as the regulatory regime for hedge funds is new in some jurisdictions, there is no data available on hedge fund fraud

Overall, IOSCO feels that additional work should be done to define common investor protection principles focusing on the need:

1 to ensure there is clear, concise and effective disclosure of the features of the hedge fund and

2 to develop valuation principles

Comments on the consultation report can be submitted to IOSCO by 31 May 2006.

Conclusions

IOSCO's stated objectives are to promote high standards of regulation in order to maintain just, efficient and sound markets, to exchange information between regulators, to promote the integrity of the markets and to establish standards of surveillance.

The documents we have detailed here meet these objectives, and should not be considered as merely descriptive; on the contrary, not only are IOSCO's standards highly regarded by regulators world-wide, but the Committee of European Securities Supervisors (CESR) looks at them for guidance in its harmonisation effort in Europe - which will eventually have an impact upon the day-to-day activities of all players in the fund industry.

Summary of the Statement of Recommended Practice (SORP)

The SORP on Financial Statements of Authorised Funds (for both AUTs and OEICs) issued by the IMA, applies to accounting periods that began on or after 1 January 2006 and replaces the SORP issued by the IMA in November 2003. However, the provisions for bond yields (ie where income will be accounted for on an effective yield basis and with reference to the purchase price) will be applicable to accounting periods beginning on or after 1 January 2007.

This SORP supersedes the previous SORP and has been approved by the Accounting Standards Board (ASB). Both the CIS and COLL Sourcebooks require compliance with SORP.

The drivers for the revised SORP include IFRS/ UK convergence standards, enhanced disclosure requirements and the COLL Sourcebook.

Presenting Financial Statements

The SORP details how audited annual statements should be presented as follows:

a Statement of total return (net investment gains or losses and net income after tax - ultimately showing the amount that is to be distributed)

b Statement of change in shareholder's net assets (this summarises the movements in total value of the fund)

c Portfolio statement

d Balance sheet

e Summary of material portfolio changes

f Statement of material accounting policies used to prepare the financial statements

g Additional details in notes to the financial statements

h Distribution table

Comparatives should be provided for the previous period for (a), (b), (d), above and notes to each and for sector percentage totals in the portfolio statement. Note that comparatives at security level do not have to be shown. If the special exemptions in the revised FRS1 'Cash Flow Statements' are met, a cash flow statement is not required. The exemptions apply to OEICs that meet all of the following conditions:

· Substantially all of the entity's investments are highly liquid

· Substantially all of the entity's investments are carried at market value and

· The entity provides a statement of change in net assets (p. 9 in SORP)

Unaudited interim statements should include (a) to (h) above plus comparatives. Note that for (a) above, comparatives should be for the last interim statements, but for the other statements above, comparatives should be the last audited statements. No comparatives are required at security level.

Short Form Accounts

If the scheme falls under CIS only then short form accounts may be sent to unitholders instead of full accounts to give a simplified assessment of the fund performance. Unitholders can still apply for full accounts. Annual and interim financial reports containing short form accounts should still contain information required by Chapter 10 of the Sourcebook. Reports containing short form accounts should contains the following statements:

· Statement of total return

· Statement of change in shareholders' net assets

· Statement of investments and other assets

· Distribution table

Note that there are no provisions within the COLL Sourcebook for short form accounts.

Short Reports

If the fund is subject to COLL rules, Chapter 4 of the COLL Sourcebook details Short Reports as the "default reporting". This is not to be confused with short form accounts; the short report is a bi-annual consumer-focused document. As mentioned earlier, short form accounts are not provided for under COLL. If you still have a CIS Scheme and you do not elect to produce short reports, short form accounts can be produced until 12 February 2007.

All retail funds under COLL must produce short reports to provide to investors, with long form reports and accounts provided upon request. COLL QIS Schemes do not have to produce short reports but must produce long form reports and accounts upon request.

With an umbrella fund under CIS, unitholders need only be provided with a report on a particular sub-fund. This is not an option currently under COLL if only sub-fund reports are provided, a report on the umbrella fund as a whole must be made available to unit holders upon request.

Derivatives

Derivatives are dealt with in the Balance Sheet under 'portfolio statement'.

They should be shown in the Balance Sheet and Portfolio Statement at their market value.

The SORP stresses that both 'motives and circumstances' in the use of derivatives are important to determine whether an item should be treated as capital or income. Annex C to the SORP details a number of derivative examples and how to account for them. The SORP emphasises that it is important to determine whether the derivative creates an obligation or a right to the fund.

Interest received or paid in relation to margin deposits should be separately disclosed.

The SORP details that FRS 13 'Derivatives and other Financial Instruments: Disclosures' (which was issued in 1998), requires an assessment of what risks arise in relation to financial instruments and how associated risks are managed. Such risks include interest rate, credit, currency, liquidity and market price risk. FRS 13 also requires a narrative disclosure note on the role that financial instruments have played during the period under review, and whether they have altered the risk profile of the fund. Note that the objectives and policies for holding derivatives must be detailed, as well as the strategies.

Effective Yield

Where there are accounting periods starting on or after 1 January 2007, income should be accounted for on an effective yield basis (ie an income calculation taking into account the amortisation of any discount or premium on the purchase price over the remaining life of the security). This may affect the level of distributable income when viewed in the context of the tax position and distribution policy of the Fund. If there has been a movement in the fair value at the balance sheet date, which is not accounted for through amortisation of the discount or premium, this must be shown as a capital gain/loss. The SORP recognises that when first implemented, there is a possibility that the amortised purchase price cannot be obtained without effort and cost. In this event, an "alternative basis of calculation should be agreed and appropriately disclosed…" (p. 15 in SORP)

Debt Securities

For accounting periods beginning before 1 January 2007, where funds invest in debt securities that are issued at a significant discount or premium to the maturity value, the total income should be spread over the life of the security on an appropriate basis. The amortisation of a discount or premium must be taken into account also. The SORP defines 'significant' in relation to a discount or premium if it is greater than the lower of:

· X percent of the redemption price, X being half the number of years of the issue term and

· 15 percent of the redemption price (p. 16 in SORP)

Stock lending

Fees gained from stock lending should be recognised as income on an accruals basis. The gross amount and any fees that have been paid to arrive at the net stock lending income amount should be detailed in a note unless disclosed elsewhere in the report.

Performance Fees

The basis of performance fee charges must be disclosed as must circumstances that are known which may affect future performance fees. Also, they should be recognised in accordance with GAAP and charged initially against income.

Taxation

Under Taxation, the following should be shown separately within the notes: UK CT, Overseas taxation, double tax relief, overseas tax credits, deferred tax and any adjustments in respect of previous periods.

Bond Rating Disclosure

Where the credit rating of bonds is not a category in the portfolio statement, an analysis should be provided at the footer of the portfolio statement (unless the existence of a licensing agreement prohibits publication).

Dilution Levy

Dilution levy charged or deducted should be shown separately, as should SDRT, where the cost is borne by the fund.

Investment in CIS

Where a fund invests in other CIS that are managed/operated by the ACD or an associate, holdings should be valued at cancellation price for dual priced funds and at single price for single priced funds. Where the investment is in CIS that are operated by other manager groups, holdings should be valued at bid for dual priced funds and single price for single priced funds.

Developments in Luxembourg Real Estate Funds

Real estate investments have attracted a considerable level of interest over the last five years due to their attractive risk-adjusted returns, low correlation with other investments, a shift of interest to alternative assets due to lower than expected returns in equities and bonds and historic low nominal interest rates. As a result, a growing number of global asset portfolios have increased their allocations to alternative investments, and within this allocation real estate is becoming the largest segment.

However, following almost five years of rock-bottom nominal interest rates, the European Central Bank raised Euribor 25 basis points at the end of February 2006 in line with the Federal Reserve, thus making bonds yields more attractive and equity more expensive to leverage. Furthermore, there is significant competition for suitable products driving down yields due to an overhang of new capital chasing a limited supply of deals. In addition, equities have shown recent sustained growth, and there is no denial that factors driving capital flows into real estate will not remain the same in the foreseeable future. Nevertheless, the European real estate market has matured into a deep and diversified market where capital flows may remain for some time.

Changing market conditions have put pressure on promoters to look for ever more creative real estate investment vehicles that meet their requirements and which are cost-efficient to operate. We will analyse how Luxembourg currently has provided the market with a considerable number of flexible vehicle formats and leads the way in creative attractive structures to meet the demanding requirements of investors and promoters.

Accessing the real estate market

Investors may generally access the real estate market through three different channels:

· Indirectly by investing in listed securities, ie real estate companies or Real Estate Investment Trusts (REITs)

· Directly creating their own portfolio of real estate properties

· Directly through investment in listed unlisted funds or structures holding real estate properties, ie regulated funds or unregulated investment companies

Investing directly in real estate through funds or structures holding real estate properties, or through funds of funds primarily investing in such structures, offers a compromise between the two extremes of an individually-managed direct investment portofolio and indirect investment through listed securities. At the end of 2005, around 56 percent of the Luxembourg real estate structures are direct investments and around 40 percent are indirect.

The higher cost of managing direct real estate vehicles is compensated by higher expected returns on final investments. Top-flight real estate promoters aim at repositioning, redeveloping and efficiently refinancing their assets so that, at the end of the process, they have converted a sub-performing asset to a stabilised asset with predictable cash flow. This value-added element of the investment strategy is possible through direct investments into real estate as compared with indirect investments where there is limited control over the performance of the underlying assets.

Another development is that more EU Member States are introducing Real Estate Investment Trust regimes (REIT regimes) in their national tax laws. The Member States that have already a special REIT regime are the Netherlands (Beleggingsinstelling), Belgium (Sociétés d'Investissement à Capital Fixe en Immobilière, SICAFI) and France (Sociétés d'Investissement Immobiliers Cotées). At present Germany and the United Kingdom are also drafting a REIT regime.

Nonetheless, when comparing the existing REIT regimes, a common denominator is that many of them are limited to domestic real estate investments and thus makes them unattractive to institutional investors looking for global investment vehicles. In this regard, the Luxembourg financial marketplace has been instrumental in providing flexible and transparent investment vehicles regardless of asset type, location, or position on the risk curve thanks to the effective optimised application of the tax legislation for holding and financing activities, a large network of double taxation treaties, and the experience of back-office agents. Such investment vehicles match the increased demand for onshore global real estate investment vehicles through regulated and non-regulated structures and offer the perfect solution to investors wanting to combine tax efficiency with an appropriately-regulated environment.

Flexible and customised investment vehicles

Investment vehicles need to fit different phases of real estate investment, from development to fully stabilised properties and from core assets at the lowest end of the risk spectrum to opportunistic assets at the other. The flexibility of using different share classes and compartments also gives investors more choice enabling institutional investors to refine their exposure to multi-asset portfolios.

At the end of 2005, almost 40 direct and indirect regulated real estate structures in Luxembourg have been identified by Ernst & Young

Some structures are designed to be "evergreen" in order to optimise set-up costs, making it possible to launch a series of investment vehicles under a common scheme. Recently, we see the emergence of "funds of funds" products, diversifying risks over a number of funds and aimed at more risk-adverse investors. The use of feeder vehicles has also allowed private banks to pool clients' capital to access a more diversified portfolio allocation.

At the end of 2005, almost 40 direct and indirect regulated real estate structures in Luxembourg have been identified by Ernst & Young. These structures qualify as Undertakings for Collective Investments ("UCIs") under Luxembourg legislation, ie those vehicles (i) investing their funds in real estate, (ii) placing their shares or units by means of a public or private offer and (iii) whose exclusive object is to invest in real estate assets in accordance with the principle of risk diversification.

Indirect real estate funds investing in mainly listed securities that qualify as a harmonised UCITS III funds are subject to Part I of the December 20, 2002 Law (the "2002 Law") dealing with Undertaking for Collective Investments ("UCIs") whereas direct real estate funds are subject to Part II of the 2002 Law dealing with Other UCIs. The Law of July 1991 deals with a subset of the Part II funds which are not intended to be placed with the public.

Nonetheless, the 1991 Law and the 2002 Law do not provide for any detailed rules regarding the investment policy or investment restrictions applicable to direct real estate funds. Such rules are provided for in the IML Circular 91/75. Chapter I, paragraph III of IML Circular 91/75 determines the rules applicable to UCIs, the principal object of which is the investment in real estate. Given that the specific provisions applicable to real estate funds are not set forth by law but rather by the IML Circular 91/75, the CSSF may on a case-by-case basis and subject to adequate justification by the promoter of the real estate fund, grant derogations from the rules usually applicable. This flexible approach permits the creation of real estate funds satisfying the needs and expectations of investors and promoters.

The law of 15 June 2004 (the "2004 Law") on the Investment Companies on Risk Capital (SICAR) was passed to offer competitive solutions to private equity and venture capital market players. Although the SICAR is designed to develop private equity and venture capital investment, real estate vehicles with the object of achieving equity gains through acquisition, development and re-development of real estate rather than through investment in stabilised properties with long-term lease agreements, can also potentially fall under the 2004 Law. Given its recent implementation, the 2004 Law accounts for only 6 percent of direct real estate funds, but a significant number of new funds to be incorporated under the 2004 Law (in a corporate or partnership form) were reported to be in the process of formation.

To summarise, under the above legal framework, Luxembourg offers a choice of three regulated fund vehicles: the FCP - a form of unit trust or mutual fund; the SICAV and/or SICAF - forms of investment companies with variable or fixed capital; and the SICAR, a more flexible regulated private equity/venture capital investment vehicle. On the other hand, un-regulated real estate investment structures utilise a typical holding company vehicle (SOPARFI).

The leading role of the FCP lead and the emerging role of the SICAR

Luxembourg investment vehicles have shifted from the traditional closed-ended transparent FCP (fonds commun de placements) or SICAV (Société d'Investissement à Capital Variable) with a limited number of institutional investors, restricted to core investment criteria and low leverage to more creative and diversified investments. The FCP and the SICAV represent 64 percent and 24 percent respectively of all direct Luxembourg real estate investments and are the main vehicles fuelling real estate investments. Using the available legislation described above, the following real estate products have been developed by promoters and illustrate how flexible the Luxembourg legal framework is to constantly shifting market need.

· Closed-ended opportunity funds direct real estate funds are normally aimed at a limited number of investors, ie pension funds, insurance companies and banks, and therefore are regulated under the 19 July 1991 law for institutional investors

· Open-ended core and core plus direct real estate funds typically adopt a SICAV or an FCP vehicle with single unit class. This type of vehicle is normally aimed at high net worth individuals and institutional investors and is regulated under the 2002 Law

· "Evergreen" umbrella structures can combine both open-and closed-ended core and value-added direct real estate sub-funds in an umbrella structure. Typically they adopt the form of a FCP with a multi-unit class and sub-funds structure. This type of vehicle is normally aimed at institutional investors and regulated under the 2002 Law although they can be accessed by other investors through feeder structures. These funds are relatively complex to set up, but are large and flexible and can be marketed to a wide range of investors globally, making them cost-efficient

· Fund of funds structures can be either open-ended or closed-ended indirect real estate funds and typically adopt an FCP or SICAV vehicle with a multi-unit class or sub-funds structure. This type of vehicle is normally aimed at high net worth individuals and institutional investors and regulated under the 2002 Law

· Real estate-private equity funds structures SICARs which adopt a transparent tax regime under a partnership form (eg Société en Commandite Simple) or a nontransparent tax regime under a corporate form (eg Société en Commandite par Action, Société Anonyme, Société Limitée). This type of vehicle is normally aimed at high net worth individuals and institutional investors and regulated under the 2004 Law

Even though the trend will continue to give the FCP a leading role among real estate vehicles, the SICAR is a flexible solution for private equity structures including opportunistic real estate investments where the promoter has no imposed investment restrictions and is less regulated.

Although under the non-transparent tax regime the SICAR is fully taxable in Luxembourg, revenues are exempt in case the underlying investments include a high risk profile or private equity type of investments. The SICAR is therefore a structure that is aimed at creating a flexible but regulated framework for vehicles that do not fit into a framework with rigid investment guidelines.

Emerging features of the Luxembourg real estate market

The Luxembourg market place has been successful in meeting experienced international investors and promoters requirements in a variety of different ways:

Tax-efficient international investments structures

Tax structuring for Luxembourg real estate funds covers both the taxation of up-stream returns to investors as well as taxation on the downstream deal structures investing in real estate assets. A combination of the appropriate investment vehicle with downstream tax efficient holding and financing structures enables promoters to create the closest thing to a synthetic international REIT-like structure.

Appropriate governance models bringing investor confidence

Current governance models for a Luxembourg real estate fund combine both elements imposed by regulation, such as the requirement to have independent service providers, as well as industry best practice, driven by the demand for greater transparency for investors. There is no doubt that promoters who have fully embraced all elements of good governance have differentiated themselves in the competition for capital.

Flexible reporting frameworks

Financial statements of Luxembourg regulated real estate funds can be prepared under either IFRS or Luxembourg GAAP. Whereas some investors and promoters either require IFRS financial statements for their own reporting, or prefer the detailed rules, guidance and disclosure requirements that come with IFRS, others prefer the flexibility of LuxGAAP. Under both GAAPs, investment properties must be carried at fair value as determined by an independent appraiser. From these financial statements, the NAV per unit is derived, often after making adjustments to re-balance transaction costs, deferred taxation and incorporation costs more fairly between investors.

Although, FCPs, which have no legal personality, are not within the scope of the EU Regulation there is an increasing use of IFRS within real estate direct structures as a quality mark. This trend is reflected in the Luxembourg market where the number of structures that have adopted IFRS as their reporting standards has risen from nil in 2004 to 15 percent in 2005.

The ability to align investors' and promoters' interests

Luxembourg real estate funds to date have been successful in aligning investor and promoter interests through innovative co-investment and performance fee structuring.

Luxembourg offers promoters a now well-recognised and leading domicile for international direct real estate funds

Performance fee models are highly adapted to the type of real estate investment vehicle. Although at present 24 percent of the direct real estate structures have performance fees, this fee scheme is rather a recent development in the Luxembourg direct real estate vehicles. In practice performance fees exists mainly among opportunistic structures and the majority of the promoters have been launching core and core plus investments without a performance fee structure. Nonetheless, over the past three years promoters have been seeking to change their strategy and this has translated into an emerging trend in both added-value and opportunistic investments which incorporate performance fee schemes.

Performance fees designed for closed-ended funds will normally have significantly different mechanics than for open-ended funds. Although performance fee accruals would have little or no impact on financing of closed-ended funds, these accruals can have a significant impact on the NAV per unit of open-ended funds and thus impact on the pricing of new issue of units. Therefore, performance fees schemes take into consideration characteristics such as the cycle of issue and redemptions of units, the frequency of the NAV calculation and the definition of distributable cash flow.

Although having a regulated vehicle creates a potential marketing advantage in the EU, the cost of launching and managing regulated structures is higher than for non-regulated vehicles. In order to minimize the impact of the cost of regulation or investors, promoters have been working on the allocation of set-up fees, fund management fees, property management fees and performance fees to optimise balance of returns earned by both the investors and promoter. There are numbers of approaches in this, including caps on launch fees charged to the fund and higher asset-management fees instead of a performance fee.

Average management fees in direct real estate structures are 1.05 percent of NAV but variance goes from 0.60 percent of NAV to 2 percent of NAV. The higher range of management fees demonstrates a direct correlation with the risk type of funds as the highest percentages are with value added and opportunistic funds.

Conclusion

Putting all the different types of vehicles and structuring options together, promoters have been able to create highly-customised and flexible products that enable them to target a wide range of investors and investment strategies.

Luxembourg offers promoters a now well-recognised and leading domicile for international direct real estate funds.

Although general market conditions for such funds are hardening, there is no doubt that Luxembourg-domiciliated real estate funds will be a significant and permanent feature of the alternative asset management landscape in Europe for the foreseeable future.

Michael Hornsby, Ernst&Young Luxembourg Head of Real Estate and

Jose Maria Ortiz, Ernst&Young Luxembourg Manager in Real Estate Team

Microfinance funds: Mixing financial profit with social good

When thinking about microfinance, very few would consider it a self-sustainable and profitable business. However in the past 30 to 40 years, the microfinance industry has been growing and has become more finance-driven. In this article we investigate what microfinance has achieved, what benefits it has brought to the most impoverished parts of the world and, more relevant to us, how a microfinance fund can be established and run.

Microfinance institutions use social collateral in the form of peer groups to ensure loan repayment

Microfinance can be defined as giving small loans to poor individuals with the goal of enabling borrowers to lift themselves out of poverty by growing their businesses. In general, it is based on the fact that the poor have skills which remain unutilised or underutilised, and on the fact that charity is not an answer to poverty. It often creates dependency and takes away peoples initiative to break from poverty.

The poor generally lack access to credit, as collateral is a prerequisite for securing loans. Furthermore, banks cannot usually cover transaction costs on small loans. Thus, microcredit is the unique way of bringing credit to those who lack access to traditional financial services.

Historical background and market size

Modern microfinance can be traced back to the mid 1970's through nearly simultaneous initiatives in Bangladesh and Bolivia. These initiatives began as charities.

The Bangladesh-based Grameen Bank, one of the first modern microfinance institutions, traces back to 1976, when Professor Muhammed Yunus launched a project to examine the possibility of creating a credit system to provide banking services to the rural poor. It was based on the formation of small groups of five people to provide "mutual, morally binding group guarantees" as collateral required by conventional banks. Today, the operations of the Grameen Bank are characterised by strong discipline, supervision, and servicing which are carried out by local "Bicycle bankers". The rigorous selection of borrowers and their projects by these local institutions, the peer pressure on these individuals by the groups, and the repayment scheme of approximately 12 months, contribute to the success of this rural banking system. Savings are also encouraged by this system.

Today, approximately $500 million is currently out in the form of micro loans, with an average loan size of $340. About 80 percent of borrowers are women.

Commercial microfinance goes back to the early 1990's with a double focus, a return to investors and a socially-responsible agenda.

How does microfinance work?

Microfinance institutions use social collateral in the form of peer groups to ensure loan repayment. Loans are taken in groups of five to eight individuals who belong to the same community. If a borrower defaults, the rest of the group is mutually responsible for the borrowed money and must work together to repay the loan.

The borrowers pay relatively high interest rates, from about 24% to 45 percent on an annualised basis. These rates may not seem attractive, but should be compared to "shark loans" from the local moneylenders who charge interest rates between 300 percent and 3000 percent annually. Industry officials justify such high rates because of the administrative costs to administer such small loans. To ensure repayments, microfinance institutions also offer shorter loan cycles than traditional banks-usually from one to 12 months.

Through microfinance the poor are allowed to escape from the traditional vicious cycle of "low income, low savings, low investment, low income".

However, some issues arise when examining microfinancing: group lending works well in the countryside and small towns, but not as well in metropolitan areas. A reason for this could be the individualistic behaviour in big cities. Also, as the poorest of the poor are often located in extreme areas, micro credit funds often go to "the richer of the poor". Why is this the case? Microfinance institutions require that borrowers achieve financial self-sustainability. Furthermore, few microfinance institutions work in remote areas where the poorest of the poor live. Thus, their services are often not designed appropriately to reach the very poor. However, legislators in the developed world are beginning to take an interest in ensuring that microfinance does reach the very poor.

Microfinance funds: experiences and challenges

Microfinance investment funds generally do not make loans directly to impoverished individuals. The funds provide capital to microfinance institutions which then lend the money to needy individuals.

Most microfinance funds accept investors with at least $100,000 or $200,000 to invest, although there are opportunities for smaller investors, with minimums of $1,000 or $2,000 to invest. Investors may choose among different types of investment vehicles, such as equity and debt investment funds, or bond-like securities backed by thousands of tiny loans.

Returns are usually lower than for other types of investments, but risk levels are not high, because default rates are typically low.

Returns are usually lower than for other types of investments, but risk levels are not high, because default rates are typically low

However, there are still too few 'investable' lenders. Many microlenders do not yet offer the transparency, consistency of policies and appropriate audits needed to attract investors. Furthermore, the investors face certain risks with these investments: even if microfinance borrowers are recognised as good lending risks, data on default and repayment rates are difficult to verify in practice. Thus, to attract commercial investors to the risk and return of microfinance, there needs to be more specific data available to investors and rating agencies.

As Saurabh Narain, of Shorenbank Advisory Services, stated during the Conference on Commercialisation of Microfinance at the University of Chicago on Friday, 20 May 2005: "they need to provide data not only on their financial performance, loss ratios, and future prospects, but also on the social impact that they are achieving and the development values they provide to the local community".

Investors also face additional risks including default from the microfinance institution and currency risk which is difficult to manage due to currency devaluation policies often practiced in politically unstable countries.

Finally, many of the new microfinance funds raise capital through private placements, and are less regulated than other funds, such as UCITS (Undertakings for Collective Investment in Transferable Securities) for instance. Many retain the investment for between five and ten years.

Thus, due to these risks, many microfinance investments are directed towards sophisticated and wealthy investors.

To respond to these issues, commercial microfinance is currently developing. Increasing microfinance institutions' size rapidly, maintaining transparency, and delivering reliable and auditable information to third parties and investors are key priorities. For these reasons, oversight authorities are being established and standardised guidelines are being developed to improve disclosure and reduce potential corruption and mismanagement. Already, most microfinance institutions that receive commercial microfinance funding are subject to formal external audits and fulfil certain reporting and accounting guidelines.

Citigroup is a pioneering institution in the microfinance field.

The Luxembourg environment

When talking about alternative types of investment such as microfinance, the range of legal vehicles available for establishing this type of fund in Luxembourg is restricted to the Société d'Investissement en Capitale à Risque ("SICAR"), or to a so-called Part II SICAV or FCP ("Société d'Investissement à Capitale Variable" or "Fond Commun de Placement", respectively).

Experience shows that a SICAR is a more suitable vehicle for direct investment into larger microfinance projects, while, in general, for all those transactions requiring the intermediation of microfinance institutions, a SICAV or an FCP are better placed, with a preference, for practical reasons, to vehicles established under the 1991 Law (only available to institutional investors).

Citigroup is a pioneering institution in the microfinance field. In Luxembourg it acts as depositary and administrator for the recently established European Fund for Southeast Europe ("EFSE"). EFSE aims to contribute to the economic development and prosperity of the Southeast Europe region through the sustainable provision of additional development finance, notably to micro and small enterprises and to private households, via qualified financial institutions.

The EFSE is established as a SICAV under the terms of the 1991 Law.

EFSE provides liquidity to microfinance institutions (Partner Lending Institutions - PLIs) which are commercial banks, regulated and non-regulated NGOs (non-governmental organisations), financial institutions, investment companies and investment funds, located in the Southeast Europe region, in the form of loans. To be eligible as a PLI, a microfinance institution must satisfy a number of criteria and provide monthly and annual reports, and annual audited financial statements to increase EFSE's overall transparency and allow reliable information to be given to the investors.

Once the PLI has been appointed by the EFSE, it can start financing or committing to financing a target group of local micro or small enterprises, or to provide housing loans or other financial products for those with no access to normal credit channels. PLIs then use repayments from micro loans to repay the loan received from EFSE.

Final remarks

In conclusion, we consider it appropriate to quote the words of Ghandi: "True development puts those first that society puts last". Today, a growing number of people and organisations view microfinancing as a financial investment as well as a form of aid which offers profit and social good and benefits to the development of poorer societies.

On the occasion of his speech at the Conference on Commercialisation of Microfinance, Robert Annibale, Global Director of Microfinance at Citigroup, stated that "with humility, we realised that there were microfinance institutions and a new breed of bankers that were developing innovative products and methodologies for servicing the "unbanked" and that the best way for us to learn and begin would be to work with such institutions as partners and clients, which would also make for a much more inclusive financial sector".

Since the establishment of the EFSE, Citigroup's Fiduciary Services have been developing their expertise in the microfinance sector which Citigroup as a whole consider not only a morally rewarding activity, but also a potentially profitable area of business for financial institutions, and for investors. Using our expertise in the field of microfinance funds, we will guide you through a more in depth analysis on this business and of the challenges involved, in a forthcoming edition of News & Views.

Property Funds in Ireland - Regulation and Additional Challenges

The rules governing the operation of property funds authorised in Ireland by the Financial Regulator (the "Regulator") are set out in the Non-UCIT Series of Notices (NU18.4), issued by the Regulator pursuant to the Unit Trusts Act 1990 as amended and the Companies Acts 1963-2005. NU18.4 has been recognised by the industry to be limited in terms of its scope since the rules therein are to a large extent limited to a small number of investment and borrowing restrictions applicable to property funds and a brief description of how Property and Property Related Assets should be valued. The purpose of this article is to provide an update on the regulatory environment and the limitations under which property funds authorised by the Regulator currently operate, and to provide details of how industry representatives and the Regulator are seeking to address these limitations.

Historically, the number of property funds authorised has been minimal and the sector is in the very early stages of development

Given the limitations of NU18.4, the industry standard at present in respect of the custody and valuation of Property and Property Related Assets has been largely devised through discussions between the Regulator and industry representatives as and when issues arise. The Dublin Funds Industry Association ('DFIA'), comprising representatives from the main industry service providers in Ireland, is currently involved in active discussions with the Regulator to devise a more robust set of rules and regulations to govern the operation of property funds. Historically, the number of property funds authorised has been minimal and the sector is in the very early stages of development.

The industry has recognised, however, an increased appetite for this type of regulated vehicle and is addressing the issues with the Regulator accordingly. The following sections detail current regulations, and how identified inconsistencies or deficiencies of the regulatory framework are being addressed.

Definitions

"Property" is defined under NU18.4 as a freehold or leasehold, with a minimum unexpired lease of 70 years, interest in any land or building. The requirement is more restrictive than, for example, the UK where a 10 percent restriction is imposed on leasehold interests with an un-expired lease of between 20 and 60 years, and Luxembourg where a minimum leasehold period is not prescribed.

"Property Related Assets" are defined under NU18.4 as securities issued by a body corporate whose main activity is investing in, dealing in, developing or redeveloping property. The definition is again limited because it does not cater for, for example, unit-linked insurance policies, REITs and property derivatives.

The DFIA has requested that the Regulator consider the constraints of the definition of Property. The Regulator has also been requested to expand substantially on the definition of Property Related Asset and to include a statement to the effect that investments that do not fall within the expanded definition be considered on a case by case basis, primarily with a view to ensuring regulation keeps apace with new types of investment instrument and to ensure that Ireland remains competitive as a domicile for property funds.

Subsidiaries and Special Purpose Vehicles (SPVs)

The single most constraining aspect of the Regulator's current position is in respect of the use of subsidiaries and SPVs. Currently, the Regulator requires the following:

· The shares issued by the subsidiary and all of its assets must be held by the trustee to the Irish Collective Investment Scheme (the "Scheme")

Irish-domiciled trustees are generally reluctant to hold any Property in their own name or in their name on behalf of a Scheme, primarily because of the inherent environmental risk involved with investment in Property. The Regulator has been asked to consider this requirement carefully with a view to permitting Property to be held in the name of the Scheme with adequate oversight of the process and due diligence discharged by the Trustee.

· The assets of the subsidiary must be valued by the Scheme

A more appropriate method of valuation would be to rely on the principle of independent valuation, as is permitted where a Scheme invests directly in Property.

· The subsidiary must be wholly owned by the Scheme

· The instrument of incorporation under which the subsidiary is established must be approved by the Regulator and this document must not be capable of amendment without prior approval of the Regulator

All of the above requirements are considered by the industry to be unduly burdensome and, in addition, they place Ireland at a competitive disadvantage vis-à-vis other jurisdictions where these requirements are not evident. As part of the lobbying process, the DFIA has requested that the Regulator clarify why these requirements are imposed. Suggested alternatives to the above are:

· Majority ownership, in that the most important factor is that an exit mechanism exists

· Clarification by the Scheme that the documentation in respect of the SPV does not in any way breach prevailing regulation

· The appointment to the boards of the SPVs by the management of the Scheme with prior approval of the Trustee

· A statement that the objectives of the SPV do not contravene regulatory requirements

Valuations

The following rules apply to the valuations of property funds:

· The management company of the Scheme must appoint a qualified independent valuer or valuers selected on a basis approved by the Regulator. Details of the appointments must be included in the prospectus and periodic reports issued by the Scheme. The Regulator must be notified in advance of the valuer's appointment and resignation

The Regulator has been requested to consider that it should be sufficient for details of independent valuers and their fees to be included in periodic statements. The requirement to disclose such details in the prospectus and to provide prior notification to the Regulator is viewed as excessive.

· The Scheme must be valued at open market value at least twice yearly, with provision being made for more frequent valuations to be undertaken if market conditions warrant it. Issue and redemption prices must be made available after the valuation of the portfolio has taken place

The DFIA has requested that a derogation be made available to professional and qualifying investor funds (PIFs and QIFs) from the twice-yearly valuation requirement.

From an operational perspective administrators will seek an independent valuation inclusive of income and expense accruals. In the event that independent valuers refuse to provide this level of detail, administrators will be required to give consideration to all miscellaneous expenses and rental income to ensure accuracy of accruals. This may also place a barrier on the reliance placed by administrators on all-encompassing indemnities in favour of administrators, for errors in Property valuations received by independent valuers, in that a significant percentage of a property's value may have to be estimated by administrators.

Investment Restrictions

Clarification on a number of the investment restrictions imposed by NU18.4 has also been sought. NU18.4 requires, inter alia:

· That a Property must be valued before it is acquired by the Scheme

The industry has taken the view that this requirement places an undue constraint on the Investment Manager to move quickly by using its skill and expertise.

· That Property Related Assets must be dealt in or traded on a market which is provided for in the trust deed, articles of association or partnership agreement. Up to 15 percent of the Scheme's net assets may consist of Property-Related Assets which are not traded in or dealt on such a market provided that these assets are acquired under the same conditions as for properties above

The industry has requested that PIFs receive an automatic derogation from this restriction. QIFs already receive an automatic derogation from this restriction under NU24.5.

· That not more than 20 percent of a Scheme's assets may be invested in any single Property. The Scheme may derogate from this restriction for a period of two years following its launch providing it observes the principle of risk spreading

Clarification has been sought from the Regulator in respect of a definition of "risk spreading".

· That the Scheme is allowed to borrow up to an amount equal to 25 percent of the value of net assets of the Scheme, such borrowing may be generally secured on the assets of the Scheme

The industry has noted that there is a substantial market for geared property pension funds which cannot be met in the regulated sector until these borrowing requirements are relaxed. A suitable debt equity ratio proposed to IFSRA is 3:1 for retail funds and 9:1 for PIFs. Again QIFs already receive an automatic derogation from this restriction under NU24.5.

Specific Issues Facing the Depositary

Under NU7.8, Trustees - Duties and Conditions - the depositary is required to hold assets on a fiduciary basis and maintain appropriate internal control systems to ensure that records clearly identify the nature and amount of assets under custody, the ownership of each asset and where documents of title to that asset are located.

There is a substantial market for geared property pension funds which cannot be met in the regulated sector until these borrowing requirements are relaxed

Questions have been raised as to how a depositary can discharge these responsibilities in respect of Property. To demonstrate that assets are held on a fiduciary basis, a depositary will normally hold assets in its name for the benefit of the Scheme. In respect of Property, depositaries are reluctant to take title given the inherent environmental risk of being the registered owner. The Regulator currently allows assets to be held in the name of an investment fund if local market practice dictates, and for certain asset categories. The industry has requested that this permission be extended to Property. Regardless of this, given that unit trusts are not legal entities and the depositaries are reluctant to take title, it would appear that fund structures will be limited to investment companies and partnerships.

With regard to the custody of the assets, the Regulator requires that assets are held by the appointed depositary or its delegate, over whom the appointed depositary has carried out suitable due diligence. It is standard market practice for title deeds to Property to be held by the legal representative appointed in the local jurisdiction where a Property is purchased. The Regulator has raised concerns in this regard and may require the depositary to appoint the legal entity as their safekeeping agent. Clarification will also be sought as to how the depositary will supervise the legal entity appointed and appraise their safekeeping procedures.

Irish depositaries are also required to ensure that the income of an investment fund is applied in accordance with prevailing regulation and the investment fund's constitutional documents. Depositaries will need to familiarise themselves with any rental or lease agreements to test proper accruals and receipt of income accurately. In addition, where property managers are appointed by the investment fund, any cash accounts opened should be opened in the name of the depositary with a mandate given to the property manager to operate the account. Connectivity will also need to be established to ensure all invoices paid receive depositary's prior approval. In addition, depositaries will need to familiarise themselves with any mortgage or lending arrangements and be comfortable that there are no inappropriate liens, charges or security interests over the assets of the Scheme.

To demonstrate that assets are held on a fiduciary basis a depositary will normally hold assets in its name for the benefit of the Scheme

Conclusion

The regulatory and procedural framework governing the administration and custody of property funds in Ireland is still under development. It is important to note, however, that industry participants are already working closely with the regulator to close any gaps, with a view to ensuring that Ireland becomes a domicile of choice for property fund promoters.

An Update on UCITS III Management Company in Ireland

The Financial Regulator recently published a final draft Guidance Note on the organisation of UCITS management companies. This document, which follows from the initial consultation document published in March 2004, seeks to clarify with activities which may be outsourced/delegated, and which may not. The main features of the final draft Guidance Note are discussed here. The consultation process closed on 17 February 2006.

The final draft Guidance Note focuses mainly (knowing that foreign management companies cannot passport their services into Ireland) on the management company's organisational requirements and outsourcing of functions and applies, mutatis mutandis, to self-managed UCITS (Undertakings for Collective Investment in Transferable Securities).

A management company cannot be authorised unless its organisational structure, management skills and number and expertise and staff are adequate for carrying out its proposed activities

Organisational requirements

A management company cannot be authorised unless its organisational structure, management skills and number and expertise of staff are adequate for carrying out its proposed activities. The Regulator considers that a management company is responsible for the following functions:

· Decision taking

· Monitoring compliance

· Risk management

· Monitoring of investment performance

· Financial control

· Monitoring of capital

· Internal audit

· Supervision of delegates

A management company may delegate functions, as long as those who conduct the business of the management company can monitor effectively at any time, the activity of the mandated service provider, and only to the extent that the management company does not become a "letterbox entity".

Authorisation for outsourced functions

If a management company wishes to outsource some of its core functions, the Regulator requires the following information to be submitted to it as part of the management company's authorisation process:

· An organisational structure, defining functions, reporting lines, insourced vs outsourced activities, and staffing levels

· Names of individuals with day-to day management responsibilities for the core functions identified above

· For the core functions outsourced, identity of each individual responsible for the function, role of the relevant service providers and details of the reporting tools available from the service providers

· Also, the Regulator requires additional, detailed information on all the core functions previously defined

Supervision of outsourced activities

Management companies willing to outsource some or all of the core functions identified above must ensure adequate supervision and oversight of the delegated activities.

· In terms of reporting, the Regulator requires appropriate arrangements to be put in place to ensure adequate information flows from the service provider(s) to the management company. To obtain authorisation for the delegation of certain functions, the Regulator requires a detailed description of: type of reports received by the management company, their frequency, the procedures in place on receipt of the report, responsibilities for escalation up to the board of the management company, details of reports required in case of exceptional circumstances, and procedures to be followed by all parties under these exceptional circumstances

· In terms of supervision of the third-party service provider, the Regulator should be satisfied that the management company's organisation and business structure is such that it is capable of adequately supervising third-party service providers. In these circumstances, where legal or regulatory requirements of a non-EU Member State prevent the management company from effectively exercising controls over the outsourced activities, the Regulator will not authorise the delegation

The consultation process

As already mentioned above, the consultation process closed on 17 February 2006.

The Dublin Fund Industry Association ("DFIA") has submitted its response, as have, we believe, most of the fund industry players.

From our point of view, and while we await the outcome of this consultation process, we would like to outline a few considerations.

The first one is that the final draft Guidance Note seems to aim at ensuring that there is direct correspondence between the core functions/activity of the management company and its board directors. We feel that this is not necessarily required as, in the first instance, the board of directors is collectively responsible for the management of the company. Secondly, if such correspondence is required, then it should also be ensured that the designated individuals have adequate and proven technical experience as a primary requirement.

In terms of organisational structure and, in particular, the outsourcing of activities, each application for authorisation will no doubt reflect the peculiarities and preferred business model of the management company, and so a case-by case analysis will be required of the Regulator.

Management companies willing to outsource some or all of the core functions identified above must ensure adequate supervision and oversight of the delegated activities

Our concern is that this case-by-case approach could eventually conflict in the medium to short term with the results of the discussions being currently held at European level (ie following the publication of the European Commission's "Green Paper on the enhancement of the EU framework for investment funds") which include also the redefinition, or clarification, of passporting rules for UCITS III management companies.

Two years of the German Investment Act:
Results and possible future development in the German hedge fund market

The German Investment Modernisation Act ("Investmentmodernisierungsgesetz", also known as "InvMG") reforming the investment fund industry in Germany, has now been in place for more than two years, having been enacted on 1 January 2004. It is timely to review the results of this piece of legislation, and to discuss possible amendments as proposed by German financial industry associations.

The principal objectives of the InvMG were to:

· implement amendment Directives 2001/107/EC and 2001/108/EC of the European Parliament and of the Council of 21 January 2002 amending Council Directive 85/611/EEC of 20 December 1985 on the co-ordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities ("UCITS Directive")

· promote Germany as an investment fund market, put a stop to the exodus of investment funds to other European countries, and establish a strong and attractive regulatory regime for onshore hedge funds

· consolidate and modernise the previous provisions of the Investment Companies Act and Foreign Investment Funds Act and provide for grandfathering rules necessary to enable existing funds to operate for a transitional period while taking steps to comply with the InvMG

Lights and shadows

Two years after the introduction of the new law, the number of hedge funds domiciled in Germany amounts to 30 (19 single hedge funds and 11 fund of hedge funds by the end of 2005) and the asset management companies ("KAGs") licensed for the hedge fund business are 13. The net cash inflow of approximately. 1 bn Euros represents an increase of 111 percent compared with 2004.

These market figures are encouraging but alternative asset classes have not yet boomed as many expected. The possibility for insurance companies to invest part of their assets in hedge funds, which many saw as the spark that would ignite a rush towards hedge funds and increase the investment in this sector by other institutional clients, has produced mixed results, as the institutional investors' response has so far been limited.

The InvMG also introduced certain options for investment companies, but not all of these have been fully exploited by the investment fund industry. For instance, for the initial capital requirements rules allow investment companies to reduce initial capital from EUR 2.5 million to EUR 730,000 unless they are also authorised to manage unit accounts of domestic or foreign funds or to manage real estate funds. Despite these opportunities existing German investment companies have not demonstrated a particular interest in reducing their initial capital, and newly established investment companies have generally started their operations with more than the EUR 2.5 million initial capital, instead of profiting from the reduction introduced by the law.

The proposals of the industry bodies

The fund industry in Germany represented by the "Bundesverband Investment und Asset Management eV" ("BVI") and the "Verband der Auslaendischen Banken" ("VAB") has expressed its opinion and proposed certain amendments to the existing legal framework that could be implemented in 2007.

· Public distribution of single hedge funds

The German Investment Act ("Investmentgesetz" or "InvG" - one of the new pieces of legislation introduced by the InvMG) does not allow for the distribution of single hedge funds to the public, whereas for funds of hedge funds this is possible under certain restrictions and subject to adequate caveats to be published in the fund's prospectus. The BVI supports, in a recently published paper, amendments to the InvG to permit the sale of single hedge funds to the public and therefore, to extend the opportunities of investments to private investors, but limiting single investments to a maximum of EUR 50,000.

· Appointment of a depositary for single hedge funds

The InvG states under Article 20 that KAGs wishing to launch a hedge fund in Germany must appoint a locally-established depotbank. For single hedge funds the InvG further states under Article 112 that the depotbank may also outsource some of its functions to comparable organisations (eg Prime Brokers), provided that the depotbank is contractually liable for any fault of the comparable organisation directly employed by it.

· The role of the prime broker and its appointment by the depotbank or by the KAG has been discussed at length in recent years with the intention of clarifying this matter. Both the BVI and the VAB are currently discussing the possibility of minimising, if not abolishing, the role of the depositary for single hedge funds with the aim of enhancing the competitiveness of the German fund environment. Under this approach, prime brokers should take over the main tasks of the German depotbank. In addition these industry associations suggest that the prospectus of the fund should inform investors that the fund will contain a warning in a prominent position stating that the control functions exercised by the depotbank are not guaranteed.

· Purchase and evaluation of funds of hedge funds

Article 113 of the InvG states that the purchase of foreign target funds by German funds of hedge funds is only possible if the target fund's assets have been entrusted to a depotbank for safekeeping, or to another comparable institution fulfilling the functions of the depotbank. Both the BVI and the VAB would like to remove these provisions to permit also the purchase of those funds which have not entrusted their assets to a depotbank or other comparable institution.

Also, according to the current legislation, KAGs must ensure that they obtain information on target funds regarding their investment restrictions, liquidity, scope of the leverage and execution of short sales. This information is not always available in such great detail as is required by law. The proposal of the industry bodies focuses on the NAV calculation of the target fund that must be calculated at least once for each calendar year by a suitable organisation independent of the KAG and the target fund manager. This value must be transmitted to the KAG in writing.

· Prospectus warnings for funds of hedge funds

The InvG currently states that funds of hedge funds must include in their prospectus a warning in a prominent position and in highlighted text stating "investors in this investment fund must be prepared and able to sustain losses of their invested capital, including a total loss".

The BVI suggests this warning to be abolished, as it is considered by the BVI to be an incorrect representation of the risk inherent in such investments. This is due to the fact that the current German funds of hedge funds only can use derivatives for the purpose of currency hedging and not for speculative reasons.

Conclusion

The issues highlighted above do not change the fact that Germany is one of the most interesting fund marketplaces in Europe, due to various factors such as the demographic trends, the private old age provisions, the presence of some of the largest institutional investors as well as the renewed efforts to promote Germany as an international investment fund market in the coming years, which is an important concern of the government in charge.

In February 2006 Citigroup became the leading player for single hedge funds in the German market

The current discussions on the future of the German investment fund market and the suggestions carried forward by the industry bodies to make the legislative framework friendlier and more competitive show a dynamism that we believe will bring positive results in the future.

Citigroup has recognised the importance of the new regulatory environment and established its full investment fund services in Frankfurt at the beginning of 2005 offering an automated one-shop platform for fund administration, depositary and KAG services.

In February 2006 Citigroup became the leading player for single hedge funds in the German market in administrating almost $240 million as fund administrator and depositary, with a 10 percent market share (market size was almost $2.4 billion at the beginning of 2006).

If you are interested in receiving additional information on the existing regulatory environment or its expected changes in Germany, feel free to contact us.

Contacts

Sean Quinn
European Head of Fiduciary Services
sean.quinn@citigroup.com
tel: +44 (0)20 7500 5619

David Morrison (London)
Fiduciary Relationship Manager
david.m.morrison@citigroup.com
tel: +44 (0)20 7500 8021

Ian Lyall (London)
Fiduciary Relationship Manager
ian.lyall@citigroup.com
tel: +44 (0)20 7500 8356

Francine Bailey (London)
Fiduciary Relationship Manager
francine.bailey@citigroup.com
tel: +44 (0)20 7500 8580

Andrew Newson (London)
Fiduciary Relationship Manager
andrew.c.newson@citigroup.com
tel: +44 (0)20 7500 8410

Bronwyn Wright
European Head of Fiduciary Relationships
bronwyn.wright@citigroup.com
tel: +353 1 622 2791

Nicola Byrne (Dublin)
Fiduciary Relationship Manager
nicola.byrne@citigroup.com
tel: +353 1 622 1056

Shane Baily (Dublin)
Fiduciary Relationship Manager
shane.baily@citigroup.com
tel: +353 1 622 6297

Juergen Ehle
Head of German Fund Services
juergen.ehle@citigroup.com
tel: +49 (0)69 1366 1409

Francis Pedrini (Luxembourg)
Fiduciary Relationship Manager
francis.pedrini@citigroup.com
tel: +352 45 1414 228

Daniel Mente (Luxembourg)
Fiduciary Relationship Manager
daniel.mente@citigroup.com
tel: +352 45 1414 492

About Citigroup

Citigroup (NYSE: C), the pre-eminent global financial services company with some 200 million customer accounts in more than 100 countries, provides consumers, corporations, governments and institutions with a broad range of financial products and services, including consumer banking and credit, corporate and investment banking, insurance, securities brokerage, and asset management. Major brand names under Citigroup's trademark red umbrella include Citibank, CitiFinancial, Primerica, Smith Barney, Banamex, and Travellers Life and Annuity. Additional information may be found at: www.citigroup.com.

About Citigroup Corporate and Investment Banking

Our Corporate and Investment Banking group achieves the extraordinary for our clients around the world. No financial institution is more committed to understanding and advancing the goals of its clients - our diverse and talented staff in some 100 countries advises companies, governments, and institutional investors on the best way to realise their strategic objectives. We create solutions for and provide the broadest possible capital and market access to thousands of issuer and investor clients, and no institution better executes the increasingly complex payment and cash management solutions required in today's global economy. Core business lines under Citigroup Corporate and Investment Banking include Global Capital Markets, Global Banking and Global Transaction Services.

Citigroup^®Global Transaction Services

www.transactionservices.citigroup.com

© Citibank, N.A. 2006. All rights reserved. The information and materials contained in these pages, and the terms, conditions and descriptions that appear, are subject to change. Any unauthorised use, duplication or disclosure is prohibited by law and may result in prosecution. Citibank, Citigroup and the Umbrella Device are registered service marks of Citigroup Inc. or its affiliates and are used and registered throughout the world. Citibank, N.A. is incorporated with limited liability under the National Bank Act of the U.S.A. and has its head office at 399 Park Avenue, New York, NY 10043, U.S.A. Citibank, N.A. London branch is registered in the U.K. at Citigroup Centre, Canada Square, Canary Wharf, London E14 5LB under No.BR001018 and is authorised and regulated by the Financial Services Authority. VAT No. GB 429 6256 29. Ultimately owned by Citigroup Inc., New York, U.S.A.

Contents

Citigroup® Global Transaction Services Fiduciary Services news&views; May 2006 Weaving through the MiFID Maze; Microfinance funds in Luxembourg CTCL home page

Citigroup® Global Transaction Services
Fiduciary Services
news&views; May 2006
Weaving through the MiFID Maze; Microfinance funds in Luxembourg

CTCL home page