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Page last published: 31 August 2007

Citigroup® Global Transaction Services
Fiduciary Services
news&views; September 2006
EC's Expert Group Reports
Single and Dual Pricing
SICAR in Luxembourg
MiFID in Ireland

Across Europe

· Expert Group Report on Investment Fund Market Efficiency

· Wolfsberg Publishes AML Guidance for Mutual Funds and Other Pooled Investment Vehicles

· The Klinz Report - Is the Existing UCITS Framework Sustainable?

· CESR Publishes Guidelines on the UCITS Notification Procedure

· Bundled Brokerage and Soft Commission Arrangements: Feedback on Retail Funds

· Single and Dual Pricing for Authorised Collective Investment Schemes: The Future

Luxembourg

· Abbey National: VAT for Investment Funds - An Important Step But Not the End of the Story

· Luxembourg Refines its Framework for Investments in Risk Capital

Ireland

· Where is MiFID and Who Can Expect What?

· The Irish Financial Regulator Investigates Management Fees

Contacts

Welcome

Summer 2006 will be remembered as one of the warmest in recent years. So we were very pleased to see on 4 July, after much perspiration, that the European Commission's three Expert Groups on investment fund market efficiency, hedge funds and private equity funds delivered their final reports. In their reports the expert groups identified areas of action for the improvement and future sustainability of the investment fund legal framework in the European Union ("EU").

The atmosphere was already getting warmer in March with the publication of the Klinz report, which identified (in a typically formal manner) the existing weaknesses in the current Undertaking for Collective Investment in Transferable Securities ("UCITS") framework. Furthermore, ongoing work on the implementation of the Markets in Financial Instruments Directive ("MiFID") has kept both regulators and financial firms busy throughout the EU. In this edition of News & Views you will find articles relating to the above and more. On the international side, the Wolfsberg Group and the Committee of European Securities Regulators ("CESR") have made an important contribution in the field of anti money-laundering and UCITS passporting, respectively. We review both in detail.

At country level, we have seen how regulatory events are increasingly EU-driven. However, there are several interesting local regulatory developments to consider.

The interpretation of the Abbey National VAT case has long been awaited; Her Majesty's Revenue and Customs ("HMRC") judged, in its Business Brief 07/06, issued in late June, that pursuant to the European Court of Justice's judgement, services which when viewed broadly as "distinct" as fund administration (and are specific to and essential for the management of AUTs or OEICS structures), are exempt from VAT. HMRC has set out various criteria that need to be satisfied so that fund administration services can avail of the VAT exemption. HMRC has also set out details on how companies can make reclaims for repayment of output tax previously paid. An important note -claims shall be limited to a three-year period.

In Luxembourg, the Commission de Surveillance du Secteur Financier ("CSSF") defined in more detail the notion of "risk capital", with reference to the ever more popular Société d'Investissment en Capitale à Risque ("SICAR") - the local legal vehicle of choice for the private equity and venture capital fund business.

In the Republic of Ireland, an important event has been the publication, in May, of the much awaited revised UCITS Notices, non-UCITS Notices and Guidance Notes, including the finalised Guidance Note 3/03 on the use of financial derivative instruments in UCITS funds. You will find detailed comments on this topic and analysis in future issues of News & Views. Finally, we thank Laurent de La Mettrie and Michel Lambion (PWC Luxembourg) for their very interesting contribution on the Abbey National VAT case, and Paul Ryan from Dillon Eustace in Dublin for his interesting analysis on MiFID and its impact on the Irish investment fund market. I hope you will enjoy our newsletter, and look forward for your feedback, which as always, is appreciated.

Sean Quinn
European Head of Fiduciary Services

Expert Group Report on Investment Fund Market Efficiency

On 4 July, the Expert Group on Investment Fund Market Efficiency published its long-awaited final report (the "report"). The Expert Group was established by the European Commission ("EC") in January 2006 with the purpose of providing hands-on commercial and technical perspective on a range of issues relating to the functioning of the single market framework for retail investment funds (Undertakings for Collective Investment in Transferable Securities, or "UCITS"). The report will play a fundamental role in determining the contents of the EC's White Paper on asset management, expected in November.

The Expert Group's mandate was to advise the European Commission on cost-effective ways to support a more efficient organisation of different stages in the European investment fund value-chain. This exercise included the identification of shortcomings in the European Union's regulatory environment preventing the investment fund industry from exploiting its full potential, and the issuing of recommendations on the steps needed in order to realise any untapped efficiency gains.

In the remainder of this document we will provide you with a synopsis of what we consider to be the salient points of the report, however we strongly suggest that you read the report and its appendices in detail.

The Inefficiencies Identified

The Expert Group has identified "a limited number of inefficiencies that are stunting the investment fund industry's development. Removing these is urgently needed to allow the fund industry to provide efficient and effective investment solutions for European investors".

The following diagram identifies five main sources of inefficiency:

· Inefficiency #1 Lengthy procedures in bringing new products to market: in comparison with other products, UCITS suffers from extensive time-to-market delays, due to both home state authorisation processes and difficulties in the notification process

· Inefficiency #2 Unexploited economies of scale: the European investment fund market is fragmented with many small, underperforming funds as well as clone funds from the same fund sponsor. As such, economies of scale are relatively unexploited.
The situation persists because of the absence of efficient mechanisms for amalgamating assets of smaller or clone funds into larger, more efficiently run operations

· Inefficiency #3 Barriers to the cross-border provision of services: the UCITS framework artificially imposes a geographic organisation of the value chain, as investment funds must have a local depositary/custodian and local management presence. The consequence is that costs are often unnecessarily duplicated with lower efficiency gains and higher operational risks

· Inefficiency #4 Non-standardised fund order processing: the cross-border processing of investment fund orders is highly fragmented at all levels in the transaction value chain. Operations are usually conducted manually in domestic markets, resulting in high operating costs and considerable operational risks

· Inefficiency #5 Tax barriers to fund operations: the lack of tax harmonisation creates inefficiencies and barriers to the single market in investment funds; identified breaches in tax treaties should be investigated and resolved by the EC as a matter of priority

The removal of these inefficiencies will be of great benefit to the investors, and should unleash new competition and sustained product performance and innovation.

The Expert Group gained a wide consensus internally on the obstacles to the further successful development of the European investment fund market, and provides a set of clear, detailed and workable recommendations on how to remove those barriers.

Streamlining the Authorisation and Notification Processes

The structure of the current notification process has been thoroughly discussed this year within the industry, mainly thanks to the Committee of European Securities Regulators' ("CESR") related initiatives. The Expert Group's primary focus has been to maintain the UCITS brand in terms of quality and investors' protection, and at the same time to improve time to market for new products. In this respect, the Expert group considered two alternative options, either to model the UCITS product authorisation and notification on the Prospectus Directive, or to rely purely on a collective investment undertaking "service passport for the operator of the UCITS". In both cases, the notification process would be operating directly between home state regulatory authority and host state regulatory authority.

Considering that the second option poses problems of self-regulation, the Expert Group suggests the following basic changes to the existing UCITS Directive (for all the details, please refer to the full text of the report):

· The home state authorisation process should be completed within 20 business days, reduced to 10 for prospecti amendments

· New funds under an umbrella structure should be approved within 10 business days

· The notification process should involve only the home state and the host state regulatory authorities. Upon request from a UCITS, the home state authority should notify the host state authority within three business days and provide the relevant host state authority with an electronic certificate stating that the UCITS product is authorised. The host state authority should not undertake any further approval, vetting or administrative procedure

· The simplified prospectus should be "repositioned as a summary prospectus". It would form a detachable part of the full prospectus with both being useable independently

· In terms of language, where the UCITS is sold in the home state only, the fund documents required for authorisation should be drawn up in a language acceptable to the home state regulatory authority. Where the product is sold in a host state, "documents written in the language of the home state should be acceptable", however the host state regulatory authority could request the summary prospectus to be translated into its official language(s). The translation should not be pre-checked by the host state regulatory authority to avoid delays in selling the fund

Facilitating UCITS Mergers and Allowing Pooling Techniques

The Expert Group believes that "both pooling and mergers are necessary and complementary options".

As far as mergers are concerned, it is suggested that a legislative framework for fund mergers covering all UCITS (including both corporate and non-corporate funds) is created, including the possibility of merging compartment, or sub-funds, of umbrella funds. Also under this approach, a non-UCITS product willing to merge into a UCITS should convert to a UCITS in advance of the merger. The Expert Group's approach in this respect is two-fold:

a Amend the existing UCITS directive, to include:

· A definition of fund mergers

· The recognition of the right to merge UCITS cross-border

· The split of responsibilities (and rights) of regulators for cross-border merger of funds

· Rules for asset valuation and determination of the exchange ratio

· Merger notification rules

· Investors' information requirements

· Tracking mechanisms for performances and names

b Introduce a "Taxation of fund mergers directive", similar to the existing Taxation of mergers directive (90/434/EC). Such directive would limit any tax-adverse implications for UCITS-to-UCITS mergers.

With reference to pooling (also defined as "commingling") techniques, the Expert Group proposes amendments to the UCITS directive for the purpose of:

· Creating so-called "Designated Commingling Structures" ("DCS") as harmonised European funds, to be used as pooling vehicles. Without entering into additional details, such vehicles should be subject to appropriate disclosure requirements, and have mechanisms in place to avoid any double-charging of fees

· Allowing the depositary to appoint a custodian based in the European Union, under its responsibility

In addition to the above, the Expert Group recommends the involvement of CESR as a venue for discussions around pooling, and as an advisor to clarify some additional concerns.

Further suggestions are also made as far as pooling for pension funds is concerned.

Effective Management Company Passport

The unclear (and inconsistent) application of the Management Company passport has always been considered by the investment fund industry to be one of the most serious weakness in the UCITS framework. The Expert Group recommendations focus on six main areas of change:

1 Remove the discrimination in the UCITS directive between contractual and corporate funds to allow foreign management companies the right to create and/or manage the former

2 Implement (and enforce) the jurisdictional separation of UCITS funds and their management companies

3 Remove any restriction to the management company passport based on the "head office" concept imposed by some member states

4 Clarify the meaning of "collective portfolio management" in the UCITS directive, ensuring these activities are exhaustively enumerated and defined using terminology commonly understood by the financial industry

5 Reconsider Markets in Financial Instruments Directive ("MiFID") activities available to management companies, and clarify whether or not MiFID-authorised investment firms are allowed to manage UCITS on the basis of their MiFID authorisation

6 Enhance co-operation between regulators to facilitate mutual recognition, ensuring "dual supervision" is as effective as in other European financial services

Convergence in the Role of the Depositary

The Expert Group has also advised on the role of the depositary which is of particular interest for Citigroup's Fiduciary Services.

The role of the depositary is, most likely, the least harmonised in the UCITS framework. The UCITS directive entrusted the depositary with two distinct missions:

1 Safekeeping of the assets of the UCITS

2 An oversight function that involves controlling the assets

Some member states, in particular the Republic of Ireland and the United Kingdom, but also Italy and Germany, have charged the depositary with additional responsibilities of a fiduciary nature.

While the safekeeping function is very similar across EU member states, the control/trustee function differs widely, with different roles and responsibilities. The Expert Group believes that more harmonisation in the depositary's role will contribute to the stability and strength of the UCITS label, and "improve confidence" between EU regulators.

The Expert Group recommends a two-step approach, as follows:

· In the short term, all member states should allow branches of EU established banks to act as depositary for locally domiciled funds, and at the same time permit custodial functions to be delegated to licensed custodians located elsewhere in the EU

· In the long term, capital requirements for depositaries should be harmonised, and further studies should be conducted to remove additional legal barriers due to different interpretation of fiduciary obligations

Conclusions

Following the publication of the Expert Group reports (two additional reports have been published by parallel Expert Groups, on hedge funds and private equity funds respectively), the EC has started a consultation process open to all market practitioners.

The EC's analysis of the reports and of the consultation feedback will be developed during the next few months and will feed into the White Paper to be adopted in November 2006. The White Paper will present the definitive set of measures that the EC intends to implement. For those measures requiring changes to the UCITS directive, the legislative process will be launched immediately afterwards with the purpose of implementing in full all the required changes within three years (a deadline defined as "rather tight" on the EC website.

Wolfsberg Publishes AML Guidance for Mutual Funds and Other Pooled Investment Vehicles

The principal aim of the Wolfsberg Group is to establish industry standards for financial services on issues such as Anti Money-Laundering ("AML"), Know Your Customer ("KYC") and Counter Terrorist Financing. In April 2006, the Wolfsberg Group published a document entitled "Anti Money-Laundering Guidance for Mutual Funds and other pooled investment vehicles" (the "Guidance"). This article reviews the principal characteristics of the Wolfsberg Group's approach.

The Wolfsberg Group is an international association of twelve global banks, including Citigroup, established in the year 2000 in Chateau Wolfsberg, in Switzerland. The Guidance is intended to be applied to any kind of "Pooled Vehicles" ("PVs"), ie any kind of vehicle established for the purpose of collective investment (including UCITS funds, hedge funds, private equity funds, funds of funds etc) whatever the legal form (corporation, trust, partnership etc), investment objective, jurisdiction, applicable regulation, target investor and distribution methodology may be.

The fact that the Guidance refers to any kind of PV does not mean that the money-laundering risk associated with each kind of PV is the same. However, even if it is always difficult to generalise, the Wolfsberg Group finds that PVs are usually perceived to entail a lower risk of money-laundering in comparison with other financial products, for three main reasons:

· Assets typically flow into PVs from other financial institutions which are themselves subject to AML regulations

· Many PVs have features making them less attractive for money-laundering purposes, such as restrictions on cash withdrawals or on third-party payments

· PVs are commonly used for long-term investment, making high turnover or short-term investment unattractive and/or suspicious

However, considering the size of the PV industry and their accessibility to investors, it is possible that criminals could seek to use PVs for money-laundering purposes. In light of these considerations, the Wolfsberg Group suggests that PVs should consider the following when designing their AML infrastructure.

Relationships Between Pooled Vehicles and Investors

The fundamental factor for understanding a PVs AML obligations is the recognition of the overall arrangements by which shares or units of the PVs are offered to investors. In particular, the Wolfsberg Group discriminates between "direct relationships" ie those relationships in which PVs process investors' applications and/or receive funds directly from them, and "indirect relationships" where shares/units are distributed through intermediaries, in which case, subject to considerations which will be disclosed in more detail in the reminder of the article, the intermediary should be considered as the customer.

Customer Due Diligence: A Risk-Based Approach

The variety of characteristics of PVs is such that no single approach to customer due diligence can be identified. In general terms, it can be said that customer due diligence generally includes: a) verification of identity of the investor and of the beneficial owner; b) understanding the purpose of the investment (does the transaction make sense from an economic point of view) and c) conducting ongoing due diligence on the customer's trading/ investment activity.

Considering that PVs entail a lower money-laundering risk compared to other financial services/products, the Wolsfsberg Group suggests that simplified customer due diligence measures may be applied by PVs, with prior consideration of the following risk factors:

1 Investor risk: the type of investors the PV will deal with (individuals, financial institutions or regulated or public companies, complex or nontransparent investors etc.) as well as the target investors (eg PVs established specifically for pension funds investment)

2 Country risk: the breadth of distribution should be considered, as direct distribution to investors resident in the same jurisdiction where the PV is established should involve lower money laundering risk compared to direct distribution on a regional or global basis

3 Condition risk: this category includes the characteristics of the PV itself, like the ability of redeeming at any time, accept or execute third party payments etc

4 Value risk: the value of permitted investments and any restrictions on methods of payments of subscriptions In the case of direct relationships, the guidance envisages PVs performing a risk-based customer due diligence on investors. In an indirect relationship, the PV should consider the level of due diligence that should be performed on the intermediary taking into account the regulatory environment in the relevant jurisdiction, and in general the intermediary's AML responsibilities. It should be noted that under the Wolfsberg Group's approach, the performance of customer due diligence by an intermediary "does not render the investor a customer of the PV. In such a situation, the investor remains the intermediary's customer".

The KYC process should also take into account the differences between investor and beneficial owner, and be capable of dealing with special situations.

In terms of investors' identification, the PV (or the intermediary) should take "reasonable measures" to identify and verify the identity of the investor. As stated above, the extent of identification procedures undertaken by the PV should be risk-based, and in lower-risk situations, simplified procedures should be applied, always in accordance with applicable laws and regulations. The required documentary evidence should be received prior to the "account opening" and in those cases where this is not received or remains incomplete, the PV should retain any redemption proceeds and not accept any further transaction as long as the required documentary evidence has not been received. Similar procedures should be taken for determining the beneficial ownership of the monies, on a risk-based approach and "where it is apparent" that the investor is acting on behalf of a third party. Finally, enhanced due diligence should be required only in the context of higher-risk situations (eg in the case of Politically Exposed Persons).

The Role of Intermediaries

In the case of indirect customer relationships, a variety of intermediaries may be involved in the distribution process of a PV. Each PV should have a policy established in this regard, but the Wolfsberg Group considers that in all cases, the PV should conduct due diligence on the intermediary, focusing on the following key factors:

· Is the intermediary subject to adequate AML regulations and supervised for compliance with such regulations?

· Alternatively, does the PV reasonably believe that the intermediary employs adequate AML procedures, such that it would be reasonable for the PV not to ascertain the identity of the intermediary's customer itself?

The most commonly-used approach to assess whether an intermediary is subject to adequate AML regulations is to refer to the country where the intermediary is established and to make sure this has implemented laws or regulations which effectively implement and meet Financial Action Task Force ("FATF") standards. It should be noted that in Wolfsberg Group's opinion a country's AML regulations "meeting FATF standards" does not necessarily imply that the country is an FATF member.

Four categories of intermediaries can be identified on the basis of the Wolfsberg Group's approach, as follows:

1 Regulated intermediary, established in a country meeting FATF standards: in this case, the PV does not need to perform its customer due diligence, and is not required to "drill down" to the intermediary's customer. The PV may allow the intermediary to open an "omnibus account" (often referred to as "nominee account", or "house account") opened in the intermediary's name, for all the transactions on behalf of the intermediary's customers

2 Unregulated intermediary, established in a country meeting FATF standards: in this case the PV is required to "drill down" and perform customer due diligence on the investors. Accounts should be opened in the name of the investors or, alternatively, transactions could be placed via an omnibus account in the name of the intermediary, provided that the PV receives from the intermediary a complete list of the underlying investors, to allow it to perform its customer due diligence

3 Intermediary established in a country not meeting FATF standards: under these circumstances, the PV is required to "drill down" and perform customer due diligence on the investors. Also in this case, the placement of orders through an omnibus account is acceptable, provided that the PV receives from the intermediary a complete list of the underlying investors, to allow it to perform its customer due diligence

4 Other acceptable intermediary: if the intermediary is an "acceptable intermediary", the PV may decide that it need not "drill down" to perform customer due diligence on the investors. An acceptable intermediary can be defined as an intermediary that applies AML standards equivalent to those established by the FATF, either because it belongs to a group of companies that are applying those standards to meet the parent's legal or regulatory obligations, or because it does so on a voluntary basis. In any case, the PV should review the intermediary's AML approach on a regular basis to satisfy itself it can treat the intermediary as an acceptable intermediary

Record Keeping and Ongoing Monitoring

The Wolfsberg Group Guidance also focuses on issues such as record keeping, transactions monitoring and overall AML program.

In terms of record keeping, the Wolfsberg Group recommends a minimum retention period of five years following the termination of the client relationship or the performance of the transaction.

For transaction monitoring, the PV, its provider or its intermediary should make use of automated systems whenever possible and establish reporting procedures for unusual activities to the relevant enforcement agencies.

All these arrangements should be part of an overall AML program, of which the PV should retain overall responsibility and that should be regularly reviewed and updated. The AML program should identify one or more Money-Laundering Reporting or Prevention Officer, and provide for adequate training arrangements.

Conclusions

The Wolfsberg Group's Guidance is broadly in line with European financial industry standards. Interestingly, only a few months ago the International Organisation of Security Commissions ("IOSCO") published its "Anti Money-Laundering Guidance for Collective Investment Schemes". We cannot judge whether this increased focus on anti money-laundering practices in the investment fund industry is due to an increased awareness of the financial industry or simple coincidence. What is clear is that, as more and more countries in the former Eastern Europe and in the Far East are developing their financial centres, the need for a global approach to regulatory production is more and more evident.

The Klinz Report - Is the Existing UCITS Framework Sustainable?

The European Parliament's Committee on Economic and Monetary Affairs recently adopted a Report on Asset Management (also known as "Klinz report" - the name of the rapporteur). The report, published in its final version on 27 March, identifies inconsistencies and weaknesses in the European Union's financial legislative framework and suggests areas for improvement.

The Klinz report, as discussed and approved by the European Parliament's Committee on Economic and Monetary Affairs, states that "the interaction between Undertaking for Collective Investment in Transferable Securities ("UCITS") directive, MiFID and its Level 2 measures, and the E-commerce directive, leave undesirable scope for interpretation and require clarification and consolidation" and draws the readers' attention "to differences between the regulation of UCITS and other investment products" calling on the European Commission, Committee of European Securities Supervisors ("CESR") and Committee of European Insurance and Occupational Pensions Supervisors ("CEIOPS") "to ensure a high level of transparency and management of conflicts of interests, notification requirements and thus equal treatment between UCITS and competing products".

The contents of the Klinz report could be considered either a criticism or a suggestion for improvements (depending upon your point of view); no matter how you want to look at it, these are the areas of concern it identifies:

1 Objectives and implementation of the UCITS directives: the objectives of investor protection and product diversity, which ensure fair conditions of competition and improving performance and competitiveness at global level, have not been achieved to a satisfactory degree and changes introduced with UCITS III have not been exhausted. In particular, additional modifications seem necessary in terms of simplified prospectus, notification procedure, abolition of tax barriers for cross-border mergers and pooling and the adaptation of eligible assets to market developments and innovation

2 Investor information and protection: the simplified prospectus requirements have not been consistently implemented. The Klinz report supports the European Fund and Asset Management Association's ("EFAMA") October 2003 proposal that the simplified prospectus should take the form of a harmonised, pan-European factsheet including standardised information on the nature and risk of financial instruments used, the total expense ratio and an understandable description of the asset management (investment) strategy The Klinz report also outlines the importance of investors' education, in terms of their knowledge of financial products, their rights in the context of customer complaints and the possibility of addressing issues to an ombudsman

3 Risk management: further studies are required on effective risk control measures and in the long term, the differing risks of the individual components of the value chain and the risk profiles of individual products should be examined more closely

4 European passport: in terms of product passport, in addition to the already mentioned concerns on the current status of the simplified prospectus, eligible assets and notification procedure, the Klinz report underlines that advertising and consumer protection provisions are not harmonised
With reference to the management company and the depositary's passport, the Klinz report "regrets the unclear legal situation created by the management company directive and calls the Commission to develop its work for achieving a real management company passport". At the same time, the depositary passport is not considered feasible in the short term, as the harmonisation of the role and responsibilities of the depositary have not yet been achieved. However, "the possibility of cross-border delegation of pure custody function, this delegation remaining a decision of the depositary to guarantee a high level of investor protection" is welcomed

5 Standardisation of fund processing: the inefficiency of fund processing is an obstacle to further growth of the asset management industry. Order processing and settlement of funds are different from clearing and settlement of securities. The industry should, in co-ordination with the European Commission and regulators, "develop an operational, standardised and consistent European model for fund processing in a secure environment"

6 Cross-border consolidation: the size and number of European funds is sub-optimal and greater consolidation would bring lower costs and/or higher net returns for investors. Tax harmonisation, along with industry initiatives such as master-feeder structures and cross-border pooling, could provide a (partial) answer to these consolidation needs. However, tax harmonisation should also be accompanied by convergence on the general legal and regulatory conditions to avoid cross-border consolidation resulting "in a small number of large management companies in a dominant position distorting competition"

7 Distribution of funds: the Klinz report supports the creation of an open architecture through competing channels of distributions, including direct distribution via the Internet. It underlines the fact that in a number of Member States the distribution and sale of investment funds are often still locally based, with very limited competition, suggesting the European Commission should investigate distribution costs to identify uncompetitive behaviours (such investigation, should be extended to all financial products).

8 Investment policy: as already mentioned, the range of eligible assets for UCITS should be extended to be in line with financial markets innovation and be based on Pan-European definitions. Any change of investment structure of an investment fund not in line with the previously defined asset allocation strategy, and any change in the risks to which the investor is exposed, should be also clearly disclosed.

9 Non-UCITS products: products such as real estate funds, hedge funds, funds of hedge funds, private equity funds, certificates and pension funds are becoming an increasingly popular type of investment. The creation of a Pan-European private placement regime, and the establishment of rules for making them available to retail investors should be taken into consideration by the European Commission.

10 Supervision and Lamfalussy methodology: the Lamfalussy methodology has proven to be a successful one in the implementation of directives such as the "market abuse directive" and the "prospectus directive". However, the Lamfalussy process is not applicable to the UCITS directive, even if some of its mechanisms have been applied to it. The Klinz report suggests the European Commission should introduce amendments to the UCITS directive, to make it Lamfalussy-compliant. At the same time, it asks national supervisory authorities to cooperate more closely, in terms of exchange of information, and draws attention to the importance of regulatory arbitrage, an issue "of considerable importance particularly because of the anticipated growth in cross-border sales of fund products to non-professional investors, the expansion of electronic marketing and advisory channels, and the interest expressed by the fund industry and its financial partners in the banking and insurance sector, in a pan-EU management company passport"

The contents of the Klinz report were widely discussed at industry level on the occasion of the Eurofi conference held in Brussels at the beginning of June, and during the Open Hearing organised by the European Commission in Brussels on 19 July. On both occasions no material comments were made suggesting that the report is pessimistic or too critical on the current UCITS legislative framework. This is primarily due to many of the issues having already been addressed by the investment fund industry.

The Klinz report, along with the European Commission's Expert Groups reports on retail investment funds market efficiency, hedge funds and private equity funds, are fundamental documents for understanding how the European asset management industry will be developing in the next few years - along with the EC's White Paper on asset management, expected for the last quarter of this year.

CESR Publishes Guidelines on the UCITS Notification Procedure

In October 2005, the Committee of European Securities Supervisors ("CESR") issued a consultation paper on the simplification of the notification procedures for Undertakings for Collective Investment in Transferable Securities ("UCITS"). After a second round of discussions (a new consultation paper was published on 5 May 2006), CESR has now published its final guidelines.

In the December 2005 issue of News & Views we described the salient points of CESR's consultation paper on guidelines intended to simplify the cross-border notification procedures for UCITS.

The work undertaken by CESR seeks to identify a common set of procedures for streamlining the notification process by virtue of which a UCITS established in a Member State can market its units/shares in any other Member State on a cross-border basis, so fully benefiting from the so-called European passport.

CESR is cognisant of the fact that the existing UCITS Directives provide limited space for comitology, as they have not been written on the basis of the Lamfalussy model. However, it is true that even within the limits of the current regulatory framework, a certain degree of convergence between the various regulators' approaches is possible and would be of great benefit to the European investment fund industry.

The Notification Procedure

· UCITS should use a standardised notification letter (a template is included in the guidelines) and the submission should be made in a "language common in the sphere of international finance" or, if this contrasts with local legislation, in one of the official languages of the host member state

· The host state authority cannot refuse a notification for reasons other than non-compliance of marketing arrangements. By way of example, divergent interpretations on whether a UCITS complies with the UCITS directive cannot be used to refuse the notification

· A UCITS can be marketed in the host state at the expiry of the two-month notification period unless the host state authority notifies the UCITS, by means of a "reasoned decision", that it is not complying with marketing arrangements. However, the notification period starts only "when the competent host state authority has received the complete notification. If the notification is not complete, the two-month period does not start" The two-month period can be shortened as much as possible, for example using e-mails and other forms of electronic transmissions when possible Finally, in those cases where a notification is incomplete or not fully satisfactory, the host state authority may request additional information from the UCITS without issuing a "reasoned decision" so as to avoid the whole process having to start again

· The certification and translation requirements for accompanying documents have been analysed as well. A self-certification will be considered sufficient, as long as the UCITS states that the documents submitted are the latest ones approved by or filed with the home state authority Accompanying documents must be sent in the original language and translated into one of the official languages of the host state (with the exception of the "UCITS Attestation"). However, the host state authority can approve the use of another language. To further facilitate the process, CESR members will provide on their websites information on the documents that need to be translated, and of the acceptable language(s)

· Specific provisions apply to umbrella funds. CESR members agree that if an umbrella UCITS only wants to market actively certain of its sub-funds in the host state, only those sub-funds have to be notified

When more than one sub-fund is notified, those can be all included in the same notification if notices are provided simultaneously. If new sub-funds are added to an umbrella UCITS, and those are proposed to be marketed in a host state, the normal procedure applies even if host state authorities may decide to apply a lighter procedure and reduce the two-month period

Content of the File

The notification file must contain a limited and defined number of documents and information, as follows:

1 The attestation from the host state authority that the UCITS fulfils the conditions imposed by the UCITS directive or, alternatively, a copy of the original attestation certified by the UCITS' directors or a suitably empowered person

2 A notification letter, a template of which is provided as appendix to CESR's guidelines

3 Latest up-to-date fund rules or instruments of incorporation

4 Latest up-to-date full and simplified prospectus

5 Latest published annual report and any subsequent half-yearly report comprising (if applicable) the whole umbrella

6 Details of the arrangements made for the marketing of units in the host member state

Modifications and On-going Process

UCITS are expected to keep host state authorities up to date on issues such as amendments to fund rules or instruments of incorporation, addition of new share classes, new prospectuses, annual and semi-annual reports. New or updated documents should be submitted without delay.

National Rules and Regulations

CESR members have agreed to publish and keep updated on their websites a list of national marketing rules and other specific national regulations. This refers to all those national provisions not falling within the fields harmonised by the UCITS directive.

Conclusions

This is another example of European regulations that will be "transposed" straight into national regulations, almost without local authorities' intervention. CESR, which has been created as one of the pillars for the Lamfalussy approach, is expanding its role beyond the borders of the Lamfalussy process and shaping itself as the single EU securities regulator, a process we surely welcome. However this is happening in the absence of a clear legal framework, a position difficult to sustain in the long term.

Bundled Brokerage and Soft Commission Arrangements: Feedback on Retail Funds

In our December 2005 edition of News & Views we brought you details of the Consultation Paper ("CP") 05/13 - "Bundled brokerage and soft commission arrangements for retail investment funds". At that time the Financial Services Authority ("FSA") was proposing that an individual or a body be appointed to represent the interests of retail investors (eg reviewing disclosures on their behalf, interacting with the investment manager if appropriate etc). One of the central themes of the consultation was who this individual should be and a number of suggestions were made, including the Depositary/Trustee for collective investment schemes and directors of the company for investments trusts.

The FSA has now issued the feedback received to CP 05/13. The feedback appears to have been generally supportive of the proposal to have an "investor's representative" appointed. However, there was divided opinion on who should fill this role and the extent of information that should be made available to investors. The FSA has therefore referred back to its risk-based approach as outlined in its "Better Regulation Action Plan", issued in December 2005. Under such an approach the FSA feels that as it wishes to rely more on principles, it does not wish to introduce additional rules. Therefore there is not "one best fit" and so no specific model will be imposed. Rather, the FSA appears to be giving firms the opportunity to demonstrate that they are in fact adopting the Treating Customer Fairly ("TCF") approach, where softed and bundled arrangements are paid for by the fund.

How is this to be demonstrated by firms? The simple answer is for firms to have sufficient oversight arrangements in place to review commission disclosures. The FSA aims to assist the trade associations representing most firms connected with this issue in developing "new standards of good practice" - the idea being that their members could refer to these also.

The FSA has also found that where retail funds bear the cost of softed and bundled arrangements, it would be beneficial to disclose information on commission disclosure to the market. This should raise transparency levels. Clearly then, the FSA is not proceeding with the rules and guidance as set out in CP 05/13 (it was proposed that the effective date for rules and guidance would be 1 July 2006). However, it would be incorrect to say that it no longer regards the issue as important. The regulator remains committed to further reviewing the effectiveness of industry-led measures over the next 18 months when it will assess whether "investment managers are making decisions on getting value for money from commission spending and are accountable to their clients for the decisions made".

Single and Dual Pricing for Authorised Collective Investment Schemes: The Future

The Financial Services Authority ("FSA") has issued Consultation Paper ("CP") 06/7 "Single and Dual pricing for authorised collective investment schemes", which contains its proposals for amending rules on how authorised Collective Investment Schemes ("CIS") are to be valued and priced.

From 12 February 2007, the CIS sourcebook will cease to exist and the transitional dual pricing arrangements for AUTs in COLL will expire. Therefore, the consultation paper is timely as the FSA needs to either require all dual-priced AUTs to convert to a single-pricing regime, allow Managers who dual-price to continue with the status quo or introduce a new form of pricing.

Until 1997, unit trusts were the only type of authorised vehicle in the UK market and dual pricing was seen as the only permitted way of valuing them. When Investment Company with Variable Capital ("ICVC") structures were introduced that same year, they were forced to adopt single pricing -the rationale being to allow for greater competitive edge in the wider mutual funds market across Europe. To a lesser extent, it also served to consolidate the position of the ICVC structure as a new, more streamlined structure. In 1999, AUTS were allowed to adopt single pricing if they so wished.

Within its consultation paper as referenced above, the FSA concludes that it does not see any apparent disadvantage to investors in using one particular pricing methodology over another. In fact, Annex 2 to the CP illustrates a table detailing estimates of comparative costs to investors. The inference from this assessment is that the FSA appears to deem it reasonable for Managers to choose which basis (ie single of dual pricing) they wish to apply. Importantly, this discretion should also be extended to Open Ended Investment Companies ("OEICs") and not just restricted to AUTs. The FSA does not wish to be seen to endorse one methodology over another. Rather, in keeping with its 'principles-based' approach, it deems that the Manager can adopt the methodology which best meets the requirements of accuracy, fairness and transparency.

It would appear that OEICs will not be in a position to choose to either dual-price or not until the 12 February 2007. For practical purposes this means that an AUT that wishes to convert to an OEIC structure before this date must operate under a single-pricing regime until then, even if the intention is to dual price. Of interest also is that it would appear under the proposals that in the case of an umbrella fund, individual sub-funds can either be dual-priced or single-priced. However, within a particular sub-fund, each class should have the same pricing basis. Changing the pricing basis should be treated as a significant change thereby requiring 60 days' notification to unitholders. Under COLL, information concerning the valuation and calculation of pricing must appear in the fund's Prospectus (this is a departure from CIS schemes, where this detail was contained within the FSA Sourcebook).

The consultation period for CP 06/7 expired on 21 July. The FSA intends to present its final rules and guidance to its Board by the end of September 2006 and publish feedback shortly thereafter. As highlighted above, the rules are due to become effective on 12 February 2007.

Luxembourg

Abbey National: VAT for Investment Funds - An Important Step But Not the End of the Story

On May 4, 2006, the European Court of Justice ruled in the Abbey National case (n° C- 169/04) and concluded that administrative services of investment funds could benefit from the exemption of article 13.B.d.6) of the 6th EU VAT Directive. As far as depositary services are concerned, the Court decided that they were outside the scope of the exemption.

Currently, article 13B(d)(6) of the Sixth VAT Directive exempts from VAT "management services to special investment funds as defined by Member States". The questions referred to the Court by the VAT and Duties Tribunal, London, concerning Article 13B(d)(6) of the Sixth VAT Directive, can be summarized as follows:

1 Do the Member States have the freedom to define the type of activities that can be regarded as "management" as well as the type of funds which may benefit from the exemption?

2 If the answer to question 1 is no and the term "management" has an independent Community law meaning, are charges of a depositary or trustee as meant in the UCITS Directive (85/611/EEC) exempt as "management of special investment funds"?

3 Again, if the answer to question 1 is no and the term "management" has an independent Community law meaning, does the exemption for "management of special investment funds" apply to services of a third-party administrative manager?

On September 8, 2005, Mrs Kokott delivered her opinion and considered that "management" is an autonomous concept of Community law from which Member States may not diverge. Based on this opinion, Member States should not have the power to define the type of activities that can be regarded as "management".

Concerning the first question, the Court concurred with the Advocate General and decided that the term "management" has an independent community law meaning. This interpretation is in line with case law and ensures a uniform definition within the Community.

The Court also clarified another point. The wording changes from one official language version of the 6th EU VAT Directive to the next when it comes to the type of funds that could benefit from the exemption. For instance, the French and Italian versions refer to funds constituted under the law of contract such as the Luxembourg "fonds commun de placement" or under trust law such as the UK "Unit Trust", while this is not the case for other versions. The Court ruled that both types of funds and funds constituted under statute could benefit from the exemption. The exemption may thus apply regardless of the funds' legal form.

Concerning the second question, the Advocate General stated that services provided by a depositary are exempt from VAT if:

· They form a distinct whole and are essential for and specific to the management of the common fund or investment company, and

· The focus of those services is not on activities of safekeeping and administration within the meaning of Article 13B(d)(5) of the Sixth VAT Directive

The Advocate General has thus expressly stated that pure custodianship functions, ie the safekeeping of securities in the technical sense, are subject to VAT. This also concerns other technical services such as drawing up statements, receiving dividends, transmitting information between share companies and their shareholders, deducting withholding taxes and issuing tax certificates.

As for the third question, the Advocate General took the position that services provided by the external manager in the form of administrative operations in the management of the fund are exempt from VAT if they form a distinct whole and are essential for and specific to the management of the fund.

Concerning outsourced functions, the Advocate General has noted that the distinctive character would be attained if the third party takes on a bundle of services that forms an essential part of all functions arising in the management of the fund. The inner coherence of the operations outsourced has to be considered to determine whether the services could benefit from the VAT exemption. Therefore, in the opinion of the Advocate General, some of the outsourced functions may, taken individually, not constitute a distinct whole.

Regarding the second and third questions, the Court agreed in part with the opinion of Mrs Kokott and departed from the strict position taken by Advocate General Maduro Poiares in the BBL case (C-8/03) regarding the same question. Mr Maduro took the position that the exemption is available only for portfolio management services and not for custody or administrative services. At the time of the BBL case, the European Court of Justice did not need to decide on this question. This explains why the question had to be examined again.

The criteria used by Mrs Kokott in her conclusions cover a broader range of services and are based on a more "economic" or "philosophical" approach since clear references are made to the purposes and schematic context of the exemption (ie to facilitate investment in common funds for small investors) to interpret the concept of management. In its decision, the Court explicitly refers to the Advocate General's developments on this issue.

The Advocate General also largely used the concepts put forward by the ECJ in the SDC case (C-2/95), ie for the exemption to apply, the services must be distinct in character in the sense of forming a distinct whole and be specific to and essential for the exempt transactions. In practice, such criteria could be difficult to apply, especially if services are outsourced to various providers. The Court also referred to the SDC case and excluded from the scope of the exemption technical supplies such as the making available of a system of information technology. The latter item seems obvious and fails to shed much more light on the scope of application of the exemption in case of sub-contracting.

Regarding sub-contracting, the Court's decision is, at first glance, clear and favourable. However, when you look at it more closely and refer to the ratio legis of the law, it could add to the uncertainty surrounding the scope of the exemption for management services of investment funds. One point is clear: the exemption could not cover any type of in/out sourcing.

However, the most surprising and interesting aspect of the Court's decision is certainly that custody services could not be considered to be management services and, therefore, could not benefit from the exemption. Referring to the definition of this activity contained in the UCITS Directive, the Court considers that services provided by a depositary could not be exempt because the function of a depositary is not to manage the fund but to control and supervise it. This is a departure from the Advocate General's opinion and could mean additional.

As explained above, custodian banks will have to charge VAT to the funds, which will represent a cost should the fund not be able to recover this VAT. Up to now, all Member States have underestimated the issue of the VAT recovery by investment funds. Indeed, the VAT suffered by funds was, in most Member States, quite minimal due to the exemption granted to most services and efforts focused more on exempting services rendered to funds as much as possible than on trying to recover VAT. This question will now become important but, in all likelihood, most funds will not be able to recover the VAT to be charged by their custodian or they will only be able to recover part of the tax.

How could it impact the fund industry in the European Union? The answer to this question will of course depend on various factors. The most obvious ones are the level of fees and the VAT rate. Currently, custody services could benefit from a 12% VAT rate in Luxembourg. This has to be compared to the rates applicable in other countries: 16% and in the near future 19% in Germany, 19.6% in France, 21% in Belgium, 17.5% in the UK, 19% in the Netherlands, 21% in Ireland, 25% in Denmark and Sweden and around 20% in most new EU Member States. Twenty percent could be considered to be an average rate in the EU. On the other hand, one should not lose sight of the competition of non-EU countries such as Switzerland or the Channel Islands where no VAT system exists or where VAT rates are very low.

The impact for the fund industry will also depend on how flexible Member States turn out to be when it comes to applying other exemptions to at least some parts of the services performed by custodian banks, computing the VAT recovery position of the banks and of the funds or applying a transitional or grandfather period. For the time being, and to the best of our knowledge, there has been no official reaction to this case. It is not a complete surprise considering that no obvious advantage appear to be the first country to react to this case and that a fact-finding exercise is surely necessary. Based on information currently available, it seems that the UK customs should issue a VAT brief, that lobbying efforts are made in Ireland to limit the impact of the case and that a circular could be expected in Luxembourg in a few months.

On a more general note, two additional comments could be made. Firstly, the case indicates a change in the interpretation method used by the Court. For the first time, the Court referred expressly to an article of a Directive other than the VAT Directive, to wit the UCITS Directive. This could mean a more homogeneous approach between the tax and the regulatory side and could bode well for the future. It is a bit surprising however to see that the Court interpreted the VAT Directive issued in 1977 by reference to the UCITS Directive issued in 1985 and modernised in 2001. Maybe, the VAT legislator had a crystal ball in 1977!

The second comment concerns the future of the exemption. In the context of the Consultation paper recently launched by the European Commission regarding the modernization of financial services, the decision of the Court will certainly be scrutinised, taking into account all elements, such as these questions of competition. The comments sent by funds and banking industry associations are likely to ask for a clarification and extension of the exemption of article 13.B.d.6), a more specific and broader definition of eligible funds and inclusion of custody services in the exemption.

As it often happens, the case brings as many questions as answers - and sometimes even more of the former than the latter! At any rate, this much-awaited decision is an important one, especially for custodian banks and for those investment management companies and funds that outsource or offshore certain activities within their own group or to a third party.

The Decision is thus partly good news for the European fund industry. In some Member States, this could mean an extension of the scope of application of the VAT exemption, claims of overpaid VAT by funds and a loss of the VAT recovery for their service providers. In some other Member States, it may have the opposite effect. At any rate, the decision will certainly impact the answers to the Consultation paper recently issued by the EU Commission "on modernizing VAT obligations for financial services and insurance". Moreover, other cases regarding VAT and investments are pending with the European Court of Justice and Abbey National is just the beginning. Indeed, the European Court of Justice will have to examine the question of VAT in the fund industry once more in various upcoming cases including the JP Morgan Charterhouse and Jurriëns Beheer cases.

Last but not least, the exemption of the intermediary services will also be under the scrutiny of the Court in the Volker Ludig case. This case could impact the distribution of the funds should the Court confirms the German interpretation that limits the scope of application to the intermediary who has a direct relationship with one of the party to the transaction and is paid by this person. A survey conducted in 2005 has indicated that most of the Member States apply the exemption also to sub-distribution services. Any change in this respect could thus hit cascade of distribution by implying an additional VAT cost.

Laurent de La Mettrie, Partner, Michel Lambion, Director, PricewaterhouseCoopers Luxembourg

Luxembourg Refines its Framework for Investments in Risk Capital

With the law of 15 June 2004 (the "law"), the Luxembourg legislator established the legal foundation for investment vehicles investing in risk capital - the "Société d'Investissement en Capital à Risque" ("SICAR"), thus enabling promoters to establish, for example, venture capital and private equity funds in Luxembourg. This represented a significant step towards complementing the investment vehicle offering available in Luxembourg by creating a regulatory framework that is more flexible and less restrictive than Undertaking for Collective Investment ("UCI") legislation, and also underscored the pivotal role of Luxembourg as the centre of excellence for the creation, administration and cross-border distribution of different types of investment funds in Europe.

Next to Undertaking for Collective Investment in Transferable Securities ("UCITS"), Luxembourg offers investment vehicles for institutional funds, real estate funds, alternative investments (hedge funds), pension funds and - since June 2004 - risk capital funds.

Since the implementation of the law, the Commission de Surveillance du Secteur Financier ("CSSF") has authorised a total of 64 SICARs with investments currently valued at around Euro 850 million (as of 31 March 2006). On 5 April 2006, the CSSF issued circular 06/241 which is intended to provide regulatory guidance on the notion of risk capital and the criteria applied by the CSSF in determining the acceptability of investment policies of SICARs.

The Notion of Risk Capital

The purpose of the SICAR is to collect funds from sophisticated investors for investments into risk capital with the expectation of achieving high long-term rates of return whilst accepting low liquidity, high volatility and low credit quality. Investments are primarily made in non-listed companies often early in their corporate development (start-ups) with the intention of growing the company to a size where the investors exit through the listing of the company on a stock exchange.

Risk capital investments are characterised by the combination of taking high risk and the intention of developing a target company. The investment objectives of the SICAR need to contain a description of the kind of risk capital that it will be engaged in and the development plan for the targeted entities. Venture capital and private equity investments are considered as the two principal forms of risk capital. Venture capital relates to investments in recently created companies (start-ups) or companies operating in an industry with high development potential.

Private equity comprises investments in unquoted private companies of often relatively small size and is thus characterised by high risk and low to no liquidity.

The concept of development relates to creating added value in the target companies by providing investment capital (either by subscribing to the share capital or by buying shares in the secondary market), close involvement in the management (either through counselling or representation on the board) and the implementation of restructuring or modernisation measures with a view to maximising profits.

Risk capital investments may be undertaken in the form of leveraged buy out ("LBO"), management buy out ("MBO"), management buy in ("MBI"), and buy-offs in the case of private equity investments, and startup and early stage transactions in the case of venture capital. The SICAR is free to choose its exit route be it by an over-the-counter sale or an initial public offering.

The legislator has also provided for the maximum flexibility with regard to the types of financing used. Risk capital may take the form of equity, debentures, bridge financing, mezzanine debt or convertible bonds.

The law facilitates the investment in risk capital by not prescribing any kind of risk diversification. SICARs may invest in heavily concentrated portfolios even to the extent that it is invested in only one target company. The differentiating factor between a SICAR and a holding company is the retention period of the investment. The SICAR would normally seek to disinvest from the target company at a profit after a reasonably foreseeable period, whereas the holding company's objective is to engage in long-term investments.

All of the above factors, ie number and maturity of projected target companies, development plan, type of financing and holding period, are taken into account by the CSSF when assessing the acceptability of the investment policy of a SICAR.

Property Investments

Whilst the law does not allow direct investments in properties, SICARs may invest in real estate companies provided that it can be demonstrated that such an investment may adequately be classified as risk capital. The critical factor in determining this is the development aspect of the proposed investment. The value added by the project may result from renovation works, the renegotiation of contracts, the renewal of leases and the restructuring of the portfolio, but the investment must constitute a particular risk which differentiates this project from a "normal" real estate investment. Such a particular risk may exist where the property is very difficult to let, is located in a distressed area, or is subject to political risk (this may, however, not be a stand-alone factor). The mere holding and management of standard properties is not an eligible investment objective given that the purpose of a SICAR is to make investments in risk capital and with the view to exiting after a limited period of time at a profit.

The elements the CSSF will consider when determining the acceptability of property investments for a SICAR are:

· Investments with high potential for capital appreciation because of the particular risks of the underlying property

· Development projects

· High risk/reward ratio

· Identity of the property manager, their compensation and property selection methods

· Financial participation of the property managers and developers

· Active management of the underlying properties and limited investment horizon

· Absence of regular rental income

· Financing methods, eg significant leverage or the provision of mezzanine debt

Acceptability of Investment Policies -Prudential Rules

· Indirect Investments: SICARs may undertake indirect investments via intermediary companies, private equity funds or undertakings for collective investment provided that the investment objective of such a vehicle is consistent with the concept of risk capital under the 2004 law. The CSSF considers hedge funds as inappropriate investments for a SICAR given that hedge funds do not seek to generate added value within the target company

This point may well give rise to some controversial arguments from hedge fund managers who regard some of their trading strategies as methods of unlocking substantial value by forcing, at times, sweeping changes within a target company

· Political Risk: Geographical factors in themselves are not sufficient to characterise an investment as a risk capital investment. It would need to be demonstrated that such investments are subject to political risk which is then also complemented by other specific risks

· Mezzanine Loans and Distressed Debt: Mezzanine financing is an acceptable form of investment provided that the target company is not listed (with the exception of providing mezzanine finance to listed companies for development purposes, eg the delisting of the target). The investment in existing mezzanine instruments or distressed debt might also be considered eligible when the purpose of the investment is the restructuring of the company concerned

· Use of Derivatives: Derivatives themselves cannot constitute an eligible investment objective; however, SICARs may employ derivates, if required, in order to meet the investment objectives of the SICAR and for hedging purposes

· Investment in listed securities: As an investor in risk capital, a SICAR would normally not be expected to invest in listed securities. However, a listing itself does not necessarily render the investment ineligible because the security could be quoted on a non-regulated market, be issued by a risk capital company, or be a small cap company with significant development potential. Investments in listed securities can also be eligible when it can be demonstrated that such an investment is part of a specific development plan for the target company or that it is envisaged to de-list the company's stock. Furthermore, on a temporary basis, a SICAR may invest liquidities into listed securities while analysing opportunities for risk capital investments in private equity or venture capital

Conclusion

Throughout the circular, the regulator stresses time and again that the key characteristics of a SICAR are the taking of significant risk accompanied by the development of the target company. Risk diversification rules, well known in UCI legislation, are deliberately absent from the SICAR regulations thus ensuring maximum freedom. The SICAR has a diverse range of financial instruments at its disposal ranging from, for example, equity participations, bonds, convertible bonds, to providing mezzanine debt and bridge financing. The long-term holding of assets and investments in "standard" real estate, derivatives and hedge funds are out of scope as an investment objective for the SICAR.

One may conclude that the regulatory framework for SICARs facilitates investments in private equity and venture capital by offering a regulated yet flexible legal vehicle.

Ireland

Where is MiFID and Who Can Expect What?

The Markets in Financial Instruments Directive ("MiFID") is almost upon us. The Level I MiFID directive was adopted in early 2004 and is designed to repeal and replace the original Investment Services Directive ("ISD").

In September, the European Commission is expected to formally adopt MiFID's Level II implementing measures consisting of a draft directive and regulation. These measures have received thorough examination from various pan-European institutions including the European Securities Committee that recently accepted them. The Level II measures are currently being analysed by the European Parliament until late July. In Ireland, the Department of Finance has been providing impacted firms with regular updates on the status of MiFID and in May released a draft statutory instrument consisting of regulations which will transpose the level I directive into Irish law.

For the most part it is fair to say that those companies currently within the scope of the ISD will be required to comply with the requirements of MiFID. However, some companies will be brought within scope for the first time, while the status of other companies remains unclear.

As MiFID approaches, issues such as how its requirements will interrelate with other major European legislation such as the Capital Requirements Directive and the existing UCITS framework and what the impact on investment firms will be, are being addressed by the Department of Finance and the Financial Regulator.

An interesting issue yet to be answered relates to the inclusion or exclusion of companies providing certain administration and or transfer agency services to collective investment schemes.

In can be argued that traditionally in Ireland, the administration of collective investment schemes has not been regarded as an ISD service. Evidencing this is the fact that the Investment Intermediaries Act, 1995 (as amended) (the "IIA"), which transposed much of the ISD into Irish law, makes special provision for investment business service (g) "the administration of collective investment schemes, including the performance of valuation services or fund accounting services or acting as transfer agents or registration agents for such funds". This investment business service does not equate to any of the investment services listed in the Annex of the ISD. Thus, traditionally an Irish fund administration company and transfer agent authorised only to perform investment business service (g) has not fallen within the scope of the ISD.

An investment business firm in Ireland providing administration/transfer agency services to collective investment schemes would not, on the face of it, be required to comply with the requirements of MiFID. Under Article 3 of the Level I directive Member States can exempt firms from the requirements of MiFID in certain circumstances. However, administrators/transfer agents that are executing orders on behalf of clients cannot be exempted under this article.

In Luxembourg it is currently deemed that a company acting as a transfer agent and registrar to collective investment schemes qualifies as an investment firm for the purposes of the ISD. Thus, this type of firm will be required to comply with the requirements of MiFID while being able to avail of the opportunity to passport to other Member States including Ireland.

The result of all this would appear to throw up the potential for two different categories of administrator/transfer agent to collective investment schemes within Ireland, one that may be required to be MiFID compliant and the other that may not.

The relevant authorities are no doubt addressing this apparent discrepancy in the application of the definition of investment services between Member States.

It should be noted that in order to avail of passporting opportunities, an Irish company acting as a transfer agent to collective investment schemes currently authorised only to provide investment business service (g) of the IIA could apply to extend its authorisation with the Financial Regulator to include investment business service (a) receiving and transmitting, on behalf of investors, of orders in relation to one or more investment instrument and (b) execution of orders in relation to one or more investment instrument, other than for own account.

That being said, an entity wishing to provide transfer agency services within Europe may look favourably on establishing operations in Ireland irrespective of the existing benefits of the jurisdiction, given the potential for the requirements of MiFID to be disapplied.

For investment business firms in Ireland generally, the issue of how to apply the requirements of the interrelating regulatory and statutory requirements i.e. between the new draft regulation, the existing handbook and code of conduct, the new combined code expected shortly and any new bills, remains to be seen.

The Department of Finance has indicated that it is currently developing a draft statutory instrument to transpose the Level II implementing directive. This will potentially be incorporated within the existing draft statutory instrument regulations, the first draft of which was published in May, as mentioned. Just how the issues outlined within this email will be addressed within the draft regulations remains to be seen. It may be the case that the Committee of European Securities Regulators ("CESR") will provide the answers within its expected guidance document.

As the deadlines for MiFID approach, to show us where we are on the legislative page, the questions of who will be impacted and how; and what will they be required to do will continue to be addressed. All will become clear in due course as the Department of Finance continues to ably address its unenviable task and as ever the Financial Regulator has indicated its willingness to liaise with industry on a bi-lateral basis to discuss issues they may arise.

Paul Ryan is director in the Regulatory and Compliance Department of Dillon Eustace Solicitors.

This article was first published in Finance Magazine-Online in July 2006 and is republished here with their kind permission.

The Irish Financial Regulator Investigates Management Fees

On 23 June 2006 the Irish Financial Services Regulatory Authority (the "Financial Regulator") published a Consultation Paper (CP 19) on "annual management fees within authorised collective investment schemes". There have been numerous discussions around fees and expenses in the last few months in the European fund industry. This article analyses the Financial Regulator's Consultation Paper and assess the impact of flat fee management fees.

This consultation began following a request from the Irish fund industry, as clarified by the Financial Regulator, "to permit annual management fees where these fees are calculated based on the initial issue price of units". The reason for adopting this type of fee arrangement being that it introduces an element of certainty in relation to costs which can be of interest for investors investing in structured products. The consultation process, which was open until 28 July, requested all interested parties provide their comments, with particular reference to:

· "global trends in relation to annual management fees of collective investment schemes"

· "the extent to which retail investors will understand the implications of a fixed management fee and the impact on investors' ability to compare charging structures across collective investment schemes"

· "the criteria that might be applied in relation to fixed management fees" in particular "to avoid circumstances where disproportionate charges would be placed on investors"

While we wait to hear the outcome of the process and the Financial Regulator's official position, we would like you consider the following:

Management Fees Global Trends

The identification of global trends is probably the ideal for organisations such as International Organisation of Securities Commissions ("IOSCO") or European Fund and Asset Management Association ("EFAMA").

In this respect, IOSCO published a report in November 2004 on "elements of international regulatory standards on fees and expenses on investment funds" (the "IOSCO report"). The report underlined how the operator of the fund is "usually remunerated through a management fee which is frequently asset-based but which may be calculated on different bases (for example a flat fee and/or a performance fee)".

There are no legal or regulatory issues, of which we are aware, which prevent such kinds of arrangement in other countries. However, it should also be said that it is unusual to see fee structures of this nature. Flat fees arrangements are common in the case of depositary or administration services, but are usually associated with asset-based arrangements, the flat fee providing for a floor in case of poor fund performance.

Investors' Awareness

The question arises as to whether retail investors would understand the implications of such management fees and whether they would be in a condition to compare the charging structure to that of another investment fund.

The IOSCO report identified a series of principles to be complied with in terms of disclosure of fees and expenses to the investor. However, under the circumstances described in the Consultation Paper it is not the quality of the disclosure which really matters (as we assume that the fee arrangements would be correctly disclosed), rather how the disclosure would be interpreted and understood by the investor.

Our impression is that while the flat fee structure is easily understood by an average retail investor (probably more than a complex performance fee arrangement), empiric studies show how, despite warnings on prospecti or marketing materials, investors make their decisions on the basis of the past performance of funds.

The impact of a flat fee is decreasing in the case of a fund's positive performances but has the opposite effect in the case of a fund's poor performance. The final outcome could be that investment decisions are even more influenced than before by a fund's past performance.

Additionally, the question is asked by the Financial Regulator as to whether this fee structure would allow an investor to compare charging structures across different investment funds. We do not believe this would be the case for two reasons. The first one is that this fee arrangement is not common, most of all in the Undertaking for Collective Investment in Transferable Securities ("UCITS") market; the second being that flat fee arrangements would not be reflected appropriately, in the calculation of the Total Expense Ratio ("TER") which is the de facto standard applied by the fund industry.

As the TER is built as a ratio between the total expenses and the assets under management, the same concerns we have raised in terms of the performance of investment fund would be applicable, mutatis mutandis.

How to Implement a Flat Management Fee

Assuming that a decision is taken, subject to regulatory approval, to implement a flat management fee, the question arises as to which criteria "might be necessary to avoid circumstances where disproportionate charges would be placed on investors".

On the basis of the analysis made so far, in the case of extremely poor performance of an investment fund whose management fees are paid purely on the basis of the initial issue price of units, there is no possibility of avoiding disproportionate charges on investors. Any mechanism introduced to avoid disproportionate charges (eg introducing a cap on fees, or different fee thresholds on the basis of the assets under management or of the investment fund's performance) would convert the flat fee arrangement into a sort of variable management fee arrangement.

Conclusions

Our view at this point is that, for investment funds such as UCITS, or for products targeting retail investors, a flat management fee arrangement is not the most appropriate one for a series of reasons.

However, such an arrangement does not appear to conflict with existing laws or regulations so it is up to the regulatory authorities to decide if flat fee arrangements can be applied, and which safeguards can be implemented to ensure investors' protection. For investment funds dedicated to professional or institutional investors we would suggest the concerned parties should have the freedom to establish any management fee structure as long as it is compatible with all laws and regulations.

In conclusion, our suggestion is that IOSCO's principles should always be taken into account:

"The conditions of remuneration of the fund operator should comply with three main principles:

· Transparency (information on fees and expenses should be disclosed in a way that allows investors to make informed decisions about whether they wish to invest in a fund and thereby accept a particular level of costs)

· Prevention of conflicts of interests, as conditions of remuneration of fund operators should not create an incentive to behave contrary to the interests of the investor

· Fairness of competition; disclosure requirements should prevent any distortion of competition among operators"

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

Iain 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

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www.transactionservices.citigroup.com

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Contents

Citigroup® Global Transaction Services Fiduciary Services news&views; September 2006 EC's Expert Group ReportsSingle and Dual PricingSICAR in LuxembourgMiFID in Ireland

Citigroup® Global Transaction Services
Fiduciary Services
news&views; September 2006
EC's Expert Group Reports
Single and Dual Pricing
SICAR in Luxembourg
MiFID in Ireland