UCITS IV: Management Companies, and passports. February 2011

February 2011

This briefing paper sets out the new provisions which will apply to UCITS Management Companies, explains how the passport is now designed to work, and summarises the changes made to the long established UCITS product passport which aim to make the notification procedures for the crossborder marketing of funds more efficient. The UK has long established and comprehensive regulation of management companies for UCITS (and other types of funds) and has always supported the idea of a UCITS passport but, even so, introduction of the UCITS IV changes will have an impact on UK authorised fund managers, whether or not they in fact exercise either of the passports which will be available for the or for UCITS funds they manage. equirements for all UCITS management companies There are new requirements in the recast UCITS Directive which affect all UCITS management companies, irrespective of whether or not they wish to exercise the passport: prudential and organisational requirements In effect the existing SYSC provisions, which are currently, will become rules. Consequently it is thought likely that the practical effect for many UCITS management companies will be relatively light in the UK. UK firms generally already comply with these provisions (which are equivalent to the comparable MiFID provisions) whereas, in other EU Member States, it may well be that the management companies do not already comply with these provisions. UK authorised fund managers will need to check the new FSA provisions which it intends to insert in a new column in the Table of Applications in Annex 1 of SYSC 1 regarding organisational structure and decision making procedures; internal control arrangements; internal reporting and communication arrangements; staffing and management issues; and maintaining adequate and orderly records of such business and internal organisation. For your ease of reference, a copy of the table is attached to this briefing paper. Of course, for many, there is a delegation by the UCITS to an investment manager or other delegates. Note that, to prevent a mere letterbox presence of a, a new provision on delegation will be introduced, specific to the UCITS Directive, whereby a management company wishing to outsource must ensure that it retains enough resources and expertise to be able to oversee its delegate effectively. The FSA will expect a notification to be made before any delegation arrangement is put in place (and SUP 15.8.6 is to be amended accordingly). In addition to the changes to the SYSC provisions, there are new provisions proposed in COLL 6.10 relating to the responsibilities of senior management to have effective control and oversight of the business, in particular as regards oversight of the implementation of investment objectives and strategies of each UCITS; ensuring there is a permanent and effective compliance function; and approval of the risk management policy for each UCITS (on which we comment further below). conduct of business requirements Again, although the provisions relating to inducements, best execution, aggregation and allocation of orders, personal account dealing and reporting of client orders are very familiar to UK fund managers, they may be unfamiliar to management companies established in other jurisdictions. It is thought that, under the FSA s COBS rules, relatively little change is required and so the UCITS IV changes should have relatively little impact on UK authorised fund managers. There will be some clarification so as to ensure application of the UCITS IV provisions properly for example, so that the inducement rules and best execution rules apply at the level of the UCITS scheme treating the UCITS scheme as the relevant client. UK firms will be very familiar with much of the relevant detail, the new UCITS provisions being derived in the main from the equivalent MiFID measures. There are a few new requirements which do not derive from MiFID, for example regarding standards of due diligence, exercise of voting rights, recording of transactions and fair treatment of unitholders, and the FSA propose to insert a new section in COLL at 6.6A covering these matters. The fair treatment of unitholders will now derive from the UCITS Directive wording but, given that it would automatically apply for a unit trust and that our open ended investment companies are unit trusts in corporate form, in practical terms this is unlikely to have any real impact. 1

risk management requirements The requirements for revised risk management processes will be the one area where UK authorised fund managers will have to consider substantive changes to their arrangements. The new requirements concern the risk management process for the company s organisation and procedures, and the way in which it monitors specific schemes. Management companies must establish and maintain a permanent risk management function which must be hierarchically and functionally independent from operating units. A must be able to demonstrate that appropriate safeguards against conflicts of interest have been adopted so as to allow an independent performance of risk management activities and that its risk management processes satisfy the requirements of UCITS Directive. The new provisions which are made in respect of Article 51(1) of the UCITS Directive will effectively replace the existing Commission ecommendation on the use of Financial Derivative Instruments by UCITS schemes. There will be various detailed changes to transpose the new provisions relating to valuation of OTC derivatives and exposures created by, and the cover required for, derivative and forward transactions. Certain matters though will still await some further European level work. For example, with the problematic options for using either the commitment approach or the value at risk approach, the FSA currently do not propose to include other advanced risk measurement methodologies because any such methodologies would first need to be approved by the European Securities and Markets Authority (ESMA) and it would seem premature to anticipate their work. Aside from the risk management issues relating to such investment matters there are new provisions proposed for COLL 6.11 and 6.12 designed to reflect the UCITS requirements for a risk management function which should be independent where this is proportionate in view of the size of the organisation and adequately resourced - and to bring together the existing UCITS III risk management process requirements with some new material on the necessary elements of the risk management process and measurement of risk, with stress testing and back testing as appropriate. Note that the FSA indicate in their Consultation that these provisions under Article 51(1) replace the current Commission ecommendation, albeit that that recommendation was made under a different Article. Despite the fact that many of the necessary arrangements will already be in place for UK management firms, it is probably inevitable there will be some considerable work in making sure that firms comply with the new provisions and introduce appropriate adjustments to their operations and procedures. Whilst much is based on the existing provisions of SYSC, COBS and COLL (derived, in respect of SYSC and COBS, from MiFID), there are some new elements notably for the distinct (and where possible independent) risk management function, identification and documentation of relevant risks, and regular reporting to senior management. Might HM Treasury and the FSA have under-estimated the costs of complying with these measures? The passport The United Kingdom has, as explained in the FSA s Compatibility Statement in the Consultation Document on Transposition of UCITS IV, consistently supported the introduction of the passport, and the FSA has confirmed that it is keen to ensure that firms are able to take full advantage of it from 2011. The interesting question may be whether, in practice, there may be more chance of management companies in other Member States (most notably in Luxembourg and Dublin) exercising the passport to manage UK authorised funds rather than UK UCITS management firms passporting out. Under the expanded UCITS IV provisions, the new passport will apply specifically to collective portfolio management, which will be distinct from any possibility of passporting individual portfolio management services etc under Article 6 of the Directive subject to the MiFID rules. The new provisions set out greater detail regarding the appropriate split of regulatory responsibilities (which is of itself something of a novelty for an EU passporting arrangement) between the regulator of the management company in its home member state and the regulator of the UCITS fund which it is appointed to manage: 2

the former, relating to the responsibility of the UCITS s home state, apply to all UCITS management companies, irrespective of any use of the passport, and are explained above. The measures relating to the organisation of the including delegation arrangements, risk management procedures, prudential rules and reporting requirements, and any other Level 2 measures drawn up to implement Article 12 of the recast UCITS Directive regarding prudential rules will, as explained above, apply generally to all UCITS management companies. the latter, relating to the responsibility of a UCITS fund s home member state, cover local rules relating to the constitution and functioning of the UCITS fund (which are specifically defined to include matters regarding valuation and accounting; pricing; dealing in units; investment matters; income distribution/reinvestment; disclosure and reporting requirements generally; the relationship with unitholders; marketing arrangements; any merging; restructuring or winding up or liquidation of the UCITS; exercise of unitholder voting rights or other rights in relation to these matters; and the obligations set out in the fund rules or the instruments of incorporation and in the prospectus of the UCITS fund). The UCITS fund s regulator is dealing with the concept of fund application rules. In the case of fund application rules, they will apply to the authorised fund manager of the UCITS scheme. For COLL purposes, authorised fund manager will be defined to include an EEA UCITS management company exercising an inwardly passporting right into the UK to manage a UK authorised fund. (Note that the term UCITS scheme is to be defined in the FSA lossary still to apply to a fund authorised in the UK. The term EEA UCITS scheme will be the definition which covers a UCITS fund authorised in any other EEA State.) Once the initial distinction above is achieved, there is a second set of distinctions to be made because a passporting can exercise passport rights either on a branch or services basis. This will involve some further complicated definition issues which will need to be worked through carefully. Indeed, in the HM Treasury/FSA Consultation Paper, it is mentioned that they are seeking the Commission s clarification that the responsibilities of respective regulators might overlap arising from the fact that two chapters of the Level 2 Directive are stated to be made under both Articles 12 and 14 but there is no attempt to clarify which of these measures are to be made under which Article. This is particularly of significance for branches, since Article 12 matters are for the home state and Article 14 matters are for the host state. For any fund management group considering taking advantage of the passport provisions so as to bring about a change of manager of an existing UCITS scheme, note that the Consultation Paper indicates that the FSA think that this should be treated as significant for COLL 4.3 purposes. There are particular issues for the FSA in the UK regarding: The Financial Ombudsman Service (FOS). The fact that there could be practical issues for a non-uk company cooperating with an FOS investigation or for an investor to try and enforce any award against the non-uk company which the FSA might make if it were not to pay voluntarily, could presumably be resolved under the new and rather comprehensive supervisory cooperation duties and powers. On complaints, HM Treasury and the FSA are seeking clarification on the meaning of Article 15 of the Directive and have set out a number of options for four scenarios under consideration. Management companies passporting into the UK would need to comply with UK complaints recording requirements. Clarification is being sought from the Commission regarding languages in which complaints must be allowed to be made. Financial Services Compensation Scheme (FSCS). It is proposed that the FSCS will be able to provide compensation coverage for UCITS collective portfolio management business in all cases where the UCITS scheme is authorised by the FSA, irrespective of the place of origin of its, which would mean that incoming EEA UCITS management companies would be subject to the relevant FSCS levies. 3

Whilst therefore it now seems that there is a political will and some detail in the specific provisions which can enable the UCITS management passport to become operable, it will be interesting to see how fund management groups wish to exercise the passport right and how some of the detailed provisions might effectively be operated in practice as we move towards implementation of UCITS IV. It may be that there will be a rather slow and cautious uptake of this possibility. Simplified notification for the UCITS product passport The product passport is well established and much used. UCITS IV will though achieve a simplification of the notification process. In future a standard form of notification must be made to the regulator of the home member state of the UCITS scheme and it will then transmit the documents to the regulators of the relevant host member states. The home regulator must do this within ten working days of the date of receipt of the notification with complete documentation. The home regulator will inform the UCITS operator once it has transmitted the file and the UCITS can begin to market in that relevant market at once, without the prior approval of the host member state s regulator. Each member state will be required to publish by electronic means complete information about the local marketing rules in its territory and will not be able to raise questions about Directive required documentation, such as the KII, the prospectus or the reports of the fund. Note that there is a need to update the documentation provided. This will remain a matter which the UCITS must notify to each host member state directly but, given that the main issues have arisen on the initial registration of funds, this is more a procedural issue than an obstacle and so should continue to cause no difficulty. Implementation measures These provisions should be implemented by 1 July 2011 and indeed certain of the Commission egulations will apply automatically with force of law from 1 July 2011 and do not need to be considered as a separate implementation by member states. Whether or not fund managers decide to take advantage of the new provisions for passporting will of course be a matter of choice. The matter for general attention though will be the new requirements for prudential and organisational issues, conduct of business and risk management requirements for all UCITS management companies. Whilst the UK is ahead of the game on regulating UCITS management companies, the need for adjustments to an existing regime can sometimes be more difficult than implementing a new regime. UK based authorised fund managers will need to consider the necessary alterations to their procedures carefully so they are fully compliant by 1 July 2011. The translation arrangements have also been made simpler. The notification etc can be in a language customary in the sphere of international finance, which would include English and so avoid the need for translation into official languages of the host member states. English language versions will be acceptable in all member states although there will be a requirement to translate the key investor information document unless the use of English in that document is approved by the host state regulator. The combination of these arrangements should ensure that some of the obstacles which have occurred in the past in exercising the product passport rights should be removed, and make the process easier, quicker, cheaper and more efficient. 4

Table of Applications in Annex 1 of SYSC 1 Part 3 Table summarising the application of the common platform requirements to different types of firm 3.1 The common platform requirements apply in the following two three ways (subject to the provisions in Part 2 of this Annex) 3.2A For a, they apply in accordance with Column A+ in the table below. + SYSC 4 common other than to a UCITS investment firm SYSC 4.1.1 ule but SYSC 4.4.1 (2) applies only to a BIPU firm ule but SYSC 4.1.1 (2) applies only to a BIPU firm SYSC 4.1.2 ule ule for a UCITS investment SYSC 4.1.2A for a UCITS firm; not applicable to a UCITS investment firm ll other firms apart from ule but SYSC 4.1.1 (2) applies only to a third country BIPU firm SYSC 4.1.2B ule SYSC 4.1.2C ule SYSC 4.1.3 ule applies only to a BIPU firm ule for a UCITS investment firm; otherwise not applicable SYSC 4.1.4 ule ule (1) and (3) (2) ule SYSC 4.1.4A SYSC 4.1.5 ule applies only to a MiFID investment firm ule SYSC 4.1.6 ule ule for a UCITS investment SYSC 4.1.7 ule ule SYSC 4.1.7A SYSC 4.1.8 SYSC 4.1.9 ule ule SYSC 4.1.10 ule ule except reference to SYSC 4.1.9 which does not apply to these firms SYSC 4.1.10A SYSC 4.1.11 SYSC 4.2.1 ule ule UK branch of non-eea bank ule applies Other firms 5

+ SYSC 4 common other than to a UCITS investment firm SYSC 4.2.1A ll other firms apart from SYSC 4.2.2 ule ule UK branch of a non-eea bank ule applies SYSC 4.2.3 4.2.5 Other firms this provision does not apply UK branch of a non-eea bank Other firms these provisions do not apply SYSC 4.2.6 ule ule for a UCITS investment firm; otherwise not applicable UK branch of a non-eea bank ule applies Other firms this provision does not apply SYSC 4.3.1 ule ule ule (but not applicable to incoming EEA firms, incoming Treaty firms or UCITS qualifiers) SYSC 4.3.2 ule ule (but not applicable to incoming EEA firms, incoming Treaty firms or UCITS qualifiers) SYSC 4.3.2A (but not applicable to incoming EEA firms, incoming Treaty firms or UCITS qualifiers) SYSC 4.3.3 (but not applicable to incoming EEA firms, incoming Treaty firms or UCITS qualifiers) SYSC 4.4.1 ule applies this section only to: (1) an authorised professional firm in respect of its non-mainstream regulated activities unless the firm is also conducting other regulated activities and has appointed approved persons to perform the governing functions with equivalent responsibilities for the firm s non-mainstream regulated activities and other regulated activities; (2) activities carried on by a firm whose principal purpose is to carry on activities other than regulated activities and which is: (a) an oil market participant; (b) a service company; (c) an energy market participant; (d) a wholly-owned subsidiary of: 6

+ SYSC 4 common other than to a UCITS investment firm ll other firms apart from SYSC 4.4.1 (e) a firm with permission to carry on insurance mediation activity in relation to a non-investment insurance contracts but no other regulated activity; (3) an incoming Treaty firm, an incoming EEA firm and a UCITS qualifier, (but only SYSC 4.4.5 (2) applies for these firms); and (4) a sole trader, but only if he employs any person who is required to be approved under section 59 of the Act (Approval for particular arrangements). SYSC 4.4.2 only applying to the firms specified in SYSC 4.4.1 SYSC 4.4.3 ule only applying to the firms specified in SYSC 4.4.1 SYSC 4.4.4 only applying to the firms specified in SYSC 4.4.1 SYSC 4.4.5 ule only applying to the firms specified in SYSC 4.4.1 + SYSC 5 common ll other firms apart from SYSC 5.1.1 ule ule ule SYSC 5.1.2 SYSC 5.1.3 SYSC 5.1.4 SYSC 5.1.5 SYSC 5.1.5A SYSC 5.1.6 ule ule SYSC 5.1.7 ule ule for a UCITS investment firm, otherwise SYSC 5.1.7A to a UCITS investment firm, otherwise SYSC 5.1.8 SYSC 5.1.9 SYSC 5.1.10 7

+ SYSC 5 common ll other firms apart from SYSC 5.1.11 SYSC 5.1.12 ule ule ule SYSC 5.1.12A SYSC 5.1.13 ule ule ule SYSC 5.1.14 ule ule SYSC 5.1.15 + SYSC 6 common SYSC 6.1.1 ule ule ule SYSC 6.1.2 ule ule SYSC 6.1.2A SYSC 6.1.3 ule ule SYSC 6.1.3A ll other firms apart from This provision shall be read with the following additional sentence at the start. Depending on the nature, scale and complexity of its business, it may be appropriate for a firm to have a separate compliance function. Where a firm has a separate compliance function, the firm should also take into account 6.1.3 and 6.1.4 as. SYSC 6.1.4 ule ule (1) (2) (3) (2) ule for firms which carry on designated investment business with or for retail clients or professional clients. for all other firms. SYSC 6.1.4 A SYSC 6.1.4A ule for firms which carry on designated investment business with or for retail clients or professional clients. SYSC 6.1.5 ule ule investment services and activities shall be read as financial services and activities 8

+ SYSC 6 common SYSC 6.1.6 SYSC 6.2.1 ule ule SYSC 6.2.1A SYSC 6.2.2 SYSC 6.3.1 ule ule ule SYSC 6.3.2 SYSC 6.3.3 ule ule ule SYSC 6.3.4 SYSC 6.3.5 SYSC 6.3.6 SYSC 6.3.7 SYSC 6.3.8 ule ule ule SYSC 6.3.9 ule ule ule SYSC 6.3.10 ll other firms apart from + SYSC 7 common SYSC 7.1.1 ll other firms apart from SYSC 7.1.2 ule ule for a UCITS investment firm, otherwise SYSC 7.1.2A to a UCITS investment firm, otherwise SYSC 7.1.2B SYSC 7.1.3 ule ule for a UCITS investment firm, otherwise SYSC 7.1.4 ule ule for a UCITS investment firm, otherwise SYSC 7.1.4A to a UCITS investment firm, otherwise SYSC 7.1.5 ule ule for a UCITS investment firm, otherwise SYSC 7.1.6 ule ule for a UCITS investment firm, otherwise SYSC 7.1.7 ule ule for a UCITS investment firm, otherwise SYSC 7.1.7A to a UCITS investment firm, otherwise 9

+ SYSC 7 common ll other firms apart from SYSC 7.17B applies only to a BIPU firm for a UCITS investment firm; otherwise SYSC 7.1.8 (1), (2) (1) applies only to a BIPU firm (2) for a UCITS investment firm; otherwise (1) (2) SYSC 7.1.9 ule applies only to a BIPU firm ule for a UCITS investment SYSC 7.1.10 ule applies only to a BIPU firm ule for a UCITS investment SYSC 7.1.11 ule applies only to a BIPU firm ule for a UCITS investment SYSC 7.1.12 applies only to a BIPU firm for a UCITS investment firm; otherwise SYSC 7.1.13 7.1.16 ule applies only to a BIPU firm ule for a UCITS investment + SYSC 8 common SYSC 8.1.1 ule ule for a UCITS investment SYSC 8.1.1A to a UCITS investment firm; otherwise ll other firms apart from SYSC 8.1.2 SYSC 8.1.3 SYSC 8.1.4 ule ule for a UCITS investment SYSC 8.1.5 ule ule for a UCITS investment SYSC 8.1.5A to a UCITS investment firm; otherwise SYSC 8.1.6 ule ule ule SYSC 8.1.7 ule ule for a UCITS investment SYSC 8.1.8 ule ule for a UCITS investment SYSC 8.1.9 ule ule for a UCITS investment 10

+ SYSC 8 common ll other firms apart from SYSC 8.1.10 ule ule for a UCITS investment SYSC 8.1.11 ule ule for a UCITS investment SYSC 8.1.11.A SYSC 8.1.12 SYSC 8.1.13 SYSC 8.1.14 to a UCITS investment firm; otherwise ule SYSC 8.2. MiFID investment firms only UCITS investment firm only SYSC 8.3. MiFID investment firms only UCITS investment firm only + SYSC 9 common SYSC 9.1.1 ule ule ule ll other firms apart from SYSC 9.1.2 ule applies only in relation to MiFID business ule applies only in relation to MiFID business of a UCITS investment firm SYSC 9.1.3 rules applies only in relation to MidFID business ule applies only in relation to MiFID business of a UCITS investment firm SYSC 9.1.4 SYSC 9.1.5 SYSC 9.1.6 SYSC 9.1.7 applies only in relation to MiFID business applies only in relation to MiFID business of a UCITS investment firm 11

+ SYSC 10 common ll other firms apart from SYSC 10.1.1 SYSC 10.1.2 SYSC 10.1.3 SYSC 10.1.4 SYSC 10.1.4A SYSC 10.1.5 SYSC 10.1.6 SYSC 10.1.6A SYSC 10.1.7 SYSC 10.1.8 SYSC 10.1.8A SYSC 10.1.9 SYSC 10.1.10 SYSC 10.1.11 SYSC 10.1.11A ule ule ule ule ule ule ule ule but applies as a rule in relation to the production or arrangement of production of investment research in accordance with COBS 12.2, or the production or dissemination of non-independent research in accordance with COBS 12.3 ule ule but applies as a rule in relation to the production or arrangement of production of investment research in accordance with COBS 12.2, or the production or dissemination of non-independent research in accordance with COBS 12.3 ule ule ule ule ule ule ule ule ule ule ule but applies as a rule in relation to the production or arrangement of production of investment research in accordance with COBS 12.2, or the production or dissemination of non-independent research in accordance with COBS 12.3 ule ule but applies as a rule in relation to the production or arrangement of production of investment research in accordance with COBS 12.2, or the production or dissemination of non-independent research in accordance with COBS 12.3 12

+ SYSC 10 SYSC 10.1.12 SYSC 10.1.15 common for SYSC 10.1.12 ; not applicable for SYSC 10.1.13 SYSC 10.1.15 ll other firms apart from SYSC 10.1.16 SYSC 10.1.17 SYSC 10.1.18 SYSC 10.1.19 SYSC 10.1.20 SYSC 10.1.21 SYSC 10.2.1 SYSC 10.2.2 SYSC 10.2.3 SYSC 10.2.4 ule ule ule ule ule ule ule ule ule ule ule ule ule ule SYSC 13

Contacts Kirstene Baillie Partner t: +44 (0)20 7861 4000 e: kirstene.baillie@ffw.com This publication is not a substitute for detailed advice on specific transactions and should not be taken as providing legal advice on any of the topics discussed. Copyright Field Fisher Waterhouse LLP 2011. All rights reserved. Field Fisher Waterhouse LLP is a limited liability partnership registered in England and Wales with registered number OC318472, which is regulated by the Solicitors egulation Authority. A list of members and their professional qualifications is available for inspection at its registered office, 35 Vine Street London EC3N 2AA. We use the word partner to refer to a member of Field Fisher Waterhouse LLP, or an employee or consultant with equivalent standing and qualifications.