CP 50 and the revised draft Central Bank Notices and Guidance Notes (Notices 2.5 and 16.2 and Guidance Note 4.07) reflect the UCITS IV Implementing Directive (2010/43/EU (the “Implementing Directive”). The revised draft Notices and Guidance Notes attempt to clarify and expand upon the contents of the Implementing Directive. They set out the procedures and arrangements to be implemented by Managers and SMICS.
The principle of proportionality is also affirmed in the revised draft Notices and Guidance Notes which recognise that Managers and SMICs are different, some being complex and some less so. It therefore allows Managers and SMICs, when implementing policies and procedures, to have regard to the nature of the UCITS or those under management, their characteristics and complexities.
The “collective responsibility” model (i.e. the model where the Board of the Manager or SMIC takes collective responsibility for the key management functions) will be abolished (except for Managers with employees) and Managers and SMICs will be required to appoint an individual director or Irish resident person (each a “Designated Person”) to be in charge of each of the existing management functions, being; (i) monitoring compliance; (ii) risk management; (iii) monitoring of investment performance; (iv) financial control; (v) monitoring of capital; (vi) internal audit; (vii) supervision of delegates; and (viii) decision taking. The Central Bank has identified two new management functions, being; (i) complaints handling; and (ii) accounting policies and procedures. Designated Persons may continue to rely on the relevant personnel in each of the delegates to carry out each function day-to-day and will receive regular reporting in line with current practice. Most of the organisation requirements for Managers also apply to SMICs. However, some of these requirements do not have to be implemented for SMICs until 30 June 2013. We have indicated the relevant requirements below. SMICs will be allowed a grandfathering period until 30 June 2013 to change from the current “collective responsibility” model to the Designated Person model.
The Central Bank has also since confirmed that while Managers and SMICs are obliged to maintain, document and comply with detailed operating procedures, it does not expect these to be contained in the Manager’s or SMIC’s Business Plan. Instead the Business Plan must outline the broad parameters of the policies of the Manager/SMIC and will cross refer to the operating procedures, where required. The operating procedures must be finalised by 1 July 2011 and will be subject to inspection by the Central Bank.
Managers are required to establish, implement and maintain decision making procedures and an organisational structure which is documented and clearly specifies reporting lines and allocates functions and responsibilities. Other requirements under this heading are obligations in respect of the security, confidentiality and integrity of information and in respect of business continuity, which may not be adequately covered in existing Business Plans. This is provided for in draft Notice 2.5.
In general, this should not involve material changes to the way Managers operate under the existing regime, however, specific aspects may have to be looked at in the context of updating Business Plans.
UCITS 2.5 requires a Manager/SMIC to satisfy the Central Bank that on a continuing basis, it has adequate management resources to conduct its activities effectively and that its delegates employ personnel with the ‘skills, knowledge and expertise necessary for the discharge of the responsibilities allocated to them”. It also provides that Managers/SMICs must retain the necessary resources to monitor the activities of third party delegates.
The Central Bank’s requirement that a Designated Person be appointed in respect of each function will be sufficient and they will be supported by personnel in the investment manager, administrator and custodian, in line with current practice. The Central Bank may require additional information, however, including the entering into service level agreements with each service provider (See Guidance Note 4.07). Currently, service level agreements are not common place between Managers/SMICs and investment managers.
Administrative & Accounting Procedures
Draft Notice 2.5 requires Managers and SMICs to make arrangements for suitable electronic systems to be in place so as to permit a timely and proper recording of transactions and each subscription and redemption order. They must also ensure that the data is secured and that confidentiality is maintained.
This Notices specifies in some detail the information that must be recorded on the transaction documentation and in respect of record keeping requirements. Compliance may require an analysis of the custodian’s records to ensure they contain all the information specified.
This requirement does not have to be complied with by SMICs until 30 June 2013.
The Central Bank will require Managers and SMICs to ensure the employment of accounting policies and procedures so that the assets and liabilities of the UCITS may be readily identified at all times. Separate accounts for each sub-fund must be maintained and the Manager/SMIC must ensure compliance with the accounting standards in the home Member State. The policy should ensure the proper valuation of assets and liabilities in accordance with fund documentation.
As noted above, this is one of the new managerial functions identified by the Central Bank. These requirements will have to be reviewed in the context of procedures in the Manager’s/SMIC’s current business plan and increased disclosures made as required. However, it is unlikely to result in material changes to the way Manager’s companies currently operate.
There is some ambiguity as to whether or not this provision is required to apply to SMICs by 1 July 2011 or from 30 June 2013.
Internal Control Mechanisms
The only requirement under this Section required to be complied with by SMICs as at 1 July 2011 is the “Permanent Risk Management Function”. The other requirements may be deferred until 30 June 2013.
Control by Senior Management & Supervisory Function
Draft UCITS 2.5 requires increased oversight by the Manager/SMIC over delegates and confirms that directors are responsible for the Manager’s compliance with its obligations. There is an obligation to regularly review and consider the effectiveness of the policies and the Business Plan and that regular reports are received by Designated Persons.
These reporting structures are substantially in place already with delegates of Managers/SMICs so while this may result in amendments to the Business Plan and enhanced reporting, it is unlikely to result in changes to the overall reporting structure. The requirement to regularly review and consider the effectiveness of policies may require more frequent updates to Business Plans than might have been the case heretofore.
Permanent Compliance Function
Draft UCITS 2.5 requires Managers/SMICs to implement and maintain policies and procedures to detect risks of failure by them to comply with their UCITS obligations. In formulating procedures, a Manager/SMIC should take account of the nature, scale and complexity of the funds under its management.
Managers/SMICs must also establish and maintain a permanent compliance function. It will be the responsibility of the compliance function to assess the adequacy and effectiveness of the measures in place and to advise and assist the relevant Designated Person to ensure compliance with the Manager’s/SMIC’s obligations.
It is likely that Managers/SMICs will continue to rely heavily on the compliance functions within each of its service providers; however, it will be required to put policies in place and document these in the operating manual to ensure they can confirm to the Central Bank that it complies with their requirements.
Permanent Internal Audit Function
Draft UCITS 2.5 requires Managers and SMICs, where appropriate and proportionate in view of the nature, scale and complexity of the business and nature and range of the schemes, to establish and maintain an internal audit function independent from the other functions of the management company. The purpose of the audit function is to assess the effectiveness of the policies and procedures of the management company, to make recommendations and report on internal audit matters to the Board of the management company.
It is likely that Managers and SMICs which take the view that they require a permanent internal audition function will continue to rely heavily on the compliance functions within each of their service providers; however, the frequency and nature of the reporting under current business plans may have to be reviewed and enhanced.
Permanent Risk Management Function
Managers and SMICs must also establish a permanent risk management function, responsible for implementing risk management policies and procedures to ensuring compliance with UCITS requirements, assessing and advising the Board on the risk profile of the UCITS funds under management and for reporting on a regular basis to the Board of the management company and to the Designated Person.
There is a degree of overlap here with the compliance function, so it is likely that the same personnel within the service providers will carry out this function and report to the Designated Person responsible for risk management. Risk management is a key managerial function identified by the Central Bank under the current management company framework but so the requirements have been enhanced, which will result in increased disclosure in the revised Business Plan and more frequent reporting. Again, the principle of proportionality applies.
Draft UCITS 2.5 requires Managers/SMICs to implement and maintain adequate arrangements to prevent ‘personal transactions ’(as defined) and other activities that may give rise to conflicts of interest or the use of confidential/inside information in such transactions. This requirement is closely connected to the requirement for Managers/SMICs to have a conflicts of interest policy in place, which is addressed below. There will therefore be an element of overlap as between the two.
This requirement is really an extension of the requirements provided for in the Market Abuse Directive (2003/6/EC) and obliges Managers/SMICs to record personal transactions and have procedures in place to report personal transactions to Manager. These will have to be documented in a revised Business Plan with the detail contained in the operating procedures.
Conflicts of Interest
All the requirements under this Section are required to be complied with by SMICs with effect from 1 July 2011
Conflicts of Interest Policy
The conflicts of interest provisions under MiFiD (2004/29/EC) are incorporated into the Implementing Directive and reflected in UCITS 2.5 and Guidance Note 4.07. A Manager/SMIC is required to establish, implement and maintain an effective conflicts of interests policy in writing and one which is appropriate to the size, complexity and nature of the management company’s business.
The policy must include:
- The identification of the circumstances which constitute or may give rise to a conflict of interest involving a material risk of damage to the interest of a scheme or other clients; and
- Procedures to be followed and measures to be adopted to manage such conflicts
Independence in Conflicts Management
The procedures to be adopted to manage conflicts must include
- Effective procedures to control the exchange of information where this may give rise to a conflict or risk of damage to the scheme or client
- Effective supervision of relevant persons involved in collective portfolio management whose interests may conflict or who otherwise represent different interests that may conflict
- Procedures to remove direct links between the remuneration of relevant persons engaged in one activity and those engaged in another activity, where a conflict of interest might arise in relation to those activities
- Measures to prevent and limit any person from exercising inappropriate influence over the way in which a relevant person carries out collective portfolio management; and
- Measures to prevent or control the simultaneous or sequential involvement of a relevant person in separate collective portfolio management activities where such involvement may impair the proper management and of conflicts of interest
Where the above measures are found to be inadequate, the Manager/SMIC shall be obliged to adopt such alternative or additional measures and procedures as are necessary.
Exercise of Voting Rights
The Central Bank Guidance requires Managers/SMICs to develop adequate and effective strategies for determining when and how voting rights attached to instruments held in the managed portfolios are to be exercised, to the exclusive benefit of the scheme.
The strategies shall determine the policies and procedures for (i) monitoring corporate events; (ii) ensuring that the exercise of voting rights is in accordance with the investment objectives and policy of the relevant scheme; (iii) preventing or managing conflicts of interest arising from the exercise of voting rights. Details of the policy must be made available to shareholders free of charge.
Normally, the exercise of voting rights is left to the investment manager’s discretion, however, we are increasingly seeing a trend towards the outsourcing of this function to third party proxy agents. Either way, Managers/SMICs will have to define the circumstances under which rights will be exercised and the investment manager or agent will be obliged to exercise the voting rights in the interests of the shareholders rather than in the investment manager/promoter group’s discretion.
Management of Activities giving rise to Detrimental Conflicts
Managers/SMICs must ensure that records of the types of collective portfolio management activities undertaken by it which have or may give rise to conflicts. If the Manager/SMIC cannot ensure that a conflict of interest cannot be prevented the Designated Person should be informed as soon as possible so that appropriate action may be taken to manage the conflict and to ensure the management company acts in the best interests of shareholders.
Most Managers are wholly owned and part of a group and so it will now have to take into account group relationships in order to manage conflicts. For example, remuneration policies may need to be reviewed within the group. EU based investment managers should be MiFiD authorised firms and therefore have these policies in place so the changes in practice should not be material, however, the Business Plan will have to be updated to incorporate the conflicts of interests policy and reporting procedures enhanced.
Risk Management Policy
UCITS 2.5 requires that the management company/SMIC must establish, implement and maintain an adequate and documented risk management policy which identifies the risks the UCITS under management are or might be exposed to. The risk management policy shall comprise such procedures as are necessary to enable the Manager/SMIC to assess the exposure for the relevant UCITS to market, liquidity and counterparty risks and the exposure of the UCITS to all other risks, including operational risks which may be material for each UCITS.
This requirement applies to SMICs with effect from 1 July 2011.
Code of Conduct
The Code of Conduct in relation to Collective Portfolio Management must be complied with by all Managers and SMICs from 1 July 2011.
Duty to Act in the Best Interests of UCITS and Shareholders
Draft UCITS 16.2 requires Managers/SMICs to ensure that shareholders are treated fairly. Also it provides that it must refrain from placing the interests of any group of shareholders above the interests of any other group of shareholders. Managers are obliged to put in place policies and procedures to prevent malpractices that might threaten the stability and integrity of the market. Fair, correct and transparent pricing and valuation models must be used for the schemes under management in order to comply with the Manager’s/SMIC’s obligations to act in the best interests of shareholders. Managers must also avoid incurring undue costs.
These obligations may trigger a review of current cost and share class structures to ensure the Manager/SMIC is comfortable that it can meet these requirements. Updates to the Business Plan will also be required.
Due Diligence Requirements
The Central Bank will require Managers/SMICs to ensure a high level of diligence in the selection and ongoing monitoring of investments in the best interests of shareholders and the integrity of the market. Management must also ensure that they have an adequate understanding and knowledge of the assets in which their schemes have invested and have written policies and procedures on due diligence and implement effective arrangements to ensure investments are made in compliance with the objectives, investment strategy and risk limits of the scheme.
There will be an onus on Managers/SMICs to ensure that personnel within the investment manager have an adequate understanding and knowledge of the assets and it will have to put procedures in place to ensure the investment manager confirms this to the Manager/SMIC and on an ongoing basis where there is a change of personnel.
When implementing the risk management policy of the UCITS under management, a Manager/SMIC must, where appropriate after taking into account the nature of a proposed investment, formulate forecasts and perform analyses concerning the investment’s contribution to the UCITS portfolio composition, liquidity and risk reward profile, before carrying out the investment.
A Manager/SMIC must exercise due skill, care and diligence when entering into, managing or terminating any arrangements with third parties in relation to the performance of risk management activities, including activities with regard to the valuation of OTC derivatives.
Best Execution & Order Handling
The MiFiD rules on best execution and the handling of redemption and subscription orders are incorporated into draft UCITS 16.2.
A Manager/SMIC must act in the best interests of the funds they manage when executing decisions to deal on behalf of the funds in the context of managing their portfolios. They must ensure that the investment manager takes reasonable steps to ensure the best possible result for the scheme, taking into account, costs, speed, likelihood of execution and settlement, order size and nature or any other relevant considerations. There is an obligation on the Manager/SMIC to review their best execution policies on an annual basis.
Managers/SMICs are required to establish and implement procedures and arrangements which provide for the prompt, fair and expeditious execution of portfolio transactions on behalf of the scheme. The orders must be promptly and accurately recorded and allocated and that instruments or cash received in settlement of executed orders are promptly and correctly delivered to the account of the appropriate scheme.
It is unlikely that these requirements will cause many changes for EEA based investment managers as they will have already implemented these procedures to comply with MiFiD and such policies are often contained in investment management agreements with the Manager/SMIC. Difficulties may arise when contracting with non-EEA managers either appointed directly by the Manager/UCITS or as a sub-investment manager.
UCITS 16.2 also sets out additional rules in relation to handling of redemption and subscription orders and aggregation of transactions.
Draft Notice 16.2 of the Central Bank Guidance requires management companies and SMICs to establish, implement and maintain effective and transparent procedures for the handling of shareholder complaints. Complaints and complaints resolutions must be recorded.
Managers and SMICs may need to examine where and how complaints arise and whether it is possible, under existing arrangements and current Business Plans, to deal adequately with shareholder complaints. For example, consideration may need to be given to determine whether distributors provide this service under existing contractual arrangements.
The requirements of the Central Bank prevent a Manager/SMIC from taking a fee or commission or non-monetary benefit, except if:
- It is paid or provided to or by the scheme under management or a person on behalf of the scheme
- It is paid or provided by the scheme under management by a third party provided there is full detailed disclosure and if it enhances the quality of the service and does no impair compliance with the Manager’s/SMIC’s duty to act in the best interests of shareholders
- They are proper fees necessary and connected to the provision of the relevant services.
Therefore, where a fee is received by the Manager/SMIC outside of these circumstances it may not be regarded as having acted in accordance with shareholders’ best interests.
In view of these requirements, a review of existing rebate, payment and general fee structures may be required.
The work required to be undertaken in order to comply with UCITS IV involves clients working with their advisers to:
- Analyse the areas that are not currently addressed or are not addressed sufficiently in the current Business Plan
- Identify the formal policies that will need to be implemented taking into account the principle of proportionality
- Assist in the drafting of policies to comply with the managerial functions outlined above and prescribed by the Central Bank
- Updating the Business Plan to incorporate the revised policies and to review the existing headings and implement the two new management functions outlined above
- Review the current overall structure, including the reporting frequency, reporting lines with each service provider and to implement the move away from the current ‘collective responsibility’ model to the ‘Designated Person’ model, where relevant, including a review of the adequacy of resources at Board level
- Discuss the proposed model with directors to ensure directors are satisfied with any proposed appointment
- Liaise with each service provider so that they may review the revised Business Plan to assess the impact on them and review any comments that may be received
- Liaise with the Central Bank to address any comments they may have throughout the authorisation process
- Liaise with directors to advise them of the changes in the final plan, their new responsibilities under UCITS IV, to convene any Board Meeting that may be necessary to procure their approval to the revised business plan; and
- The extent necessary, to carry out a review of the impact of the UCITS IV arrangements on the prospectuses for each of the funds and all contractual arrangements with each service provider.