The EU’s Revised UCITS Directive (UCITS V) Published: The Main Provisions

The EU’s much discussed legislation to amend Directive 2009/65/EC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (the “UCITS Directive”) was published in the EU Official Journal on August 28, 2014.

Directive 2014/91/EU of the European Parliament and of the Council of 23 July 2014 amending Directive 2009/65/EC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) as regards depositary functions, remuneration policies and sanctions — widely known as “UCITS V” — will affect the existing regulatory framework for undertakings for collective investment in transferable securities (“UCITS”) in three main areas: 1) the role of the depositary; 2) remuneration; and 3) sanctions. In particular, UCITS V clarifies and strengthens the depositary function.

UCITS V also aligns the UCITS legislation with certain aspects of the EU Alternative Investment Fund Managers Directive (“AIFMD”).

EU member states have until March 18, 2016, to transpose UCITS V into national law.

UCITS V also requires the European Securities and Markets Authority to draft guidelines clarifying the exact scope of the UCITS V remuneration requirements and their practical application. These guidelines will be preceded by a public consultation, which should take place over the coming months.

UCITS V will have a far-reaching impact. According to statistics published by the European Fund and Asset Management Association, as at the end of 2013, there were over 35,000 UCITS funds with approximately 6.9 trillion euros (U.S.$9.1 trillion) in assets sold in 86 countries. Moreover, these numbers are set to increase. In a recent survey commissioned by Matheson and conducted by the Economist Intelligence Unit, 56 percent of the 200 managers surveyed predicted that their firms would have over U.S.$1 billion in UCITS (by assets under management) by 2016.

Ireland is a location of choice for UCITS funds, with 80 percent of Irish domiciled funds structured as UCITS.

This article provides an overview of the main provisions of UCITS V.

Overview of UCITS V

UCITS V focuses on three main areas:

• a new depositary regime which includes a clarification of depositary eligibility, duties, liabilities and disclosure, and a set of rules under which tasks and responsibilities can be delegated — mainly focusing on the sub-custodian network;

• rules governing remuneration policies of both management companies and investment companies managing UCITS that must be applied to key members of the UCITS managerial staff; and

• the harmonisation of the minimum administrative sanctions regime across EU member states.

One of the purposes of UCITS V is to align the UCITS Directive with the depositary rules, rules on remuneration and sanctions provisions under the AIFMD.

Provisions Impacting Depositaries

The provisions on depositaries deal with depositary eligibility, duties, delegation, liability, and disclosure.

Depositary Eligibility

UCITS V establishes, for the first time, an exhaustive list of entities that are eligible to act as depositaries for UCITS’ assets. These entities are: 1) national central banks; 2) credit institutions authorised under the EU Capital Requirements Directive (Directive 2013/36/EU); and 3) a legal entity authorised by the competent authority under the laws of the EU member state to carry on depositary activities under the UCITS Directive, subject to the fulfilment of certain capital, prudential and organisational requirements.

For Irish depositaries, the third limb includes entities authorised by the Central Bank of Ireland under the Irish Investment Intermediaries Act 1995.

UCITS V provides that an investment company and, for each of the funds it manages, a management company can appoint only a single depositary. UCITS V also requires the depositary’s appointment to be evidenced by a written contract which must regulate the flow of information deemed necessary for the depositary to perform its depositary functions.

Both of these requirements already exist under Irish law.

UCITS V repeats the prohibition set out in the UCITS Directive against any company acting as both management company and depositary or investment company and depositary.

UCITS management companies, including self-managed investment companies, which have appointed a depositary that does not meet UCITS V’s eligibility criteria before March 18, 2016, have an additional 24 months in which to appoint an eligible depositary, that is, until March 18, 2018.

Duties of the Depositary

The UCITS Directive contains a number of provisions which set out a depositary’s oversight and safekeeping duties.

UCITS V clarifies these duties. Regarding the safekeeping duties, UCITS V distinguishes between financial assets that may be held in custody and other assets that may not, a distinction which is also important for the purposes of liability. As compared to the UCITS Directive, UCITS V sets out new cash monitoring duties. It also stipulates that UCITS’ assets are to be segregated from those of the depositary. UCITS V expressly provides that, in performing all of its tasks, a depositary must act honestly, fairly, professionally, independently and solely in the interests of the UCITS or its investors.

Cash Monitoring

The depositary must ensure that cash flows are properly monitored and, in particular, that all payments made by or on behalf of the investors, upon the subscription of units of the UCITS, have been received, and that all cash of the UCITS has been booked in cash accounts that are opened in the name of the UCITS or another specified entity and maintained appropriately.

Asset Segregation and Re-use of Assets

UCITS’ assets must be segregated from the assets of the depositary so that any financial instruments on the depositary’s book held for a UCITS can be distinguished from the depositary’s own assets and can at all times be identified as belonging to that UCITS. A depositary is prohibited from using the assets which it holds in custody for its own account.

Moreover, a depositary may re-use assets for the account of the UCITS only after the following conditions are fulfilled:

• the re-use of the assets must be executed for the account of the UCITS;

• the depositary must be carrying out the management company’s instructions on behalf of the UCITS;

• the re-use must be for the benefit of the UCITS and in the interests of the unitholders; and

• the transaction must be covered by high quality and liquid collateral received by the UCITS under a title transfer arrangement, the market quality of which at all times amounts to at least the market value of the re-used assets plus a premium.

This prohibits the type of re-hypothecation seen in AIFMD structures, but will facilitate UCITS which wish to engage in initiatives such as securities lending.

Delegation of Depositary Safekeeping Duties

UCITS V considerably tightens up the provisions regulating the delegation by depositaries of their duties set out in the UCITS Directive. Specifically, it explicitly prohibits depositaries from delegating oversight and cash monitoring duties. While a depositary may delegate safekeeping duties, this is subject to the fulfilment of certain conditions. Depositaries are not permitted to delegate these duties with the intention of avoiding the UCITS V requirements.

In order to delegate the safekeeping functions defined in UCITS V, the depositary must be able to demonstrate that there is an objective reason for that delegation, and must exercise all due skill, care and diligence in the selection, appointment, periodic review and ongoing monitoring of the third party entrusted with the delegated function(s) and of the arrangements of the third party in respect of the matters delegated to it.

Like the appointment of the depositary, the delegate’s appointment must be evidenced in writing.

In addition, the third party delegate must at all times fulfil a number of specified requirements, some general and some connected with specific functions. Generally, the delegate must:

• carry out its functions honestly, faithfully, professionally, independently and solely in the interests of the UCITS and its investors;

• have structures and expertise that are adequate and proportionate to the nature and complexity of the assets entrusted to it;

• segregate the assets of the depositary’s clients from its own assets and from those of the depositary, and respect the same requirements regarding the safekeeping and re-use of assets as the depositary; and

• take all necessary steps to ensure that, in the event of its insolvency, the UCITS’ assets are unavailable for distribution among the delegate’s creditors.

In addition, the delegate must be subject to:

• an external periodic audit to ensure that the financial instruments are in its possession; and

• effective prudential regulation, including minimum capital requirements, and supervision in the jurisdiction concerned.

However, even in the absence of effective prudential regulation where local laws require that certain financial instruments be held in custody by a local entity, the depositary may still delegate its functions to the extent necessary to comply with those laws once instructed to do so by the investment company or management company on behalf of the UCITS. Investors must be informed both of the circumstances justifying the delegation and of the risk involved prior to their investment.

Depositary Liability

Under the existing UCITS Directive, a depositary is liable to the management/investment company and its unitholders for its: 1) unjustifiable failure to perform its obligations or 2) improper performance of them. The liability to unitholders may be invoked directly or indirectly through the management/investment company, depending on the legal nature of the relationship between the depositary, the unitholders and the management/investment company.

UCITS V widens the circumstances in which a depositary’s liability may arise to explicitly include loss resulting from the depositary’s negligent failure to properly fulfil its obligations under the UCITS Directive. According to UCITS V, unitholders in the UCITS may invoke the liability of the depositary directly, or indirectly through the management/investment company in two circumstances: 1) in the event of the loss of a financial instrument held in custody by the depositary or its third party delegate; and 2) for all other losses suffered by the unitholders as a result of the depositary’s, or its delegate’s, negligent or intentional failure to properly fulfil its obligations under the UCITS Directive. In both cases, the unitholders’ ability to invoke the depositary’s liability must not lead to duplication of redress or to the unequal treatment of the unitholders.

In the event of the loss of a financial instrument held in custody, the depositary must immediately return a financial instrument of identical type or the corresponding amount to the UCITS or the management company acting on its behalf. In the case of such a loss, liability is strict: The depositary may avoid liability only if it can prove that the loss is attributable to an external event beyond its reasonable control, the consequences of which were unavoidable despite all reasonable efforts to the contrary.

In contrast to the AIFMD, it is not possible under UCITS V for a depositary to contractually discharge liability in case of the loss of assets by the depositary or its delegate. The AIFMD does provide for contractual discharge of liability in favour of a delegate in certain circumstances.

Disclosure

Schedule A of Annex I of the UCITS Directive sets out information that must be contained in the prospectus, in so far as that information does not already appear in the fund rules or instruments of incorporation annexed to the prospectus.

UCITS V replaces the existing provisions relevant to depositaries. Pursuant to the new provisions, the prospectus must contain:

• the identity of the depositary and a description of its duties and of conflicts of interest that may arise;

• a description of any safekeeping functions delegated by the depositary, the list of delegates and sub-delegates and any conflicts of interest that may arise from such delegation; and

• a statement that up-to-date information regarding the two above points will be made available to investors on request.

The Central Bank of Ireland already requires the prospectus to disclose the material provisions of the contract between the management company and the depositary, as well as a brief description of the duties being performed and the relevant termination provisions. These disclosure requirements continue to apply.

Remuneration Provisions for UCITS Management Companies

UCITS V requires UCITS management companies, including self-managed UCITS, to implement remuneration policies and practices (“RPPs”) that:

• are consistent with and promote sound and effective risk management of the UCITS;

• discourage disproportionate risk-taking which is inconsistent with the risk profiles or fund rules governing the relevant UCITS;

• are in line with the business strategy, objectives, values and interests of the management company and the UCITS it manages or the investors; and

• include measures to avoid conflicts of interest.

Application and Scope

The RPPs are to apply to any staff members whose professional activities “have a material impact on the risk profiles of the UCITS they manage”. These categories of staff should include any employees and any other members of staff at fund or sub-fund level who are senior managers or exercise supervisory or risk management functions, as well as other employees/contractors in the same pay bracket as senior management and risk takers whose activities can materially impact the risk profile of the management companies or the UCITS they manage.

According to the recitals, the RPPs should also apply: 1) to persons who have the power to exercise influence on staff who carry out activities which materially impact the risk profile of the UCITS they manage, including investment policy advisers and analysts; and 2) in a proportionate manner “to any third party which takes investment decisions that affect the risk profile of the UCITS because of functions delegated to it”.

While this latter provision suggests that the remuneration provisions should apply to non-EU-based investment managers, its scope is not entirely clear. Nor are the recitals legally binding. Consequently, the exact scope of the remuneration provisions will largely depend on the approach taken by the European Securities and Markets Authority (“ESMA”) when drafting its guidelines on remuneration.

The RPPs must respect a number of principles specified in UCITS V (the “remuneration principles”), which address both governance, and pay structure and risk alignment.

UCITS V also contains provisions dealing with the establishment of a remuneration committee, enhanced disclosure, and supervisory oversight.

While the general obligation to have sound RPPs applies to all management companies, regardless of their size or systemic importance, the remuneration principles are themselves subject to the principle of proportionality. This means that management companies need to comply with those principles only in a way and to the extent that is appropriate to their size, internal organisation and the nature, scope and complexity of their activities.

ESMA’s guidelines on sound remuneration policies under the AIFMD give extensive consideration to the principle of proportionality for the purpose of the AIFMD remuneration provisions.

Moreover, the U.K. Financial Conduct Authority (“FCA”) has also published guidance on this issue (the “FCA’s guidance”). According to the FCA’s guidance, if an alternative investment fund manager’s (“AIFM’s”) assets under management are less than a specified threshold, then the presumption arises that it may disapply the rules dealing with variable instruments in remuneration, retention, deferral and ex post incorporation of risk for variable remuneration, subject to a review of the other criteria. According to the FCA’s guidance, the thresholds are:

• less than 5 billion pounds (U.S.$8.3 billion) in the case of AIFMs which manage portfolios of alternative investment funds (“AIFs”) that are unleveraged and have no redemption rights exercisable during a period of five years following the date of initial investment in each AIF; and

• less than 1 billion pounds (U.S.$1.7 billion) in the case of AIFMs which manage portfolios of AIFs in other cases, including any assets acquired through the use of leverage.

The Director of Market Supervision at the Central Bank of Ireland, Gareth Murphy, referenced the FCA’s guidance in his speech at a funds congress on March 29, 2014, observing, “We see considerable merit in the interpretations which the UK FCA have provided which align the interests of risk-takers and investors and which seek to ensure that the effective management of AIF assets is preserved”.

Governance

UCITS V views effective governance as a necessary condition for a sound remuneration policy. It entrusts those non-executive members of the management body who have sufficient expertise in risk management and remuneration with the tasks of adopting and reviewing that policy at least annually and with overseeing its implementation. The policy’s implementation must also be subject, at least annually, to central and independent internal review for compliance with RPPs adopted by the management body.

UCITS V requires “significant” management companies to establish a remuneration committee. Whether or not a management company is sufficiently significant is to be evaluated in terms of its size, the size of the UCITS it manages, its internal organisation and the nature, scope and complexity of its activities. The remuneration committee is responsible for preparing decisions regarding remuneration, including those which have implications for the risk and risk management of the management company or the UCITS concerned and which are to be taken by the management body in its supervisory function.

Pay Structure and Risk Alignment

Several of the UCITS V remuneration principles seek to ensure that remuneration is effectively aligned with risk. In particular, UCITS V stipulates that RPPs should be designed to discourage risk taking inconsistent with the risk profiles, rules or instruments of incorporation of the managed UCITS.

UCITS V does not limit the ability of management companies to pay variable remuneration, with the exception of guaranteed variable remuneration. Nor does it impose bonus caps. However, it sets out a number of principles addressing: the relationship between fixed and variable remuneration; performance assessment and measurement; deferred payments; remuneration in instruments; early termination payments; pension payments; and anti-circumvention measures.

Disclosure

Under UCITS V, the prospectus, the key investor information document (the “KIID”), and the annual report must each provide information on the remuneration policy.

The prospectus must include either details of the remuneration policy itself, or a summary of that policy and a statement that the details of the actual policy may be found on a specified website and that a paper copy will be made available free of charge upon request. The KIID must include a statement to the same effect.

The UCITS’ annual report must disclose the total remuneration paid by the management company and by the UCITS to its staff, together with the number of beneficiaries, and, where relevant, performance fees paid by the UCITS. The aggregate amount of remuneration must be broken down by category of employees or other staff members. The annual report must also describe how the remuneration and benefits have been calculated, detail the outcomes of the periodic reviews of the remuneration policy and its implementation and contain any material changes to the adopted remuneration policy.

Supervisory Oversight

UCITS V requires ESMA to issue guidelines on the application of the remuneration principles. These principles must take into account existing principles developed for other sectors of financial services, including the EU Capital Requirements Directive (Directive 2013/36/EU), the EU Markets in Financial Instruments Directive (Directive 2004/39/EC) and European Commission Recommendation 2009/384/EC on remuneration policies in the financial services sector.

Sanctions Regime

The UCITS Directive requires EU member states to impose administrative and/or criminal sanctions at least for specified infringements of the directive, and provides that administrative sanctions must be effective, proportionate and dissuasive.

UCITS V clarifies and expands upon the member states’ obligations in this respect. In particular, it sets out non-exhaustive lists of the types of breaches of the UCITS Directive which must give rise to penalties and the type of penalties which must be provided, including specifying the minimum level of administrative pecuniary sanctions for serious breaches of the UCITS Directive.

UCITS V requires competent authorities and UCITS managers to establish whistle-blowing mechanisms including protection for “whistle-blowers”. Member states must facilitate whistle-blowing through the establishment of effective and reliable mechanisms to encourage reporting of potential or actual breaches, including secure communication channels. Management companies, investment companies and depositaries must have in place specific, independent and autonomous channels for their employees to report breaches internally. Employees of investment companies, management companies and depositaries who report breaches within those entities must be protected against retaliation, discrimination or other types of unfair treatment, at a minimum.

Competent authorities must report each year to ESMA aggregated information on measures and sanctions imposed, and inform ESMA of any individual measures and sanctions they have published.

Implementation of UCITS V

As mentioned above, EU member states have until March 18, 2016, to transpose UCITS V into national law.

Implementing measures providing greater clarity on certain provisions of UCITS V will also need to be prepared.

Implications and Next Steps

Although the application of the new rules is not likely to occur until March 2016, UCITS and UCITS management companies need to start preparing for those rules now.

Depositaries will need to perform an analysis to assess the impact of the new depositary safekeeping, delegation and liability rules on their businesses.

In light of the new liability provisions for depositaries, depositaries may wish to review their sub-custody networks and determine if changes are needed to initial and ongoing due diligence processes.

Firms can begin addressing the strategic aspects of the new provisions and assessing their capabilities, products and processes.

Depositaries should assess information technology requirements (i.e., reporting and record keeping aspects); human resource aspects; and the existing and required processes which will need to be adapted to this new regulatory framework — especially in the management of sub-custodians and other correspondents.

Shay Lydon and Michael Jackson are Partners in the Dublin office, and Aiden Kelly is a Partner in the New York office, of Matheson. The authors may be contacted at shay.lydon@matheson.com, michael.jackson@matheson.com and aiden.kelly@matheson.com.