UCITS V formally approved
New depositary, remuneration and sanctions rules on the way for UCITS
After several months of delay and political wrangling, UCITS V was approved by the European Parliament on 15 April 2014, just days before the end of term. For the most part, UCITS V aligns with AIFMD on remuneration and depositary requirements and additionally lays down a new framework on the application of sanctions for breaches of UCITS rules.
While many of the UCITS V requirements will be familiar to the industry under AIFMD, applying the depositary and remuneration framework to the much larger UCITS sector will certainly present practical challenges.
Getting UCITS V over the line
UCITS V has been approved at a time when the politics of the EU is strongly focussed on enhancing investor protection and more tightly regulating financial service providers, particularly in relation to risk taking and bonuses. During the legislative process, certain MEPs were eager to apply further requirements on remuneration, such as bonus caps and the inversion of performance fees in negative performance periods. These more controversial elements were ultimately voted down by the Parliament itself and more recently the debate centred on the application of the remuneration rules to delegates. The final version represents a carefully negotiated compromise, with the European Commission and ESMA tasked with working out some of the practical details. We can expect both the Commission and ESMA to draw on AIFMD as they develop the UCITS V framework.
UCITS V requires UCITS management companies to establish, oversee and review remuneration policies that promote sound risk management and to disclose aggregate information on remuneration in the UCITS annual report. Rules on variable remuneration include:
- At least 50% of variable remuneration should comprise of units of the UCITS or equivalent ownership interests (unless the management of UCITS accounts for less than 50% of the total portfolio managed by the management company)
- At least 40% of variable remuneration should be deferred over a period which is appropriate “in view of the holding period recommended to investors” and for a period of at least 3 years
- Variable remuneration should be subject to overall financial performance and downward adjustment by way of malus (pre-vesting) or clawback (post-vesting) adjustments
Determining the range of staff captured will be one of the key tasks for UCITS management companies. The wording in UCITS V is more detailed than AIFMD in referring to “any employee and any other member of staff at fund or sub-fund level who are decision takers, fund managers and persons who take real investment decisions, persons who have the power to exercise influence on such employees or members of staff, including investment advisors and analysts”. The remuneration rules should also apply “in a proportionate manner” to delegates that impact on the risk profile of the UCITS.
Crucially, ESMA has been requested to issue guidelines on how this will work in practice. This is consistent with the approach taken under AIFMD, with ESMA issuing guidelines on how to determine so-called “identified staff” subject to the detailed rules. Proportionality will feature in the application of those guidelines with ESMA required to take into account “management company size, internal organisation, and the nature, scale and complexity of activities”.
Interaction between remuneration frameworks
A key complexity is that separate remuneration frameworks now exist or are planned across the various regulatory regimes, including CRD, MiFID, AIFMD and UCITS. These requirements continue to evolve, with employees potentially subject to distinct but overlapping sets of remuneration requirements. In light of this challenge, ESMA has been specifically requested to coordinate with the EBA in order to come up with a solution to how the different regimes will interact. This may draw on recent clarifications by the FCA and ESMA which rely on recognising “equivalence” between the different sets of rules. Equivalence addresses the challenge of making regulated portfolio or risk management delegates subject to the remuneration requirements of the management company. In practice this may only work for delegates regulated by other EU regimes and concerns remain over how to treat non-EU portfolio and risk management delegates under the new rules. ESMA’s guidelines will be central in forming an approach.
The UCITS depositary framework is aligned with AIFMD, clarifying new safekeeping, oversight and cash monitoring duties. The strict depositary liability should be watertight under UCITS V, allowing no possibility for a regulatory or contractual discharge of liability for financial instruments held in custody. UCITS V differs from AIFMD in this regard, as contractual arrangements can be structured under AIFMD to discharge depositary liability subject to strict conditions and objective reasons. Only if there is an “external event beyond reasonable control”, such as a natural disaster, is the depositary off the hook for the loss of the asset under UCITS V. In a reversal of the burden of proof, the onus rests on the depositary to prove that a loss was an external event. If it cannot do this, the depositary must return an equivalent of the lost asset without undue delay to the UCITS. The risk and cost profile is consequently changing for depositaries, with implications for pricing and capital (see our AIFMD Depositary White Paper for more on this subject).
Other depositary requirements
New, more prescriptive requirements apply in relation to the delegation of safekeeping, the segregation of assets and monitoring of cash flows. A depositary may delegate safekeeping only subject to strict criteria while delegation of oversight and cash flow monitoring is not permitted. Due diligence and operational oversight of the sub-custody network is consequently likely to increase under UCITS V. For assets that cannot be held in custody, new recordkeeping and ownership verification duties apply. Many of these requirements are likely to be clarified along similar lines to AIFMD in the Level 2 measures.
Reuse of custody assets
UCITS V imposes new requirements on the “reuse” of custody assets, understood to mean practices such as securities lending and repos in UCITS. Reuse comprises “any transaction of assets held in custody including, but not limited to, transferring, pledging, selling and lending”. Proposals from the European Parliament had laid down an outright ban on resuse but this is now permitted, subject to new conditions. The reuse must be “for the benefit of the UCITS and the interest of the unit-holders and the transaction must be covered by high quality and liquid collateral received by the UCITS under a title transfer arrangement. The market value of the collateral at all times has to amount to at least the market value of the reused assets plus a premium”.
In relation to depositary eligibility, the compromise text finally settled on an extension of eligibility from the Commission’s initial proposal. A depositary may be a credit institution, a national central bank or other legal entity authorised by member states that is subject to ongoing supervision as well as minimum capital, prudential and organisational requirements. Additional high level requirements regarding infrastructure, policies and procedures, record-keeping, organisation, business continuity and senior management have been added. Non-credit institution depositaries will be satisfied with this outcome. Furthermore, UCITS that have appointed a depositary which is not compliant with the new eligibility criteria, have a further two years following implementation to appoint a depositary that meets the new eligibility requirements.
A Commission study published in 2010 revealed divergent sanctioning powers and practices in relation to UCITS breaches across member states. UCITS V seeks to promote consistency by requiring member states to lay down rules on administrative sanctions that should be “effective, proportionate and dissuasive”. The Directive sets out broad categories for UCITS breaches for which national regulators must provide penalties. These penalties include a public statement which identifies the person responsible and the nature of the breach as well as a temporary suspension or permanent bans for repeated and serious breaches. Under the final text, national regulators may decide on a case-by-case basis not to publish the identity of persons involved where they consider that this would be disproportionate.
Companies will be subject to maximum fines of at least €5 million or 10% of annual turnover and individuals to maximum fines of at least €5 million. While the Commission proposal would have required ESMA to issue guidelines to national regulators on a catalogue of administrative measures and sanctions, this requirement has been removed from the final text, allowing member states flexibility in reconciling the requirements with national administrative and judicial regimes. A member state may also decide not to lay down rules for administrative sanctions for breaches which are subject to national criminal law.
ESMA has been given some new responsibilities in this area. National regulators must report information on sanctions they have issued to ESMA and ESMA will publish aggregated information on such sanctions in its annual report. The intent is clearly to monitor member state efforts towards convergence and three years after entry into force, the Commission will report on progress made and the need for further harmonisation. ESMA is also empowered to set up a European-wide whistle-blower mechanism for the reporting of breaches on national rules implementing UCITS.
UCITS V was formally endorsed by the European Parliament on 15 April and will likely be published in the EU’s Official Journal in June 2014. Member states will have an 18 month implementation timeframe, meaning that the UCITS V framework would need to be in place by late 2015. The Commission is required to adopt various Level 2 delegated acts as part of the implementation process and will seek to align the rules with AIFMD insofar as possible. ESMA will also be required to develop technical standards and detailed remuneration guidelines. Public consultation is envisaged under the UCITS V implementation process. This will be of critical importance given the compliance and cost implications for the UCITS industry.