United States: Investment Managers Warn European Commission On Outsourcing Implications From The UCITS Directive III Proposal

The Investment Management Association (IMA) has warned the European Commission (EC) that its otherwise excellent proposals to amend the Undertakings for Collective Investments in Transferable Securities Directive III (comprising Council Directive 85/611/EEC, Directive 2001/107/EC (the Management Directive) and Directive 2001/108/EC (the Product Directive)) (UCITS) may nevertheless cause serious losses to those of its members who currently offshore the following back-office functions: the Valuation (NAV) Report, and maintenance of the unitholder register.

According to the IMA, at least thirty of its members, with managed funds of around £8 billion, have offshored various back office functions, including the Valuation (NAV) Report, and maintenance of the unit-holder register, in Dublin. Under the new proposals these members may have to bring these backoffice functions back to the UK, at their own cost.

UCITS

The original 1985 UCITS Directive was designed to harmonize all legislation relating to applicable investments and investment undertakings, thus facilitating passporting. Passporting is the means whereby an undertaking can offer its goods or services in any Member State under the same conditions as in its Home Member State. This process is designed to facilitate the EU goal: the Single Market.

However, each Member State thwarted the original design by imposing a web of individual marketing regulations. Consequently, the Management Directive and Product Directive were adopted in 2001, both of which amend the original Directive. The Management Directive was designed to assist investment undertakings passport themselves throughout the EU and widen the activities they are allowed to undertake. The Product Directive was designed to allow investment funds encompass a wider range of financial instruments, thus assisting cross-border marketing of units of such funds.

Commission Passport Shake-Up Proposal

While the Management Directive and Product Directive harmonized the legislation and assisted passporting to a degree, the Commission felt that fund investments were still not a Single Market product worthy of the name and that too many investment undertakings and investments were domiciled in their host Member State and patronized by host Member State consumers.

Accordingly the Commission published on 15 November 2006 a White Paper on enhancing the Single Market Framework for Investment Funds and followed this up with ‘Working Document DG Markt Services: Initial orientations of possible adjustments to UCITS Directive’ (Working Document) in which it proposed various changes to UCITS, including a specification of which central administration functions must be located in the same Member State in which funds are domiciled.

The Current UCITS Rule

The current rule requires management groups to establish a fully functional management company in each country where they domicile their funds. The aim of this rule is to avoid the creation of letter box UCITS funds and companies and to facilitate the work of the supervisory authorities (such as the Financial Services Authority) by ensuring that all relevant documentation is kept in their country, thus allowing fund managers to manage funds domiciled in another Member State without generating fiscal or supervisory uncertainty. There are two requirements to this rule: that a registered office of the management company be situated in each applicable Member State, and that the central administration functions of such management company be located in the same Member State as the registered office. It is up to the Member States to determine what these central administrative functions are.

The Proposed UCITS Rule

The proposed rule is a partial but not full passport. It removes the requirement to situate a registered office in each Member State where funds are domiciled, but specifies the central administration functions as the Valuation (NAV) Report and maintenance of the unit-holder register, and will require management companies to carry out these functions in the Member State where the funds are located. It is this proposal that the IMA is objecting to. According to the IMA at least thirty UK domiciled funds with £8 billion of assets under management have offshored various back-office functions, including the Valuation (NAV) Report, and maintenance of the unit-holder register in Dublin.

IMA’s Objection

Sheila Nicoll, deputy chief executive of the IMA, stated that if the EC’s proposal were adopted, UK management companies offshoring back office functions to Dublin "would have to go through the whole process of getting their funds re-domiciled in Dublin or would have to break the offshoring contract and bring the [back office functions] back to the UK."

EC’s Response

The EC’s response is that it is not asking management companies to domicile all currently offshored administration functions in the same Member State as the funds, but only the Valuation (NAV) Report, and maintenance of the unit-holder register. Niall Bohan, head of the asset management unit in the EC’s internal market directorate, said that management companies would still be free to outsource the Valuation (NAV) Report, and maintenance of the unit-holder register so long as such outsourcing took place in the Member State in which the funds were domiciled.

Given the current reluctance of management companies to passport under the UCITS directive, it’s hard to disagree with the EC’s conclusion: not only are they implementing the benefit of a management company passport for investment companies and common funds/unit trusts while avoiding the creation of letter box entities and mitigating risks, they are also facilitating legal certainty by proposing a harmonized approach to the definition of central administration functions required on the territory of a given Member State.

Equally however, it’s hard to disagree with the IMA’s objection that the EC’s proposal is not the full passport its members were hoping for, and that the definition of the central administration functions set out under the proposed partial passport could entail considerable costs for affected members.

The EC’s response to the IMA’s objection is that it has addressed this very point: the Working Document states: ‘implementing a partial passport will have limited (initial) compliance costs for the management company. These could be the result of (one-off) investments in IT/communication systems between the management company main office and the administrative centre, of restructuring of operations, etc. Given that some management companies’ activities are de facto already performed outside the fund’s domicile, these investments may already have taken place. In any case, in the long-term compliance cost would be close to zero.’

The above may be true. However, the costs of the EC's assumption that such investments may already have taken place will have to be defrayed by those management companies affected by the proposed change to the current regime.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.