This DechertOnPoint summarises regulatory developments at the European Union, supra-national and UK levels in the investment funds and asset management sectors during the past two weeks.
EU and International Regulatory Developments
Feedback on the Commission's Consultation on UCITS V
The European Commission has recently held a consultation to review the current regulatory framework applicable to UCITS depositaries and to introduce provisions on remuneration for UCITS managers. The object of the consultation was to gather evidence on any foreseen costs and benefits relating to the main changes that the Commission envisage making in those areas. Responses to this consultation have revealed wide support for the Commission's initiatives, which are perceived as significant and positive steps forward in order to improve investor protection—notably through a more harmonised EU regulatory framework—and to enhance fair competition between all UCITS providers.
The responses to the consultation highlighted the following main conclusions:
- With respect to UCITS depositary functions, clarification of UCITS depositaries duties and the liability regime is perceived as the key policy priority given the role that UCITS depositaries exercise in investment protection, and more specifically:
- Alignment with AIFMD. The UCITS V review initiative needs to be conducted in accordance with relevant requirements of the AIFMD in order to enhance consistency in the regulatory framework applicable to the depositary function; responses also advocated the use of consistent terminology between the AIFMD and the UCITS regimes, although a simple alignment with the AIFMD was not thought to be appropriate as UCITS investors obtained through the process of fund passporting are mainly retail investors.
- The liability regime. The two most controversial aspects of the feedback related to (i) the reference to "force majeure" in the Commission's consultation enabling a discharge of liability on the part of the UCITS depositary; and (ii) the obligation to return "lost" assets without delay (where according to the AIFMD standards, depositaries also need to return "lost" assets without undue delay). In this context, a majority of respondents highlighted the fact that the key outstanding issue is to determine when an asset can be considered as "lost".
- UCITS holders' rights. The UCITS holders' rights should be clarified and aligned, regardless of the legal form of an UCITS fund. Some respondents also suggested that the Commission should introduce UCITS class actions in order to ensure that retail investors can benefit from all existing legal tools to protect their interests.
- Supervision. This was highlighted as being essentially a single market issue in responses to the consultation. The majority of stakeholders believe that the competencies of supervisors should be further harmonised and that competent national authorities should be allowed to enforce EU rules in a more effective and harmonised manner.
- On managers' remuneration policy, the majority of the responses stressed that remuneration rules should be adjusted to the UCITS model, and some suggested that the rule that a substantial portion of variable remuneration should consist of units or shares of the fund or investment company concerned is simply not suitable in a UCITS environment.
These responses will now be taken into account in an impact assessment that is to be produced by the Commission and published with its proposal for amendments to the UCITS Directive in July 2011.
The MiFID Review
HM Treasury in the UK ("the Treasury") published on 9 February 2011 its joint response with the UK's Financial Service Authority ("the FSA") submitted on the European Commission's consultation on the review of MiFID. (The Commission published its consultation on amending this Directive (2004/39/EC) on 8 December 2010 and it closed to public responses on 2 February 2011).
In their response, the Treasury and the FSA noted with surprise the short consultation period and suggested that this is not conducive to sound policy making by the Commission nor to the production of carefully considered legislative proposals. (However, some commentators have pointed out that the Commission has embarked on a hidden agenda of steam-rolling through a series of financial services measures, normally in the form of new Regulations rather than directives and with minimal involvement of the European Parliament in order to achieve closer harmonisation in the internal market for financial services in the EU usually by exploiting the process of qualified majority voting to achieve more political integration than hitherto in response to the continuing financial crisis in Europe).
In their response, the Treasury and the FSA provide responses to some of the key questions raised in the consultation and list their key concerns include those relating to small and medium sized enterprises ("SMEs"), investor protection, third-country provisions, automated trading, commodities and transparency. The Commission will now consider consultation responses and prepare a formal legislative proposal for adoption in mid-May 2011.
In more detail, key concerns raised by the UK authorities are:
- SMEs. The Commission should consider updating a wider package of reforms targeted towards SME financing.
- Investor protection. The Commission should prevent product providers from in effect setting the remuneration levels for all firms providing investment advice, not merely those the advice of which is independent.
- Amendment validity. There were significant concerns about the validity of the amendments proposed to the existing execution only and client classification regimes.
- Third-country provisions. Strong reservations were expressed concerning the Commission's proposal to introduce a third country regime within MiFID based on the principle of exemptive relief for equivalent jurisdictions since this was considered to undermine the principle of free movement of capital and the ability of EU firms to carry on international business outside the internal market of the EU without hindrance.
- Automated trading. the Treasury is currently sponsoring a research project to explore how computer-generated trading is likely to evolve in the future, which it hopes will inform the debate in this area, and urges that care should be taken by the Commission not to introduce measures based on the assumption that high-frequency trading ("HFT") is in itself harmful to the markets (although others have argued that HFT, in certain circumstances, already infringes certain national market abuse regimes).
- Organised trading facilities (OTFs). The UK authorities believe there is no justification for the Commission's proposed broad-ranging category of OTF. The European Commission's new "catch-all" venue category of OTFs is now meeting with substantial resistance in both the UK and Germany, whilst the French appear to support what would become a fourth trading regime. In its consultation document the Commission suggests ... "In order to address evolving market practices and technological developments, and mitigate harmful regulatory arbitrage, a broad definition in MiFID could be introduced to suitable regulate all organised trading occurring outside the current range of MiFID venues". Any bilateral or multilateral facility or system operated by an investment firm or market operator "on an organised basis", and not captured by the three existing venue categories (exchanges, multilateral trading facilities or firms acting as systematic internalisers) would thus fall into the proposed new OTF category, and be subject to MiFID's transparency and other obligations. Broker crossing systems, for example, would be OTFs, as would future swap execution facilities and other venues for standardised derivative contracts. Only genuinely ad hoc, bilateral OTC trading as well as order-routing and execution-only facilities would then fall outside MiFID. In making this proposal, the Commission has gone beyond the technical advice it received last summer from the CESR.
- Commodities. Particular concerns were expressed about the adoption of position limits proposed by the Commission, with a need for further evidence of their utility, and other proposals, such as position management counter market manipulation without risking possible unintended consequences (including harming market liquidity) which appear to be inherent in the Commission's regulatory proposals for this sector.
- Transparency. It was considered essential that any transparency regime targeted at derivatives and corporate bonds should take account of the diverse range of asset classes, the trading characteristics of which can differ significantly and which require more tailored requirements than at present proposed, including incorporating a system of waivers.
IOSCO Report on Trading of OTC Derivatives
The International Organisation of Securities Commissions (IOSCO) published a report on 18 February 2011 on the trading of over-the-counter ("OTC") derivatives.
This report examined:
- the characteristics of both exchanges and electronic platforms;
- the characteristics of OTC derivatives products relevant to organised platform trading, including standardisation and liquidity considerations;
- the benefits and costs of increasing organised platform trading: these were discussed in relation to the G20 leaders' stated objectives of improving transparency, mitigating systemic risk and protecting against market abuse in the OTC derivatives markets, and also the various benefits derived from increased standardisation of contracts, central clearing and reporting to trade repositories; and
- regulatory actions that could be used to increase the movement of OTC derivatives trading to organised platforms.
ESMA: Executive Director Nominated
The three new European Supervisory Authorities were officially established on 1 January 2011: the European Banking Authority in London (EBA), the European Securities and Markets Authority in Paris (ESMA) and the European Insurance and Occupational Pensions Authority in Frankfurt (EIOPA). In the second week of January the nominees for the Chairmen of the three authorities were announced: Andrea Enria (EBA), Steven Maijoor (ESMA) and Gabriel Bernardino (EIOPA) and the appointments were later confirmed in early February. At around the same time, the European Parliament's ECON Committee held informal pre-hearings with the candidates for the position of Executive Director.
The ESMA Board of Supervisors has recently nominated the FSA's Verena Ross to the post of Executive Director of ESMA, subject to confirmation by the European Parliament. The Executive Director will be entrusted with the day-to-day management of ESMA. In line with the Regulation establishing ESMA, the Executive Director will serve a term of five years, renewable once. The European Parliament may give this candidate an interesting ride as it is understood that some of the political groupings harbour concerns on the UK securing the post in light of perceived "over-lobbying" in the positioning of candidates and moves to block certain influential figures, notably French, in the new board by an alliance of Member States led by the UK.
European Commission Consultation on Financial Sector Taxation
A tax on financial activities (a "FAT") relates to the total sum of profits and remunerations of financial institutions. It would therefore tax corporations, rather than the individual participants involved in a financial transaction. A tax on financial transaction (an "FTT") would hit all kinds of capital movements, including equity, bonds and derivatives. The first discussions at EU level on the two options were carried out at the ECOFIN Council at the beginning of September 2010 on the basis of a European Commission informal document. In October 2010, the EU Commission published a Communication on taxation of the financial sector, weighing up the viability and potential revenue gains to be made from an FTT and a FAT. At the end of February 2011, the Commission launched a consultation on financial sector taxation, seeking views on the impact and feasibility of various policy options in this area, the potential design of the tax and possible problems. In particular, the policy measures that are analysed in the Commission's consultation paper include an FTT and a FAT. Any debate on how the revenue raised is to be spent will be held at a later stage, however!
The Commission set out its reasons for additional taxation of the financial sector in a paper published in October 2010. It is now seeking views on policy options to address:
- substantial public financing support during the financial crisis, the need for fiscal consolidation and possible under-taxation of the financial sector;
- 'undesirable behaviours' for the society as a whole (i.e., systemic risks); and
- 'the unco-ordinated patchwork of national measures which may (i) create incentives for tax-driven relocation either within the EU or outside the EU and distortion of competition; and (ii) create situations of either unrelieved double taxation or non-taxation.'
According to the Commission's consultation, the proposals cannot be separated from potential changes to the regulatory framework, especially the possible introduction of a bank levy (recognising that several Member States have proposed or already operate national systems of bank levies).
This consultation period ends on 19 April 2011. The Commission intends to publish proposals on the taxation of the financial sector by the summer of 2011.
UK Regulatory Developments
OFT Concludes its Market Study on Equity Underwriting and Associated Services
The Office of Fair Trading ("OFT") published its market study into equity underwriting and associated services at the end of January 2011. The OFT's market study considered the different types of follow-on share issues used by FTSE 350 listed companies to raise capital in the UK, including how such services are purchased, how they are provided and how the regulatory environment affects their provision. In its report on the market study, the OFT sets out its findings as to how the market works, identifies its key concerns and suggests options for achieving more cost-effective outcomes.
The OFT concluded that there had been a significant increase in the fees paid to investment banks since the onset of the financial crisis and that fees have been slow to fall in line with the stabilisation of the equity markets from mid-2009 onwards and subsequent reductions in risk.
Whilst the OFT's study did not raise any significant concerns in relation to the available choice of providers of equity underwriting services and the concentration of equity underwriters amongst investment banks, the OFT considered that concerns about the level of fees are best tackled by companies and institutional shareholders rather than by further regulatory intervention by the authorities (such as the OFT itself or the Competition Commission).
This OFT study thus complements, and reaches similar conclusions to, the earlier Rights Issue Fees Inquiry ("the RIF Inquiry") the report of which was published in December 2010—in essence that companies and institutional shareholders are better placed to address concerns than the competition authorities. For this reason, the OFT has also provisionally decided not to make a market investigation reference to the Competition Commission at this stage. (Responses on the OFT's decision in that regard may be submitted to it until 11 March 2011).
The OFT has thus made less specific and less onerous recommendations even than the RFI Inquiry and, notably, no changes to legislation or regulations are recommended (whereas the RFI Inquiry recommended that changes were made to the Listing Rules, the Transparency Obligations Directive and the Stewardship Code).
Changes to Improve the Competitive Position of Authorised Investments Funds with Holdings in Non-Reporting Offshore Funds
HM Treasury made regulations on 9 February 2011 that introduce changes for authorised investment funds ("AIFs") with holdings in non-reporting offshore funds ("NROFs").
Investments by AIF's in NROFs (unlike investments in reporting funds) can give rise to taxation on any capital gains arising from such investments. Accordingly, the tax position of some AIF's (albeit probably a small number) will be improved as a result of a change brought in by these regulations to treat certain holdings that would otherwise be NROF's as if they were reporting funds provided certain conditions are satisfied.
In addition, the regulations also increase the proportion of assets that an AIF can hold in NROF's from 20% to 50% before their investors become automatically subject to a different and often less favourable income tax treatment. Hedge or alternative funds are quite often NROFs and so these changes will be of significance for AIFs that invest in such funds.
These changes should better align the competitive position of AIF's with offshore funds.
The regulations concerned (the Authorised Investment Funds (Tax) (Amendment) Regulations 2011) are due to come in to force on 6 March 2011.
Offshore Funds (Tax) (Amendment) Regulations 2011
HMRC published on 28 February 2011, for industry comment, draft legislation amending the Offshore Funds (Tax) Regulations 2009, which govern the tax rules on reporting funds.
In addition to provisions published in draft on 20 December 2010, the draft regulations now incorporate proposed changes to the rules for reporting funds, including:
- adjustments to the reported income per unit, on the basis of accounting income, for funds that do not operate equalisation: (the draft regulations set out the formula for calculating the adjustment and rules governing the computation period and transitional provisions are also included);
- an amendment permitting offshore funds to access the trading and investment "white list";
- alterations to the genuine diversity of ownership rules to allow it to apply at sub-fund level;
- an extension of time limits for application for entry into and withdrawal from the reporting funds regime;
- new rules for calculating the reported income of a transparent reporting fund; and
- clarification of the scope of reporting requirements where audited accounts are not available.
For non-reporting funds that are invested at least 90 per cent by asset value in unlisted trading companies, gains realised on the disposal of the shares will be exempt from the tax charge on offshore income gains.
In relation to fiscally transparent funds, corporate investors will be able to look through all transparent offshore funds and the loan relationship rules will apply to the underlying assets where relevant.
HM Government intends to make the regulations by late April 2011 and they will come into force before the end of May 2011.
Pension Fund Management and VAT
A case brought by the Wheels Common Investment Fund ("Wheels") and the National Association of Pension Funds ("the Wheels case") was heard before the First-tier Tax Tribunal from 10 February to 15 February 2011 on whether the management of occupational pension funds is exempt from VAT. The Tax Tribunal has now decided to refer the matter to the European Court of Justice ("the ECJ").
At the hearing, Counsel for Wheels based his case on the principles established in the earlier JP Morgan Fleming Claverhouse Investment Trust plc decision ("the Claverhouse case"), contending that, since occupational pension schemes facilitate investment in securities, they should be regarded as funds, and that it would be a breach of fiscal neutrality to treat them any differently from other funds that are regarded as special investment funds ("SIFs") and which are therefore exempt from VAT under EU law. In response, Counsel for HMRC argued that since occupational pension funds are not in direct competition with SIFs there is no breach in fiscal neutrality to treat them differently. Therefore, even if they can be said to be SIFs, the UK is acting legally in exercising its discretion to exclude them from the exemption.
As the Tribunal decided to refer the case to the ECJ, the parties to the case have now been asked to agree the exact questions being referred and to submit these to the Tribunal by 5 April 2011. (It is understood that HMRC expects the questions to be similar to those posed in the Claverhouse case). However it is not expected that the ECJ will hear the case until the first half of 2012. A further update will be issued when news of the decision reaches us.
HM Treasury's Second Consultation on the New UK Regulatory Structure
HM Treasury published on 17 February 2011 a further consultation paper on the new UK regulatory architecture, A new approach to financial regulation: building a stronger system. The consultation builds on the government's proposals announced in its July 2010 consultation paper and reflects the responses to that consultation, (including the House of Commons Treasury Select Committee's report on the new structure published in February 2011).
The new regulatory body responsible for conduct of business regulation, as well as most of the FSA's existing market regulation functions, is now to be called the Financial Conduct Authority (or "the FCA"). (Its previous working name was "the Consumer Protection and Markets Authority" (or CPMA) The names of the other two new regulatory bodies, the Financial Policy Committee ("the FPC") and the Prudential Regulation Authority ("the PRA") remain unchanged.
The consultation paper includes further details and proposals in the following key areas:
- the primary legislation introducing the reforms will amend rather than repeat and replace the Financial Services and Markets Act 2000 ("FSMA");
- the core statutory objectives of the new regulatory bodies: the FCA's objectives are to include a greater focus on competition issues;
- the macro-prudential tools potentially available to the FPC are to be designed to address systematic risk, including capital requirements, liquidity and collateral requirements;
- the firms to be dual regulated by the PRA and the FCA, which will include investment firms classified as BIPRU 770K firms, and also Lloyd's of London, as well as other insurers and deposit-takers;
- the accountability mechanisms for the new regulators;
- co-ordination between the new regulators, including in crisis management situations;
- the PRA's "judgement-led approach" to prudential regulation;
- the FCA's more "interventionist" approach to conduct of business and product regulation (which is likely to be very controversial in the financial services industry and with product providers in particular); and
- the extended enforcement powers of the PRA and FCA, including powers to publicise that a warning notice has been issued to a firm (and which have already attracted adverse media comment).
Whilst the Treasury's consultation document is a further important stage in the restructuring of the UK's financial regulatory architecture, important details on how the new bodies will function in practice are still awaited despite this 138-page consultation.
With regard to the Financial Ombudsman Service ("FOS") it is proposed that it will remain as an independent dispute resolution service, and the FCA will take on the FSA's existing functions in relation to the FOS. A number of changes are planned, however. The statutory function and responsibilities are to remain quite distinct from those of the regulatory body and this distinction should become clearer as a result of the FCA's greater focus on improving firms' retail conduct and the action it will take to tackle potential causes of consumer detriment before their effects become widespread. The FCA is also proposed to have tools at its disposal to act early and decisively, including new regulatory powers to require firms to establish and operate consumer redress schemes. This is to ensure that the FOS is then able to focus on its function to deal with individual disputes on a case-by-case basis. (In addition, there will be a statutory obligation for the FOS and the FCA to publish and maintain a memorandum of understanding to replace the voluntary understanding that already exists between the FOS and the FSA).
Comments are invited on a series of broad questions raised in the consultation until 14 April 2011. The Government then intends to publish a White Paper and draft primary legislation for Parliamentary pre-legislative scrutiny, but remains committed to its timetable for introducing the primary legislation in Parliament in mid-2011 and establishing the new regulatory system by the end of 2012.
Meanwhile, the FSA intends to make the transition to the new regulatory structure at the end of 2012, and in April 2011 will replace its currency risk and supervision business units with a prudential business unit and a consumer and markets business unit. Following that, the focus will be on progressively changing the regulatory processes (insofar as the FSA's current statutory remit allows this) so that the FSA can begin to operate distinct prudential and conduct approaches to regulation. This approach is intended to provide an opportunity to "road test" some important elements of the new supervisory structure before the formal transition at the end of 2012.
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