Opinion of the Economic and Social Committee on the "Proposal for a European Parliament and Council Directive amending Directive 85/611/EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS)"(1)

(1999/C 116/11)

On 26 October 1998 the Council decided to consult the Economic and Social Committee, under Article 198 of the Treaty establishing the European Community, on the above-mentioned proposal.

The Section for Single Market, Production and Consumption, which was responsible for preparing the Committee's work on the subject, adopted its opinion on 11 February 1999. The rapporteur was Mr Levitt.

At its 361st plenary session (meeting of 25 February 1999), the Economic and Social Committee adopted the following opinion with 60 votes in favour and four against.

1. Introduction

1.1. Directive 85/611/EEC(2) on Undertakings for Collective Investment in Transferable Securities (UCITS) established a "single licence" regime for Collective Investment Undertakings (i.e. an authorisation for products to be sold throughout the Single Market on the basis of approval in one Member State). Collective Investment Undertakings are now established in all Member States, whereas before the adoption of the Directive in 1985 they were not widespread. However, the Directive's impact has been limited by the fact that its single licence regime applies only to investments in transferable securities (essentially shares and bonds) traded on a stock exchange or similar regulated market.

1.1.1. It is now proposed to maintain the basic principles of the UCITS Directive but to extend its scope. These basic principles are: investor certainty, transparency, asset quality and proper regulation. This cannot guarantee that individual investors will never make a loss, but they can be confident that UCITS will comply with sound basic standards and that they will be properly regulated.

1.1.2. Markets have developed since the original Directive was adopted in 1985. That Directive was itself the result of proposals originating in the 1970s. Since 1985 financial markets have developed, variations in the implementation of the Directive by different Member States have emerged, and the importance of the Single Market in financial services has been reflected in the EU's aims and legislative development, including the clarification of some of the key principles and concepts. In a number of regards, therefore, the 1985 Directive needs to be brought up to date.

1.2. The proposed legislative framework would, according to the Commission, ensure a high level of protection for individual investors by setting standards both for the investment products and for the managers undertaking the investment. As regards the products, the proposed rules would ensure that funds raised from the public were invested in suitably qualified assets and that risk-spreading requirements were respected. As for the portfolio mangers, the rules would impose strict market access and operating conditions and controls.

1.3. Two amending Directives have been proposed(3). The focus of this Opinion is on the proposal concerning the "product" (the investment fund). It would extend the range of financial assets in which collective investment undertakings benefiting from the single licence may invest. In future, UCITS would be permitted to invest not only in listed shares and bonds, but also in bank deposits (cash funds), money market instruments (money market funds), standardised options and futures contracts dealt on regulated exchanges and in units of other collective undertakings (funds of funds). The proposed rules on risk spreading would also recognise the validity of new investment management techniques already widely and successfully employed, such as those based on investing in shares of different issuers according to the same weightings as is used in the basket on which a particular stock-index is based.

1.4. The other proposal(4) focuses on the financial intermediary which may manage UCITS and is the subject of a separate Opinion(5).

1.5. The UCITS proposals were foreseen in the Action Plan for the Single Market and are part of the effort to improve the functioning of the Single Market in financial services, in accordance with the request of the 15-16 June European Council in Cardiff.

1.6. The ESC in its opinion(6) on the Commission's original 1976 UCITS Proposal concluded that "while the proposed directive may be considered as a step forward ... it does not fully achieve the objectives mentioned ... namely (i) to improve conditions of competition, (ii) to standardise as far as possible the obligations imposed on UCITS, (iii) to abolish restrictions on the free movement of units and (iv) to ensure a better inter-penetration of capital markets."

1.7. Those criteria are still relevant. The present proposal is intended to improve their attainment.

2. Summary of the Commission document

2.1. Overview

The aim of the proposal, according to the Commission, is to remove barriers to cross-border marketing of units of collective investment undertakings through:

2.1.1. the extension of the freedom to be marketed throughout the EU collective investment undertakings investing in financial assets other than transferable securities: i.e. to units of other collective investment undertakings; money market instruments; bank deposits; standardised options and futures contracts;

2.1.2. amendments in the light of new portfolio management techniques to allow for "tracker" funds, where shares representing the underlying assets of an index are held and which enable the ceiling of 10 % investment in one issuer to be raised to a maximum of 35 %. The aim is to allow for flexible risk spreading;

2.1.3. removal of uncertainties concerning the definition of "transferable securities" to make it clear that money market instruments are covered;

2.1.4. The proposal would also introduce minimum risk control measures concerning transactions which Member States allow UCITS to enter into for purposes of "efficient portfolio management", especially the use of financial derivatives, including over the counter (OTC) derivatives and securities lending transactions where the UCITS acts as lender.

2.1.5. The proposal clarifies the requirement that subsidiaries of UCITS should normally be incorporated in a Member State.

2.1.6. The proposal ascribes to the UCITS Contact Committee, set up by the original UCITS Directive, comitology powers for the introduction of technical adaptations to the Directive.

2.1.7. The proposal introduces new transparency requirements to provide investors with additional information, including replication of stock-indices and investment in financial derivatives.

2.2. Specific Amendments (see Annexe)

2.2.1. Amendment 1 - Article (1) 2 defining UCITS enables investment funds to invest in a wider range of financial assets.

2.2.2. Amendment 2, adding a new paragraph 8 to Article 1 makes clear that "transferable securities" may include different types of instruments and is intended to ensure a clearer common understanding among Member States; "money market instruments" are considered to be included in the category of "transferable securities".

2.2.3. Amendment 3 proposes additions to paragraph 1 of Article 19 of the original Directive and identifies liquid financial assets other than listed transferable securities which qualify as eligible investments for UCITS. The list includes units of other UCITS, bank deposits, financial futures and options dealt in on regulated markets and non-listed money market instruments issued by qualified issuers.

2.2.4. Amendments 4 and 5 propose deletions to Articles 19.2.b and 19.3 and Article 20 and follow from the inclusion of money market instruments in the definition of "transferable securities".

2.2.5. Amendment 6, proposes additions to Article 21 in the original Directive which permits UCITS to employ "techniques and instruments" for efficient portfolio management without specifying the types of techniques and instruments. Taking into account the new portfolio management and hedging techniques which have been developed since the Directive was adopted in 1985, this amendment is intended to clarify that UCITS may conclude transactions involving all sorts of financial derivatives, including derivatives not dealt in on regulated markets [over the counter derivatives (OTC)] and that UCITS may act as lenders in security lending transactions. Transactions would, however, be subject to measures intended to eliminate or reduce to an acceptable degree the risks involved.

2.2.6. Amendment 7, proposes a new Article 22a to allow the replication of stock indices. According to the existing Article 22, UCITS may invest no more than 10 % of their assets in securities issued by the same issuer. Today, a widely adopted management technique for UCITS investing primarily in shares is based on the replication of the composition of certain stock-indices which, according to the Commission, represent a useful benchmark for such investments. The aim of the amendment is to introduce more flexible risk-spreading requirements for investments in shares involving underlying assets of qualified stock-indices, to facilitate the replication of such indices. The amendments would raise the limit in Article 22 to a maximum of 35 % for investment in shares from the same issuer when the aim of the UCITS is to replicate the composition of an approved stock-index.

2.2.7. Amendment 8 proposes a new Article 24. At present UCITS may only invest up to 5 % of their assets in other UCITS. This ceiling has been considered unnecessarily restrictive by Member States and the investment fund industry and the amendment would raise the ceiling to a maximum of 35 %, provided that the UCITS invests in at least five different collective investment undertakings in order to ensure diversification of risk.

2.2.8. Amendment 9 proposes a new Article 24a to facilitate investment in bank deposits. Amendment 9 also proposes a new Article 24b. At present UCITS are permitted to invest in derivatives only for purposes of "efficient portfolio management" and the amendment is, according to the Commission, intended to allow UCITS to invest, as part of their general investment policy, in standardised financial futures and options dealt in on regulated markets.

2.2.9. Amendments 10 and 11 amend Article 25.2 of the original Directive and set a ceiling of 10 % of the UCITS assets which may be invested in money market instruments issued from a single body.

2.2.10. Amendment 12 proposes a new Article 25.3.e intended to clarify that subsidiaries of investment companies constituted as UCITS should normally be incorporated in a Member State on the grounds that such subsidiaries should be considered part of the organisational structure of such companies which, in order to ensure effective supervision, have to be entirely located within the EU. The new Article 25.3.d identifies the exceptional cases in which UCITS may hold subsidiaries in third countries.

2.2.11. Amendments 13, 14 and 15 (Article 26.1.2, Article 41.2 and Article 42) refer to the technical consequences of broadening the investment possibilities for UCITS.

2.2.12. Amendment 16 proposes a new Article 53.a to enable comitology powers to be exercised by the UCITS contact committee under Article 53 of the original Directive to facilitate technical amendments to the Directive in future.

2.3. There are a number of respects in which the existing text of the proposal needs to be clarified or amended, as explained below.

3. Specific comments

3.1. The amendments summarised in section two above are to be welcomed. They extend the scope of the financial assets concerned, subject to a number of strict conditions.

3.2. Money Market Instruments (Amendments 2 and 3)

3.2.1. The treatment of money market instruments in proposed Article 1.8(b) together with proposed Article 19.1(i) is confusing. Article 1.8(b) refers to money market instruments other than those which, for the purposes of Article 1.8(b), are normally dealt in on the money market. If it is intended to allow investment in money market instruments dealt both on a regulated market and on non-regulated markets, the wording of Article 19.1(i) "money market instruments which are not dealt in on a regulated market" should be replaced by "money market instruments other than those which, for the purposes of Article 1.8(b), are normally dealt in on the money market".

32.2. The second indent of Article 19(1)(i) should read as follows: "issued by an undertaking any securities of which are admitted to official listing on a stock exchange or are dealt in on another regulated market which operates regularly and is recognised and open to the public or...".

3.3. Funds of Funds [Amendments 3 and 8, amending Article 19.1(e)]

3.3.1. The proposal to allow the developments of "funds of funds" is to be welcomed. This allows UCITS to create balanced, diversified funds in a manner which is much more economical than creating a new, entirely separate fund to invest directly in stocks and bonds.

3.3.2. The Commission recognizes that the restriction on the ability of UCITS to invest up to 5 % of their assets in other UCITS should be lifted, and this is to be welcomed. The question arises as to what should be the new limit. On the one hand, there is the need to ensure prudential protection of investors through risk-spreading, i.e. the avoidance of excessive investment in a single or narrow range of entities. On the other hand, a single UCITS in which other UCITS may invest would itself have a widely diversified portfolio. The former consideration implies a limit on the extent to which a UCITS can invest in another UCITS, while the second consideration implies that the limit need not be very low. For example, approximately half of global market capitalisation consists of US equities, so it could be argued that a UCITS solely devoted to the management of a widely diversified US portfolio could form 50 % of the assets of another UCITS - so, according to this reasoning, the 35 % ceiling o investment in another UCITS is too low. On the other hand, a jump from the present 5 % ceiling to 50 % is rather radical, nd on balance the Commission proposal of a 35 % limit appears to be a reasonable compromise which, in the Commitee's opinion, should be adopted.

3.3.3. The Committee notes that there is no provision for a waiver from the percentage share of the "fund of funds" in the liabilities of each eligible UCITS, which is kept to a maximum of 10 %. The Committee thinks this ratio should be raised to 35 % because the 10 % rule is highly restrictive: it is difficult to check compliance with a ratio where the denominator changes every day because it represents the assets of another UCITS. This difficulty will obviously be heightened for the investments of the "fund of funds". No such ratio is laid down for direct investments by an individual or legal entity.

3.4. Inconsistency between the treatment of derivatives (Amendments 6 and 9, proposing Articles 21.3 and 24b)

3.4.1. The proposal to amend Article 21 clarifies that all UCITS can invest in over the counter (OTC) derivatives for purposes of efficient portfolio management, and this is to be welcomed. This does not change the status quo, at least as it exists in several Member States. However the new Article 24b does not allow UCITS to use such derivatives in specialist futures and options funds, where only "standardised" contracts may be used. This could also unjustifiably restrict the activities of UCITS operating in countries where derivatives exchanges are less well developed.

3.4.2. The case for the distinction is not made. While it is true that OTC derivatives bring with them counterparty risk which is not present with exchange-traded standardised contracts, this risk needs to be controlled rather than facing a blanket prohibition.

3.4.3. The appropriate response is to require the competent authorities to ensure that an appropriate quality and spread of counterparties are used, subject to appropriate limits, and that controls and prices are strong, with positions revalued at the same interval as the fund and that the risk is duly monitored by the UCITS (see also 3.4.6 below).

3.4.4. Derivatives can be used both to reduce and manage risk as well as to increase risk but Article 24b appears to be written from the viewpoint which regards derivatives as only increasing risk.

3.4.5. Cover requirements for derivatives (Article 24b.1). The Directive requires that derivatives exposure should be covered by other assets. This is to prevent derivatives being used as leverage for large uncovered exposures. According to the ninth recital, the Commission is asking for derivatives deals to be covered by underlying securities of the same type (e.g. shares contracts covered by shares). In the Committee's view, such an obligation would prevent all deals other than hedging. It therefore seems unnecessarily restrictive and should be abolished. It is not necessary that there should be exact congruence between the underlying portfolio and the derivative exposure because UCITS would not then be able to use derivatives to obtain protection from risk because they would be holding the same position in both the derivative and the covering securities. Full correlation between the underlying portfolio and the derivatives exposure is unnecessary, but what is important is that the fund should be able to meet its liabilities.

3.4.6. If UCITS undertake OTC transactions, the counterparties to such transactions should be qualified institutions recognised by the UCITS competent authorities and the assets should be capable of being valued at the same interval as the fund. The fund should be able to sell or liquidate the derivative instrument at any time, and the maximum exposure in respect of any one counterparty should be no greater than 10 % of the value of the fund.

3.4.7. There would be merit in bringing in a single article all the dispositions relating to UCITS' use of derivatives. This would enhance clarity. It seems to the Committee that it is also necessary to amend Article 21, so that UCITS may use derivatives based on any of the assets that they are permitted to hold. They should continue to be able to use foreign exchange derivatives to cover their foreign exchange exposure.

3.5. Stock Lending (Amendment 6, inserting Article 21.4)

3.5.1. Securities lending transactions can be collateralised not only by cash or securities but also by letters of guarantee. The words "or other appropriate security" should therefore be added after "appropriate collateral".

3.5.2. The Commission proposal rightly suggests the safeguard of a third party custodian when a UCITS lends securities to its depository. However, a similar effect can be achieved by other means, for example the use of segregated accounts. The Directive should be amended to allow UCITS to lend securities to their depositories, provided that they take all the steps necessary to avoid any confusion between the assets of the depository and the collateral raised for the benefit of the UCITS. At the very least, the collateral must be registered in a guarantee account opened in the name of the UCITS on the books of the depository.

3.6. Replication of Stock Indices - Tracker Funds (Amendment 7, inserting new Article 22a)

3.6.1. The present Directive can prevent UCITS investing to replicate the composition of a certain stock-index, when a particular company issue accounts for more than 10 % of a national stock market. This is because UCITS cannot invest more than 10 % of their assets in the securities of a single issuer.

3.6.2. The proposed directive would increase this limit to 35 % in the case of the index approved by the competent authorities. However, the increase in the limit would only be allowed where the UCIT seeks to "replicate the composition of an index", and full replication of an index can be an expensive method of reproducing the economic effects of an index, especially for smaller funds where statistical sampling techniques and the use of derivatives may be used to seek to replicate the return.

3.6.3. Consequently, in Article 22a.1 the words "the aim of the UCITS investment policy is to replicate the composition of a certain stock index" should be replaced by "the management objective corresponds to the evolution of a specific index of financial instruments". The Committee feels that the draft's wording is too strict and would not allow products which aim for performance which exceeds a particular index.

3.6.4. The proposal to increase the investment limit to 35 % for tracker funds alone raises two questions. Is it prudent? Does it have unintended distortive effects?

3.6.5. The 35 % limit is too high, even if a 10 % limit is too low. The rationale for UCITS is to allow small investors to have the benefits of diversification normally reserved for investors able to afford large portfolios. A limit of 20 % should be sufficient to ensure that all major indices can be tracked. This should be supplemented by an aggregate limit of 50 % of the total assets of the fund, composed of investments in individual entities each of which is over 10 % of the fund's assets. It may be noted that the proposal to raise the ceiling on investment in a specific entity reflects the fact that a certain company may represent well over 10 % of the market capitalisation in some Member States (i.e. it accounts for more than 10 % of the shares in the stock index). However, one of the effects of the single currency will be a reduction in the emphasis on national stock indices and the growing importance of pan-EU indices, as investors switch the focus of their portfolio management from countries to sectors and to major international companies. A number of pan-European stock and bond indices have already been developed to reflect this trend and to meet investors' needs. Consequently, a major international company which represents over 10 % of the stock index of its country of origin will account for a substantially smaller proportion of the assets in the pan-EU index. In short, while the proposed increase in the ceiling is to be welcomed, the problem which it addresses seems likely to diminish in significance over time.

3.6.6. The proposal, by reserving a higher limit for tracker funds, could unintentionally distort the market in their favour and to the detriment of managed funds. Managed funds seek to beat indices. The only way to do this is to be overweight in certain stocks. If managed funds are restricted to a 10 % limit, there could be circumstances where they could not even have a neutral weighting for a particular issuer, let alone be overweight in that stock. If the diversification rules are to be relaxed, they should be relaxed for all funds.

3.6.7. The requirements of Article 22a(2) should not apply to index-tracking funds.

3.7. Cash Funds (Amendment 9, inserting new Article 24a)

3.7.1. The proposal to allow the creation of funds investing in cash deposits is to be welcomed. It is also right that such funds be subject to appropriate regulations. However, these should be both relevant and proportionate. The Commission's proposal should be revised to reflect this.

3.7.2. Article 24a.1 limits investments to credit institutions which offer "sufficient financial and professional guarantees". EU credit institutions are subject to the authorisation criteria and capital and risk-spreading requirements of EU Directives. These take up internationally agreed standards which are generally applied to all internationally active banks. It is not clear what the proposed Directive is seeking over and above this. In addition, the application of a 10 % limit suggests that bank deposits are as risky as stocks and bonds. This is not the case, and a limit of 30 % would be more appropriate to reflect the high degree of regulatory oversight to which EU banks, and other banks which meet international standards, are subject.

3.7.3. Article 24a.3 requires funds to warn investors that the UCITS invests in bank deposits. It is right that investors should be informed clearly about the nature of the UCITS and its risk profile but this is disproportionate. This provision, which is very similar to Article 24b.2 on risk warnings for derivatives, treats deposits as if they were as risky as derivatives.

3.7.4. Finally, Article 24a.4 forbids deposits with the fund's depository. This is too absolute. Provided that appropriate procedures are in place to ensure that there is appropriate diversification and independent investment analysis, and provided that investment decisions are truly independent, then there is no need for a blanket prohibition.

3.7.5. This article also highlights a lacuna in the Directive. Limits are couched in terms of investment limits. This could leave other forms of exposure uncovered. For example, in addition to a deposit, a UCITS might have exposure to a credit institution arising from a bond or equity holding, and counterparty credit risk arising from an OTC derivatives transaction. There is a case for inserting global exposure limits into the Directive.

3.8. Risk Warning on Futures and Options Funds (Article 24b.2)

3.8.1. The proposal requires that "promotional literature must include a prominent statement drawing attention to the fact that the UCITS invests ... in the financial futures contracts and options. These documents shall also contain a warning that the investment in the units of such a UCITS is only suitable for experienced investors".

3.8.2. Such warnings are highly appropriate for futures and options UCITS which are used to take speculative positions. However, derivatives can be used to create funds which are entirely appropriate for inexperienced investors where such a warning would be misleading, for example:

- index tracking funds - derivatives can often be used to track an index in a manner which is cheaper and more efficient than holding all the components of the basket in the appropriate proportions; and

- protected funds - derivatives are used to limit the capital losses which investors can suffer on equity investments, including the offering of guarantees that investors will suffer no capital loss.

3.8.3. The proposition that investors in futures and options funds always need additional warnings and that they are only suitable for experienced investors therefore needs to be qualified. As they stand, these proposals contradict the Commission's intention to allow the development of index funds.

3.9. Ban on use of non-EU Subsidiaries [Amendment 12, amending Article 25.3(e)]

3.9.1. The Commission proposes to ban the use of non-EU subsidiaries by UCITS on the grounds that effective supervision requires the location of any subsidiaries within the EU. This is not reasoning which is applied elsewhere in single market legislation, and a number of Member States do allow UCITS to make use of such subsidiaries. Provided the competent authorities are satisfied that they can effectively supervise the activities of a non-EU subsidiary and that it does not threaten the interests of unit-holders, there is no need for a blanket prohibition. A ban may have a negative effect if, for example, it prevented UCITS being given the benefit of double taxation treaties between third countries

4. Conclusions

4.1. The ESC welcomes and approves the Commission's proposal and urges the Council and Parliament to consider it with all speed. But there are a number of points on which further attention and some amendments appear to be required.

4.1.1. Specifically, the Committee urges the Commission to take account of its concerns regarding:

- ambiguities in the Draft Directive about money-market instruments (3.2 above);

- inconsistency in the treatment of derivatives (3.4);

- restrictions on stock lending (3.5);

- replication of stock indices and tracker funds (3.6);

- inconsistent treatment of tracker funds and actively managed funds (3.6.6);

- restrictions on investment in bank deposits (3.7);

- risk warnings on investment in futures and options funds (3.8);

- the ban on the use of non-EU subsidiaries (3.9).

Brussels, 25 February 1999.

The President

of the Economic and Social Committee

Beatrice RANGONI MACHIAVELLI

(1) OJ C 280, 9.9.1998, p. 6.

(2) OJ L 375, 31.12.1985, p. 3.

(3) COM(1998) 449 final and COM(1998) 451 final.

(4) COM(1998) 451 final.

(5) OJ C 101, 12.4.1999.

(6) OJ C 75/10, 26.3.1977.

APPENDIX

to the opinion of the Economic and Social Committee

This appendix sets out how the Commission's proposal amends the 1985 Directive.

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