EN COMMISSION OF THE EUROPEAN COMMUNITIES Brussels, 12.7.2005 SEC(2005) 947 COMMISSION STAFF WORKING PAPER Annex to the :





GREEN PAPER



ON THE ENHANCEMENT OF THE EU FRAMEWORK

FOR INVESTMENT FUNDS







Background Paper







{COM(2005)314 final} Table of contents Introduction 1.UCITS and asset management company 1.1.The UCITS “model” 1.1.1.Economic trends 1.1.2.The UCITS passport 1.1.3.Legal/administrative barriers to UCITS Notification procedure The product rules 1.2.AM company framework: passport and other permitted activities 1.2.1.The asset managers Fund processing functions An important role: voting rights exercise

1.2.2.The management company passport UCITS asset management company Self-managed investment companies 1.2.3.Other permitted activities of management companies 2.Investor protection 2.1.Managing conflicts of interests in asset management 2.2.Organisational controls on funds and their managers 2.2.1.Depositary as custodian of investor assets 2.2.2.Depositaries’ control over operation of funds 2.3.Regulation of sales process 2.3.1.General disclosure requirements 2.3.2.Disclosure of fees and commissions 2.3.3.Legal uncertainties in UCITS distribution framework UCITS-Directive: harmonisation of the public marketing of UCITS Advertisement rules under UCITS directive MIFID rules 2.4.Investor confidence 3.Changing features of EU fund industry 3.1.Additional single market freedoms? 3.1.1.Greater freedom of choice of depositary?

3.1.2.Cross-border mergers and pooling techniques Cross-border fund mergers Cross-border pooling techniques 3.2.New distribution pattern 3.2.1.Changing conflicts of interest? Conflicts of interest in integrated architecture New conflicts of interest in fund distribution Considerations on distributor commissions 3.2.2.Clarification of rules for new distribution channels E-commerce and distance marketing Listing of investment funds 3.2.3.Needs for clarification of private placement 3.3.Changing risk patterns 3.3.1.Potential conflicts of interest and fund governance Debate on fund governance and fund management oversight What impact on the current governance framework? 3.3.2.Increasing operational risks Is outsourcing a solution? Capital requirements 4.Overall asset management landscape

4.1.Other collective investments: non-harmonised products 4.1.1.Development of non-harmonised products competing with UCITS 4.1.2.Policy issues regarding non-harmonised products Market fragmentation and risk of regulatory arbitrage Retail investor protection Financial stability concerns Depositary role in respect of alternative investment strategies 4.2.Level playing field with other financial products competing with funds 4.2.1.With pension funds (Fund schemes as occupational pension schemes) 4.2.2.With life-insurance Regarding disclosure requirements In particular: regarding unit-linked insurance products Regarding tax treatment 4.2.3.With investment certificates Annex A: Pooling techniques, advantages, risks Annex B: Some national frameworks related to alternative funds Background Paper on UCITS Review Introduction In most of Europe, the intermediation role between savers (money offer) and borrowers (money demand) has historically been played by the banks. In recent years, non-bank financial institutions have emerged to meet the demand from investors who prefer entrusting their money to specialised institutions (asset managers), better able to diversify risks and to improve the performance of their portfolio. This has led to an important expansion of the asset management industry which has developed a wide range of products (collective investment schemes alongside discretionary management), investing in a wide range of markets and instruments and more adapted to investors’ preferences. Asset management plays a key role in the economy by allocating economic resources and investing in companies, thereby enabling real sector activity to expand and develop. Investment funds have also potential to assume greater importance as public sector pensions remain under funding pressure and occupational pension funds shift to defined-contribution basis.

EU legislation (Directive 85/611/EEC, so called “UCITS I” Directive) introduced in 1985 aimed at two objectives: §To facilitate the cross-border offer of investment funds for the retail investor, it designed an Undertaking for Collective Investment in Transferable Securities (UCITS) model, intended for cross-border circulation. §As a corollary to this, to protect retail investor by limiting fund risks through strict rules on the investment policy of funds. Institutionalised risk-diversification, through fixed investment limits, has proven to be one of the successes of the UCITS model. The discretion of the fund manager is legally restricted so that investors do not have to rely on the skills and the due diligence of the fund manager alone. Investment funds are emerging as the main market-based mechanism for asset-gathering and long-term savings management in Europe. In many Member States, they dwarf assets under management by life insurance and occupational pension vehicles. EU-wide, 28,830 UCITS funds have amassed some € 4,100 billion (78.75% of the European open-ended fund market) at the end of 2004. On the one hand, these figures show that the UCITS “label” has been successful. On the other hand, the creation of a European passport for UCITS and a greater integration of the capital markets in recent years, have not lead to the anticipated acceleration in the sales of cross-border funds. Excluding so-called “round trips”, not more than 16.1% of the total number of UCITS are truly sold on a cross-border basis, i.e. to one or more countries which are not the national home of the sponsor company of the UCITS. Nevertheless, this figure is increasing (from 13% in 2002). Moreover, among a total of €234 billion in new capital placed in UCITS throughout Europe in 2004, the share of cross-border sales has been “surprisingly high, at around 60%”. The accession of 10 new Member States has enlarged EU financial markets, providing old Members with greater commercial opportunities. The fund market in most of the new Member States is still rather underdeveloped. According to FEFSI figures, at the end of 2003, net assets under management (UCITS and non-UCITS) in Poland, Hungary and the Czech Republic were respectively 0.153%, 0.075% and 0.072% of the total net assets for the EU-15. It remains, however, to be seen how the competition forces will affect the new Member States’ often less mature asset management industry and to which extent cross-border sales will increase. Source: www.hedgefundintelligence.com + Van Hedge Fund Advisors International + EFAMA + EVCA Basically, fund distribution in most countries is still dominated by national financial groups which offer in-house products. It is therefore difficult and costly for foreign fund promoters to compete with well established distribution channels. Only in the case of the UK, is the share in distribution of independent intermediaries (Independent Financial Advisers or IFAs) much higher than that of banks. Other distribution channels are insurance companies and increasingly the internet. The situation is, however, changing gradually as banks are opening their distribution networks to third party funds. This allows them to attract clients seeking “the best product in the market”, enlarge their offer (particularly for specialised products) and improve their profitability (since fund manufacturers often “retrocede” part of the fees and contribute to the marketing costs). The move towards open architecture is, however, slow and the potential for a more “open” distribution still high. The 2001 amending directives (2001/107/EC and 2001/108/EC) require the Commission to assess the functioning of the directive. The first objective of the UCITS review is to assess whether, and to what extent, UCITS legislation has facilitated the integration of the single market for harmonised funds. The UCITS review must also consider more far-reaching issues concerning the scope of the harmonising framework (e.g. hedge funds) and regulatory design (role of depositaries, self-managed investment companies). Article 2 of the Directive 2001/108/EC of the European Parliament and of the Council of 21 January 2002 amending Council Directive 85/611/EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS), with regard to investments of UCITS (Official Journal L 041, 13/02/2002 P. 0035 – 0042) 1. No later than 13 February 2005, the Commission shall forward to the European Parliament and the Council a report on the application of Directive 85/611/EEC as amended and proposals for amendments, where appropriate. The report shall in particular: (a) analyse how to deepen and broaden the single market for UCITS, in particular with regard to cross-border marketing of UCITS (including third-party funds), the functioning of the passport for management companies, the functioning of the simplified prospectus as an information and marketing tool, the review of the scope of ancillary activities and the possibilities for improved collaboration of supervisory authorities with respect to common interpretation and application of the Directive; (b) review the scope of the Directive in terms of how it applies to different types of products (e.g. institutional funds, real-estate funds, master-feeder funds and hedge funds); the study should in particular focus on the size of the market for such funds, the regulation, where applicable, of these funds in the Member States and an evaluation of the need for further harmonisation of these funds; (c) evaluate the organisation of funds, including the delegation rules and practices and the relationship between fund manager and depositary; (d) review the investment rules for UCITS, for example the use of derivatives and other instruments and techniques relating to securities, the regulation of index funds, the regulation of money market instruments, deposits, the regulation of "fund of fund" investments, as well as the various investment limits; (e) analyse the competitive situation between funds managed by management companies and "self-managed" investment companies. In preparing its report, the Commission shall consult as widely as possible with the various industries concerned and with consumer groups and supervisory bodies. (…) The assessment of the effectiveness of the UCITS legislation must be undertaken having regard to the twin goals of a high level of investor protection and integration of markets for harmonised funds on the basis of the UCITS ‘product passport’. From a longer term perspective, social and economic developments (contribution to finance pensions, Lisbon agenda, competitiveness of EU…) as well as new trends and emerging risks in asset management can fit deeper consideration on functioning of the asset management business. For EU legislator, the objective should be to facilitate the emergence of a cost efficient and dynamic European fund industry that deserves the trust of its retail investor base. 1.UCITS and asset management company

1.1.The UCITS “model” 1.1.1.Economic trends The market for UCITS funds has grown rapidly, with the total number of funds in Europe rising from c. 10,000 in 1993 to over 28,000 in 2003. The fastest growth was recorded in the mid-1990s, although the number of funds has since reached a plateau; contracting slightly in 2003 (as showed in the table below). In the same year, this stagnation contrasted sharply with a 20% increase in the number of active cross border funds. Cross border funds, as a proportion of the UCITS market Fund type 2002 2003 change Total funds 28,459 28,189 -0.9 % Cross border funds 3,750 4,529 20.8 % Cross border funds / Total funds 13.2% 16.1% Source: FERI; Lipper Next figure illustrates that in 2003 the number of cross-border notifications increased in all but three Member States compared to 2001. Figure: Trends in cross-border notifications of UCITS Source: PWC & Lipper Despite this increase, the share of cross-border funds remains relatively modest, representing just 16% of the total number funds. In addition, having access to a market does not always mean being broadly sold. Thus, although the number of foreign funds in some Member States is an important proportion of the total number of funds available domestically, their market share may not be very significant. One of the reasons for this is the fact that big domestic financial groups, which control distribution networks, tend to offer in-house products. The diversity of EU Member State’s tax regimes is also considered as one important barrier to the trade of funds across borders . Barriers are sometimes the result of historical developments (and cultural preferences) or the desire to privilege the use of a particular investment vehicle (e.g. pension funds). Tax constraints generate often additional administrative requirements and are powerful financial disincentives. Concrete examples of such requirements are the need to appoint a tax representative or to make a complex tax computation . A clear illustration of a financial disincentive could be the fact that dividends distributed by foreign funds are subject to a withholding tax. Further identified barriers to a greater integration of the European market for investment funds lies in the obstacles to cross-border fund mergers and pooling techniques. Finally, cross-border transaction processes are characterised by inconsistent operational protocols which put up costs. Finally, the fact that client preferences vary from country to country makes it difficult for fund manufacturers to create a “one size fits all” product that can be sold across the EU market. Investors often prefer funds investing in a particular instrument (e.g. national stocks vs. international stocks, debt instruments vs. equity…). In some countries they may demand particularly products that “guarantee” their capital or a certain return. Sometimes clients may find it more acceptable to pay redemption fees than entry fees. Quite often they will rely in their bank for advice (because this has always been their partner for all kinds of financial operations). And finally, in a few countries, investors seem to feel comfortable using the new technologies to build their portfolios. It seems, however, that the main cultural obstacle highlighted by the industry would be the existence of different languages . All in all, very few consider that cultural barriers are insurmountable . As a result of those hurdles to the circulation of investment funds, the offer to investors continues to be fragmented and biased towards national products. Market fragmentation has led to a proliferation of the number of funds. These often have a sub-optimal size which impedes fund managers and administrators to properly benefit from lower costs derived from economies of scale. This translates into higher costs for the investors. Distribution in most EU countries has been traditionally dominated by local banks. This is the result of historical and cultural developments which led to a situation where universal banks were for many years the main intermediaries between borrowers and savers. Their prevalence on the European financial scene has been consolidated through mergers and acquisitions and an enlargement of the services provided (including asset management). They are the logical choice for many Europeans used to employ the services of “the bank around the corner” to deal with all kind of financial matters. Banks have traditionally offered customers only in-house products. The situation is different in the UK where banks have long faced competition in their role of financial intermediaries. Thus, the “polarisation” regime , introduced in 1987, has supported the development of Independent Financial Advisors (IFAs) as a distribution channel . The recent entry into force of the “de-polarisation” regime may, however, affect the UK’s distribution structure . Despite their traditional tendency to distribute “proprietary” funds, banks are starting to open their distribution networks to third party funds (open architecture). This allows them to attract clients seeking “the best product in the market”, enlarge their offer (particularly for specialised products) and improve their profitability. However, the move towards open architecture is slow. Most European third party funds (TPF) distributors are “semi-open” with 33% of them offering less than 5 TPF and only 6% putting in their list of products more than 49 TPF . In addition to this, 46% of fund distributors do not offer even one TPF . Moreover, gradually, other non-bank financial institutions are starting to offer financial products (such as funds) and services. Nevertheless, they have to compete with the well established and widespread bank networks. Insurance is another traditional distributor of funds which is particularly prominent in the UK, Sweden and Germany. Distribution via insurance companies often benefit from favourable fiscal treatment and, as in the case of banks, from widespread networks. The range/classes of products that they offer, even if similar to investment funds, may have other purposes such as the coverage of certain risks. They can also be less liquid since the policy is designed to be held for an agreed term and earlier redemptions may lead to heavy penalties.

IFAs, which are generally not tied to a particular product provider, act on behalf of the investors advising them on the most suitable product. In the UK, following the “de-polarisation”, to be able to hold themselves as “independent”, IFAs should provide advice on products from across the whole market and offer their clients the possibility to pay fees for the advice they receive. In other EU countries, with the exception of Germany, the role of IFAs in fund distribution is negligible. Internet is another channel that allows fund manufacturers to sell their products without having to develop costly local distribution networks. It is increasingly used by (ever more sophisticated) investors not only as a source of information but also to directly purchase investment funds. Additionally, it is becoming an important working tool for advisors. Many studies in the past years have predicted an important surge of volumes traded via fund supermarkets. For instance, the Heinemann report identified fund supermarkets (together with insurance companies) as a channel expected to expand the most in the 2003-2013 period. Likewise, the CERULLI report on European Fund Supermarkets estimated that between 10% (in Spain) to 25% (in UK and Germany) of the net new inflow into mutual funds by the end of 2005 would be via supermarkets. A high degree of market penetration has however not materialised yet. For instance, according to the FSA, the market share of fund supermarkets in funds distribution in the UK market is around 5%. To date, only in some Nordic countries does internet have an important market share in the distribution of funds. Recent estimates indicate that mutual funds’ assets on all platform-based systems were above € 60 billion at the end of 2003 which is a relatively small part of Assets under management for the whole industry. ‘Funds of funds’ have emerged as an easier way for asset managers to circumvent rigid distribution structures and to avoid the costs of setting local distribution systems. The diversification they offer seems to be appreciated by investors. However, they are often not aware of the double layer of fees that they are incurring. Recent studies point to a high annual growth rate for funds of funds in the near future. Wrapping the product and applying a management commission compensates for the lower margin associated to open-architecture and makes it an attractive strategy. Similarly, the changes introduced by the UCITS III directive should facilitate the marketing of fund of funds within the internal market. 1.1.2. The UCITS passport Development of a single market for investment funds was the legislator’s first concern. The product “passport” was the tool the UCITS Directive introduced in order to facilitate the free circulation of fund units. To this end, the UCITS Directive aimed at creating a diversified financial product with a low risk-profile suitable for retail investors. The directive contains both general and specific requirements. Regarding the general requirements, one can refer to the following: ·authorization of UCITS by the competent authorities of a Member State; ·sufficient good repute and sufficient experience of the directors of the depositary and the management company; ·with respect to the unit trust, approval of the management company, the fund rules and the choice of depositary; ·with respect to the investment company, approval of its instruments of incorporation and the choice of depositary. Furthermore, in order to protect investors, notably against market risks, the Directive applies a formal/quantitative approach by means of specific elements: ·Exhaustive enumeration of eligible assets (securities, money market instruments, deposits, investment funds and derivatives); ·Establishment of fixed quantitative investment limits (issuer concentration limits, counterparty risk, limits referring to a certain type of asset, limits referring to the issuance of an issuer; limit to market risk); ·Explicit exclusions or permission of certain investment techniques (no short sales, no borrowing, permission of index replication, permission of leverage through derivatives). The passport is based on the principle of mutual recognition. A UCITS which shall be marketed in another Member State needs to be authorised in its Home Member State. This authorisation is valid for all Member States because the conditions for the authorisation, the structure and the investment policy of UCITS have been coordinated. The UCITS is exclusively subject to the supervision of its Home Member State. The UCITS has only to comply with a simple notification procedure in the Host Member State which neither constitutes a re-authorisation nor a re-approval of the marketing of the product. The Host Member State authority has two months to verify whether the marketing arrangements comply with the provisions of the Directive and with its own marketing rules. The Host Member State will be able to require the fund to comply with the rules governing the marketing/advertising of UCITS on its territory as these rules have not been harmonised by the Directive. 1.1.3.Legal/administrative barriers to UCITS §Notification procedure Difficulties, costs and delays associated with the notification procedure, are perceived by market participants as a major obstacle to market integration. The “simple” notification procedure is being beset by practical problems. It is often confused with “registration” and seems sometimes in practice more to amount to an “authorisation of distribution” than to a mere notice of information. This is also due to divergent interpretations of the notification requirements themselves: some Member States require further information, translation requirements are diverse and more or less onerous, some Member States require the appointment of a local representative whereby the details of this appointment can vary. In terms of procedure, the average time limits for the notification procedure are widely variable and very often superior to two months. Supervisory authorities also have different practices regarding the start of the 2 months-period provided for by the Directive. Finally, the fees levied on the notification procedure and on the maintenance of the notification can considerably vary. Consequently, the notification procedure seems perceived as expensive and time-consuming. Some industry voices consider that the notification procedure sometimes does not facilitate the distribution of funds on a cross-border basis. It should be noted that the procedure is deemed to enable the Host Member State authority to exercise its control functions over the advertisement of the UCITS in accordance with local marketing rules, which are not harmonised. This automatically implies – at least to a certain extent – that the notification requirements are heterogeneously interpreted and applied because the authority has to ensure that the information delivered within the margins of the notification procedure corresponds to local requirements on marketing and advertising. Some industry actors have estimated that direct costs of initial notification can be roughly estimated to have totalled more than € 20 million euros by the end of 2003 for the whole industry. Adding the costs of maintaining notification across the EU, this would mean a cost of € 25 million per year for the industry as a whole. Apart from these direct costs, another one is the operational risk to asset management companies of failing to maintain registration. Consequently, provided that direct sales to retail investors are uncommon and that providers predominantly sell UCITS indirectly trough third party distribution, some industry players question the need for notification procedure. At this stage, regulators have not expressed a clear position about the costs and the benefits of the notification procedure. In addition, it should be noted that reduction of costs should be profitable to final investors, provided that savings are passed on to them. §The product rules

The product rules are divergently interpreted by the different Member States. The same product can be deemed as UCITS in one Member State and ruled out in another. UCITS have been successful in gaining consumer confidence mainly because of their determined scope. However, the complexity of many financial products and the speed of financial innovation results in a permanent emergence of new products. This makes it more and more difficult for national authorities, but also for fund managers to determine whether a product complies with the rules of the Directive. In some areas, such as the wider use of derivatives and the possibility to leverage a UCITS, these developments have been taken into account. Thanks to the Commission recommendation on derivatives 2004/383/2004 the rules on leverage and the use of derivatives can be applied in a way that gives fund managers more flexibility and certainty as regards the management of UCITS portfolios. Divergent interpretations of core directive provisions (e.g. on eligible assets) can lead to uncertainties as regards the question of whether the notified product actually fulfils the UCITS criteria or not. In this respect, the ongoing work to clarify definition of eligible assets is certainly one important step to achieve a harmonised understanding of investment rules characterizing the UCITS product. 1.2.AM company framework: passport and other permitted activities 1.2.1.The asset managers The asset management firm is responsible for the management of the investor’s assets. It “creates” the products according to clients’ preferences, market tendencies and their own in-house specialisation. Some asset managers are more or less independent departments or subsidiaries of a universal bank. In other cases, they are fully independent firms which have been created around the expertise of some managers in particular geographical markets, financial instruments or strategies. They are, therefore, often more specialised and offer a narrower range of (sometimes more sophisticated) products than the AM firm of a banking group. As other functions of the AM business, the fund management is also subject to changes aiming to rationalise costs and to increase the supply to clients. Thus, the asset management function may be outsourced to another asset manager. This can be done through the distribution of third party funds or by the use of multi-management. By spreading assets among multiple managers, investors can benefit from a diversification of management styles (and therefore of risks). Multi-management includes funds of funds (mainly for retail investors) and manager of managers (typically offered to institutional clients). Nevertheless, the double layer of fees may partly counter-weight the positive effects of diversification. As regards the concrete situation in the EU, different countries mean different situations. In continental Europe, the predominance of universal banks in the financial arena translates into a high proportion of asset managers belonging to those financial groups. The picture is somewhat different in UK where small independent asset managers (boutiques) are more heavily represented. It is, however, not clear which combination of tied/independent asset managers is the optimal one (i.e. which would enhance the efficient functioning of the AM industry). Furthermore, it is not established if both types of managers face the same constraints. Geographically, asset managers having the highest amount of assets under management are located in the UK, France and Germany. Unfortunately, it is difficult to find comparable sources of European data. §Fund processing functions The Asset Management Working Group (AMWG) highlighted in its final report that cross-border processing of fund units is a key issue for the European investment management industry. Actually, the industry claims that the European cross-border fund processing landscape is suffering from a high level of fragmentation at both trading and post-trading levels. For instance, orders are typically placed through bilateral arrangements between the distributors and the manufacturer. They are largely processed through domestic market infrastructures which are different from one market to the other. In some markets this is also true of settlement, whilst in others the settlement infrastructure is provided almost totally by central securities depository (CSD). In addition, execution of fund orders and initiation of settlement processes are often manual and differ among the many domestic markets. Fragmentation is also reflected by the huge variety of communication standards (still including phone calls or faxes, nevertheless being replaced by standardised protocols), distribution channels and business practices . This results in higher operating costs and operational risks in the transaction value chain and could represent a limitation to the future development of the fund sector/industry in EU. The move toward an open architecture increases the number of distribution channels and transfer agents (TA). The continuous growth of fund types will increase their number. Hence, processing volumes are expected to expand not only in terms of number of orders but also in terms of fund data. The funds industry in Europe would need to adopt an integrated flexible infrastructure and to improve processing efficiency in both domestic and cross-border fund sectors. These improvements require first co-operation among market players. The creation of the EFAMA/FEFSI’s fund processing standardization group at European industry level or the association DIAMS are two examples of this needed co-operation. Once European standards are embraced by the industry, they will need to be endorsed by organisations and implemented among industry actors. §An important role: voting rights exercise The fund managers’ primary responsibility is to manage the investments in the sole interest of their clients. In order to pursue this objective, fund managers have to act responsibly as shareholders among others by making considered use of their voting rights in companies they invest. As soon as March 2001, the Myners Report reviewing institutional investment in the United Kingdom, recognized that “effective intervention, when appropriate, is in the best financial interests of beneficiaries” and recommended that “[fund] managers should routinely consider the possibility of intervening in investee companies as one of the means of adding value for their clients”. While the UCITS Directive remains silent on shareholder activism, the so-called “Winter Report” and the Corporate Governance Action Plan go further without, however, proposing to make shareholder voting mandatory. Some Member States regulations strongly recommend the voting rights exercise, whereas other EU-countries require information from fund managers about the way they have used or not used their shareholders’ rights. The principle of transparency on the fund manager vote is broadly recognised. Thus, according to IOSCO, two principles should be respected by asset managers: §shareholder rights attaching to collective investment scheme (CIS) portfolio securities belong to the CIS – these rights should be considered by CIS operators and any exercise of those rights must be carried out in the best interests of the CIS and

§public disclosure of CIS practices relating to corporate governance both encourages proper exercise of rights and allows CIS investors to make informed investment decisions. That being said, the voting rights exercise by investment funds raises two kinds of issues. First, as far as the voting right exercise should be carried out in the sole interest of investors, the issue of possible situations of conflicts of interest which may arise in exercising shareholder rights by asset managers can be raised (e.g. when the asset management company is part of a financial group which could have various financial relationships with the issuer where the asset management company invested). The final investor and regulatory authorities should also be clearly informed about the asset management company position/policy related to the issuer and about the final behaviour of the asset management company. Second, exercising voting rights will not be cost free. The costs might, sometimes, outweigh the potential benefits of voting for the funds potentially leading to "free riding". When exercising voting rights, a management company must consider the sometimes extensive list of issuers in which its funds are invested, take into account more and more complex resolutions, attend General Meetings, expect timely and useful information from the issuers etc… This is even more relevant when the issuer is based abroad, which raises the question of vote in absentia and proxy voting. Considering such costs, some AM companies delegate the exercise of voting rights to specialised providers (voting agents offering research, analysis, proxy or electronic voting and vote disclosure services). Finally, it should be highlighted that the Commission’s services are considering proposal for a directive on shareholders’ rights. It would include a system designed at EU level, which would address some critical issues attached to cross-border voting. 1.2.2.The management company passport §UCITS asset management company The core business of a UCITS management company is the collective investment business. UCITS management company needs to be authorised in its Home Member State in accordance with the relevant provision of the Directive. The introduction of the management companies’ passport would therefore imply that a management company would be empowered to manage a UCITS constituted in another Member-State by the means of a branch or under the freedom to provide services. Cross-border collective investment management would therefore encompass setting up or managing UCITS in another EU-jurisdiction. Until now, management companies have not been able to avail of this possibility. §The option to set-up a UCITS in contractual form in another jurisdiction is clearly excluded by the text of the Directive. The Directive sets out that a UCITS shall be deemed to be situated where the management company of a contractual fund or a unit trust has its registered office. §With respect to corporate type of funds, the text of the Directive seems to evoke the possibility for a management company to set up UCITS in another EU-jurisdiction. However, the Directive does not provide for the necessary set of tools to put such a scenario into practice. The UCITS would be supervised by the authority of its Home Member State whereas the management company would be under the supervision of the Member State in which it had been authorised. Noting that the full management company passport is not really functional, respondents to the AMWG report’s consultation widely agreed with the Expert Group’s recommendation to broaden its scope. It is difficult, however, to assess the extent to which this will deliver significant commercial benefits (e.g. in terms of reduction of costs, acceleration of the market integration, supervision difficulties…). So far, the only solution to enable a management company to manage the assets of UCITS located in another jurisdiction is through delegation arrangements. But, this solution is limited. Under a typical scenario, the UCITS appoints a management company in its own jurisdiction which delegates its functions to a management company in another Member State. Otherwise the UCITS may take the form of a self-managed investment company which delegates functions to another management company located in another Member States. Delegation arrangements have the advantage of clear-cut legal responsibilities of the parties involved. The delegating entity will always remain legally responsible for the management of the UCITS and directly vis-à-vis the UCITS Home Member State authority. This includes its responsibility in case of misbehaviour of the management company to which the relevant functions have been delegated. Having supervisory perspective, such solutions may ensure that legal responsibility and lead supervisor responsibility remain in jurisdiction of delegating entity. It is not clear how the lead supervisor will perform the necessary regulation controls in respect of functions that are delegated cross-border. Despite providing some welcome flexibility, delegation is not a panacea. From a business perspective, delegation arrangements always require the involvement of a fully equipped and completely functional fund manager in the Home Member State of the UCITS which would then delegate the functions to the management company which genuinely intends to provide the respective service. This is a way round which is likely to produce additional and unnecessary costs. In addition, from a legal point of view delegating would never allow a full transfer of competences to the delegated management company intending to provide the service, since the delegating entity must not become an “empty shell”. In contrast, in the case of a “true” management companies’ passport there would be no need to have a separate entity in place in the jurisdiction of the UCITS. The management company could directly provide its services to the fund in another jurisdiction. Since it would be the genuine manager of the fund it could also provide all the services without any legal restriction. Special know-how or expertise of certain management companies could effectively be exploited. A “true” management companies’ passport could therefore contribute to facilitating the business of fund managers and might offer the prospects of a cost-efficient business organisation. This might also be beneficial for investors provided these advantages are passed on to them. On the other hand, the “true” management companies’ passport would lead to a split of supervision of the UCITS and the UCITS management company. The Directive does not provide for the specific measures to address this situation, e.g. to organise the joint collaboration of both supervisors involved or to resolve questions related to a potential misbehaviour of the management company. Currently, the supervisory authority responsible for the UCITS would have no legal means to call the management company directly to account because it is located in another jurisdiction. It is argued that spilt supervision would go against the inherent advantage of having one supervisor responsible for the manager and the fund (and its administration). §Self-managed investment companies The amendments of the UCITS-framework aimed at harmonising the operating conditions for self-managed investment companies, i.e. those investment companies which do not appoint a management company. In particular, the Directive aimed at aligning the operating conditions for self-managed investment companies with those of management companies. Therefore, minimum capital requirements and requirements for the internal organisation of the self-managed investment company were introduced. However, in contrast to management companies where the introduction of these requirements entailed the creation of an activity-related passport and an enlarged scope of permissible activities, self-managed investment companies, by virtue of their construction, do not benefit from further freedoms as regards cross-border business. In this respect they are still considered as a “product” which benefits from the product passport. The introduction of minimum requirements for self-managed investment companies was mainly motivated by investor protection considerations. In parallel to other types of UCITS which shall only be marketed if the management company complies with certain pre-requisites, it should be ensured that the management of a self-managed invest company equally fulfils certain qualitative criteria. Furthermore, a level playing field regarding the conditions for market access for UCITS- managers should be ensured. For the time being; it is too early to know the extent to which the model of the harmonised self-managed investment company within the meaning of the Directive has been substantially availed of. However, experience from some Member-States suggests that the model of self managed investment company is appreciated. In particular, self managed company allows creation of funds with a limited management capacity/cost component which can delegate the AM functions to other entities. Accountability of AM companies: IAS 27

IAS 27 (Consolidated and Separate Financial Statements) was issued in December 2003 and is applicable to annual periods beginning on or after 1 January 2005. It has the twin objectives of setting standards to be applied in the preparation and presentation of consolidated financial statements for a group of entities under the control of a parent; and in accounting for investments in subsidiaries, jointly controlled entities, and associates when an entity elects, or is required by local regulations, to present separate (non-consolidated) financial statements. IAS 27 applies to the preparation and presentation of consolidated financial statements for a group of entities under the control of a parent . It also applies to accounting for investments in subsidiaries, jointly controlled entities and associates in the separate financial statements of a parent. This accounting norm replaces the former fragmented approach whereby funds benefited from national exemptions in consolidation requirements. It seems that the AM industry does not support the concept of fund consolidation and, hence, is not prepared to the current implementation. The industry, notably the private equity sector, argues that this new rule would be meaningless (NAV calculation under IAS 27 would only give a vague picture of the situation of the group) for most of funds and that its implementation is costly. 1.2.3.Other permitted activities of management companies It should be recalled that, originally, in order to ensure investor protection, collective investment management should only be carried out by entities specifically dedicated to this business purpose. Therefore, the original Directive restricted the scope of activities to this business alone. This approach of specialisation was intended to help prevent conflicts between the management companies’ business interests and those of fund investors. It was also meant to prevent management companies to carry out business activities whose risk-profile would be detrimental to the fund investors’ interest. To date, the Directive allows management companies to carry out other activities in addition to the collective investment management: the investment services of individual portfolio management, advice and safekeeping of fund units. Furthermore, management companies are now empowered to distribute the units of the funds that they manage directly by themselves in a Host Member State via a branch or under the freedom to provide services and without the need to rely on a third party. In contrast to collective investment business, the Directive provides for the necessary legal instruments to give effect to these business scenarios on a cross-border basis. In this respect, one important step towards a single market for asset management was made. However, the cross-border provision of these activities may encounter further obstacles (e.g. hurdles resulting from the notification requirements, tax issues, etc.). Two potential areas which might impede the cross-border business of management companies can already be identified: ·Distribution of third party products: The possibility to market funds on a cross-border basis encompasses the distribution of the own products of a management company. Whether this possibility also would encompass the distribution of third party funds is not clear according to the text of the Directive: Distribution of third-party funds is not explicitly mentioned as an additional service management companies are allowed to provide. Annex II of the Directive mentions the function “marketing”, but without any further specification (third-party funds or only “own funds”). Currently, this uncertainty does not seem to cause an insurmountable hurdle to the cross-border business of management companies: at present, apart from developments in Italy and Germany the cross-border distribution of third-party funds does not play a major role for the functioning of the European asset management industry. To the extent that this “marketing” entails a process of selection of funds and assistance of offers in choosing/promoting certain funds to individual investors, it needs to be considered whether this involves acting as an intermediary or UCITS manager. ·Lack of coherence in the regulatory framework applicable to the collective and the individual portfolio management (UCITS-Directive, Markets in Financial Instruments directive - MIFID): In case UCITS management companies make use of the extended business opportunities and carry out both collective and individual portfolio management they are subject to two different set of rules regarding the organisational structure of the company. For the management of UCITS the provisions of the UCITS-Directive have to be observed whereas the rules of the MiFID have to be applied to the individual portfolio management. In certain similar areas such as the management of conflicts of interest, client reporting or outsourcing, the regulations in the MiFID considerably deviate from those of the UCITS-Directive. The MiFID-Directive partly contains more elaborated or more demanding standards and – due to the fact that it is a Lamfalussy-Directive- also features a higher level of detail. For legal reasons, the UCITS manager might therefore be obliged to separate the two business segments although this might be hardly feasible in practice. A question remains in the activity of setting up structured and/or guaranteed funds. Those funds enjoyed significant growth and increasing popularity among retail investors since the mid-eighties. By September 2004 the total net assets of some 2,668 guaranteed/capital protected funds in Europe amounted to € 174.3 billion. France, Spain, Netherlands, Belgium and Luxembourg are the markets where these types of funds have acquired a significant market share. Today’s market conditions have only amplified the role of fund products that offer an investment guarantee or a capital protection element to investors. With respect to the type of guaranteed funds two types of product should be distinguished: ·Guaranteed funds in the economic sense, where by the means of portfolio management techniques (employment of derivatives etc.) investors should be protected from the volatility of markets; and ·Guaranteed funds in the legal sense, with an additional formal guarantee provided by an external guarantor (either by the management company or a third party). The use of hedging or capital protection techniques is foreseen in the UCITS III directive. However, the question exists whether these guarantee techniques are properly disclosed in the sales documents. The provision of guarantees in the legal sense (i.e. providing an additional formal guarantee by the management company) is not explicitly mentioned in the exhaustive enumeration of services a management company is empowered to provide. It needs to be considered that providing guarantees amounts to an own financial service separate from collective investment management with own characteristics and gives rise to specific risk-profile. Such an activity could require safeguards to ensure that the management company is actually able to fulfil its obligations in case the guarantee is called upon. Where the guarantee is underwritten by the management company any inability for the company to meet its engagement could give rise to significant difficulties for investors and questions of unfair trading as well as misleading information. This could damage the reputation of the sector as a whole. Therefore, appropriate capital adequacy rules for the management company may need to be considered as a corollary to provision of guarantees. They are not considered by the current framework and suitable convergent methods need to be found in order to ensure an EU-wide harmonised approach. Another business opportunity which is occasionally mentioned as an activity of interest for management companies is the reception and transmission of client orders related to other financial instruments. This would enable management companies not only to sell investment funds to their clients, but also other types of financial products such as transferable securities or money market instruments. This could be interesting with respect to institutional clients and would possibly enable management companies to complete their range of services. In conclusion of the first section, this portrays a heavily qualified picture of progress in integrating European markets for UCITS products. The key-objective of the European UCITS-framework (i.e. to facilitate the circulation of fund-units across Europe as a contribution to a European capital market) is being gradually achieved. Actually, UCITS is the only retail financial product which is subject to substantial cross border trade in the EU. The UCITS model is considered well-established within Europe and also accepted beyond. Thus, many consider important to maintain a so-called “UCITS label”. However, the cross-border offer of UCITS is frequently hampered by administrative obstacles: the product rules are sometimes divergently interpreted by the different Member States; the management company passport has not materialised in practice; the simplified prospectus has yet to prove its worth in helping investors to exercise informed investment decisions. This underlines the need for considering whether the product passport could be improved from a practical perspective and whether the competition could be increased in order to promote financial innovation and product quality. Finally, delegation has emerged as a key-tool in giving management companies flexibility in organising their business; it has permitted the development of cross-border out-sourcing arrangements under the ultimate responsibility of the delegating management company. This solution is probably not the optimal one from an economic point of view. What further steps, if any, are needed to allow management companies to manage a fund constituted/administered in another Member State? 2.Investor protection Investor protection consists in the prevention of misleading, manipulative and fraudulent practices. It is also related to the prevention of loss due to malfeasance or negligence on the part of those that organize and operate funds. With respect to market risks, the goal is not to protect investors from suffering any market-driven loss, but rather to enable investors to understand the risks that pertain to investments in a specific fund. However, to some degree, the UCITS directive attempts to limit investors’ exposures to excessive losses, for instance by limiting investment in derivative instruments or by setting some diversification requirements. In order to limit investors’ exposures to excessive losses, the directive applies a formal/quantitative approach rather than qualitative risk controls. Nevertheless, some first elements of a risk-based approach touch have been introduced in UCITS III directive. The latest amendments of the Directive impose an adequate risk-measurement process for UCITS, some basic principles to capture the overall risk of a UCITS-portfolio (market risk, counter party risk or issuer default risk). The Commission recommendation on derivatives (2004/383/EEC) aims at specifying some of these principles within the margins of the current framework as a first step towards the development of a risk-management system for the area of fund management. Indeed, more flexibility in quantitative terms (leverage of 2, use of derivatives) is accompanied by a high-benchmark in qualitative terms (sophisticated risk-management systems).

Apart from the basic investor protections inherent in the product/investment rules, the directive foresees investor protection safeguards. Beyond the product approach, the investor protection from losses due to malfeasance or negligence relies on the oversight of fund operation by the depositary and on disclosure requirements. 2.1.Managing conflicts of interests in asset management Conflicts of interest are inherent in almost all principal-agent relationships. The collective investment industry is no exception. The operation of a fund potentially entails conflicts of interest between those invest in the fund and those who organise and operate it. Some text-book situations which might give rise to conflicts of interest: §Personal trading by staff and investor interests (‘front running’); §Management companies carrying out business activities whose risk-profile might be detrimental to the fund investors §Management company and distributors/promoters relationships: The choice of funds that the promoter offers to investors may be influenced by sales commissions (trailer fees, retrocession) paid by the management company which may not be disclosed to the investor. Alternatively, the choice of funds offered to the investor might be subject to conflicts of interest if the promoter belongs to a parent undertaking which manages funds. §Management company and depositaries relationships: Conflicts of interest may also arise in the relationships between the management company and the depositaries. Both must act in the best interest of the investors. But, how does the selection of depositaries lead to potential issues for independent oversight? §Management company and broker: high levels of portfolio turnover in order to generate transactional income for broker (‘churning’). Alternatively, the choice of broker might be influenced by so-called “soft dollar” arrangements or bundling which benefit the management company but where payments in kind are not shared with or disclosed to investors. §Management company and placement agent/underwriter relationships: entities which combine the activities of fund management with underwriting of security issues may be faced with the temptation to “stuff” its funds portfolios. §Etc. Conflicts of interest may be more pervasive in situations where a number of functions or relationships are internalised in a single entity as is frequently the case in the European marketplace where fund management is, by and large, undertaken by entities which are subsidiaries of banking or bank-assurance groups (90% in continental Europe, 70% in UK). However, conflicts of interest are not confined to companies tied to a universal bank: independent asset managers may also be faced with the need to manage conflicts of interest. The effective management of conflicts of interest is necessary to ensure that the interests of the fund manager are aligned with those of the investor and to minimize or otherwise address these conflicts of interest. The UCITS Directive provides that each home Member State has to draw up prudential rules which require that each management company is structured and organised in such a way as to minimise the risk of UCITS’ or clients’ interests being prejudiced by conflict of interest between the company and its clients, between one of its clients and another, between one of its clients and a UCITS or between two UCITS. According to the UCITS Directive, each management company shall not be permitted to invest all or a part of the investor’s portfolio in units of units trusts/common funds or of investment companies it manages, unless it receives prior general approval from the client. However, conflicts of interest arise not only at the level of the management company. They may manifest themselves elsewhere in the distribution chain. MiFID provides for a more comprehensive approach to the policing of conflicts of interest as they arise in investment firms. The approach of MiFID is that all conflicts of interest that could compromise investor interests should be identified. Once identified, structures should be put in place to manage them. To the extent that they cannot be managed in a way that provides confidence that investor interests are not effectively safeguarded, the conflicts of interest shall be disclosed to the client. MiFID does not envisage structural solutions (apart from designation of compliance officer), such as ‘unbundling’ of activities giving rise to conflicts. These requirements will govern conflicts of interest arising between different activities of investment firms (as defined in the MiFID). However, for the time being, the application of these MiFID provisions to UCITS management companies is not foreseen by the legal framework - even when providing individual portfolio management services in addition to their UCITS management activities. 2.2.Organisational controls on funds and their managers Functionally separate depositaries are one of the pillars of the UCITS framework. The “UCITS III” Directive has not amended the applicable rules for the depositary, which are still based on the 1985 version of the directive. Moreover, it requires that the depositary be located in the same Member State as the management company/fund thereby excluding the possibility for a UCITS to designate a depositary in another Member State. From the beginning, the depositary has been entrusted with the double mission of safekeeping of funds assets and carrying out a certain number of oversight functions to ensure that the assets are managed legally by the management company (cf. Art. 7 and 14 of the UCITS Directive). This covers namely supervision of unit issuance, sale, redemption and cancellation, ensuring that instructions of the management company and calculation of unit value are carried out in accordance with fund rules and regulations (for contractual funds and unit trusts), and supervision of transactions involving fund’s assets as to delivery of consideration and application of fund’s income. Beyond such provisions, Member States have followed different traditions in relation to oversight, sometimes strengthening the role of the depositary, sometimes empowering auditors or independent directors. However, we will focus here on the depositary.

2.2.1.Depositary as custodian of investor assets The UCITS Directive simply states that the “unit trust’s assets must be entrusted to a depositary for safekeeping”. The Directive does not specify the contents of this responsibility. According to the Vandamme commentary, safekeeping naturally encompasses the everyday administration of the assets (collection of dividends, interest payments, subscription charges…). The Directive also expressly provides for the possibility of “sub-custody” as it mentions that “the depositary’s liability shall not be affected by the fact that it has entrusted to a third party all or some of the assets in its safekeeping”. Even if it is relatively easy to agree on the rather general concept of “safekeeping”, the general provisions of the Directive in this respect have led to various views in Europe: “bare” custody (safekeeping + administration), surveillance over sub-custodians, segregation of assets, more or less active role as to the administration of the assets… and lack of clarity on liability and compensation of investors. This may imply safeguarding not only assets and administering them, but also dealing actively with the preservation of rights and the delivery of obligations attached to assets held under custody (shareholders’ rights, tax returns…). One can mention, inter alia, the following examples from the Member States: §Informing clients of: relevant corporate actions, items needed for drawing up tax returns, events affecting the client’s rights in respect of the assets, and execution of trades on behalf of the client. §Issuing at least a yearly attestation on the number and nature of securities held in custody. §Ensuring that assets of client (management company), custodian assets and UCITS assets are segregated with a Central Securities Depositary. §Performance of a certain number of quality checks on the clearing & settlement of trades. These additional roles imply usually additional organisational requirements such as information processing systems, accounting procedures and internal controls. 2.2.2.Depositaries’ control over operation of funds The UCITS directive gave depositaries a key role in ensuring high standards of investor protection by exercising certain control functions over the AM company and ensuring sound administration of the fund. The depositary exercises a range of micro-controls usually at the level of the fund and its administration (check trades are compliant with fund rules, check valuation, reconcile orders, monitor trade errors,…). Because of this essential role for investor protection, the 1985 Directive provided for protection against conflicts of interest by way of two provisions: (i) impossibility for a single company to act both as management company/ investment company and as depositary and (ii) both management company and depositary shall in any event act in the best interests of the unit/share holders. As explained above, Member States have developed different approaches for oversight, thus for depositaries fund control tasks. Following the “a minima” harmonisation of the UCITS Directive, different depositaries models have been developed throughout the Member States. In certain Member States, the depositary is thus performing additional or reinforced controls. One can take as examples: §Core role in “corporate life” of the fund, where the depositary is to represent investors’ interests (for instance at the fund’s creation, but also in case of change of investment manager, mergers or liquidation). §Auditing of fund’s portfolio and accounting methods, approval of assets statement, annual report on the compliance of the fund management with the applicable rules and regulations. §Whistleblower role in case of irregularity (vis-à-vis fund manager, fund operator, auditor or regulator). §Checks on execution prices, on negotiations, on the qualities of the counterparties. §Other additional provisions like, for instance, faculty to introduce actions on behalf of clients. Thus, in many countries, the depositary can be compared to a gatekeeper, i.e. a first line of defence for the investor. This is for instance the case when it is entrusted with a whistleblower function. In some countries, it performs functions which in other countries are performed by auditors, such as auditing of portfolio and accounting methods of the fund. One could argue that the day to day relations of the depositary with the management company give it a unique insight into the functioning of the fund and the best opportunity to detect and address anomalies. On the other hand, the development of sub-custody agreements may give less weight to this argument. Recently a broader question has arisen as to the coexistence of the two functions (safekeeping + control), which are of different nature, within the same entity. There are some good arguments to allow depositary and safekeeping to be undertaken by the same entity. The depositary, especially through its custody mission, is involved on a daily basis into the life of the fund. No significant operation (trading, rebalancing) involving the assets of the fund can be done without its assent (passive or active). This gives the depositary a unique position to perform its oversight controls. These controls also occur on day-to-day basis as opposed, for instance, to the auditor, who only intervenes ex post. It can be said that this daily involvement in the functioning of the fund provides the best possible guarantee for investor protection and explains the relatively low record of high profile funds failures in Europe until now. The development of alternative investment strategies (see part 4. below) provides another good argument: more and more complex strategies can be better supervised if the depositary – or some external party – is involved in the day to day monitoring of the assets controlled by the fund manager. It can be argued that an external third party supervisor for such strategies (as opposed to a depositary) would be technically more costly and might also entail, for instance, confidentiality issues. However, one could argue that the “control + safekeeping” model is under more and more pressure due to market trends. The emergence of global players providing custody services has lead to a concentration in the custody. Confronted with increased competition (more pressure on prices from the fund managers, notably due to bear markets) and investments (notably in the field of IT), custodians have indeed opted for a race to size. The domination by “global custodians” is more and more evident (large investment banks, securities houses and trust companies). American custodians are expanding in Europe: in 2004 alone, Deustche Bank custody business was purchased by Citigroup, ABN AMRO by State Street and ING Barings by Northern Trust. Current league table for global custodians is as follows (Source: www.globalcustody.net , January 2005):

Ranking Provider Nationality Worldwide assets ($ Bn) 1 State Street US 9,100 2 Bank of New York US 8,906 3 JP Morgan US 8,014 4 Citigroup US 6,640 5 BNP Paribas securities services F 2,958 6 Mellon Group US 2,946 7 UBS AG CH 2,436 8 Northern Trust US 2,400 9 HSBC UK 1,572 10 Société Générale F 1,352 Concentration of players can be first seen as a chance for asset managers as economic of scale savings should deliver lower costs. It could also be seen as a risk for competition – and, so, for the reduction of prices - as strategic barriers to entry will develop. However, some argue that there will always be room for “niche” custodians who will be able to deliver a more tailored approach, better expertise on high added value services or a more individualized customer relationship. Moreover, there has been a recent trend among asset managers for solutions involving outsourcing of activities to different service providers rather than the use of one single outsourcer, which shows the limits of the “custody +” model, as outsourcing to one single contractor might be seen as a risk in itself for fund managers. Finally, it should be noted that the role of the custodian in addressing operational risks is extremely broad. Studies carried out on the most significant or probable operational risks within asset management occupations reveal that the main operational risks to which management companies are exposed can be limited or hedged by the custodian, with the notable exception of misleading the investor, which can be subject to consistency control or warning procedures implemented by the broker. The surveyed firms’ perception is the following (Source: Oxera 2001 and Edhec 2003): leading operational risks in terms of the amount of potential losses Risks Possible mitigation by custodians Breach of client guidelines Strong Misdealing Weak Unit trust mis-pricing Medium Risks from new business (manager transition) Strong Fraud Medium leading operational risks in terms of frequency Risks Possible mitigation by custodians Breach of client guidelines Strong Misdealing Weak Settlement problems Strong Unit trust mis-pricing Medium Failure to reconcile assets Strong 2.3.Regulation of sales process 2.3.1.General disclosure requirements According to the UCITS directive the following disclosure requirements have to be observed: Simplified prospectus, full prospectus, financial reports (annual and half-yearly) and the fund rules/instruments of incorporation. The Directive requires that the simplified prospectus be offered to investors free of charge before the conclusion of the contract. The full prospectus and the annual and half-yearly reports shall be supplied to investors on request. The fund rules or instruments of incorporation shall also be made available to investors (either as an integral part of the full prospects or by informing investors that they may obtain this information on request). One of the key-requirements for cross-border distribution according to the amended Directive is the simplified prospectus. The requirements for the simplified prospectus have been specified by the Recommendation on the simplified prospectus which has only recently entered into force. Thus, it is too early to assess its application. The report to be produced by CESR (see below) on this will provide a good basis for that assessment. Some concerns expressed that some Member-States implemented it in a demanding way resulting in the inclusion of too much information not relevant to investor. 2.3.2.Disclosure of fees and commissions An investor considering investing in funds may be faced with a wide array of fees and charges. These include not only management fees and administration charges but also entrance and exit fees, (possibly) success/performance fees and load fees. In addition, the investor may ultimately be forced to foot the bill for hidden costs in the management, trade-execution and distribution chain. There are features of the remuneration process for management companies and promoters which may amount to higher aggregate charges for investors. This is notably the case for bundling, soft commissions at the level of brokerage services, and retrocession fees at the distribution end. A proscriptive approach to some of these issues has been considered by some regulators. However, in general, it has been preferred to place the emphasis on disclosure of fees and commissions. A disclosure-based approach may be particularly appropriate in a European context where business models and distribution architectures are beginning to open up. Interfering with management companies revenue or incentive structures could prevent them from developing certain market access strategies. It also does not give sufficient credit to investors who are becoming more aware of the costs and charges associated with investing in funds. As investor familiarity with these products develops, management companies which fail to provide for sufficient fee disclosure may find themselves punished by investors voting with their feet. Improved transparency - in particular, as regards of costs and fees - is a key issue which must be addressed to maintain investors’ confidence. Provisions to this aim have been included in the UCITS Directive and the Recommendation on the Simplified Prospectus. For instance, the Prospectus for UCITS has to include information on the remuneration payable to third parties. The Commission Recommendation on the Simplified Prospectus has sought to promote a composite measure of fees and charges. Therefore, based on IOSCO standards, the total expense ratio should be disclosed. Furthermore, it is recommended to disclose the portfolio turnover rate, the existence of fee-sharing agreements and soft-commissions as well as the transactions costs when they are deemed to be available. The Recommendation also contains elements for the presentation of past-performance. Nevertheless the question of to what extent is the Recommendation put into practice remains. Additionally, are TER figures really comparable across funds and countries? Are all the relevant charges visible to the investors? Could a clearer break-down of fees help to promote investor-driven competition between different players in the distribution process? Hence, at the end of 2004, CESR circulated a questionnaire on the Recommendation. Almost all of the supervisory authorities have responded. CESR will now analyse to what extent national authorities have given effect to the UCITS Recommendations before reporting to the ESC in the course of this spring. Some industry initiatives have also tried to address potential issues that may undermine investor’s protection. In many Member States, the industry has established codes of conduct which include standards for the distribution of funds. These codes of conduct may complement or sometimes even make up for legislative measures. They may sometimes specify general distribution or advice requirements for investment funds. However, two questions remain: 1) to which extent are these codes/self-regulations respected? 2) What is their enforceability (national authorities’ competence) in case of non compliance? 2.3.3.Legal uncertainties in UCITS distribution framework The most relevant sets of rules applicable to UCITS-distribution are the UCITS-Directive and the MiFID. The UCITS-Directive primarily focuses on the public marketing of UCITS, i.e. the placement of the product on the market and on disclosure requirements relevant for this marketing. The MiFID governs cases where the distribution of collective investment schemes or the provision of advice is undertaken by an investment firm. The possibility given to Member States by the MiFID to exempt the reception/transmission of orders and the advice exclusively related to collective investment undertakings from the obligations of the Directive creates, however, some uncertainty. In addition, even if UCITS-Directive and MiFID are closely interconnected with respect to the sales process, the concrete implications of this relationship are not always easy to determine: Which documents have to be provided in case UCITS are distributed by an investment firm? What is the relationship between the “public marketing” referred to in the UCITS-Directive and the distribution activities addressed by MiFID? Which rules apply in case a management company wishes to sell third-party funds (as far as permissible)? These issues beg the question of the need of clarification on the interactions between both directives. §UCITS-Directive: harmonisation of the public marketing of UCITS The UCITS-Directive focuses on the public marketing of UCITS: in this respect, the Directive provides the legal basis for the right of the UCITS to be marketed (i.e. to be placed on the market) to the public in its Home Member State (on the basis of its Home Member State authorisation) and in other Member States of the EU through the introduction of the product passport and the related notification procedure. The Directive clearly focuses on the establishment of these rights. The disclosure requirements previously mentioned are part of this process. For instance, the full and the simplified prospectus have to be submitted to the Host Member State authority in order to complete successfully the notification procedure. The rules on the sales documents and the related disclosure requirements of the UCITS-Directive are also relevant for the promotion for sale of UCITS to individual investors themselves. For instance, any potential subscriber of a UCITS needs to be offered the simplified prospectus before the conclusion of the contract. This document shall enable investors to make an informed judgement of the envisaged investment and the risks attached thereto.

With respect to the efficiency of these instruments it should be noted, that for none of these sales documents the Directive requires compulsory delivery. The Simplified Prospectus is the only document which shall be offered to the investor. However, even in this respect, the Directive is content with a mere offer and does not require “hand” delivery. The other documents have only to be supplied on request. It should further be noted that the addressees of the obligations to offer or to supply the sales documents are not explicitly mentioned. There are certainly strong reasons to believe that any potential fund distributor should be obliged to fulfil these obligations. However, the drafting of the Directive may cause some uncertainty as regards the concrete circle of addressees of these requirements. There are no rules in the Directive specifically dedicated to the question of how the sales process of UCITS is organised (i.e. the way in which manager, promoter and adviser interface with the potential end investor), how advice related to funds should be delivered or regarding suitable fund promoters. §Advertisement rules under UCITS directive The UCITS-Directive harmonises the public marketing of UCITS. However, it has refrained from harmonising the rules for the advertising of UCITS. The advertising rules are therefore under national discretion. Rules on advertisement for instance concern rules on promotion or misleading advertisement (rules on unfair competition). Some Member States require an advance approval for the advertising material or establish restrictions as regards the entities which are entitled to carry out advertisement. However, it should be noted that there are a number of developments which might lead to a further harmonisation of the advertisement of funds: For instance, it needs to be clarified to what extent MiFID and initiatives such as the Directive on unfair business to consumer commercial practices which is to be formally adopted in June 2005 will lead to further harmonisation. With respect to MiFID this will also depend on the final content of the Level 2 measures implementing MiFID. The outcome of this process needs therefore to be awaited. §MIFID rules The execution of orders or provision of advice in respect of UCITS to individual investors as a financial activity is an investment service subject to the rules of the MiFID. The reception and transmission of orders and the advice related to other collective investment undertakings (real estate funds, hedge funds or private equity funds) also constitutes an investment service. In principle, all the rules applicable to investment firms should therefore be applied to fund intermediaries/investment firms involved in the offer, provision of advice in respect of collective investment schemes. This includes provisions on authorisation, supervision, requirements for the internal structure and the management of conflicts of interest, client reporting etc. Thus, even if MiFID does not contain rules specifically dedicated to the distribution of fund units it aims at ensuring that the distribution of fund units is subject to the same quality standards than the distribution of other financial instruments. Whether these rules of the MiFID also apply to management companies distributing third party funds (as far as permissible, see point 1.2.3) might be subject to further clarification. It should be noted that the Directive grants Member States the option of exempting the business of reception and transmission of orders and advice exclusively related to collective investment undertakings from the obligations of the Directive. In these cases, the Member States have nevertheless to ensure that the activities of the entities carrying out these investment services in relation to collective investment schemes are regulated on a national level. The minimum requirements are thus established at national level. Accordingly, the duties set out by the MiFID will apply to those distributors and advisors which provide their services not only in relation to funds but also in relation to funds in combination with other financial products. For reception/transmission of orders and advice in respect of collective investment schemes, it will depend on whether Member-State exercises its option to exclude these services. With respect to UCITS, the Directive contains a further derogation: in case of the reception and transmission of orders related to non-complex financial products, the Directive allows that the investment service is provided on an execution-only basis, i.e. there is no need to undertake a comprehensive test of whether the envisaged product is appropriate for the client. UCITS are explicitly mentioned in this context. However, UCITS products can rather diverge as regards their complexity and their risks (for instance, plain-vanilla products, more sophisticated products using leverage through derivatives etc.). This might beg the question of whether there is a need to consider a more differentiated approach to these investment services related to UCITS. In addition, there might also be a need to clarify the application of the execution-only rule to non-harmonised funds such as real-estate funds, hedge funds or private equity funds. 2.4.Investor confidence In 2002, the Basel Committee’s quantitative study pointed out that internal fraud events in asset management business were less than 1% of internal fraud events in financial services. Two OXERA studies show that fraud is one of the least frequent risks in the industry ranking. However, fraud is the fifth risk in the ranking of potential impact in terms of loss. A Bank of New-York study reveals that 60% of the financial firms surveyed reported that the level of client’s trust had deteriorated over the past 10 years. Overall 44% of participants believe that the mutual fund industry has lost business over the last five years directly as a result of lack of trust. Mis-selling is believed to be an important factor having damaged trust by 65% of contributors, where only 37% think late trading is an important factor. Hedge funds are identified as an area of particular concern by over 50% of respondents. Long only mutual funds are viewed as an unlikely source of problems with just 5% of respondents expressing concerns. Investors are not reporting increased cases of fraud in asset management business. The UK financial ombudsman report shows that complaints in the area of portfolio and fund management decreased to 921 in March 2004 from 1,044 in March 2003. In France, the AMF mediateur noted an increase in complaints on collective investment schemes, mainly due to complaints about guaranteed funds. These figures are, of course, not representative of the EU-market. Unfortunately, data on fraud in asset management on a European basis are not readily available. An explanatory factor may be that industry does not want to incur “reputational risk”. In case of fraud, the AM companies or banking group to which the former belong may prefer to compensate customers from their own assets via out-of-court settlements. Market timing and late trading have been found to be relatively rare practices in EU. CESR members conducted extensive investigations to assess whether these mis-practices were prevalent in Europe’s investment fund industry, following the US regulatory authorities’ findings in autumn 2003, in which they found evidence of abusive practices in the US mutual fund market. In November 2004, CESR reported that abusive business practises which exploit the mutual funds for the benefit of some privileged investors (such as late trading or market timing) are rare in Europe. Nevertheless, a key finding of the investigation was that internal processes of the management companies should be improved as this may be a source of potential weakness in the future which could lead to cases of mis-practices developing. Finally, some Member-State authorities have undertaken national investigations resulting in changes to regulatory/supervisory practices. It should be noted that some EU-countries have set up investor compensation schemes in case of asset losses, despite the fact that the 1997 investor compensation schemes Directive does not apply to collective asset management. These schemes protect investors’ monies and securities against the risk of theft, embezzlement, other forms of fraudulent misappropriation or the loss of investor assets in the event of firm default resulting from negligence or breakdowns in the firms’ systems and controls. However, there are a range of risks that do not qualify for compensation cover, at least in some Member States, or where compensation is not certain (e.g. bad advices, third-party default no leading to the AM company default, poor investment management, etc…). This raises the question of whether ex-post compensation of investors’ losses should be improved in EU in the field of AM. In conclusion of the second section, the figures show that asset management sector is so far less affected by fraudulent activities than other sectors. This does not amount to consider that AM is exempt of fraud, conflicts of interest or dysfunctions. The UCITS investor protection framework would thus appear quite complete and well adapted. Nevertheless, considering the paramount importance of investor confidence, investor protection remains a permanent regulatory concern. In order to maintain continued confidence in the asset management industry, there will be a need for unwavering commitment to effective controls which ensure that decisions taken by fund managers are motivated only by the interests of the investor. The crux of the issue will probably be to ensure the effective management of conflicts of interest which might affect decisions taken by management companies and/or promoters and an effective and independent oversight on fund operation. A second area for consideration concerns the fair disclosure to investors of fees and charges relating to investments in funds. The Recommendation on the simplified prospectus advocated that Member States provide for clear disclosure of all relevant costs, charges and soft commissions to investors. An assessment of the functioning of simplified prospectus could consider whether regulatory principles to avoid investor abuse are sufficiently clear in terms of substance and addressee.

The sales process of UCITS is mainly governed by the UCITS-Directive and MiFID. UCITS provisions focus on the sales documents and related disclosure requirements. MiFID governs cases where the distribution of collective investment schemes or the provision of advice is undertaken by an investment firm. The possibility given to Member States by the Directive to exempt the reception/transmission of orders and the advice exclusively related to collective investment undertakings from the obligations of the Directive creates, however, some uncertainty. In addition, even if UCITS-Directive and MiFID are closely interconnected with respect to the sales process, the concrete implications of this relationship are not always easy to determine. This begs the question of the need to clarify the interactions between both the directives. 3.Changing features of EU fund industry This section will consider three broad sets of issues: §needs in AM industry for more single market freedoms; §new distribution patterns leading to new risks and to needs for legal certainty related to new EU-texts; §and changing risk patterns which are emerging in AM business. 3.1.Additional single market freedoms? 3.1.1.Greater freedom of choice of depositary? The UCITS Directive requires that the depositary be established in the same Member State as the management company of a contractual fund or of the UCITS itself in the case of an investment company. This restriction was originally justified by two considerations: due to the very close relation between the depositary and the management company/ investment company, it was considered logical that the same competent authority be in charge of authorizing and supervising both entities and, accordingly, that the two entities be in the same location. However, more and more players, including industry and national authorities are promoting the idea of freedom of choice of depositaries for European management companies. This could increase competition on a fragmented market and lower costs for the investors. Thus, the AMWG report evokes the question of whether the depositaries should have passporting rights, i.e. be able to provide their services on a cross-border basis, or, alternatively, to promote greater freedom of choice of depositaries. It is argued that the current fragmented state of the depositary market throughout Europe entails increased costs for management companies and for investors and impairs the development of a pan-European investment fund business. The possibility to be able to choose one’s depositary cross-border is also perceived by the industry as an additional flexibility in the way management companies organise their activity. Many respondents to the public consultation which took place following the release of the AMWG report showed a consensus on the merits of such a passport. However, due to the current discrepancies in national regulations, supporters of this idea usually agree on the prior need to better define the role, the missions and the liability of the depositary at European level. Indeed, the rules of the UCITS I Directive have left ample room for discrepancies in the depositaries regimes from one Member State to the other. There is, for instance, a great variety of institutions performing this role (credit institutions, investment firms, central banks, insurance undertaking, “other regulated legal persons”…), even if credit institutions have a leading share of the market. The AMWG report and the Commission communication on depositaries both insist on the prior need for convergence on prevention of conflict of interest, control duties and liabilities. IOSCO has launched a work to analyse risks associated with AM functions and examine the possible risk control solutions which might be appropriated. A recent IOSCO report describes oversight of fund managers in the different jurisdictions. It stresses that the independent entities responsible for such an oversight should be empowered with sufficient tools to exercise its functions in an effective independent manner. This debate thus leads to questions without “off the shelves” answers. Furthermore, depositary is often some kind of “pre”-supervisor in its oversight functions and it might be difficult to passport these oversight functions. 3.1.2.Cross-border mergers and pooling techniques The number of funds in Europe is relatively high. It is some three times higher than in the US for a market size which is about the half of the US one. Consequently, it is considered that the average European fund size is sub-optimal. This would impede fund managers and administrators to properly benefit from lower costs derived from economies of scale. It is also argued that a greater fund rationalisation within the EU would considerably reduce fund management and administration costs. The reasons for this proliferation of funds are varied. Often, the creation of new funds responds to cultural preferences or marketing reasons (“new is better”). Sometimes, it is just due to the desire of asset managers (in particular those belonging to banking groups) to enlarge their offer of products to clients. Image concerns may lead to a situation where a bank resulting from the merger with another one maintains the range of products offered by each of them. There are many obstacles to merging investment funds on a cross-border basis. Most of the obstacles are of fiscal or regulatory nature. The obstacles to asset pooling and cross-border fund mergers were highlighted by the AMWG as important barriers hindering the efficient functioning of the market for investment funds and preventing the industry from reaping economies of scale that could drive costs down. §Cross-border fund mergers The UCITS-Directive itself is silent on the conditions under which funds could be merged on a cross-border basis. It contains rules for the replacement of the management company and the depositary of a fund (approval of the competent authority); however it does not explicitly mention the issue of mergers of either domestic funds or of funds with different nationalities. Even if cross-border mergers are not explicitly excluded, the Directive does not seem to put in place the necessary safeguards to carry out such type of operation and to address issues related to moving a fund from a jurisdiction to another. This has, however, not prevented individual instances of cross-border merger. According to some industry research there is a potential for annual savings through cross-border fund mergers ranging between 5 and 15 basis-points (i.e. between € 3.1 billion and € 8.6 billion for the whole European industry). Increasing the size of funds by the means of mergers would allow benefiting from economies of scale which should also lead to a lower average TER. This cost-reduction would be beneficial to investors provided that these potential advantages are passed on to them. Managers experience cost/economic obstacles. According to them, fund mergers can be an expensive and time-consuming project. Regarding consumer behaviour, there is the danger that investors will pull their money out of the fund which should be merged. Furthermore, a merger is costly and demanding in terms of the associated technical processes related to transfers and custodian/depositary services. However, it seems that according to industry experience these issues are not critical. If a merger is well prepared and communicated to investors, there should be less risk of withdrawals. Fund mergers face also tax hurdles and some regulatory obstacles. For instance, many Member States apply a rather strict approach in case the fund to be merged is under their jurisdiction and is to be transferred to another Member State. Heterogeneity of institutions acting as depositary and the lack of convergence regarding their operation conditions might also have a negative impact on the possibilities to merge UCITS cross-border.

Fund mergers may not be the magic potion that their advocates suggest. Although domestic fund mergers are certainly much easier to carry out, it seems that they have not yet brought a greater rationalisation of the local markets. Apparently, local companies do not make frequent use of the possibility to merge funds even if provided for by local legislation. The reasons for this might be rather complex and certainly deserve further exploration. The question of whether the costs and the time needed to organise a merger constitute one of the reasons should also be considered. §Cross-border pooling techniques Pooling is the technique by which several investment funds or sub-funds of an umbrella fund pool their assets. It enables participating funds to invest through one or several pools, the objective being to benefit as if invested directly in the portfolio of pooled assets. In case of cross-border pooling the participating funds are established in different jurisdictions. There are two different ways in which pooling can be achieved: “virtual cross-border pooling ” and “entity pooling ” (or master-feeder” funds). Certain IT-based “virtual” pooling techniques are not per se excluded by the current UCITS-framework. However, there are de facto, a number of obstacles to these techniques: §Taxation barriers: entity pooling is confronted with specific problems regarding withholding tax. These issue can be resolved if a pool is considered transparent for taxation purpose. As each country uses different criteria to determine whether an entity is transparent or not, it is difficult to create a structure which is considered transparent by all Member States. §Different accounting regimes. §Custodial arrangements: requirement that the custodian needs to be domiciled or established in the same jurisdiction than the investment fund. §No harmonised approach to master-feeder-structures: entity pooling and master feeder structures are particularly difficult to establish because they are not recognised under the current UCITS regime. §Barriers resulting from reluctances from supervisors in relation to operational risks, spam of control, and split of nationality between the pool and the participating funds. Noting that a more suitable framework for pooling techniques is not insurmountable task, the industry advocates that pooling techniques should be promoted. See in annex A the description of these two techniques, their potential advantages and the risks resulting therefrom. 3.2.New distribution pattern 3.2.1.Changing conflicts of interest? §Conflicts of interest in integrated architecture In the integrated architecture, which is still dominant in many European countries (particularly in continental Europe), banks and insurance companies distribute only in-house products. In other words, investors are being offered funds designed and managed by the AM company belonging to the banking or insurance group that distributes them. This raises the question of whether such integrated distributors advise investors on the basis of the group’s interests or the investor’s own interest. On the other hand, commercial banks, as well as insurance companies distributing in house products emphasise their eagerness to protect the house-reputation (reputational risk) and their good awareness/knowledge of client situation and needs. §New conflicts of interest in fund distribution Integrated architecture is losing ground to “open architecture” whereby two new kinds of actors distribute funds: more or less independent (not capitally linked) advisory marketing structures and individual financial advisors, which are generally not tied to a particular product provider. Both categories act on behalf of the investors and advise them on the most suitable product. Open architecture represents a broader offer for investors who can really access to the best funds in the market. Moreover, some reduction of costs can be expected from a specialisation of the fund manufacturer in asset management and of the distributor in the marketing of the fund. In this case, the risk of conflict of interest relating to in-house product (i.e. advising only in-house product, even if they are not the most suitable for investors) takes another possible form. Indeed, the non-tied distributor offer might be influenced by remuneration considerations (i.e. they might advise investors on funds from which it/he/she receives a higher “retrocession”. Refer to “considerations on distributors commissions” below). 68% of respondents to the BoNY study mentioned in section 2.4 above agree that intermediaries are more interested in earning commissio