8.1 Summary

Chapter 2 describes the main characteristics of a UCITS. It furthermore de­scribes possible legal structures, fiscal implications and related European regulations. It begins with a description of the characteristics of an investment fund. Although there is no standard definition in the literature, the same elements are always used to describe an investment fund. These include the collective nature, structure (with a separate management company), aim to invest and not to do business, and the pooling of assets.

The management company, depositary, unitholders and regulator are the key parties involved in a UCITS. Zetzsche refers to a triangular relationship between the depositary, management company and unitholders. He calls this the ‘investment triangle’. The UCITS occupies a key role at the center of this triangle. The management company carries out the UCITS management tasks, which include managing investments, administration and the distribution of units. The depositary is entrusted with the safe­keeping of the UCITS’ assets and the unitholders entrust their capital to the UCITS.

The UCITS Directive offers UCITS three options in terms of legal structure. It can be set up as an investment company, a common fund (in accordance with contract law) or a unit trust. An investment company is defined in the UCITS Directive as a company regulated by a statute. The provisions on a common fund only mention that it must be regulated by contract. The Directive does not elaborate further on these concepts. The consequence of this limited description is that member states have considerable freedom in setting up the UCITS legal structure. As regards investor protection, it is important that the legal structure limits the liability of unitholders and ensures asset segregation. However, these are not requirements under the UCITS Directive. It would be wise to include them in order to guarantee compliance with them by all UCITS regardless of the UCITS home member state. The legal structures a UCITS can take in the three member states studied do comply with these requirements. The relevance of the legal structure for the level of investor protection provided is otherwise limited. There is consensus in the literature about this. The freedom that member states have to choose a legal structure is therefore desirable.

In practice, the legal structure is very important because of the associated fiscal consequences. A UCITS is subject to different tax rates. The most important taxes are the corporate tax and the tax on income that arises from underlying investments of the UCITS. The member states studied have drawn up specific provisions regarding corporate tax to prevent double taxation. There are significant differences in how the member states deal with tax on income from investments. Depending on its legal structure and home member state, these differences can have material consequences for the results of a UCITS. This impedes market integration.

The UCITS Directive is not the only EU Directive that is important for UCITS and UCITS management companies. Other Directives and Regulations are important in determining whether unitholders in a UCITS are offered effective and uniform protection. The most important ones are listed in Chapter 2. The main conclusion is that a number of specific topics and risks have been addressed outside the scope of the UCITS regulations. Obligations regarding the distribution of units are not included in the UCITS Directive but in MiFID II and IDD. There are specific obligations for specific investment instruments and techniques such as derivatives and securities lending. The risks that are specific to these instruments and techniques are addressed separately by the regulator.

Chapter 3 explains why investment funds are actually subject to supervision and why this supervision is more extensive than for other issuers.

The most convincing argument for the need to supervise investment funds comes from Morley. He argues that the conflicts of interest at investment funds are more prominent than at other issuers. In his view, these conflicts of interest are the result of the structure of the investment fund, i.e. the separation between the investment fund and the management company.

A management company is an organization separate from the investment fund. The unitholders in the investment fund are not owners in its man­agement company. Nor do they have any control over the management company. The management company performs however all tasks related to the management of the investment fund. The management company and the unitholders in the investment fund do not necessarily have the same interests. The management company’s interest is in having as many unitholders in the investment fund as possible, paying the management company the highest possible fee for the least possible effort on the part of the management company. This is, of course, inconsistent with the in­vestor’s interest in the investment fund. The investor is interested in exactly the opposite: paying the lowest possible fee for greatest possible effort.

The separation between investment fund and management company is more elementary than the separation between ownership and control that applies in the case of normal issuers. In theory, the board of directors at these companies at least does what the owners want; there is some sort of delegation. In order to mitigate conflicts at interest between investment funds and management companies regulation seems inevitable. The reg­ulation can be regarded as a form of product regulation. This conclusion has several implications for the regulation.

First of all, the management company and not the UCITS should be gov­erned by the UCITS provisions. Not the product or the owner of the product but the manufacturer (or in some cases the distributor) should be responsible for compliance with the regulations. It is pointless to direct requirements to the UCITS (the product). The management company should be responsible for complying with the requirements. Furthermore, it is questionable whether UCITS without a separate management company should be part of the UCITS regime. The set-up and related risks do not differ from ordinary issuers. I can’t see convincing reasons to regulate these institutions more extensively than other issuers. The notion that the UCITS directive is product regulation also has consequences for the type of requirements. Main objective should be to mitigate the conflicts of interest between UCITS and its management company and to make sure that all UCITS operate in a similar manner to make them comparable. The legislator has chosen the set-up of detailed requirements in combination with assigning the depositary with the duty to monitor compliance with these regulations. Another possible approach would have been to give a body (such as the fundboard) the fiduciary duty to act in the unitholders best interest. This approach has been chosen in the US.

The stated aim of the UCITS Directive is to facilitate market integration for investment funds. UCITS Directive I opened the door to the cross-border marketing and sale of units. The aim of EU lawmakers was to establish a European market for investment funds in order to increase the contribution of private individuals to the capital markets. The starting point for UCITS Directives IIIA and IIIB was also market integration, and the aim was to broaden the scope of the Directive and make UCITS more attractive.

In recent decades, the requirements for UCITS have increased exponentially with the entry into force of UCITS Directives IV and V and the UCITS Directive IV Implementing Directives and Regulations. In addition, ESMA has made an important contribution to the creation of a harmonized Europe rulebook. This shifted the focus of the UCITS regulations from market integration to the protection of unitholders, central to which is the mitigation of conflicts of interest between management company and investment fund.

Chapter 4 describes the undertaking for collective investment in transferable securities. The first striking aspect is that various requirements of the Directive apply to the UCITS self instead of to the management company. These concern the appointment of a depositary, the creation of a prospectus, key investor information document and semi-annual and annual reports, and applying for authorization. This is different in the AIFM Directive where the AIFM is responsible for all these tasks and, in my view, is not a good choice. If appointed, the management company should be the party to which all the requirements apply. After all, it is the management company that carries out all of the relevant tasks. Moreover, this minimizes the risk of ambiguity regarding responsibility and liability in the event the rules are not complied with.

The definition of a UCITS comprises five elements. It is (1) an undertaking of which (2) the sole object is the collective investment in transferable securities or other liquid financial assets of (3) capital raised from the public and (4) which operate on the principle of risk spreading and (5) the units of which are, at the request of holders, repurchased or redeemed, directly or indirectly, out of those undertakings. All five of the elements are ex­plained in Chapter 4. In my view, an investment fund that meets all these five requirements is a UCITS and governed by the UCITS Directive. It cannot choose to be governed by the AIFM Directive. Given that two of these elements concern the intention of the investment fund, it would not be complicated to not fall under this definition and, in practice, an investment fund does have the choice to be governed by the AIFM Directive. This also seems desirable, as there is no conceivable reason why an investment fund falling under this definition should not be able to be authorized as an AIF.

A UCITS is required by law to be authorized. The Directive gives a summary of the minimum conditions the authorization application must satisfy. If the UCITS has a separate management company, the regulator of its home member state is only required to assess three matters: These are:

In practice, regulators require more information before approving a UCITS application, such as information with regards to the investment policy, risk management, the prospectus and the KIID. The European documentary requirements are limited and should be expanded, as a UCITS may be traded anywhere in the European Union and a host member state may only set additional requirements that are not included in the Directive. To prevent a race to the bottom, additional national regulations should not be relied on exclusively. These additional national regulations are extensive in Ireland and Luxembourg. There is currently no evidence of a race to the bottom. Before the UCITS units can be distributed in other member states, the competent authorities in these member states must be notified of this. The notification procedure is described in detail in the UCITS Directive.

The investment policy must comply with various limits and restrictions. These requirements are one of the characteristics that distinguish UCITS from alternative investment funds. The investment universe comprises transferable securities, deposits, units in other investment funds, derivatives and money market instruments. Techniques in the context of good portfolio management are also permitted. Among other things, the limits relate to transferable securities, derivatives, counterparty risk and leveraging. The limits are not well substantiated and are partly outdated. In my view, the limit system should be updated. Very few EU provisions are devoted to calculating the net asset value, reporting amendments to the investment policy and the consequences of investment restrictions. Luxembourg and Ireland have filled this gap themselves, which is partic­ularly beneficial in terms of legal certainty. In the Netherlands, no additional requirements have been set with respect to these topics. However, in 2009, the Netherlands Authority for the Financial Markets made a number of recommendations in this context based on a market assessment that was carried out.

The transparency obligations for UCITS are extensive. Transparency is a key pillar of investor protection under the UCITS regulations. Investment opportunities have been expanded over time under the condition that a UCITS provides transparency on them. Extensive transparency obligations would therefore be fitting. The system used – with extensive requirements in the prospectus, the core details in the key investor information document and the periodic reporting in the semi-annual and annual reports – is comprehensive.

A UCITS can be terminated as a result of a merger or liquidation, but cannot be converted into an AIF. The rules on liquidation are not uniform. In view of the many legal forms that a UCITS can take, a detailed liquidation procedure is not desirable either. General obligations concerning, for example, the role of the regulator, communication or timelines would not be out of place in the UCITS Directive. Mergers are dealt with in detail in the regulations, Focusing on unitholder communication, the importance of unitholders and the role of the regulator.

Chapter 5 describes the requirements and tasks of management companies. Management companies may not perform management tasks without authorization. If the regulator in the home member state has authorized the management company to do so, the management company may carry out various activities. Needless to say, the management company may perform all the tasks related to managing UCITS. These include administration, investment management and marketing. A conscious choice has been made not to describe the tasks in detail, to ensure sufficient flexibility for management companies to perform different tasks. In addition, management companies may also manage investment funds that are not a UCITS, provided that the management company is subject to additional prudential regulation. Finally, the management company may also carry out investment services, including individual portfolio management, the provision of investment advice, and the safekeeping and administration of units in investment funds. These last two services are regarded as non-core services. In other words, services that are linked to the main business of the management company. As regards the performance of these investment services, the relevant obligations from MiFID II apply.

The UCITS regulations set a number of governance requirements for management companies. These requirements specifically concern the responsibilities of the board of directors and senior management and the quality of the senior managers at the management company. The UCITS Directive sets extensive requirements with respect to remuneration. In addition, a management company is obliged to establish a number of functions, such as a supervisory body, compliance function, risk management function and an internal audit function. These functions are required to carry out a number of specific tasks.

In order to facilitate the efficient conduct of its business, member states may allow management companies to outsource one or more tasks. This outsourcing does not affect the liability of management companies towards their unitholders and regulator, and is subject to a number of conditions. These conditions are general and not further elaborated on. The AIFM regulations do, however, elaborate on various principles. In my view, these elaborations should also be included in the UCITS regulations.

Moreover, the UCITS regulations contain various rules on conduct for management companies. The main aim of the requirements is to ensure that a management company works with honesty and integrity in the interests of the UCITS it manages and the unitholders of these UCITS. Specific provisions are included on aspects such as commissions, order processing, best execution, and subscriptions and redemptions. Many of these requirements have been copied from MiFID I and are also included in the AIFM Directive and AIFM Regulation. In MiFID II, a number of these rules have been modified to reflect the most recent insights. Logically, these modifications should also be implemented in the UCITS regulations.

As regards conflicts of interest, various provisions have been drawn up. Yet conflicts of interest have not been defined anywhere. The literature states that conflicts of interest should not be seen as differences in interest. Rather, conflicts of interest should in particular describe or comprise competing interests. Management companies should avoid conflicts of interest wherever possible. But if they cannot be avoided, the management company should protect the interests of the clients and UCITS. Management companies should draw up policies to that effect. The UCITS regulations attach considerable importance to separating tasks and responsibilities. Integrating checks and balances in this way reduces the chance of a unitholder being affected by a conflict of interest. If it is not possible to guarantee that the interest of the UCITS or unitholders will be not harmed, the unitholders must be notified.

The UCITS regulations contain few provisions on costs. This is striking as it is an important topic and IOSCO has published detailed provisions on the subject. In 2005, the European Commission concluded that the costs of UCITS were higher than the costs of comparable US mutual funds. The Commission hoped that the implementation of UCITS Directive IV would broaden the investment spectrum for UCITS, thus enabling them to achieve greater economies of scale. However, in 2019, ESMA concluded that the costs of UCITS are still too high. As such, the inclusion of more detailed provisions regarding costs would seem desirable in my opinion.

UCITS management companies have a European passport. This enables them to perform the management tasks in EU member states other than that in which it was authorized. A management company may also manage a UCITS that is established in another member state from its own member state. The management company may perform management tasks in other member states, both through a branch and under the freedom to provide services. This passport has been recognized in all member states since the entry into force of UCITS Directive IV and is, as such, uniform. With cross-border services, it is not always clear which regulator is competent and which member state's rules must be complied with. This is mainly the case with cross-border UCITS management, when both the law of management company's home member state and the law of the UCITS home member state seem to apply. An example of such problems relates to the investment policy, as the home member state regulator of the UCITS is responsible for supervising the investment policy and investment limits and the home member state regulator of the management company for supervising the risk management. These aspects overlap in various ways, so the risk of overlapping supervision is not inconceivable.

Chapter 6 describes the requirements for depositaries. Depositaries have had an important place in UCITS regulations since the introduction of UCITS Directive I. They have two key tasks: to safekeep the assets of a UCITS and to supervise the UCITS management company. The purpose of safekeeping is to protect the assets of a depositary from being lost in the event that a party affiliated to the UCITS goes bankrupt. The purpose of supervision is to ensure that the UCITS and its management company comply with the UCITS regulations. The huge number of UCITS in Europe makes it almost impossible for regulators to do that themselves. Since the introduction of UCITS Directive V, the requirements for depositaries have been considerably increased. In order to gain a full understanding of these requirements, it is important to have insight into the Madoff affair. Therefore, Chapter 6 begins with a short summary of this scandal.

Four UCITS went bankrupt as a result of the Madoff affair. They had outsourced a number of investment tasks to BLMIS, an American entity that Madoff had founded. The depositaries of these UCITS had also outsourced the custody to an entity that was controlled by Madoff. This outsourcing by both the management company and the depositary was not mentioned in the prospectus or in any other official documents. Nor were the responsible regulators informed of it. BLMIS used a Ponzi scheme and rather than investing the money, they faked transactions to make it look like they were making a stable return each year. When the fraud was exposed and the UCITS went bankrupt, the unitholders and bankruptcy trustees of the UCITS sued the depositary and the management company. This resulted in long court cases, some of which are still ongoing, and which have revealed that there the liability of the depositary was insufficiently uniform. In none of the countries have unitholders been able to recover all their losses, despite the very obvious mistakes that were made in the management and custody.

Based on these differences and outcomes, EU lawmakers decided to adjust the UCITS regulations. The UCITS Directive has been modified and a Regulation setting out the obligations of depositaries have been drawn up. In this context, it is important to note that this concerns not only the rules regarding depositaries were ineffective, but also the supervision of the UCITS and the management company. However, lawmakers chose to only tighten the rules for depositaries.

Since the introduction of UCITS V, all UCITS have been required to appoint a depositary. This is a considerable step forward from UCITS Directive IV, in which – as an exception – investment companies whose units were traded on a regulated market were excluded from this requirement. UCITS (and not management companies) must appoint a depositary and enter an agreement with that depositary. This is not logical, in my view. In most cases, the UCITS will not be able to perform the activities included in the agreement itself and it is more effective for unitholders to address the management company in the event of mistakes.

The UCITS regulations contain requirements for parties wishing to act as a UCITS depositary. This is desirable given the important tasks that depositaries have to perform. The regulations require that depositaries perform these tasks properly and have laid down a strict liability regime. However, this is pointless unless depositaries also have sufficient capital (or an appropriate insurance arrangement) to pay damages in the event of liability. Yet this is not a requirement currently. Authorized credit institutions are allowed to act as a depositary but they are not the only ones. EU member states have the freedom to accept entities as a depositary that comply with a few high-level principles and have a minimum equity capital of EUR 730,000. This is a rather small minimum given the strict liability regime for depositaries. In my view it would have been better to just allow credit institutions as depositaries. The minimum equity capital for credit institutions is also disproportionate to the amounts that are managed by UCITS. However, by far the most credit institutions have a much larger capital position. This certainly applies to the credit institutions that provide custody services as well. If only credit institutions were allowed to be authorized, this would increase the level of protection. A number of countries, including Luxembourg, have chosen this approach.

Various provisions are also dedicated to the independence of a depositary in relation to its management company. The lawmakers have decided to allow depositaries to be part of the same group as the management company, or to have a link with the management company. Independent decision-making is required in that case. One can question whether independent decision-making is a realistic requirement in all circumstances when companies belong to the same group and stakes are high.

The tasks that a depositary is required to perform are described in detail in the UCITS Directive. Depositaries must be entrusted with the safekeep­ing of the UCITS assets and carry out various monitoring functions. The regulations give a clear description of which financial instruments must be held in custody, how that has to happen and how safekeeping of the other assets must be performed. Various provisions are dedicated to the monitoring tasks as well. The usefulness of the level of detail in the provisions could be disputed. Although this is a political decision, it makes the regulations at least uniform and does not lower the level of investor protection.

While until UCITS Directive V, the UCITS regulations barely laid down any requirements on the outsourcing of safekeeping, outsourcing is now the subject of detailed rules. Detailed descriptions are given on select­ing, monitoring and collaborating with a sub-custodian. The delegation rules also create a level playing field. It is not possible to get around the custody requirements by delegating them to another entity. Until 2018, a key component of the delegation requirements was administrative segregation. The Directive and Delegated Regulation required UCITS assets to be held in separate accounts throughout the custody chain. In 2017, the ESMA advised EU lawmakers to amend this, as a call for evidence and various roundtable talks had revealed that administrative segregation did not always lead to legal segregation which was the ultimate goal of the regulator.

The ESMA concluded that the realization of legal segregation depends on securities processing systems, national laws on property rights for transferable securities and the conditions for national recognition or protection in the event a party in the custody chain becomes insolvent. None of these elements are fully harmonized within the European Union. The ESMA shifted the focus to other elements, such as reconciliation and the obtaining of legal certainty by depositaries on the insolvency laws of the country in which the third party is established. At the ESMA’s request, the Commission amended the Delegated Regulation on the safekeeping duties of depositaries in 2018 to include these elements in the Regulation. As a result, the obligation to hold UCITS assets in individual accounts throughout the custody chain no longer applies. It is now possible for a sub-custodian to hold an account for the assets of all a depositary’s clients

With the entry into force of UCITS Directive V, the liability regime in relation to custody was clarified and improved. Depositaries are liable for the loss of assets, unless they can demonstrate that various grounds for exclusion have been met. A detailed description is given of these grounds for exclusion and, in practice, it will be difficult to prove that all the requirements have been met. The burden of proof for this lies with the depositaries. Liability with regard to delegation has also been clarified. The depositary remains liable at all times. For losses arising from noncompliance with other obligations under the UCITS Directive, depositaries are liable only to the extent the losses are a result of negligence or intent.