UCITS IV on its way to final adoption!

On January 13, 2009, the European Parliament approved, in plenary session, a new proposal for a European Directive, commonly denominated “UCITS IV” by the financial industry, with the view to amending the existing UCITS Directive 85/611/EEC. UCITS IV will definitively be adopted by the European Council soon¹ and should substantially enhance the market efficiency of UCITS and investor protection.

The initial 1985 UCITS Directive, (entered into force in 1988), has been the key driver contributing to the significant development and success of the European investment fund industry over the last two decades. The UCITS Directive implemented a coordinated regulatory framework for investment funds including a European “passport” allowing the shares/units of UCITS styled investment fund domiciled in one European Member State to be freely distributed in other European Member States. A first attempt at enhancement in the 1990’s (“UCITS II”) failed due to the absence of a common position of Member States on the potential passport of the depository activities and master-feeder structure.

However, the industry continued to pressure for enhancements to the original Directive to further develop the single European financial market and this eventually led, in 2001, to the adoption of the twin “UCITS III” Directives which aimed to increase investor protection by introducing the concept of European management companies and the simplified prospectus.  UCITS III also substantially increased the flexibility of UCITS products thanks to the enlargement of the scope of eligible assets. Since the implementation of UCITS III in 2003, the UCITS brand has grown in strength such that UCITS assets under management amounted to EUR 4, 6 billion at the end of 2008, representing 75% of the European investment fund market.

Despite the positive impact of, the UCITS III Directives, they are now eight years old, and with the rapid evolution of the investment fund market, both the industry and the Commission considered it necessary to further enhance the UCITS market and brand. Among the identified points of improvement requiring a modification of the current European regulatory framework, the time and the administrative burden encountered when marketing funds on a cross-border basis, the lack of readability of  sales documents dedicated to investors, the proliferation of funds of a sub-optimal size and the lack of flexibility in organising the industry value chain are the most important. UCITS IV will address these issues.

The marketing of funds on a cross-border basis

Today, a UCITS domiciled in one Member State may be freely marketed in another Member State thanks to the “passport” process consisting of the UCITS merely notifying the respective host country regulators. However, the current Directive permits the host regulator a maximum review period of two months. This review period thus slows the speed to market UCITS in an increasingly competitive marketplace. Although the 2006 CESR guidelines on notification have streamline the process somewhat, it still remains cumbersome and adds unnecessary delays.

One of the objectives of UCITS IV is to reduce as much as possible these administrative barriers. Whilst various fund documentation will still need to be prepared and submitted as part of the notification process; it will become a regulator-to-regulator process based on the principle of approval of the home country regulator and will not last more than ten working days. A UCITS wishing to target other Member States will only have to deal with its home regulator and as soon as the latter will notify its approval to both the UCITS and the host regulator, the UCITS will be entitled to immediately begin marketing activities in that other Member State. There will no longer be a possibility for the host country to block or delay the marketing of UCITS in its territory. Whilst the host country regulator may still review and comment on information pertaining to the local marketing arrangements, this can only take place post notification.

The readability of the simplified prospectus

Two sales documents are of primary importance to insure that potential subscribers are well informed; the full and the simplified prospectus of the fund. The full prospectus is an extremely detailed document on the UCITS that is often very technical and potentially difficult for some retail investors to understand. The simplified prospectus, introduced by UCITS III is, in theory, a more appropriate sales document, as it is shorter in its content and as it focuses only on the key information important to investors in making an investment decision. However, since its 2001 introduction, the simplified prospectus has not proved to be the success hoped for and is considered as being not sufficiently harmonised and useful for retail investors. Furthermore, the issue of the simplified prospectus entails considerable overhead charges and is time-consuming for the fund industry, especially as in many cases a simplified prospectus was produced for each sub-fund.

UCITS IV will put an end to the inefficiency of the existing “simplified” prospectus and will replace it by a much shorter new sales document, the so called “Key Investor Information” (“KII”).  The content, form and presentation of the KII will be common in each Member State to improve its readability, its understanding and potential comparisons between UCITS.

The size of European funds

The European fund market is characterized by a high number of funds of small or medium size. At the end of September 2008, the average European fund was more than six times smaller than an average American fund. This has significant cost issues for the industry and, ultimately, for end investors, as it is not possible to extract the economies of scale from European funds as occurs within the US.

UCITS IV will enhance and facilitate a more efficient and cost effective fund industry by (i) facilitating domestic and cross-border mergers of UCITS irrespective of their legal forms (corporate or contractual) and (ii) allowing for master-feeder structures, i.e. structures where a UCITS (the feeder) invests at least 85% of its assets into one other UCITS (the master).

The flexibility in organising the industry value chain

Today, although a UCITS fund may be marketed cross border into other EU Member States via the notification procedure described above, its management company is not permitted to do the same by acting as a management company for UCITS domiciled in other Member States.

UCITS IV will enforce a full passport of UCITS management companies, allowing a management company approved in one Member State and operating in that Member State to render collective portfolio management services to UCITS funds in other Member States, irrespective of their country of domicile. As such the management company is responsible for three key functions: portfolio management, administration and marketing, and these functions will be held in the country of the management company or in another country depending on the delegation rules applicable to the management company.

Challenges and opportunities for Luxembourg

There is no doubt that UCITS IV is a real and valuable opportunity to increase the European investment fund market efficiency. The challenge for cross-border promoters and the Luxembourg financial marketplace is to determine how best to take advantage of the enhanced flexibility and opportunities granted by UCITS IV while maintaining a high level of investor protection.

In that context, the reactivity of Luxembourg will be key. PwC is confident that the Luxembourg financial marketplace will take the opportunity of UCITS IV to further reinforce its leading position in Europe, thanks to its UCITS expertise, its substantial infrastructure, its multilingual environment and the global branding of the Luxembourg UCITS product distributed worldwide.

To comply with the UCITS IV Directive, Luxembourg, as well as the other Member States will need to implement UCITS IV in its national legislation by July 1, 2011 at the latest.