Overview

  The investment fund sector has grown significantly in the last decade which has necessitated the investment managers to improve the liquidity risk management, transparency, and investor protection through the AIFMD (Alternative Investment Management Fund Directive). However, the European Commission had recommended a few areas of revision of AIFMD and provisions for better alignment with the undertakings for collective investment in transferable securities (“UCITS”) with the revised AIFMD. This marks the fifth amendment to the UCITS framework since the last UCITS V amendment which came into effect in 2014. On 25th November 2021, the European Commission ("Commission") published legislative proposals ("Proposals") to amend the Alternative Investment Fund Managers Directive and the UCITS Directive. The Proposals form part of a legislative package in which the Commission seeks to deliver on several key commitments in the EU's Capital Markets Union ("CMU") plan We discuss the key proposals for fund companies in this forum.

Timelines

• Q4’21 – UCITS VI proposals released by ESMA
• Q4’22 – Discussion and agreement by European Council/Parliament
• Q1’23 – Final proposals/standards to be published
• Q4’24/Q1’25 – Implementation deadline

Key proposals

The below picture depicts the changes to the UCITS Directive to align the framework more closely with AIFMD:

Below are the details of the proposed changes

1.      Delegation

  The existing proposal allows for the efficient management of investment portfolios and for sourcing the necessary expertise in a particular geographical market or asset class. The new proposal is an extension which emphasizes on achieving a coherent approach to delegation activities by European investment fund managers (i.e., UCITS management companies and EU alternative investment fund managers ("AIFMs") and regulators.

Some of the main proposed delegation measures are outlined below. 

a.      Objectively justify delegation

The proposal states that a UCITS management company must be able to objectively justify its entire delegation structure aligned with an existing AIFMD provision. 

b.      More detailed delegation rules 

ESMA will publish the regulatory technical standards ("RTS") by Q1’23 providing detailed rules and limitations on delegations under which a UCITS management company will breach the UCITS Directive prohibition from being a "letter-box" entity. 

c.       Information on resources and delegation frameworks in applications for authorization  

The applications that are submitted to national competent authorities ("NCAs") for authorization as UCITS management companies should provide information on the human and technical resources that the firm will employ, and more detailed information on the management structure and reporting lines.  Information on the firm's delegation arrangements and resources for overseeing delegates also needs to be provided.

d.      Minimum resources 

The proposal states that every UCITS management company (and self-managed UCITS) must have at least two full-time staff residents in the EU.  

e.      Delegation of MiFID add-on services 

The Proposals will extend the scope of the delegation requirements to capture the delegation of ancillary "MiFID add-on services"2 in addition to primary UCITS management company functions. 

f.        Regulatory reporting and reviews 

The Proposals require all EU NCAs to report annually to ESMA any instances where UCITS

management companies which they regulate are delegating more portfolio management or risk management functions to entities located in non-EU countries than they are retaining. ESMA will, at least every two years, be required to review how NCAs are applying the conditions on delegation and the measures taken to prevent UCITS management companies from becoming letter-box entities. The delegation notifications should include the following information on the undertaking for collective investment (“UCI”) concerned:

• Information on the delegate, specifying the delegate’s domicile and whether it is a regulated entity
• A description of the delegated portfolio management and risk management functions
• A description of the retained portfolio management and risk management functions
• Any other information necessary to analyse the delegation arrangements
• A description of the NCA’s supervisory activities, including desk-based reviews and on-site inspections and the results of such activities
• Any details on the cooperation between the NCA of the fund management companies and the NCA of the delegate.

Based on the reports from the ESMA reviews, it is proposed that the Commission will (within two and a half years of the revised UCITS Directive entering into force) conduct a further review of the UCITS delegation regime to assess whether it is effectively preventing the operation of letter-box entities within the EU. 

2.      Liquidity risk management

The proposals aim to introduce a minimum set of harmonized liquidity management tools ("LMTs") across the UCITS and AIFMD regimes and empower fund managers and regulators to use these LMTs in stressed market conditions. 

The proposed measures will assist in reducing liquidity pressures on funds and mitigating against broader systemic risk implications in market-wide stress situations.

The main measures proposed are outlined below:

a.      LMTs

Below are the prescribed set of liquidity management tools in the UCITS annexure

• Temporary suspensions of subscriptions and redemptions 
• Swing pricing
• Redemption gates
• Anti-dilution levy
• Redemption notice periods
• Redemptions in kind
• Redemption fees 
• Side pockets

b.      Required LMTs 

In addition to being able to temporarily suspend subscriptions and redemptions, UCITS management companies will be required to provide for at least one additional LMT for each UCITS.  The selected LMT could be pertaining to (i) redemption gates; (ii) notice periods; or (ii) redemption fees) as appropriate for the relevant UCITS, considering its investment strategy, liquidity profile and redemption policy.

The UCITS management company will have the final decision on the appropriate LMT to use in any case. UCITS management companies will be required to implement policies and procedures for the use of any LMTs. ESMA will develop RTS(Q1’23): (a) to define and specify the LMTs' characteristics and (b) on criteria for the selection and use of LMTs by UCITS management companies.

As an extension of the existing facility of an NCA to direct a temporary suspension of redemptions in a UCITS, the Proposals provide for an NCA to require a UCITS to activate any of the prescribed LMTs where this is considered to be in the interests of the unitholders or of the public. In order to be effective, it is possible that all UCITS' constitutional documents will need to be updated to factor for this scenario – that is, provide the facility to apply all eight LMTs when required.  Recognizing the impact, a UCITS can have in other EU member states where investors are located, the Proposals provide that an NCA in an EU member state where the UCITS is marketed may request that the NCA in the home EU member state of the UCITS require the application of an LMT.

3.      Regulatory reporting

The AIFMD supervisory reporting regime will be reviewed, and a UCITS supervisory reporting regime will be introduced (details to be published in Q1’23), to (1) avoid reporting duplications for asset managers, (2) standardize the reporting process (data standard, frequency, and timing), and (3) remove limits on data that can be requested by NCAs. The European Commission will be tasked with tailoring this new regime through delegated and implementing acts, based on recommendations from ESMA. 4.      Depositaries

Central securities depositaries ("CSDs") are not currently deemed to be delegates of UCITS depositaries.  The Commission considers that this can prevent depositaries from performing oversight properly as there may be an absence of a stable flow of information when a fund's assets are being kept by a CSD.

It is therefore proposed to include CSDs in the custody chain, albeit that as they are already regulated, there would not be the usual full due diligence requirement.

The way forward

The proposed amendments signal a significant step forward in harmonization of the AIFMD and UCITS regulation as well as reinforcing oversights from NCA and ESMA. The delegation oversight and reporting should encourage the fund companies to revisit their portfolio management and risk management policies. ESMA is expected to analyze the industry feedback and publish the final amendments within six months and expect the funds to be compliant with the new regulations by 2024.