A Better Grasp of Non-financial Risks

The European Fund Management Industry Needs a Better Grasp of Non-financial Risks — December 2010

3. Risks and Responsibilities in the Fund Industry

As the Madoff fraud made clear that the heterogeneity in the protection of unit-holders could undermine the single market for funds in Europe, a political agenda sprang from a desire to clarify, homogenise, and strengthen the UCITS regime, particularly as regards the liability of depositaries. In May 2009, Charlie McCreevy, Internal Market Commissioner, announced that he intended to clarify and strengthen the provisions of the UCITS regime, in particular those regarding the liability of depositaries: “One of the consequences of the Madoff scandal in the EU is that it affected retail investors who had invested in certain UCITS funds the assets of which had been entrusted to a Madoff entity as a sub-custodian” (EU 2009b); the subsequent CESR (2010) review of the liability regime of the UCITS depositaries showed that the depositaries’ (rather undefined) obligations of safekeeping in the UCITS directive have been transposed in diverging ways by member states. If a better EU definition of depositary rules is a necessity for harmonisation, one should beware not to replicate country models that have proved obsolete. In regulatory initiatives, failure to reflect can have consequences as catastrophic as those of the failure to regulate. Here, the risk is that an excessive regulatory focus on the role of the depositary in the protection of unit-holders will lead to exorbitant practical liabilities for EU depositaries. 3.1 Country Regulations and Legal Origins Regulation of parties in the fund management industry is the result of legal origins, of the history of banking and fund management, and of a country’s status

as a producer or consumer of funds. We review these guidelines, which we think European regulators and politicians should take into account when designing “better regulations” suitable for countries and parties with different cultures. 3.1.1 Civil-Law vs. Common-Law Countries Analyses of regulations and of governance systems usually focus on legal origin (La Porta et al. 1998). In common-law countries, fiduciary duty is broader, and all parties can be held liable to the end-investor, whether they have direct contract with the investor or not. Thus the British depositary (including, in relation to an authorised unit trust scheme—AUT—the trustee) and the directors have a direct fiduciary duty to act in the best interests of the unit-holders and the fund. The trustee in common-law countries is usually forbidden to act in its own interest in any situation (for instance, it cannot pocket any refund on interest rates unless this practice is explicitly allowed by the client). The same requirement prevails throughout the Commonwealth. Parties in civil-law countries are usually bound by explicit contractual or legal obligations. Parties not bound by contracts usually have no liability to one another, so the responsibility for any loss is where it occurs, usually in the fund or in the investment firm, a poorly capitalised entity. However, when a depositary or an investment firm outsources its functions to a third party, it remains liable to end-investors (UCITS III, art. 5g). Similarly, in common-law countries the valuator has fiduciary duties, and this liability is often made explicit. The valuator also reports directly to the regulator

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An EDHEC-Risk Institute Publication