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

(the indemnities paid out for valuation mistakes are publicly available). In France, the valuator is purely a sub-contracting entity with little liability in addition to that contractually agreed with the investment firm. Luxembourg is a civil-law country that requires an independent valuator, probably because it competes directly with common-law countries for the domiciliation of funds. Thus, in civil-law countries, losses were isolated where they occurred, usually in the investment firm. That these firms have low capital requirements has probably contributed to the strange determination to have the depositaries insure the end-investor against losses. Although common-law countries are often thought to offer better investor protection than civil-law countries (fiduciary duties in common-law systems are greater), this may not be the case in the fund industry. After all, in the fund industry, the explicit duties of depositaries in civil-law countries have contributed to investor protection by ensuring professional oversight of compliance and preventing the most severe forms of tunnelling (theft); by contrast, in common-law countries, the actual involvement of boards in monitoring and governance is slight, 13 and board members have very limited liability. Both systems have drawbacks. In common- law countries, the principle of fiduciary duty leads to the recognition that each party is responsible for its actions; because the duties are not practically defined, this principle leads to reliance on court procedures, which ends up being costly. Regulation in civil-law countries, French regulation in particular, perhaps, has

historically avoided the excessive reliance on court procedures; French regulation, however, relies essentially on depositaries, the most highly capitalised parties, to protect unit-holders, but asking depositaries to provide insurance-like services to unit-holders is a dead-end because depositaries are not insurance companies, they are not capitalised as such, and, last, this system certainly does not give fund managers incentives to disclose and manage risks. The French system, by focusing on an administrative approach to depositary protection, has recently been unable to avoid the recourse to courts, because the complexity of arrangements in modern fund management means that the regulation is outdated. Likewise, a logical consequence of the administrative approach to protection is that France has long delayed adding class actions to its legislative arsenal. Jurisdictions that rely essentially on the contract have understood that the absence of a clear definition of depositary checks (associated with the bookkeeping of assets that are not safe-kept in depositaries’ networks) and of clear disclosure of large non-financial risks such as sub-custody risk was threatening the stability of their legal framework. Without communication of non-financial risks, unit-holders are in effect deprived of the necessary information to understand the contract that binds them to investment firms and depositaries; without a clear notion of best practices for depositary controls, it is very unclear when depositaries and investment firms have been remiss, and who is responsible for investor losses. That both systems have recently shown their drawbacks after the expansion of available assets and techniques in UCITS

13 - Khorana, Tufano, and Wedge (2007, 6) note: “The SEC has mandated that boards have 75% independent members, but our results suggest that it is boards composed wholly of independent members that seem to be most vigilant with respect to performance”; they remark that boards have exercised their right to take the management contract away from the original fund sponsor only on very rare occasions.

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An EDHEC-Risk Institute Publication