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

investor funds can be distributed only to qualified investors (as defined by non-UCITS notice 24.8) and have investment constraints less restrictive than those of UCITS funds. Professional investor funds can be likened to hedge funds and are available only to professional investors. The Irish regulatory framework 26 borrows from corporate law. Irish regulation of investment funds accords relatively great importance to the board of directors: at least two Irish directors are required, and directors must demonstrate sufficient expertise and have a good reputation. The Irish standard also requires full independence and is thus more stringent than that of the United States. Where the trustee/depositary 27 utilises the services of a sub-custodian the trustee must ensure that these standards are maintained by the sub-custodian, but the trustee has no specific responsibility for sub-custody: it will be held liable for losses if there is an unjustifiable failure to monitor and to exercise due diligence. So, the trustee has an obligation of means. Monitoring of compliance is the responsibility of the trustee/depositary; the administrator, which must be independent of both the board of directors and the trustee/depositary, is in charge of valuing the units. The required transparency of fees and expenses is similar to that in the United Kingdom; valuation errors must be reported to the regulator, and the industry standard for an admissible error is fifty basis points (quite large, perhaps, for money-market funds and strict for equity funds). A code of practice dictates that the valuation of units be done independently of the asset manager; prices from the

counterparty of the derivative transaction can be used. In Ireland, investment firms retain responsibility for the valuation of fund units, which probably comes from the UCITS requirement (art. 31) that investment firms be responsible for producing the key investor information. Luxembourg has civil legal origins. Most of its civil laws come from French culture (Napoleonic code), but its tax code has Germanic origins. Luxembourg is the second largest fund centre in the world after the USA. € 1.8 trillion is managed as UCITS and non-UCITS, a figure that accounts for 26% of all the assets managed by the European fund industry in 2009 (ALFI 2010). There are two distinct legal frameworks, one for “public funds” 28 (including UCITS or Part I funds, and non-UCITS Part II funds, or regulated alternatives), and one for specialised funds (SIFs) for well-informed investors. Specialised funds (SIFs) 29 have very relaxed obligations and can freely take on non-financial risks such as unlimited exposure to prime brokers. Luxembourg requires that most fund services be provided by Luxembourg companies (custody as well as central administration, a task that includes valuation). Most of the country’s laws governing investment funds originate in corporate law and in EU financial regulations. As such, monitoring duties are given to the board, as in other corporations. Likewise, the board is entrusted with all responsibilities not the direct responsibility of shareholders or unit-holders. Technically, the board is elected at the general meeting (even if, in practice, it is initially hired by the promoter or the investment firm and there 3.1.3.5 Luxembourg: A Fund Industry with Relatively Recent Depositary Rules

26 - The Irish regulatory framework relies on the Unit Trust Act of 1990 (for unit trusts), on the Companies Act of 1990, part XIII (for open-ended fixed and variable capital funds), on the Investment Limited Partnership Act of 1994 (for partnerships), and on the Companies and Miscellaneous Provisions Act of 2005 (for contractual funds). UCITS and non-UCITS notices (IFR 2010a, 2010b) provide a detailed overview of requirements for both types of funds. The responsibilities of trustees are defined in UCITS notices section 4.4 and non-Ucits (NU) notice section 7.11. 27 - Irish regulations use the term trustee for all types of funds, and trustee can thus be understood as the Irish term for depositary. 28 - Public funds are bound primarily by the law of 20 December 2002 (CSSF 2002a). 29 - SIFs are subject to the law of 13 February 2007.

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An EDHEC-Risk Institute Publication