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

is little participation by unit-holders), and board members (known as administrators in Luxembourg) must be approved by the Luxembourg supervisor (the CSSF); shareholders must vote on remuneration at the general meeting at the same time as they approve the annual accounts; in short, greater responsibility is borne by board of directors. This responsibility, though an important arrow of the legislative quiver, has not contributed in the past to strong monitoring, as illustrated by the Madoff case; funds may also limit the liability of the board to unintentional unjustifiable failure to perform. The promoter is also responsible for the losses posted by the fund, if he or she contributed to an ill-founded fund. Luxembourg has created a European fund industry to serve both European and non-European markets. So it also created a body of regulation whose primary aim was to make business easy; that it is inspired by an older civil code as well as by corporate law has helped make Luxembourg regulation less detailed than that of other civil-law jurisdictions such as France and Germany. The supervisory authority has no power of enforcement, so investors must resort to civil courts, with costly litigation and often unfavourable outcomes. On the whole, many rules are relatively flexible; providers of asset management services must, however, be located in Luxembourg. Until relatively recently, depositary rules in Luxembourg were, for two additional reasons, relatively vague. First, Luxembourg, a small country with all parties initially located in walking distance of the regulator, took, so to speak, a middle way. From civil law, for instance, it took the obligation to have a depositary, and it has been found and

reaffirmed recently (Berthat 2009) that the depositary has an obligation of restitution from the civil code of 1804. 30 There is no mention, however, of an obligation of restitution in the decrees and circulars for parties of investment funds, which mention an obligation of supervision. From corporate laws, it accorded greater importance to the board, of which the promoter is usually a member. Second, the growth of the Luxemburg fund industry dates to the 1990s, and the original regulatory focus was on competition rather than on consumer protection (after all, the consumers of Luxembourg’s products are foreigners). It may be for this reason that until recently there was no detailed code of conduct or best practices for doing business; face-to-face discussions with the regulator were more typical. The Madoff scandal underscored the weaknesses of this system of governance, and by 2009 changes, including the publication of codes of conduct, were on the drawing board. The use of an independent valuator has been made obligatory, an obligation that provides transparency for investors in alternative funds, yet does not supersede managerial responsibility for valuation, as input from the manager may be required for products that are hard to value. 31 Valuation errors 32 are systematically reported to the regulator, which compiles summary statistics. Depositaries must oversee the valuation process, but need not formally validate NAV. The board of directors also has greater obligations and supervisory duties than in France. The Luxembourg regulator, the CSSF, may prohibit directors who have failed to oversee funds in an appropriate manner

30 - The law of 14 March 1804 in the civil code reads: “The depositary shall return the same as that which he received”. 31 - The depositary has greater responsibility for the valuation of contractual funds, in application of UCITS (article 7). 32 - Circular CSSF 02/77 (CSSF 2002b) defines rule that apply in the case of NAV calculation errors.

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An EDHEC-Risk Institute Publication