A Better Grasp of Non-financial Risks

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

4. Which Possible Protection of Unit-Holders?

The need for better governance Eddy Wymeersch, president of the CESR, has sharply criticised the governance of the fund management industry. In Autret (2009) he criticised the lack of transparency of management bodies and of the information provided to retail investors, the lack of specific guidelines for the management of conflicts of interest, and, most of all, the lack of checks and balances. He argued that the current practices are far from meeting the recommendations of the International Organization of Securities Commissions (IOSCO) and do not meet the standards of ordinary corporations; he noted that monitoring compliance is insufficient. Boards of directors or, when there are none, investment firms, are the main parties responsible for management of non-financial risks. EU laws impose no fiduciary duties on boards of directors, but corporate law (especially in common- law countries and in countries such as Luxembourg, where the rules for investment firms draw on corporate law) assigns them clear fiduciary duties: like depositaries and investment firms, they must act solely in the interest of end-investors. In practice, these principles are too vague, and we argue that the fiduciary duty of the board and of the chief compliance officer of the investment firm should be reinforced and should include a formal responsibility to end-investors to ensure high standards of governance and risk management, 42 and to define appropriate remuneration packages for the investment managers and the investment firm. Institutional investors could also participate in better fund governance by contracting more monitoring services. As is well known, it is usually the investment firm that

provides end-investors the performance measures used to determine the manager’s pay; in addition, it is usually the investment firm, not the unit-holders, that determines the investment manager’s remuneration, a practice that creates additional discrepancies between the remuneration of the investment manager and that of the end-investors, on top of the discrepancies that arise from the poorly designed remuneration contracts: at present, a very sub-optimal maximum expense ratio with no link to the welfare of the unit-holder is used to determine the remuneration of the investment firm. Class actions Investors are largely inactive, in daily management as well as in annual meetings, in fund governance. After losses or possible errors by the investment firm, it is hard for them to assign blame, as they themselves are highly fragmented and may be of slender means. This is especially the case in countries such as Luxembourg, where the supervisor has no power of enforcement. Class actions make it possible for investors, as clients, to pool their means to make effective claims, regardless of the underlying legal structure. Class actions are typical of common-law countries and empower consumers or investors; they provide means of appeal in the event of misleading information. Class actions are uncommon in the French system, and they are not currently a weapon in the European legal arsenal. All the same, if the belief is, as it currently is, that retail investors should be given access to ever-riskier funds (UCITS as well as structured products) and that administrative oversight of non-financial risk is incomplete, it is necessary to make use of this tool, typical of common law, in European law. When it is hard to assign responsibilities,

42 - Capture of the board by the investment firm is a possibility that cannot be eliminated; giving a clear mission and responsibility to the board, however, diminishes the likelihood of conflicts of interest causing a board’s failure to perform.

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An EDHEC-Risk Institute Publication