Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry

Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry - December 2012

1. Regulation and Non-Financial Risks

in the fund and settled with one of them in November 2012.

effective management of non-financial risks to take place, it is necessary that these risks be acknowledged as material and that the responsibilities and liabilities of the various links in the fund management chain be clearly identified. To rebuild investor confidence, transparency on non-financial risks will be key. 1.1. Non-Financial Risks and the Global Financial Crisis The global financial crisis has served as a wake-up call about non-financial risks in the asset management industry. A series of high-profile incidents, blow-ups and scandals has underlined the materiality of non-financial risks and prompted regulators to review the adequacy of regulation in force with respect to the prevention and management of non-financial risks. The Madoff fraud: sub-custody risk On 11 December 2008, the United States Securities and Exchange Commission revealed that registered broker-dealer and investment adviser Bernard Madoff Investment Securities LLC, had been operating a giant Ponzi scheme for years resulting in losses to its investment advisory clients, which the perpetrator estimated at USD50bn (SEC, 2008). A handful of UCITS funds directly entrusted assets to entities controlled by Bernard Madoff; the majority of these assets belonged to the investors of LuxAlpha, a vehicle set up by UBS and registered with the Luxembourg regulator (CSSF) Another major UCITS feeder-fund was Thema International Fund Plc, a Dublin- based entity whose custodian was HSBC. HSBC has offered settlement to investors

The Madoff fraud demonstrated that it was possible for a UCITS to lose all of its assets to non-financial risks, without any of the parties entrusted with the protection of investors – the investment firm, the board of directors, the depositary – safeguarding the security of the fund, and with investors having to seek redress in the courts. While the fraud led to lawsuits against depositaries and custodians that had delegated custody to a Bernard Madoff entity, it also exposed legal uncertainties about the UCITS framework, in particular with respect to the duties and liabilities of depositaries, as well as stark differences in terms of administrative sanctioning powers of supervisors across Member States. The UCITS Directive requires competent authorities to approve the choice of depositary for each fund (Article 4, 85/611/ EEC). Depositaries are entrusted with the safe-keeping of the fund’s assets (the nature and scope of which are not defined in the Directive) and fund administration and oversight functions; while they are allowed to delegate safe-keeping, sub-custody of assets does not affect their liability (Articles 7 and 14). In accordance with the law of the Member State where the fund manager is registered, depositaries are liable to the UCITS manager and investors for any loss suffered by them as a result of “unjustifiable failure to perform” their obligations or “improper performance” of these (Articles 9 and 16). In effect, either directly or indirectly 7 , UBS delegated management as well as custody of the feeder fund’s assets to entities

7 - The vehicle registered two days before it became forbidden under Luxembourg law to combine management and custody in the same hands. As this exemption was being phased out, UBS SA allocated management of the fund to another entity of the UBS group, and subsequently to a third-party; effective management and custody of assets remained in the hands of Bernard Madoff (LuxAlpha, 2009).

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An EDHEC-Risk Institute Publication