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

3. Proposal towards Better Management of Non-Financial Risks

Such firms are required by MiFID to collect such information as is necessary for it to understand the essential facts about a client and have “a reasonable basis” for believing that a transaction to be recommended, or entered into in the course of portfolio management, (i) meets the client’s investment objectives; (ii) does not entail investment risks that would not be financially bearable by the client; (iii) is such that the client has the necessary experience and knowledge to understand the risks involved (Amenc, Ducoulombier, Goltz and Tang, 2012). There is no reason to believe that investment risk is limited to financial risk – therefore the investment firm should be required to assess whether the client understands both the financial and non-financial risks of the product and whether the total risk of the investment is financially bearable by the investor. Distributors should inform non-professional clients of the non-financial risks of each product being considered and should thus have sufficient information about these risks to discharge their responsibilities. Clarifying the responsibility of distributors would prompt them to seek relevant information, which would lead them to demand that information documents provide full transparency on non-financial risks from product manufacturers and, where relevant, depositaries. Lacking clear and comprehensive information about these risks, the distributor should deem the product unsuitable and act accordingly, lest it become liable for breach of duty and mis-selling.

Inadequacy of the KIID or the Prospectus with respect to transparency about non-financial risks is thus not only the problem of the asset management company: it puts the distributor at risk of mis-selling and turns the depositary into a scapegoat since it hides risks linked to the custody and administration of the fund (Amenc and Sender, 2010). It is the distributor’s duty to ensure that the client receive fair, clear and non misleading information about all relevant financial and non-financial risks that products present; the distributor receives due compensation to discharge its duties and this compensation covers its liability. Professional investors who wish to cut out the intermediary to avoid paying (outright or hidden) distribution fees, de facto acknowledge their ability to assess by themselves the quality of the information provided by the manufacturer. They should thus accept responsibility for due diligence and be prevented to seek compensation from the distributor or the manufacturer for alleged mis-selling. The role of the depositary Depositaries should be reasonably expected to hold the best information about some key non-financial risks such as counterparty and sub-custody risks – they also experience firsthand problems with the safekeeping and valuing of instruments. Under UCITS V, the liability of the depositary with respect to the assets under custody is clear and aligned with the restitution obligation. There could be a regulatory requirement for the depositary to disclose the percentage of a fund’s assets under management that are covered by this restitution duty; and to assess, at least

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An EDHEC-Risk Institute Publication