On March 12 2018, the European Commission published its proposal for the cross-distribution of funds, which in the context of the Capital Markets Union (CMU) aims at reducing regulatory barriers for fund managers seeking to market and offer their funds in several EU Member States.
The European Commission built this proposal on a public consultation on barriers to cross-border distribution of funds launched in June 2016, and on an inception impact assessment of July 2017.
The various contributions strongly supported an initiative addressing cross-border distribution of funds and identified a range of barriers. These barriers include differing marketing requirements and practices, the imposition of local agents, additional national disclosure requirements, non-transparent regulatory fees, inefficient procedures for updating notifications, a lack of support for online and direct distribution and more broadly a lack of transparency regarding national requirements.
While the UCITS and AIFM directives’ marketing passports have had some success in supporting the distribution of funds across EU Member States, most investment funds are still organised along national lines and are on average significantly smaller in size than their American counterparts. The objective of this proposal is thus to streamline and reduce the costs associated with the cross-border distribution of funds.
In this briefing we examine some of the core elements of the proposal and how the proposal fits in the broader policy developments in EU financial regulation, how some material barriers are not tackled in the proposal and what possible next steps in the EU legislative process might be.
This new legislative framework will consist of two legislative pieces, a directive and a regulation that amend provisions of the UCITS and AIFM Directives considered as burdensome or insufficiently clear thus allowing for gold plating in the process of transposition into national legal systems, and further align implementation of AIFMD and UCITS requirements.
Streamlining local agent requirements
Even if there is no obligation on UCITS to have local facilities in each Member State where UCITS is marketed, in practice many Member States require that facilities are present in their territory, which can be viewed as protectionist rules. These requirements to have local agents have limited added value given the rising use of digital technology and can also act as deterrents small fund managers to offer their products cross-border.
Without prohibiting requirements in national legislation to appoint local agents in the host Member States, the proposal prescribes precise conditions under which a local agent may be required (Article 92 UCITS).
Whilst requiring that facilities should be made available in each Member State where marketing activities are carried out and serve situations such as making subscriptions, payments or repurchasing or redeeming units, fund managers are allowed to use electronic or other distance communication means with investors.
Centralised database of UCITS and AIFs
The proposal also introduces a requirement to enlarge ESMA’s central database (Article 10 of the proposed regulation) to include all management companies, AIFs and UCITS. This database may facilitate ESMA’s mandate it received from the European Commission in October 2017 requesting the ESAs to issue recurrent reports on the cost and performance of the main categories of retail investment, insurance and pension products.
If ESMA already published its first report on the impact of charges on mutual fund returns, the new obligation to create databases will with no doubt contribute to the collection of more data and facilitate ESMA’s work.
Some Member States particularly attractive to investment funds, such as Ireland or Luxembourg, might raise specific concerns about the creation of these databases which would shed more light on the size and types of investment funds and national regulatory and supervisory practices.
Simplifying (de-)notification procedures
Where funds are marketed on a cross-border basis and there is a need for documentation to be updated or modified, asset managers are required to give written notice to the competent authority of the host Member State. The proposed directive proceeds to an alignment of the national procedures applicable to changes to the notification procedure for UCITS across fund types and across Member States.
In particular, the proposal introduces a precise time frame for the communication of decisions by competent authorities (Article 17 of UCITS).
Moreover, it proceeds to the facilitation of the de-notification procedure to minimise or avoid regulatory fees. A new Article 93a is introduced into the UCITS Directive. In this case of de-notification of a fund by a manager once they cease marketing in a particular Member State, asset managers may be authorised to de-notify the marketing of its UCITS only if a maximum of 10 investors who hold up to one per cent of assets under management of this UCITS are invested in this UCITS in an identified Member State (Article 93a of UCITS).
More competences are granted to home Member State regulators since the competent authority of home Member State of the UCITS concerned will verify the compliance with this requirement including transparency and publication requirements toward investors and the repurchase offer.
A similar amendment is made to the AIFMD wishing to discontinue their marketing activities (Article 32a of AIFMD). In this case, an AIFM can be authorised to de-notify the marketing of an EU AIF it manages only if there are a maximum of 10 investors who hold up to one per cent of assets under management of this AIF in an identified Member State.
Tackling fragmented marketing rules between Member States
EU funds marketed cross-border are usually required to comply with national requirements set by host Member States, which differ across the EU. Significant costs can be incurred in researching each Member State’s financial promotion and consumer protection regime. As a result, the more harmonised rules on marketing are included in the proposal for a regulation, to avoid differing implementations by Member States.
The proposal introduces principles which marketing communications must fulfil, namely (i) the communications are identifiable as such, (ii) are fair, clear and not misleading and (iii) present risks and rewards of purchasing units or shares of a AIFs and UCITS in an equally prominent manner (Article 2 of the proposed regulation). In order to ensure a level playing field among collective investment undertakings, these requirements on marketing communications both apply to UCTIS and AIFs.
Furthermore, the regulation introduces more transparency regarding national marketing requirements, requiring competent authorities to publish on-line all applicable national laws and administrative provisions governing national marketing rules.
One of the unanswered questions is how this standard will relate to rules existing in MiFID II and PRIIPS regarding disclosure and marketing communications.
Pre-marketing for AIFs and ‘reverse solicitation’
The proposal introduces a harmonised concept of pre-marketing (Article 4(1)(xi) AIFMD). In some Member States where pre-marketing is permitted, its definition and conditions vary significantly and while in other Member States the concept does not exist.
The concept of pre-marketing is not introduced for UCITS as they are usually marketed to retail investors and it would not be deemed compatible with the required level of investor protection.
Pre-marketing is limited in scope though. It must concern an investment idea or strategy where no actual AIF is already established. This means that investors are unable to subscribe to the units or shares of an AIF during the entire duration of pre-marketing. This also means no offering documents, even in a draft form, are permitted to be distributed to potential investors during this stage. If as a result of pre-marketing investors end up signing on or purchasing shares in an AIF, then the pre-marketing will be considered as having been marketing and as having to need to comply with the existing marketing rules (Article 31 and 32 AIFMD).
We understand the conditions attached to pre-marketing are meant to address concerns of large scale use of ‘reverse solicitation’ by non-EU asset managers. In the absence of conditions, it may be possible for non-EU managers to approach investors through pre-marketing and then have investors purchase shares through ‘reverse solicitation’ whereby investors proactively approach the asset managers. It would allow non-EU asset managers to circumvent the AIFMD. We understand this is particularly relevant in the context of the UK’s withdrawal from the EU.
Increasing the transparency around regulatory fees
Investment funds can be subject to regulatory fees imposed by home and host Member States that vary significantly in both scale and how they are calculated.
This proposal thus introduces high-level principles to ensure more consistency in the way regulatory fees are determined. Competent authorities will be required to publish and maintain on their websites central databases on the fees or charges or relevant calculation methodologies (Article 7 of the proposed regulation).
ESMA will be notified of this information and will publish on its website a dedicated interactive database listing the fees or charges levied by the competent authorities.
The proposal in the broader policy context
Strengthening supervisory convergence
UCITS and AIFs funds have been so far regulated by directives, which are more flexible than regulations since they require EU countries to achieve a certain result but leave them free to choose how to do so.
Indeed, given the heterogeneity of national markets and practices around investment funds, directives were considered as better suited than regulations.
However, the European Commission has decided this time to issue a directive but also a regulation to address cross-distribution of funds. The choice of a regulation harmonisation is not innocuous as it fits in the horizontal aim of the Commission to have more ‘supervisory convergence’.
This is one of the core objectives of the CMU Action Plan issued in September 2015, which is linked to the idea of creating a European single market with a similar regulatory framework for firms operating across several Member States to ensure a level-playing field.
Strengthening supervisory convergence lies also at the heart of the legislative proposal issued in September 2017 on the ESAs review currently being discussed in the Council and the European Parliament, aiming at giving the ESAs – and in particular ESMA – a more direct role in supervising market participants and enforcing certain EU legislation.
What about the non-regulatory barriers?
Not all the factors affecting cross-border distribution are covered in this proposal. Differential tax treatments are also likely to create barriers to cross-border business.
If the broader objective behind this proposal is to increase the attractivity of investment funds by creating a favourable regulatory environment, there are still discriminatory withholding tax within the EU or national tax reportings required in several Member States which are detrimental for non-local players.
In December 2017, the European Commission put forward a code of conduct on withholding taxes to help Member States reduce costs and simplify procedures for cross-border investors in the EU. It aims to reduce the challenges faced by smaller investors when doing business cross-border. Nevertheless, there is generally a lack of harmonisation in the tax treatment of financial services and products across EU Member States, resulting in an unlevel playing field between domestic and foreign products constitute an important barrier to the cross-border distribution of financial services.
This situation is unlikely to see any progress soon given the lack of legal competence of the EU on tax issues.
Next steps and key dynamic – keeping the scope limited
Now that the Commission has published its proposal, it will move ahead in ordinary legislative procedure, being negotiated between the Council and the European Parliament.
In the Council, Member States might express concerns over the powers given to ESMA, as they are currently doing on the ESAs review. We expect certain Member States such as Ireland and Luxembourg to closely scrutinise the proposals and have reservations on some of the elements.
In the European Parliament, we expect the EPP Group will be given the position of rapporteur to lead the negotiations on the proposal, with Brian Hayes (EPP, Ireland) a likely candidate as rapporteur. In the S&D group, Pervenche Beres (S&D, France) and Jakob von Weizsäcker (S&D, Germany) to take a keen interest. For the Greens, we expect Sven Giegold (Greens, Germany) to have strong views.
A main question in the negotiations – both in Parliament and in the Council – is whether the negotiations will remain contained to the Commission proposal. Our expectation is both the AIFMD and UCITS directive will undergo a more fundamental review during 2018 and 2019.
However, some MEPs and Member States may seek to expand the scope by introducing other amendments to UCITS and the AIFMD. For example, the issue of delegation of portfolio management may emerge in the negotiations.
Moreover, it may be that the S&D and Greens use the opportunity to already raise issues around the fees and costs of investment funds.
Questions and answers