The European Commission’s proposals to amend the UCITS Directive

1. Background

(a) What’s been published?

On 25 November 2021, the European Commission (the Commission) published its proposed amendments to the Level 1 text of the AIFMD, together with an Annex (together the Proposal).

The Proposal also contains amendments to the UCITS Directive on delegation, liquidity risk management, and reporting intended to ensure that the regimes covering UCITS and AIFs are as fully aligned as possible.

(b) Timing?

The Proposal will now be reviewed by the EP and Council, each of which will consider what changes it wishes to see to the Commission’s position.

The EP and Council will, in time, open negotiations to reach an agreed text. This will then be formally endorsed by each institution before being published in the Official Journal.

There will then be an implementation period before the new rules come into effect – the Commission is proposing that this should be two years. Since the EP’s and Council’s negotiations may well take us deep into 2022, this means that, realistically, the rules are unlikely to be effective until 2024 or 2025.

(c) Does this affect the UK?

As the UK was a member of the EU when the UCITS Directive entered into force, it implemented the Directive’s provisions into national law. Following the UK’s departure from the EU, the large majority of the regime has been maintained, at least for the time being, by the onshoring of the relevant legislation.

Since, to be a UCITS, a fund must be EU domiciled and managed by an EU ManCo, one significant consequence of Brexit, is that UK UCITS fall outside the EU regime.

However, to ensure that the UCITS regime remained operative in the UK following Brexit and to make amendments to reflect the UK's status outside the EU, the UK government introduced a number of measures to correct "deficiencies" in UK legislation.

No doubt, the UK government will be looking closely at the Commission’s proposals. Some, of course, such as those which affect the ability of UK (and other non-EU) ManCos to gain access to EU investors will have no relevance to the ability of non-UK managers to access the UK market, so there is no reason for the UK to amend its regime with equivalent provisions.

For the other proposals, though, it seems likely to be some time before we know whether (and, if so, to what extent) the UK government will look to reflect similar measures for the UK regime.

(d) Why has the Proposal been published?

Article 69 of the AIFMD required the Commission to review the application and scope of the Directive and, if necessary, propose appropriate amendments.

To assist the Commission in its work, in August 2020, ESMA set out its views as to the changes that were required to align the UCITS and AIFM regimes in a letter to the Commission. The Proposal takes these comments into account.

2. What does the Proposal say?

The amendments which the Proposal seeks to make to the UCITS Directive are centred on three areas

• Delegation
• Liquidity Management Tools and
• Reporting

Looking at each in turn:

Delegation

A number of changes in the Proposal seek to align the UCITS regime with that already in existence under the AIFMD while other provisions would be new.

Under the current text of the UCITS Directive:

• a ManCo may delegate some of its functions to a third party ‘if the law of the [ManCo’s] home Member State allows management companies to delegate to third parties for the purpose of a more efficient conduct of the companies’ business, to carry out on their behalf one or more of their own functions’ and provided a number of conditions (set out in Article 13(1) of the Directive) are complied with
• Article 13(2) prevents a ManCo from delegating its functions to the extent that it becomes a letter-box entity.

Under the Proposal:

• the ManCo would simply have to notify its NCA prior to any arrangements taking effect where it sought to delegate one or more of the functions set out in Annex II (i.e., investment management, administration or marketing) and
• the wording of Article 13(2) has been harmonised with that under the AIFMD and the Commission will set out Level 2 measures to specify the conditions under which the ManCo would be deemed to have become a letter-box entity.

New provisions would include:

• Delegation to Third Countries: requiring that, where a ManCo delegates more portfolio or risk management functions to third country entities than it retains itself, it must notify ESMA of various specified items of information, including a description of the delegated and retained functions as well as details of the cooperation between the ManCo’s NCA and the supervisory authority of the delegate.
  The content and presentation requirements of such delegation notifications will be developed by ESMA as a new Level 2 measure
• EU “substance”: requiring that, to help demonstrate substance in the EU, a ManCo’s conduct of business is decided by at least two full time employees (or by at least two natural persons who are committed full time), resident in the EU
• Objective reasons: requiring UCITS ManCos to justify their “objective reasons” for delegation (in line with the current AIFMD requirement)
• ESMA monitoring and reporting: charging ESMA with conducting regular peer reviews of how NCAs apply the delegation rules, with a particular focus on preventing the creation of letter-box entities and with providing regular reports, at least every two years, to the Commission, EP and Council on market practices regarding delegation to entities located in third countries

The Simmons view

After fears that delegation were becoming something of a political football around the time of the UK’s exit from the EU, the Commission’s proposed changes are, in the end, relatively modest and it is reassuring to see that there is no attempt to significantly alter the ability of a ManCo to delegate portfolio management or risk management functions to third party delegates.

However, prospective ManCos should take note of the changes when seeking authorisation while existing ManCos will need to consider carefully what adjustments would be required to comply with the amended delegation rules, particularly the requirement for EU residency of two persons conducting the ManCo’s business on a full-time basis. Such ManCos may need to consider their existing delegation arrangements and whether any re-papering and/or regulatory notification would be required as a result.

Liquidity Management Tools (LMTs)

LMTs allow the managers of open-ended funds (including all UCITS), to address redemption pressures when markets are stressed, and help better protect investor interests.

The European Systemic Risk Board (ESRB) and ESMA have recommended that the rules in AIFMD and UCITS around the use of LMTs should be harmonised and the changes included in the Proposal would apply equally to UCITS as they do to open-ended AIFs.

The Proposal would insert a new Article 18a and a new Annex IIa within the UCITS Directive, while Article 84 would be amended.

The new Annex contains eight categories of LMT available to UCITS ManCos. These are:

1) Suspension of redemptions and subscriptions
2) Redemption gates
3) Notice periods
4) Redemption fees
5) Swing pricing
6) Anti-dilution levy
7) Redemptions in kind and
8) Side pockets

The Proposal would require a UCITS ManCo to

• choose to adopt at least one LMT from points 2 to 4 of the list above
• implement detailed policies and procedures for the activation and deactivation of any selected LMT and the operational and administrative arrangements for its use
• notify its NCA ‘without delay’ about activating or deactivating an LMT.

ESMA would be tasked with developing draft Level 2 regulatory technical standards (RTS)
(a) to define and specify the characteristics of the above LMTs and
(b) on the selection and suitable use of LMTs by a UCITS ManCo.

NCAs would be given power to require a UCITS ManCo to activate or deactivate a relevant LMT. The NCA would also have to notify other relevant authorities, ESMA and ESRB before it required activation or deactivation – ESMA is mandated to develop RTS to set out when intervention by an NCA would be warranted and in which situations a NCA may exercise its powers in respect of LMTs.

The Simmons view

In most cases, UCITS currently reserve the right (or have the possible regulatory power in certain circumstances) to suspend dealing and they also typically apply one other LMT from the list of (redemption gates, notice periods or redemption fees) although there hasn’t previously been a harmonised level of regulatory “encouragement” for them to do so as they all have potentially negative implications for investors seeking to realise their investments. The regulatory drive here though is coming from the desire to control the more systemic impact that unconstrained forced sales of otherwise liquid assets can have in stressed markets.

For existing funds that do not currently have the necessary tools available, we wait to see how such powers may be introduced as member states will have different rules in this area and one would normally expect some form of investor consent or other engagement to be a pre-requisite for the introduction of such measures.

These issues may, perhaps, be fleshed out as the EP and Council start their scrutiny of the Commission’s proposals and it is to be hoped that further clarity will be given as ESMA develops the RTS to define exactly what the new proposals mean in practice.

Reporting

To align the transparency regime under UCITS Directive better with AIFMD, in particular with respect to the information reported to NCAs, a new Article 20a would be inserted into the UCITS Directive which would require the ManCo to “regularly report to [its home NCA] on the markets and instruments in which it trades on behalf of the UCITS it manages”.

In addition, ESMA would be required to develop the following Level 2 measures:

• draft RTS, specifying what details the UCITS ManCo would need to report – the RTS would take into account other reporting requirements to which the UCITS ManCo is subject and
• draft implementing technical standards (ITS), dealing with the format and data standards for such reports as well as their timing.

The draft RTS and ITS would have to be submitted to the Commission within three years of the amended Directive entering into force (see ‘Next steps’ below).

Finally, within two years of entry into force, ESMA would be required to submit a report to the Commission on the development of an integrated supervisory data collection, looking primarily at how to:

• reduce areas of duplications and inconsistencies between the reporting frameworks in the asset management sector and other sectors of the financial industry and
• improve data standardisation and efficient sharing and use of data already reported within any EU reporting framework.

The Simmons view

These measures represent further attempts to plug the gaps between UCITS and AIFMD which have resulted from the fact that the latter regime was created as a response to the financial crisis whereas the UCITS regime pre-dated that push for greater levels of regulatory oversight of the financial markets. The Proposal would harmonise the data available to NCAs to enable better monitoring of the market impact of the investment activities of both UCITS and AIFs. The price of harmonisation is further cost and complexity for UCITS ManCos and barriers to entry for new market entrants.

3. Next steps

Although the Proposal does not put forward a root and branch rewriting of any aspect of the UCTS or AIFMD regimes, as can be seen from the above, there are some points which could warrant close interest from ManCos.

The Proposal will now be the subject of, no doubt, intensive negotiations, with the EP and the Council each having its own views.

There is, then, still room for changes to be made and trade associations and other industry participants will be seeking to engage with those involved over the coming months with a view to improving the final version.

Simmons & Simmons will be actively engaged in this work throughout.

Whatever form the final agreed text takes, though, it seems unlikely at this stage that the changes will come into effect until 2024, or even, perhaps, 2025.