Closet index trackers

ESMA’s approach to closet index trackers

In February this year, the European Securities and Markets Authority (ESMA) published a statement concerning the possibility that certain European collective investment funds may be “closet index trackers”.

ESMA is focusing its attention on the alleged practice in the European collective investment management industry of “closet indexing” or “index hugging”. This practice involves a fund manager claiming to manage a fund portfolio in an active manner, whilst the fund stays, in reality, very close to the relevant benchmark.

Obviously, this undisclosed low level of management requires less involvement and commitment by the fund manager than one would expect to be necessary if a fund was managed actively.

Conversely, investors are exposed to the downside of being requested to pay higher performance fees (in line with those of actively managed funds) than those typically charged for passive management.

In addition, investors may incur further damage in that they will not receive the return/risk profile they were expecting based on the fund’s documentation, upon which they relied when taking their investment decisions.

In its statement, ESMA noted that according to the current fund disclosure rules, fund managers must provide investors with “information that is fair, clear and not misleading”. In this respect the Key Investor Information Document (KIID) required by the UCITS IV Directive should be a powerful tool to ensure clear product disclosure.

ESMA stated that it will work closely with national competent authorities in order to better investigate the closet indexing practice and to ensure that fund managers fully comply with disclosure obligations.

CONSOB spotlight on the issue of “closet indexing”

Rumours in the press recently reported that the Italian Stock Exchange Regulation Authority (CONSOB) was in the process of actively investigating collective investment funds which were acting as “closet index trackers”. CONSOB has not commented on this news.

The closet index tracking phenomenon is not new to CONSOB, which in its Communication No. 0055927 of July last year, drew the attention of market players to possible unfair practices in connection with the charging of management fees and/or performance fees by foreign and round trip UCITS funds distributed in Italy.

CONSOB noted that according to the Bank of Italy’s Collective Portfolio Management Regulation, dated 19 March 2015 (the “CPM Regulation”), investment funds governed by Italian law can charge management fees and/or performance fees to their clients, subject to all conditions laid down by sections 3.3.1.1 and 3.3.1.2 of the CPM Regulation being strictly met.

In addition, when UCITS funds are placed or distributed in Italy, investors must be provided with full information and disclosure of all costs, to be shown in the KIID to be delivered to the investor.

CONSOB also noted that intermediaries must take all reasonable steps to identify and properly manage any conflict of interest which may arise when selling and/or distributing collective investments funds, pursuant to Section 21 of the Financial Act and Section 23 of CONSOB and Bank of Italy joint regulation of 29 October 2007, (the “2007 Joint Regulation”).

In practice they must avoid behaviors that would result in charging investors high performance fees which are more favourable to fund managers.

To give an example, according to section 3.3.1.1 of the CPM, performance fees on the management of Italian law governed funds are determined not more frequently than every 12 months. This is the period of time used to assess whether the relevant performance benchmark has been exceeded. This period, however, seems to be far shorter in certain EU States. As a consequence, fund managers might have a conflict of interest when seeking actively to sell or promote certain foreign funds because they will generate greater returns in terms of performance fees.

Potential risks for fund managers

As far as Italy is concerned, fund managers are subject to the supervising and sanctioning authority of CONSOB and the Bank of Italy.

Closet indexing practices would clearly amount to a breach of the obligations contained in section 21 of the Financial Act (including those of the Intermediary Regulation No. 16190/07) which require, inter alia, financial intermediaries to act in a diligent, fair and transparent manner in the interests of customers and of the integrity of the market.

The practices would likely result in a range of illegal conduct, such as not disclosing or misrepresenting material information to investors regarding the real investment management strategy , thereby potentially adversely affecting a client’s investment decisions and return expectations and ultimately leading to the fund manager receiving performance fees to which it was not entitled (in that they would be significantly higher than they should have been in relation to the actual management activity undertaken).

Fund managers should actively implement all necessary steps to prevent and manage conflicts of interests, which may expose them to material adverse consequences. These could include judicial proceedings being issued against them by investors seeking compensation for losses and high pecuniary sanctions being levied by CONSOB and, last but not least, also in terms of significant reputational risk.

Judicial proceedings for mismanagement/damages

Where closet indexing practice involves foreign funds which are placed/sold in Italy, investors would typically sue the ManCo and/or the distributors before the Italian courts, seeking damages on the basis that the illicit conduct/damage occurred in Italy.

The jurisdiction of the Italian courts and the applicability of Italian law may be open to challenge depending on the circumstances. As a matter of fact, different conclusions and different defensive strategies may be pursued, depending on a number of factors. These are likely to include which entity has been sued (whether the ManCo and/or its directors and/or the distributor, etc.), whether the claim is based on tortious or contractual liability, and whether jurisdiction and applicable law clauses contained in the contractual documentation (eg prospectus/portfolio management agreement) can be enforced.

Another concrete risk is that of a consumers association filing a collective/class action claim against a fund manager either to obtain compensation for damages on behalf of the class or to obtain an interim remedy. Such a remedy might include a declaratory judgment confirming the illegality of the fund manager’s practice and ordering, inter alia, the fund to cease the illegal conduct and/or to amend its contractual documentation accordingly (eg, prospectus/portfolio management agreement) and/or to reimburse customers for all excess fees paid).

Pecuniary administrative sanctions

As explained above closet indexing practices are a breach of section 21 of the Financial Act. Use of such practices would also result, pursuant to section 190 of the Financial Act, in the ManCo being potentially exposed to pecuniary sanctions issued by CONSOB ranging from €30,000 up to an amount equal to 10% of the fund’s turnover.

In addition to the above, CONSOB can issue a pecuniary sanction from €50,000 up to €5m against individuals engaged in management, administrative or control functions and/or against staff when the relevant breach of the Financial Act provisions is a consequence of a breach by the individual in question of their duties.

Such a sanction would be issued by CONSOB following the completion of an investigation into the fund/fund manager(s) and the fund under investigation being granted the possibility to object to the charge and submit a defence.

CONSOB’s decision, which is immediately enforceable, can be appealed within 30 days to the Court of Appeal where the defendant has its registered office or domicile. The Court of Appeal upon application by the defendant can also stay the enforceability of CONSOB’s decision, subject to certain civil procedure requirements being satisfied.

Reputational risk

Reputational risk is possibly the most dangerous downside of both judicial proceedings and of CONSOB’s sanction procedure.

With respect to judicial proceedings, it is quite customary for Italian Courts, when declaring the illegality of certain financial/commercial practices, to order the publication of the judgment in the national press.

Likewise, as regards a CONSOB decision, it should be note that, pursuant to section 195-bis of the Financial Act CONSOB’s sanctioning decisions must be published in CONSOB’s Bulletin (also available via CONSOB’s website) which is publicly available.

Publication is not prevented by any appeal against a CONSOB decision. In such a case, however, the fact of the appeal must be mentioned in the Bulletin.

Finally, CONSOB must notify the European Banking Authority about sanctions applied and any appeal filed against them by financial intermediaries providing investment services to clients.

What’s next?

It is likely that both ESMA and CONSOB will continue to monitor closely these practices with a view to identifying them and taking all necessary measures to procure that they are discouraged.

In the meantime, fund managers should ensure that their conflicts of interest procedures are in place, that they are complied with and if necessary, that they are enhanced in order to prevent any such practice from developing.

ESMA and CONSOB will be particularly keen to scrutinise those funds which may be considered potential closet indexers where they have described themselves as active managers in their documentation and KIIDs. Therefore, fund managers should carefully check internally that their management approach/performance objectives are fully and fairly reflected in the contractual documentation delivered to the client and that the client has been made fully aware of them.