In this OnPoint, we report on the recent Supervisory Briefing issued by the European Securities and Markets Authority (“ESMA”) on the supervision of costs in UCITS and AIFs published 4 June 2020 available here (the “Briefing”). The Briefing seeks to promote regulatory convergence on the supervision of costs in UCITS and AIFs by European regulators (“NCAs”) by outlining criteria for NCAs to assess and supervise the obligation for UCITS management companies and AIFMs (“Management Companies”) to prevent “undue costs” being charged to investors. As part of this, ESMA proposes the introduction of a new ‘pricing process’ to be prepared by Management Companies which will identify and quantify all costs charged to the fund and which will ultimately assist NCAs in their supervision of this area.
The substance of the Briefing follows recent regulatory focus on fund fees (as further discussed below) although it is not as targeted on investment management fees as the value-for-money assessment requirements of the FCA in the UK1 and the SEC in the U.S..2
ESMA Survey of ‘Undue Costs’
Following a European-wide survey among NCAs3, ESMA has found that, while Management Companies are required by legislation to act in the best interests of unitholders and the integrity of the market4 and to prevent undue costs being charged to those unitholders5, there is divergence on the interpretation of and supervisory approach to ‘undue costs’ by NCAs. ESMA deems that divergence leaves room for regulatory arbitrage, risks of hampering competition and different levels of investor protection depending on a fund’s domicile.
Pricing Process
In order to level the playing field, ESMA has sought to provide a common framework for NCAs to consider in assessing the level of funds’ costs by suggesting that NCAs require that Management Companies develop a ‘pricing process’ to document how they determine and review fund costs charged to investors. The pricing process will provide an in-depth cost analysis of each fund and will be required to be prepared at the initial launch stage (for new funds) and maintained on an ongoing basis (for all funds).
The pricing process will identify and quantify all costs charged to the fund, whether they are paid to the Management Company itself, third parties (such as fund service providers) and/or directly paid by the investors (such as entry and exit costs). It will also need to address the following elements:
- Whether the costs are linked to a service provided in the investors’ best interest, i.e. whether the costs are (a) necessary for the fund to operate in line with its investment objective or (b) necessary for the ordinary activity or regulatory requirements of the fund;
- Whether the costs are proportionate to market standards – ESMA suggests assessing this by means of a comparative costs table against funds with similar characteristics in order to detect outliers;
- Whether the fee structure is consistent with the characteristics of the fund (e.g. higher costs associated with more complex strategies);
- Whether the costs borne by the fund are sustainable taking into account the expected net return of the fund and also based on its risk profile and investment strategy;
- Whether the costs ensure equal treatment of investors (with an exception for AIFs not distributed to retail investors that appropriately disclose preferential treatment);
- Whether there is any duplication of costs (e.g. the same type of fee is not included in two different cost categories) and that costs are properly separated and accounted for. To this end, it is expected that a clear distinction between the costs charged to the fund and those paid directly to the Management Company and any other party should be made;
- Whether a cap on fees is applied and clearly disclosed to investors;
- Whether any performance fee calculation is compliant with the Guidelines discussed below;
- Whether all costs are clearly disclosed to investors in line with applicable rules; and
- Whether the pricing process and all charged costs are based on reliable and documented data, in order to ensure the ability of the NCA to reproduce ex post the calculations made by the management company on a single portfolio level.
The pricing process operated by a Management Company will then form part of the relevant NCA review. NCAs are expected to incorporate the review of pricing processes at all stages in their supervisory activities (i.e. authorisation stage, off-site inspection, on-site inspections, material fund updates, thematic reviews and assessment of investor complaints). The key focus of the NCAs will be to ensure that any fee or commission is aimed at remunerating a service provided to the fund.
Increased Focus on Fund Fees
The Briefing is the latest in a line of recent efforts to obtain fair, transparent and proportionate fund fees for investors in UCITS and AIFs.
In August 2019, we discussed how ESMA’s concern in respect of ‘closet index trackers’6 culminated in an update to its UCITS Q&A in respect of benchmark disclosures7 and the Central Bank of Ireland’s (“CBI”) Thematic Review on Closet Indexing. The purpose of the updated UCITS Q&A and the CBI Thematic Review was to ensure that investors are not disadvantaged by Management Companies charging disproportionate fees in respect of ‘closet indexing’ funds, i.e. those funds which claim to be actively managed while, in reality, the investments and performance of the fund tracks closely to an index. The findings from the CBI Thematic Review also imposed an obligation on all Irish Management Companies (whether in scope for the review or not) to consider on an annual basis whether the particular UCITS under management had delivered its stated investment objective and whether it remained a viable and suitable investment for investors. As part of this, Management Companies are now also required to document and assess, inter alia, the UCITS performance, fee structure and investor base.
More recently, ESMA published its Final Report, ‘Guidelines on performance fees in UCITS and certain types of AIFs’8 (the “Guidelines”) which sought to harmonise how fund managers charge performance fees to retail investors, as well as the circumstances in which performance fees can be paid. The Guidelines seek to enhance investor protection by ensuring consistent and transparent performance fee calculation for all applicable funds and that all performance fees remain proportionate to the investment performance of the fund (e.g. by dis-applying artificial NAV increases following new subscriptions).
On an international basis there has also clearly been a move towards ‘value for money’ for investors in investment funds. Summary details on the U.S. and UK initiatives on this are included in our August 2019 article referenced above.
Next Steps / Conclusion
Similar to what we have seen following ESMA’s paper on ‘closet index trackers’ and its consultation on performance fees, we expect the Central Bank and other NCAs to follow ESMA’s recommendations and to introduce a new requirement on Management Companies to prepare a pricing process in respect of each of their funds under management. Indeed, in Ireland we have already experienced the Central Bank focusing further on UCITS fees in particular during the authorisation process whereby it has sought justification as to the level of fees proposed to be charged.
At this stage it is unclear how NCAs will introduce ESMA’s recommendations into their regulatory regime, i.e. by way of guidance or by legislative amendment to current Regulations. However, in the meantime Management Companies will need to initiate the implementation of a pricing process, noting that further detail may follow through industry engagement with ESMA and NCAs in advance of the formal introduction of the requirements. Irish Management Companies will also need to consider how the pricing process will be incorporated into their “CP86” compliance framework.
We will continue to monitor the industry developments in relation to the Briefing, but if you would like to discuss any particular aspect of these developments, please contact any of the Dechert professionals listed below or your regular Dechert contact.
Footnotes
1) FCA Handbook Collective Investment Schemes – 6.6.19 to 6.6.27
2) Disclosure regarding approval of investment advisory contracts by directors of investment companies, Final rule, SEC, August 2004.
3) July 2019 survey which focused on how NCAs supervise the relevant cost-related provisions in the UCITS and AIFMD frameworks on the obligation to prevent undue costs being charged to investors.
4) Article 14(1) Directive 2009/65/EC (“UCITS Directive”) and Article 12(1) Directive 2011/61/EU (“AIFM Directive”)
5) Article 22(4) Commission Directive 2010/43/EU (“UCITS Level 2 Directive”) and Article 17(2) Commission Delegated Regulation (EU) No 231/2013 (“AIFMD Level 2 Regulation”)
6) Statement - Supervisory work on potential closet index tracking
7) Section II, Question 8
8) Final Report - Guidelines on performance fees in UCITS and certain types of AIFs
