UCITS IV — Rules of Conduct and the Challenges facing Management Companies and Self-Managed Investment Companies

Under the auspices of UCITS III, management companies (“ManCos”) and self-managed investment companies (SMICs) have been organised and maintained in accordance with the requirements of the Management Directive (Undertaking for Collective Investment in Transferable Securities Directive 2001/107) such that the board of directors are required to carry out eight key functions, being: decision taking, monitoring compliance, risk management, monitoring investment performance, financial control, monitoring capital, internal audit and supervision of delegates in the course of their management of the relevant UCITS.

UCITS IV seeks to build upon this governance framework, requiring ManCos and SMICs to have sound administrative procedures; safeguard arrangements for electronic data processing; and adequate internal control mechanisms to include: (i) rules for personal transactions by employees; (ii) rules for investing on own account; (iii) documenting transactions so that they may be reconstructed according to their origin, parties, nature, time and place; and (iv) establishing assets of a fund are invested in accordance with fund rules, instruments of incorporation and legal provisions in force. The net effect of these new requirements is to elaborate on the existing eight key functions under UCITS III and to impose two additional functions (being complaints handing and accounting policies and procedures). The UCITS IV Directive (Article 14) also provides for the implementation of rules of conduct by the ManCo/SMIC to cover the following key areas: due diligence requirements in respect of the appointment of third parties, handling of orders, best execution, complaints handling, inducements, fees, rebates and soft commissions, voting rights, malpractices, conflicts of interest, personal transactions and records and business continuity.

Given the breadth of these rules of conduct, this article seeks to focus on three key areas which have provoked the greatest degree of interest from the industry.

Due diligence requirements – appointment of third parties

Under UCITS IV, the ManCo/SMIC must put in place due diligence procedures which shall be complied with prior to the appointment by the ManCo/SMIC of any third party service provider. Such due diligence procedures should include inter alia carrying out background checks on the relevant service provider to establish regulatory status of the service provider, the expertise of the service provider in the UCITS product and an assessment of the knowledge and understanding of the assets and markets accessible to UCITS. In addition, the ManCo/SMIC should assess the compliance and administration procedures of the service provider, the number of client complaints and existence of a complaints policy, the resource capacity, staff expertise and turnover of the service provider, the organisational structure, business continuity planning, corporate governance and management reporting and the financial stability and capital adequacy of the service provider.

In ensuring that the ManCo/SMIC has carried out a due diligence process on the service provider, the intention is that the board of the ManCo/SMIC is fully aware of the internal processes and structures of the service provider such that they can effectively service the UCITS and that the service provider can adequately meet the standards expected of them vis-à-vis UCITS funds.

Best execution

UCITS IV also requires the ManCo/SMIC to take all reasonable steps to obtain the best possible result when executing orders on behalf of the UCITS which will involve taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other relevant consideration.

In determining the relative importance of each of these factors in the context of the UCITS under management, the ManCo/SMIC will take into account the objectives, investment policy and risks specific to the UCITS; the characteristics of the order; the characteristics of the financial instruments that are the subject of that order; and the characteristics of the execution venues to which the order can be directed.

For each class of financial instruments, the ManCo must define the key execution factors that will be taken into account when executing orders and information and the execution venues/entities that best suit its requirements. The ManCo must also assess which venues are likely to provide the best possible result for the UCITS on a product-by-product basis.

Shareholders must be made aware of the best execution policy in place and it is up to the ManCo/SMIC to ensure that the policy is kept up to date. From a practical perspective, the policy of the ManCo/SMIC is likely to reflect the best execution policy pursued by the investment manager of the UCITS and the expectation is that the investment manager would report on an ongoing basis to the ManCo/SMIC on the execution venues, trading counterparties and pricing.

Fees and commissions

Another key area of interest is the requirement to establish and implement a policy on fees and commissions. The policy and procedures should include the periodic review of fees and commissions by the ManCo/SMIC and where the ManCo/SMIC, or any of its respective delegates, successfully negotiates the recapture of a portion of the commissions charged by brokers or dealers in connection with the purchase and/or sale of securities for the UCITS, the rebated commission must be paid to the UCITS. Perhaps the key consideration is the requirement that the ManCo/SMIC shall at all times act in such a way as to prevent undue costs being charged to the UCITS and its shareholders. This requirement necessitates that the ManCo/SMIC keeps a watchful eye on third party service contracts to ensure that suitable fee disclosure is made to include all soft commissions, retrocession fees and nonmonetary benefits. In addition, all fees charged by the UCITS must be designed to enhance the overall quality of service to the shareholders of the UCITS.

While UCITS IV will ultimately increase the workload of the directors of the ManCo/SMIC it successfully identifies the shortcomings with the existing UCITS framework and that as a result of the implementation of UCITS IV, the UCITS product will ultimately be better managed and supervised. The changes brought in by UCITS IV will ensure that the UCITS product is fine-tuned to reflect 21st-Century financial markets and the increased focus on corporate governance within the global funds industry.

Note: The effective date for the implementation of changes (including those relating to rules of conduct) is 1 July 2011.

Elaine Keane is a senior associate in the investment funds group at the Dublin office of international law firm Maples and Calder.

This article first appeared in AIMA Journal (Q2 2011, Pages 24 – 25). For more information, please visit