A long-awaited European Union directive promises to ease mutual fund sales throughout the Continent. But with a key deadline approaching, implementation may be a problem. As always, the devil is in the details.
The EU passed the measure, the Undertakings for Collective Investment in Transferable Securities, dubbed Ucits III, back in February 2002. It's designed to replace an earlier version passed by the European Community in 1985; a second incarnation was scrapped at the final hour in 1997. The latest directive includes reforms that will move the industry toward a long-desired goal: selling one fund with one manager, one prospectus and one administrator throughout the EU. Currently, discriminatory local regulations mean that only 10 percent of mutual fund sales in Europe are cross-border. Ucits III will also allow for the first time cross-border sales of money market funds and funds of funds as well as greater flexibility in the use of derivatives.
There's one catch: Before the directive can take effect, each country in the EU must pass legislation incorporating the edict into its own national law. (The one exception is the U.K., where the job of enacting the directive falls to the regulator, the Financial Services Authority.) The EU stipulates that member states must enact these laws by March 2004; if they don't, they will be in breach of EU rules and may be fined by the European Commission. So far, though, only Luxembourg has enacted the full directive. Draft laws are in circulation in Austria, Ireland and Sweden. The U.K.'s FSA has enacted part of the Ucits directive and is in consultation with financial services executives about how best to interpret the remaining provisions. Industry sources suggest that in the U.K. the EU ruling will be translated in ways that are broadly supportive of the single-market goal.
Because of this foot-dragging, most fund managers aren't rushing to prepare for the promised new freedoms. Says Philip Warland, senior adviser in the European regulatory practice in the London office of PricewaterhouseCoopers: "It is hard to see what the first-mover advantage would be when the regulations remain to be concluded in important jurisdictions. There is very little incentive now in risking the possibility of getting something wrong."
Luxembourg's law is supportive of a single market, but its statute includes none of the important details about how the directive should be implemented. Legislators are evidently leaving that to Luxembourg's regulatory authority, the Commission de Surveillance du Secteur Financier.
Whereas the U.K. regulator made public its preliminary understanding of the EU directive, in France the consultation process is being conducted behind closed doors. In Germany and Italy even the most sophisticated observers of the regulatory scene have little intelligence about the details of the Ucits III debate. But industry executives suspect that these three countries will translate the EU directive in ways that compromise the goal of a single market. All have large domestic fund industries that their governments will seek to protect.
The EU edict has two parts: the product directive and the management directive. Fund managers are generally enthusiastic about the prospect of offering new products and selling them more easily across borders, activities addressed in the product directive.
They're less keen on the second piece of the ruling, the management company directive. This provision authorizes management companies and defines the scope of their activities. In theory, it should allow greater flexibility in the choice of where funds are managed and how they are marketed and administered. But some suspect that the provisions could actually have the opposite effect, depending on how national regulators interpret them.
Says Lorna Nolan, head of business and product development at London-based Gartmore Investment Management, "Being able to use central management of funds across Europe would create enormous efficiencies for fund managers."
Nolan sees the greatest potential in the provisions of the product directive that allow the new freedom to offer funds of funds. (Specifically, the measure permits Ucits-registered funds to invest in other Ucits-registered funds.)
"This will bring open architecture a step closer, as local distributors will be able to structure funds of funds around any fund under Ucits," she says.
Richard Eats, head of retail and product development at Threadneedle Investments, a London-based money manager, is most excited about the possibilities for money market funds and derivatives trading.
Threadneedle, in fact, is one of just a handful of money managers that have filed the necessary paperwork with the FSA to offer a Ucits IIIcompliant product in the U.K. Its UK Limited Issue Fund will be a concentrated absolute-return U.K. equities product, with a maximum holding of 30 stocks. It will make aggressive use of derivatives, be able to hold as much as 100 percent of its assets in cash and employ futures to shift its exposure to equities. At the moment, Threadneedle will offer this product only in the U.K.
As industry executives and consultants studied the EU directive, they realized that it says nothing about the thorny issue of tax treatment. Yet the London office of PricewaterhouseCoopers has identified several tax barriers that effectively discriminate against funds owned by foreign firms in most of the EU's 15 member states.
In Germany, for example, an investor in a foreign fund has to pay the full capital gains tax. If the investor puts money into a German fund, he pays only half the tax, and if he invests in a domestic insurance product, there is no tax due at all.
Still, it's the management company directive that many executives are scrutinizing most closely. This offers the prospect of achieving a long-desired industry goal: the establishment of funds offering one prospectus for the entire EU. "The idea that you can register a document with, say, the Financial Services Authority in London and then use that same document all around Europe is a great one if it works," says John Ingamells, head of public affairs at Fidelity International, the London-based subsidiary of U.S. mutual fund giant Fidelity Investments.
But will it happen? The Fidelity executive says it's far from a sure bet.
"We are waiting for individual countries to publish the details of how this will be implemented in the member states," says Ingamells. "There is a real risk that we will have to continue to register each prospectus with each national regulator."
The management company directive also addresses fund administration and portfolio management. Under current law administration must take place in the same jurisdiction as the fund domicile, and it's the domicile of the fund that defines the fund company's tax obligations. As a result, J.P. Morgan Chase & Co. and other custodians have significant administrative operations in Luxembourg and Dublin, the industry's two favorite low-tax environments. Legally, portfolio management is also supposed to take place in the same jurisdiction as the fund domicile. But practically speaking, a fund portfolio manager may, for example, work out of a London office. To meet the fund's legal obligations, however, an entity must exist in Luxembourg.
Many executives had hoped that the single-market philosophy of Ucits III would eliminate these restrictions so that a fund could be legally domiciled in Luxembourg or Dublin, say, with portfolio management taking place in Frankfurt and administration in London.
But Chris Edge, head of mutual funds at J.P. Morgan Investor Services, believes that Luxembourg and countries with large domestic fund markets, such as France and Germany, will want to maintain the status quo, insisting that administration and management continue to take place in the same jurisdiction. They will do this, Edge and others suggest, because they want to protect their domestic fund administrators and producers from outside competition. The current obligation to establish a central fund domicile serves as a disincentive to foreign firms looking to sell their funds in France or Germany.
Although industry executives relish the prospects offered by the ruling's product directive -- the freedom to do cross-border sales of money funds and funds of funds and to use derivatives more aggressively -- they worry that the management directive will impose costly new regulatory burdens that will outweigh Ucits III's benefits.
For one thing, the management directive requires management companies to maintain more regulatory capital than they had in the past. "All that the management company directive has achieved is the creation of a higher level of substance and oversight routines for funds to comply with, which will add to costs," says J.P. Morgan's Edge.
More simply, Julie Patterson, director of regulation and tax at the London-based Investment Management Association, says: "The benefits of the directive are slipping away, and what we are left with is a new set of obligations. One example is the need of management companies to maintain regulatory capital."
Since Ucits III was eight years in the making, some fund executives are disappointed with the considerable uncertainty that surrounds the new ruling.
"I have to shrug my shoulders," says Fidelity's Ingamells. "This is a very poor return for eight years of work. The objective of being able to offer a single fund with a single manager from any jurisdiction still seems far away."
