Common use of UCITS Clause in Contracts

UCITS. Since the Global Financial Crisis, international work in relation to shadow banking, coordinated by the Financial Stability Board, identified certain areas of investment funds that required closer scrutiny.360 In particular, “the money-market fund reform… has drawn the UCITS sector into the shadow banking reform agenda”.361 UCITS and their use of collateral transactions was flagged as potentially problematic due to raised concerns in relation to hidden leverage, runs and therefore systemic risk.362 UCITS is a European harmonised regulated fund product that can be sold on a cross-border basis within the European Economic Area based on its authorisation in one EU Member State.363 This means that funds authorised in one EU Member State can be marketed in another EU Member State via a passport mechanism.364 Underpinning UCITS is a comprehensive legal frame- work for the regulation of harmonised investment funds within the EU. Origin- ally introduced in 1985, the UCITS rules have been revised several times, most 358 Managed Funds Association, “MFA Comments on Second FSB/IOSCO Consultation Document – Methodologies for Identifying Non-Bank Non-Insurer Globally Systemically Important Financial Institutions” (29 May, 2015) 1 at 7, available at: ▇▇▇▇▇://▇▇▇.▇▇▇▇▇.▇▇▇/ library/pubdocs/479/pdf/Managed%20Funds%20Association%20(MFA).pdf. 359 President’s Working Group, Hedge Funds, leverage and Lessons of Long-Term Capital Manage- ment (1999), available at: ▇▇▇▇▇://▇▇▇.▇▇▇▇▇▇▇▇.▇▇▇/press-center/press-releases/Pages/ report3097.aspx. See also, ▇ ▇ ▇▇▇▇▇▇, The Global Financial Crisis: From US subprime mortgages to European sovereign debt (2016) 210; ▇ ▇▇▇▇▇▇, Booms and Busts: An Encyclopedia of Economic History from the First Shock (2015) 72 – 74. 360 European Commission, “Consultation Document: Undertaking for Collective Investment in Transferable Securities” (26 July 2012) 1 at 2, available at: ▇▇▇▇▇://▇▇.▇▇▇▇▇▇.▇▇/finance/ consultations/2012/ucits/docs/ucits_consultation_en.pdf. See also, Finance Watch, “Answer to the public consultation from the European Commission on UCITS” (18 October 2012), available at: ▇▇▇▇▇://▇▇▇.▇▇▇▇▇▇▇-▇▇▇▇▇.▇▇▇/wp-content/uploads/2018/08/121018_ Answer_to_EC_Consult_UCITS.pdf. 361 ▇▇▇▇▇▇▇ (n 350) 260. 362 European Commission, “Green Paper on Shadow Banking” (2012) COM/2012/0102final at paragraphs 4, 6.3 and 7.2, available at: ▇▇▇▇▇://▇▇▇-▇▇▇.▇▇▇▇▇▇.▇▇/legal-content/en/ALL/? uri=CELEX%3A52012DC0102. See also, European Commission (n 360) 1 at 2-3. 363 UCITS also enjoy a high level of recognition in many non-European Economic Area coun- tries, such as South Africa, Asia and South America. 364 Recital 5 UCITS as regards the clarification of certain definitions. recently through the UCITS V Directive, which came into force on 18 March 2016.365 With the enactment of the AIFMD, investment funds in Europe are classified into two broad categories, namely UCITS and Alternative Investment Funds. In general, investment funds are investment products created for the sole purpose of gathering investors’ capital and investing that capital collectively through a portfolio of financial instruments such as bonds, equities and other securities.366 The UCITS category includes mutual funds and pension funds – these funds are available to retail investors and one of the distinguishing features of UCITS from Alternative Investment Funds is that UCITS raise funds from the public, while Alternative Investment Funds raise capital privately.367 365 The UCITS framework is made up of the following EU legislation: Directive 2014/91/EU of the European Parliament and of the Council of 23 July 2014 amending Directive 2009/65/ EC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) as regards deposit- ary functions, remuneration policies and sanctions; Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities - This is a ‘framework’ Level 1 Directive, which has been supplemented by technical implementing measures (as follows); Commission Directive 2007/16/EC of 19 March 2007 implementing Council Directive 85/611/EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) as regards the clarification of certain definitions; Commis- sion Directive 2010/43/EU of 1 July 2010 implementing Directive 2009/65/EC of the European Parliament and of the Council as regards organisational requirements, conflicts of interest, conduct of business, risk management and content of the agreement between a depositary and a management company; Commission Regulation (EU) No 583/2010 of 1 July 2010 implementing Directive 2009/65/EC of the European Parliament and of the Council as regards key investor information and conditions to be met when providing key investor information or the prospectus in a durable medium other than paper or by means of a website; Commission Directive 2010/42/EU of 1 July 2010 implementing Directive 2009/65/EC of the European Parliament and of the Council as regards certain provisions concerning fund mergers, master-feeder structures and notification procedure; Commission Regulation (EU) No 584/2010 of 1 July 2010 implementing Directive 2009/65/EC of the European Parliament and of the Council as regards the form and content of the standard notification letter and UCITS attestation, the use of electronic communication between competent authorities for the purpose of notification, and procedures for on-the-spot verifications and investigations and the exchange of information between competent authorities; and, Commission Implementing Regulation (EU) 2016/1212 of 25 July 2016 laying down implementing technical standards with regard to standard procedures and forms for submitting information in accordance with Directive 2009/65/EC of the European Parliament and of the Council. See also, European Securities and Markets Authority, “Fund Management” (2020) available at: ▇▇▇▇▇://▇▇▇.▇▇▇▇.▇▇▇▇▇▇.▇▇/regulation/fund-manage- ment. 366 European Commission, “Investment funds: EU laws and initiatives relating to collective investment funds” (accessed 27 April, 2020) available at: ▇▇▇▇▇://▇▇.▇▇▇▇▇▇.▇▇/info/business- economy-euro/growth-and-investment/investment-funds_en. 367 ▇▇▇▇▇▇▇ (n 349) 296-297. A defining feature of the UCITS framework is characterised by the offer to investors of on-demand liquidity. In particular, a “UCITS shall repurchase or redeem its units at the request of any unit-holder”.368 To guarantee the liquidity of the UCITS product are the specific portfolio diversification require- ments as outlined under Article 52, which is reinforced by the list of eligible and non-eligible assets as specified under Article 50.369 For instance, Article 52 (1) and (2) state that a UCITS shall invest no more than 5% of its assets in transferable securities or money market instruments issued by the same body and, the risk exposure to a counterparty of the UCITS in an OTC derivative transaction shall not exceed 10%.370 However, no financial institution is immune to risk. In fact, it has been noted that possible regulatory shortcomings in the UCITS sector need to be addressed.371 ▇▇▇▇ ▇▇▇▇▇▇ has warned of the potential fragilities in the sector and stated that UCITS are a potential source of systemic risk.372 Because the UCITS framework offers ‘on-demand liquidity’ to investors – what happens if leveraged UCITS funds have assets that “fundamentally aren’t liquid or might become illiquid in a downturn”?373 Such a situation arose in June 2019 where the UCITS sector had “some $30 trillion tied up in difficult-to-trade invest- ments”.374 This caused ▇▇▇▇ ▇▇▇▇▇▇ to state that UCITS “funds are built on a lie, which is you can have daily liquidity… The damage of that ‘lie’ for financial stability is that it leads to the expectation for individuals that it’s not that different from having money in a bank”.375 Such a situation is very similar to a classic bank run where funds can be withdrawn – en-masse – and financial institutions are therefore forced to deleverage thereby exacerbating systemic risk. An infinitely preferable approach would arguably be regulation that better aligns the redemption terms with the actual liquidity of the under- lying investment. 368 Article 84 (1) UCITS. 369 Articles 50 and 52 UCITS. 370 Article 52 (1) and (2) UCITS.