EVENTS

Date:	Thursday, May 18, 2006
Time:	9:30 AM -- 11:30 AM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

May 2006

The Regulation and Structure of Collective Investment Vehicles outside the United States

The U.S. structure for collective investment, in which individual corporations hire outside investment advisers, is unusual among developed economies. Most other industrialized nations use structures based on a direct contractual relationship between the fund manager and the investor. In such structures, there is no intervening corporation, but there are mechanisms intended to substitute for some of the fiduciary responsibilities of a corporate board of directors. In this conference, the tenth in the series, "Is There a Better Way to Regulate Mutual Funds?" mutual fund experts from Canada, Luxembourg, France, and the United Kingdom gathered to discuss collective investment structures in their respective countries and how they compared to the U.S. corporate model. A particular focus of the discussion was how the non-U.S. collective investment structures address issues such as conflicts of interest in the governance of collective investment

Peter J. Wallison
AEI

The collective investment industry in the United States is unusual in permitting only one basic structure for managed collective investment--a corporate structure which can be either a corporation or a business trust. Under this structure, the corporation or trust holds the assets of the fund and outsources the management and administrative functions through a contract with an investment adviser. Because this arrangement is said to give rise to a conflict of interest--the adviser wants to make as much profit as possible from the relationship to the fund, and is thus in a position to take advantage of the relationship to the detriment of the shareholders--a board is in place to see that the adviser is working in the investors’ interests. In contrast, most foreign collective investment vehicles do not follow this corporate structure. Under the structures found in other countries, the investor contracts directly with the adviser to manage the investor’s funds collectively with those of others. This is very much like the contractual relationships we see in every other area of our daily lives in which we pay a fee for a service. Thus, other developed countries have adopted structures that treat the process of collective investment as something like an everyday fee-for-services transaction, while we in the United States treat it as a special case, in which investors need special assistance and protection. Interposing a board of directors is probably the most expensive way of protecting investors, but it may be that these additional costs produce necessary additional protection for U.S. investors. On the other hand, the contractual structures used elsewhere ultimately may do just as well.

Richard Saunders
Investment Management Association

Until 1997, the only open ended retail collective investment scheme available in the United Kingdom was the unit trust--a contractual as opposed to a corporate model. Under the unit trust arrangement, investors give their money to the manager who places it in a trust, with units of the trust representing the investor’s interest in the underlying assets. The manager makes the investment decisions for the investors’ funds and appoints an independent trustee, who is responsible for issuing and redeeming units, as well as the custody and oversight of the funds. This creates a potential conflict of interest because while the trustee is supposed to oversee the manager, the manager appoints the trustee. The United Kingdom deals with this conflict through regulation: both the manager and the trustee must be entities authorized by the Financial Services Authority (FSA), and the regulator must also authorize the fund itself.

In 1997, the United Kingdom introduced open-ended investment companies (OEICs), which can be sold elsewhere in the European Union. An OEIC is established under a form of company law as opposed to trust law. Similar to the system in America, an OEIC owns the underlying assets and investors own shares that reflect their interests in those assets. An OEIC must have a board, and while independent directors are permissible, the only board member required is the authorized corporate director, who happens to be the investment manager. In practice, nearly all OEICs’ boards are comprised of the manager alone. In addition, there exists a depository who has the same responsibilities for custody and oversight that the trustee has in the unit trust.

OEICs were designed to replicate as closely as possible the characteristics of unit trusts but within a corporate structure, and for all intents and purposes, the two are identical from the investor’s standpoint. The purpose of introducing the OEIC was to provide a vehicle capable of being recognized in continental Europe; there were no other advantages seen to the corporate form. In both cases, the authorized fund manager is responsible for making the day-to-day investment decisions of the fund, pricing scheme assets, and maintaining financial records. Other than in the purely technical matter of whether he holds the assets in trust, the role of the trustee and the depository are identical. The depository or trustee, who is independent of the manager, must safeguard all assets of the scheme, oversee all the manager’s activities, and ensure compliance with regulations of the FSA. Indeed, FSA regulation is the cornerstone of investor protection in the United Kingdom.

Rebecca A. Cowdery
Borden Ladner Gervais LLP

While Canadian mutual funds can be organized as trusts or as corporations, the difference in structure has few ramifications for the funds’ practical operations. Most are established as trusts out of tax considerations. The governance of all Canadian mutual funds centers on the role of the fund manager, a separate entity that is responsible for the business and affairs of the mutual fund. Typically, the manager is the entity that establishes the fund, though in operating the fund, the manager may outsource all services, including portfolio management, fund administration, valuation, and accounting. In addition to the manager, there is a custodian, a functionally independent third party--the custodian can be part of the same group as the manager--who holds the fund assets.

Under the trust structure, the fund trustee is typically the manager--only a few funds have trustees that are individuals or trust companies. Canadian laws require trustees to be individuals or registered trust companies, but allow fund managers to act as trustees of their mutual funds. Because the manager/trustee is a separate entity from the mutual fund, conflict of interest arises. To remedy this and to protect investors, Canada regulates the fiduciary responsibilities of the fund manager and prohibits certain related party transactions between the manager (and entities related to the manager) and the mutual fund.

Fund governance is generally conducted at the level of the board of the fund manager. Boards of fund managers are not required to have any independent directors, although some Canadian fund managers have independent directors on their boards. Whereas a fund manager is owned by a public company (and several Canadian fund managers are so held), fund governance is also considered at the public company board level, which requires independent directors by law. Under the corporate structure for mutual funds, independent directors may act as directors of the corporate mutual fund, since they are required by corporate laws (not securities regulation), but in effect, the governance of the corporate fund still takes place at the level of the fund manager. In Canada, the concept of independent oversight does not exist as it does in the United States, with its independent directors, and in the United Kingdom, with the depository.

In Canada, regulation specifies that the manager must generally act in the investors’ best interest, must be accountable for disclosure about the fund, and must see to annual audits of financial statements by qualified auditors. All portfolio managers--different from fund managers--must be registered with the provincial securities commission. Furthermore, investors have the right to redeem shares and vote on fundamental changes in the fund in which they are invested.

In Canada, there is no national equivalent of the U.S. Securities and Exchange Commission; government regulation of mutual funds, as with other securities, takes place at the provincial level.

Robert Hoffmann
Association of the Luxembourg Fund Industry

Luxembourg is one of the leading locations for investment funds (also referred to as undertakings for collective investment, or UCIs). The regulations applicable to Luxembourg UCIs comprise mainly laws (which transpose European directives) and circulars issued by the Luxembourg supervisory authority (the CSSF). UCIs may be primarily established under two separate legal structures: FCPs (fonds commun de placement), common funds similar to the unit trust in the UK, and SICAVs (société d'investissement à capital variable), investment companies with variable capital, similar to the OEIC of the United Kingdom. An FCP has no legal personality and must be managed by a Luxembourg management company. The management company of the FCP will appoint the custodian and an independent auditor. The management company and the custodian must act in the sole interest of the investors. The SICAV, on the other hand, has a legal personality. It may either appoint a management company or designate itself as a self-managed investment company. In any case, the SICAV must appoint a Luxembourg custodian and an independent auditor. The management company of a SICAV that has chosen to appoint a management company has the same responsibilities as it does under an FCP. UCIs may also be established in forms other than the FCP and the SICAV.

Because Luxembourg is a small country, its mutual fund industry is export-driven, primarily in Europe, but extending to over 150 countries throughout the world. In 1988, Luxembourg became the first country in Europe to transpose the European directive on undertakings for collective investment in transferable securities (referred to as UCITS). This gave Luxembourg the ability to capture a great deal of the market for UCITS, funds that, under certain conditions, can be freely traded “cross border” (i.e. throughout the Europe Union). For example, a fund complex which would set up a UCITS with the European passport in Luxembourg could then sell it in any country of the European Union with minimum formalities. It should be noted that most UCITS established in Luxembourg outsource specific tasks to specialized entities. Due to this separation of functions, which is fully enforced by the CSSF, conflict of interest is a minor issue for these Luxembourg funds. Luxembourg-based UCITS are subject to Luxembourg regulations. However, when distributed abroad, UCITS are also subject to certain regulations of the importing “host” country in respect of marketing rules.

Pierre Bollon
Association Française de la Gestion financière AFG (French Asset Management Association)

The French industry for collective investment boasts a wide variety of products. Similar to the industry in Luxembourg, there are UCITS (undertakings for collective investment in transferable securities) and non-UCITS funds. Furthermore, the legal structures for French products mirror those found in Luxembourg: there are SICAVs (société d'investissement à capital variable) and there are FCPs (fonds commun de placement). As of late, the market for FCPs--the contractual funds--has been growing faster than that for corporate funds. There are two main reasons for this. First, unlike SICAVS, FCPs do not have boards and are not required to hold general shareholder meetings, and are thus less expensive to manage. Second, in the past, a value-added tax was applied to FCPs but not to SICAVs. Within the past two years, this discrepancy in the tax code has been amended.
 
In regard to regulation, the main difference between France and the United States is that in France, the management company is heavily regulated. Every management company must be authorized and monitored by the national securities regulator, and neither a SICAV nor an FCP can start without securities commission (Autorité des Marchés Financiers--i.e. French SEC) authorization. The regulation of the management company touches many areas, including decision-making procedures, internal control and regulatory compliance mechanisms, data recording, risk management policies, fiduciary duty, and capital requirements. Also, in recent years, the internal audit function has become increasingly important, and all funds require a compliance officer. Another important aspect to regulation is the role of the depository, which must be legally and structurally independent from the management company, and is in charge of the safekeeping of the assets and monitoring the management company. Furthermore, this regulation takes place on three levels: the European Union level, the national level, and at the level of professional self-regulation.

To combat the effects of conflict of interest, the French system relies on four pillars. The first is regulation, just as it is in the United Kingdom. Second is that all management companies must be authorized by the French securities commission. Third, there are numerous checks and balances, ranging from internal auditors to compliance officers to peer pressure from the industry at large. The fourth pillar is disclosure and competition.

AEI research assistant Dan Geary prepared this summary.