Legal Updates

On 24 May 2023, the European Commission published its much-anticipated Retail Investment Strategy (Strategy) which proposes significant changes to a number of European directives including the MiFID Directive and the Insurance Distribution Directive, as well as proposing targeted changes to the UCITS and AIFMD frameworks.

In this briefing, we provide an overview of what may change for UCITS management companies and AIFMs (FMCs) in the area of costs and fees if the targeted changes to the UCITS and AIFMD rules are implemented in the manner proposed in the Strategy.

Background

Under the existing UCITS and AIFMD frameworks, FMCs are required to ensure that shareholders in the funds which they manage are not charged undue costs. Since 2020, there has been an increased regulatory focus on the area of costs and fees.

In June 2020, ESMA issued a Supervisory Briefing on Costs in UCITS and AIFs (ESMA Supervisory Briefing) with the aim of promoting convergence on the supervision of costs in UCITS and AIFs by EU national competent authorities (NCAs), including the Central Bank of Ireland. In the ESMA Supervisory Briefing, ESMA outlined its expectation that all FMCs should put in place a documented and structured pricing process in order to ensure that investors are not charged undue costs. Following a common supervisory action carried out by ESMA and all NCAs in 2021 on costs and fees borne by UCITS funds (CSA), ESMA published its Final Report (ESMA Final Report) in May 2022 in which it set out its findings from the CSA and restated the need for UCITS management companies to implement a documented pricing process. However, ESMA also outlined its expectations that FMCs should review costs and fees charged to funds under management

on at least an annual basis^[1].

In March of this year, the Central Bank of Ireland issued a “Dear Chair” letter in which it confirmed that it expected all Irish FMCs (whether structured as UCITS management companies or AIFMs) to implement a documented pricing process and to review costs and fees charged and the methodology for calculating those fees on at least an annual basis^[2].

So what is changing for FMCs under the proposals put forward by the European Commission in the Strategy?

What is changing for FMCs under the proposals set down in the strategy?

• Enhanced obligations relating to charging of undue costs

The Strategy places the existing obligations imposed on FMCs under the ESMA Report and the Dear Chair Letter to implement and periodically review a documented pricing process and carry out an annual assessment of fees and costs on a legislative footing. It also sets down some high-level criteria that must be satisfied in order for a cost to be considered “due” while providing that the detailed criteria for such assessments will be incorporated into regulatory technical standards or “Level 2 measures”.

• Payment of compensation to investors and reporting of undue costs to regulators, depositary and fund auditors.

Consistent with the existing expectations of both ESMA and the Central Bank, FMCs will be required to assess at least annually, whether undue costs have been charged to investors, taking into account the specific criteria outlined in the legislative proposal.

However, the proposals set down in the Strategy go further than either ESMA or the Central Bank by proposing to amend the UCITS and AIFMD directives to provide that if the FMC determines that investors have been charged undue costs in the previous year, they will be required to pay compensation to such investors^[3].

Furthermore, under the proposals set out in the Strategy, any FMC which determines that it has charged undue costs to investors will be required to report this information not only to its own NCA and the NCA of the relevant fund (where different) but also to the depositary and the auditors of the fund in question.

• Comparison with Peer Funds

As part of its overarching objective to ensure that only products that deliver “value for money” are offered to retail investors, the Strategy expands on the recommendations contained in the ESMA Supervisory Briefing and the ESMA Final Report that FMCs compare the costs and fees charged to a fund against those charged to peer funds.

In this regard, the European Commission has proposed that all UCITS funds and all AIF funds marketed to retail investors must, as part of the annual review of costs, compare the costs charged to the relevant fund against an appropriate benchmark published by ESMA.

If the costs and fees borne by the relevant fund (or share class) are higher than the relevant ESMA benchmark, there is a presumption that such costs are undue and will not deliver value for money unless it can be determined otherwise. In such circumstances, the FMC must carry out additional testing and assessments and establish whether such costs and fees are justified and proportionate notwithstanding that they deviate from the relevant ESMA benchmark.

If the FMC cannot demonstrate that the costs and fees borne by the fund are justified and proportionate (or if the costs and fees do not comply with the other criteria set down by the FMC in its pricing process), the FMC cannot be marketed to retail investors.

Under the Strategy, ESMA will be required to develop these benchmarks, referred to as “value for money benchmarks”, where it is feasible to do so and will be required to update those benchmarks on a regular basis. The European Commission has noted that where a relevant benchmark is not available, this does not alleviate the FMC from the obligation to demonstrate that costs and fees are justified and proportionate.

• Reporting of costs and fees to NCAS

In order to allow ESMA to create and publish such appropriate “value for money” benchmarks to enable fund comparisons, the European Commission has proposed in the Strategy that all FMCs will be required to report to their NCA information on the costs borne by investors and the performance of the relevant fund (or, where applicable, share class).

• Introduction of concept of “Eligible Costs”

Interestingly, the European Commission has provided that regulatory technical standards should set down a list of “eligible costs” which can be charged to a fund and the conditions under which NCAs may authorise on a case-by-case basis costs which are not included in that list of eligible costs. This aligns with the existing practices in some EU Member States where a finite list of costs which can be charged to funds have been published by the relevant NCA. It is worth noting that in an Opinion on Undue Costs of UCITS and AIFS published on 17 May 2023, ESMA recommended that the list of costs already contained in the PRIIPS Level 2 measures^[4] be used as a starting point for assessing whether or not a particular fee or cost is eligible so it will be interesting to see whether this recommendation is carried across into the finalised delegated acts when published.

Conclusion

The legislative proposals put forward by the European Commission must now be considered by the European Parliament and the Council of Europe. Once a finalised text is agreed, ESMA will be tasked with drafting related regulatory technical standards which will provide the detailed rules on the pricing process and the annual assessment of fees and charges.

Negotiations between the three institutions on the legal text are likely to be closely monitored by FMCs given the potential implications for existing pricing processes and costs structures if implemented as currently proposed.

We will keep you updated on relevant developments however in the meantime, if you have any questions arising from this briefing, please get in touch with any of the authors or your usual contact in Dillon Eustace.

Footnotes:

[1] For a detailed overview of the ESMA Final Report, please refer to our briefing on this topic.

[2] The Dear Chair letter is considered in greater detail in our separate briefing on this topic.

[3] In an Opinion published by ESMA on 19 May 2023, ESMA had made a similar recommendation regarding the reimbursement of undue costs to investors which it noted should be made “without undue delay”.

[4] Annex VI Part 1.I of Commission Delegated Regulation (EU) 2017/653 as amended