No KIIDing - Hefty Fine from UK Regulator Underlines Importance of Compliance by UCITS
A fine of over £18 million was recently imposed by the UK regulatory body, the Financial Conduct Authority (the “FCA”), on a fund manager for a range of compliance breaches, including failing to ensure that its KIIDs were prepared in compliance with the applicable requirements. This update examines the regulatory obligations relating to KIIDs generally, the facts of this specific case and potential steps to be taken to ensure compliance based on the lessons from the case.
Obligations concerning KIIDs
The “Key Investor Information Document” or “KIID” is a short two page (or three page for structured products) summary document that all UCITS are required to produce. The obligation to produce this document was included as part of the UCITS IV1 reforms and became effective in 2012. The KIID replaced the “simplified prospectus” that was required under UCITS III,2 and was designed to address some of the shortcomings of the simplified prospectus.
The KIID is designed to assist potential investors to make informed investment decisions by providing essential information in a harmonised short format that facilitates the comparison of relevant product features, including costs and risk profile. It is mandatory for all UCITS to produce this document and to provide it free of charge in advance of a subscription. In order to ensure the maximum level of harmonisation in the preparation of KIIDs, UCITS IV provided the European Commission with the power to adopt measures specifying the detailed and exhaustive content, form and presentation of the KIID and this detail is included in a supplementing regulation (the “Regulation”).3
The general requirements relating to the preparation of KIIDs include obligations to ensure they are written in a concise manner using non-technical language so as to be understood by retail investors. They are required to be “fair, clear and not misleading” as well as being consistent with the main prospectus. Civil liability may be incurred where a KIID does not meet these requirements. Including sufficient disclosures and risk warnings can, however, be challenging given the strict limitations regarding the length of the KIID.
The Invesco Case
Invesco Asset Management Limited (“IAML”) and Invesco Fund Managers Limited (“IFML”) (together “Invesco Perpetual”) manage some of the largest retail funds in the UK and assets under management in these totalled over £70 billion by December 2013. IFML was the management company for the UCITS in question and had appointed IAML as the portfolio manager with discretionary powers regarding investment activity. IFML retained regulatory responsibilities towards the funds in question notwithstanding the delegation in relation to investment activity. The FCA announced in April 2012 that it was imposing a fine of $18,643,000 (reduced from over £26 million due to a discount under the FCA’s executive settlement procedure) on Invesco Perpetual for various deemed compliance breaches as set out in its Final Notice of 24th April 2014 (the “Notice”). Apart from determining that there were shortcomings in the KIIDs, other reasons for the FCA determining to impose the fine included breaches of applicable investment limits and failing to put adequate controls in place to ensure that all funds were valued accurately and that all trades were allocated fairly between funds. The Notice also details the rationale for the fine in each case.
With regard to the element of the fine relating to the KIIDs (which amounted to under £2 million of the total fine), leverage had been introduced into certain of Invesco Perpetual’s funds through the use of derivatives. This was disclosed in the relevant prospectus and the KIIDs also referred to the use of derivatives, stating in each case:
"The Fund may use derivatives (complex instruments) in an attempt to reduce the overall risk of its investments or reduce the costs of investing, although this may not be achieved”.
However, the FCA noted that the effects of the use of derivatives by the UCITS was not confined to the matters specified in this statement in the KIID and as such it was misleading.
Disclosures and Risk
There is a specific obligation for KIIDs to specify the main categories of eligible financial instruments that are the object of the investment policy. However, it is also necessary to include a description of the “essential features” of the UCITS about which an investor should be informed and this must include an explanation in simple terms of the factors that are expected to determine performance where specific asset management techniques such as hedging, arbitrage or leverage are used.
As mentioned above, the disclosure used was found to be misleading and unclear because it only emphasised the potential benefits of the use of derivatives and not all of the downside risks. Specifically, the FCA was concerned that this disclosure did not reflect the actual impact of leverage through use of derivatives, which meant that there would be a likelihood of greater fluctuations in the NAV, including the magnitude of losses, than if the net asset value (“NAV”) was not leveraged.
The level of leverage actually introduced into the relevant funds in this case was only equivalent to 5% of the NAV at its highest point (although this could have been up to 20% under the terms of the prospectus). However, this was still held to be sufficiently material to impact on the required disclosures.
Synthetic Risk and Reward Indicator (“SRRI”)
KIIDs must include a SRRI which is comprised of a series of numerical categories on a numerical scale from 1 to 7. There also is a requirement to include a narrative explanation of all risks which are materially relevant to a fund and which are not adequately captured by the SRRI. It can be noted that the SRRI of the relevant funds was set at 6 out of 7, indicating a high level of volatility. However, even this supplemental information was not deemed sufficient to ensure that the KIIDs’ disclosures were clear and not misleading. It should be noted that the Regulation does specifically require a narrative disclosure of details of the risks relating to the use of derivatives where these are material.4
Bearing these various points in mind and in the wake of correspondence with the FCA, the following expanded wording was included in revised KIIDs issued by the UCITS:
“Investments in the Fund may include financial derivative instruments. Such instruments may be used to obtain, increase or reduce exposure to underlying assets and may create gearing: therefore their use may result in greater fluctuations of the Net Asset Value of the Fund. The Manager will ensure that the use of derivatives does not materially alter the overall risk profile of the Fund”.
The determination of the FCA as set out in the Notice gives an overview of the applicable law and provides clarification regarding the approach in the UK when assessing KIIDs for compliance. It also provides guidance as to how other European regulators may approach a similar situation. As such there are valuable insights for all UCITS, including those in the dominant cross-border UCITS jurisdictions of Ireland and Luxembourg. It provides evidence, in particular, that:
- including references to techniques or specific instruments alone does not necessarily suffice for compliance;
- complete disclosure of both positive and negative implications of relevant asset management techniques is required;
- there is no set materiality threshold but a 5% level of leverage can be deemed significant or material; and
- reflecting a risk in the SRRI cannot be taken as a substitute for clear narrative disclosure regarding the impact of techniques such as use of derivative contracts.
Failure to comply with any of these points will expose a UCITS to the risk that it is in breach of the general requirement to be clear and not misleading and consequently to both civil liability and a regulatory fine or other penalty. It can be noted that a fine was levied in this case notwithstanding the fact that the FCA found that the breaches by Invesco Perpetual had not been “reckless or deliberate”.
In view of the guidance contained in the Notice, it is advisable for UCITS and their management companies to undertake a review of all KIIDs in order to verify compliance with the guidance. KIIDs are by their nature evolving documents and there is a general requirement for them to be reviewed and updated on at least an annual basis. Accordingly, these points should, at least, be taken on board at the next formal review of each KIID. However, in light of the negative publicity and financial cost inherent in any regulatory censure such as that contained in the Notice, it would be advisable for boards to consider whether the findings of this case warrant an immediate review of any KIIDs in circulation, particularly where derivatives are used and leverage employed.
How Dechert can Help
As a leading advisor to asset managers, investment funds and other financial services firms, Dechert represents many of the world’s largest asset managers as well as new and emerging managers. Dechert’s international Financial Services Practice features an industry-leading group of experienced lawyers who focus on structuring, establishing and providing on-going advice to European-domiciled funds including UCITS. Our range of offices in all of the key European fund centres allow us to provide an international perspective on best practice and to then apply our experience locally to ensure compliance for funds in each jurisdiction.
1) 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 (UCITS)
2) Directive 2001/107/EC of the European Parliament and of the Council of 21 January 2002 amending Council Directive 85/611/EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) with a view to regulating management companies and simplified prospectuses
3) 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
4) Article 8 (5) (e)