Regulatory Update - Free Movement (published by FEAM, November 2005)

03 January 2006

Stefano Febbi, Raimondo Maggiore

If the EU wants an efficient funds industry, it should grasp the opportunity to create a true framework for cross-border consolidation, says the Federation of European Fund Managers

Consolidation among European banks has brought many benefits. Liberal outsourcing and delegation rules have smoothed the integration of the asset management, custody, fund administration and distribution functions of both acquirer and target. But achieving the same synergies across different mutual fund product ranges, particularly when domiciled in different jurisdictions, has proved harder.

An efficient, union-wide solution for cross-border fund consolidation is a key part of the attempt to make the European Union’s fund industry more efficient. Under the current framework, fund groups are left struggling to align multiple domiciles, product types, objectives, fee structures and track records. Given the scale-driven nature of asset management and an ever-more competitive environment, maintaining poorly performing, small products in uncompetitive domiciles is becoming increasingly untenable.

The extent of the problem becomes apparent when you compare the average size of European funds with those in the US. In 2004, the EU’s fund management industry had 4,186bn of assets under management, while the US had $8,216bn (e6,886bn). But the EU derived its assets from 29,077 funds, compared to 7,952 US funds.

This has not gone unnoticed within the EU. Its green paper on the enhancement of the EU framework for investment funds, published by the European Commission1 on 12 July 2005, seeks information on the commercial or economic logic for cross-border fund mergers.

The Federation of European Asset Managers (FEAM) created a working group on cross-border mergers earlier this year to examine the options available to asset managers looking to consolidate products on a cross-border basis, and to assess whether the EU has at its disposal the necessary legislative tools to break down the artificial barriers to fund consolidation.

The FEAM case study focused on UCITS funds domiciled in five major jurisdictions (Italy, Germany, France, Ireland and Luxembourg), examining the practical difficulties involved in consolidating fund ranges across these jurisdictions.

According to the report issued by the European Commission’s asset management expert group, a true, legally binding merger results from an agreement between legal entities to consolidate their activities, assets and liabilities in a manner that produces a single entity (in the context of a corporate vehicle).

The major benefit associated with a true legal merger, as opposed to any other form of amalgamation, is the simplicity of the transaction whereby all assets and liabilities are transferred, leaving no shell containing liabilities and contingent liabilities to be liquidated by the promoter.

No such mechanism for the true legal merger of UCITS funds currently exists across the five jurisdictions covered in the case study, either in the context of a corporate vehicle or a contractual fund.

The current EU proposals on cross-border mergers state that national laws should apply to such crossborder activity. An extension of the application of those rules to collective investment schemes would mean that cross-border mergers of these vehicles would not be subject to any more restrictive or different approval methods than are proposed for other EU commercial undertakings.

Missed opportunity

However, both the proposal for a cross-border merger directive and the takeover directive exclude collective investment schemes, and the FEAM working group believes the Commission has missed a valuable opportunity.

The argument that such legislative initiatives could only apply to corporate structures is countered by the numerous practical examples in various national laws where regulatory authorities apply company law principles to contractual or trust-type funds, where the need arises. By way of example, in the absence of specific legislation for true cross-border mergers, legal practitioners are forced to extrapolate from the principles of domestic corporate tax law.

It should be noted that it is not currently possible to obtain a definitive ruling from a domestic tax authority as to whether or not such an interpretation would be applied in a cross-border scenario, because there is no single tax authority involved in such circumstances.

Ideally, an EU directive should clearly state the tax treatment to be applied in the case of all crossborder mergers of funds domiciled within the EU. Indeed, the FEAM working group noted that a simple requirement to apply the same tax treatment to cross-border mergers as to domestic ones would reduce the majority of tax barriers in this area.

Certain jurisdictions have, as a practical alternative, agreed ‘schemes of arrangement’, whereby funds can transfer their assets (‘in specie’) to another fund in another domicile in return for units or shares in the target fund. However, such schemes can be complicated and involve a potentially difficult regulatory approval process, and they fall somewhat short of a true legal merger.

In one example studied by the working group, a series of Irish-domiciled, stand-alone UCITS funds, structured as public limited companies, were ‘merged’ into a corresponding sub-fund of a Luxembourg umbrella fund managed by the same promoter. The mechanics of the scheme involved a transfer of the assets only of each fund in exchange for units of equal value in the target sub-fund. This left the obvious problem of the remaining liabilities, which the scheme of arrangement provided would be taken over by the promoter of the transferring fund – as required by the Irish regulator.

While this would obviously be done in return for a figure calculated to cover foreseeable accruals, the inability to transfer both assets and liabilities together resulted in a potential burden falling on the local manager.

Also, once the assets had been transferred, the Irish-domiciled shells remained in existence and had to be de-listed, de-registered, de-authorised and then liquidated by the surviving manager. The cost of all these final steps can be significant.

In the absence of a true merger, the major advantage of such a scheme is that only the transferring fund need make any decision. A further benefit is the fact that the acquiring fund is receiving only assets in the transfer, and the value of such assets is independently verified by the receiving and transferring entities’ auditors. No other due diligence is necessary.

But there are equal disadvantages. Tax issues are intensified due to the lack of harmonisation across domiciles. And there are other consequences, including the cost of administering such a scheme – for example, shareholder communication, legal, audit and other professional fees.

While true cross-border mergers are not possible, the same cannot be said of mergers of entities within a single jurisdiction. This allows consideration to be given to the two-step concept of first redomiciling the foreign fund and then carrying out a local merger.

Redomiciliation can be an effective first step in achieving a pure, clean merger with no residual ‘shell’, but only where it is possible to both efficiently redomicile, and then locally merge, the funds.

However, as examination of previous examples indicate, the process is all too often lengthy, complex and costly. Decision-making must take place at two or more levels before completing the transfer. And the ancillary costs are effectively borne by the unit holders twice: once when the fund is re-domiciled, and then again when it is merged.

In the absence of legal or regulatory assistance, or indeed in the presence of legal or regulatory obstruction, promoters have found ‘commercial workarounds’ which allow them to achieve some degree of amalgamation. But such improvised measures (such as liquidations followed by an ‘encouragement strategy’, asking liquidated unit holders to switch to a more advantageous product) result in significant leakage of assets, often as much as 35-40%. The workarounds are made more difficult by a degree of unit-holder apathy and regulatory protectionism.

A local presence

Legislating for true cross-border mergers is not a panacea. International promoters will continue to maintain small, uneconomic fund ranges in unfashionable domiciles for reasons other than cost. Maintaining a local presence through locally domiciled funds – investing in local capital markets – will remain an important feature of the European fund landscape.

However, as European banking consolidation gathers momentum, the need for an effective legal mechanism for mutual fund consolidation will become more pressing, and banks will want to see the synergies of their mergers reflected in their asset management divisions.

The FEAM working group believes that, despite the current lack of appetite within the internal market for further proliferation of legislation, the Commission should not shy away from addressing the removal of national barriers, either through legislation or by taking direct action against any member state it believes to be hindering the free movement of capital.

In the long term, consolidated legislation in this area should include specific measures to accommodate cross-border mergers of collective investment schemes of all types – and all barriers, tax or otherwise, should be removed.

• See the funds europe website (www.funds-europe.com) for the full text of this report and a comparative table outlining the case-study results.

Note: 1. COM (2005) 314 final

This article was first published by FEAM in Funds Europe magazine, November 2005, and subsequently in Finance Ireland, December 2005.

Authors

Raimondo Maggiore

Raimondo Maggiore

Co-managing partner
Italy

Call me on: +39 02 30 35 60 00