The European Securities and Markets Authority (Esma) in May in which it called for legislative amendments to the Undertaking for collective investment in transferable securities (Ucits) directive and the Alternative Investment Fund Managers Directive (AIFMD). For now, a “lack of supervisory convergence” leaves the door open to “regulatory arbitrage” and different levels of investor protection.

“If we want to enhance retail investors’ participation in capital markets, we should ensure that the expected return of investment products isn’t impacted by undue costs. That investors get value for their money is even more important in the current market situation, with heightened inflation and tightening of financial conditions,” said Verena Ross, chair of Esma, in a published by the EU’s financial markets regulator and supervisor. “By further harmonising the notion of undue costs among member states, the proposal aims at preventing investors from being charged with undue costs and ensuring appropriate compensation for investors.”

“Definition of undue cost”

The CSSF, Luxembourg’s financial regulator, last October issued a on Esma’s common supervisory action on the supervision of Ucits costs and fees. “The main takeaway is, if your fund is too small, and if the fixed costs are consequently too high, there is little chance that you can give a return to investors,” said funds lawyer Attilio Veneziano, founder of Veneziano & Partners, who sat down with Delano to talk about the recent Esma opinion. “This is where the CSSF left it, and said, ‘Keep an eye on the fixed costs.’”

“With this opinion, they [Esma] are proposing to introduce a definition of undue cost,” said Veneziano. “They want to introduce it in the Ucits directive and in the AIFMD directive.”

Why is such a definition necessary?

“They want to increase sensibility on this issue,” explained Veneziano. “They feel that, basically, the industry is mature enough to say, ‘It’s not only about you being able to manage a fund, but it’s about you being able to do it efficiently.’”

“So if they succeed, as we believe, in introducing this notion of ‘undue cost,’ what would be the consequence? The consequence would be that if a manager incurs a so-called ‘undue cost,’ there is a legal basis for a national competent authority to go after them and say, ‘You have to refund investors because you have incurred undue cost, and you will be fined because you have incurred this undue cost.’”

One of Esma’s mandates is to create “supervisory convergence,” noted Veneziano, and “to ensure as much as possible that the treatment is the same” in different member states.

Priips regulation “benchmark” for costs to be disclosed

“Esma is using this approach, whereby, for them to define what is an undue cost, they look at the costs that are eligible. And the Priips [Packaged retail and insurance-based investment products] regulation has an annex that says, ‘These are the costs that have to be disclosed,’” Veneziano explained. These costs set the “benchmark”--anything included on this list would be eligible.

Some examples of the costs to be disclosed include “one-off costs” that are paid directly by the retail investor or deducted from a payment received by or due to the retail investor, or “recurring costs” such as transaction costs or payments that are made to management companies, according to Esma.

In its opinion, Esma notes that the European Commission should first clarify the eligibility of the list of costs included in the Priips regulation, which will provide “clarity” on the topic and “ensure that all costs charged to the fund and its investors will be appropriately disclosed.”

National competent authorities can, however, decide to accept other costs if these are, for instance, related to a particular strategy, said Veneziano.

Esma proposes developing draft regulatory technical standards that would “specify under which conditions NCAs [national competent authorities] may authorise on a case-by-case basis additional cost categories which are not included under [the Priips regulation].”

Make operations more efficient, less expensive

However, “if a cost is eligible, but is incurred in a disproportionate manner, that cost becomes ineligible,” added Veneziano.

Recently, with the first version of the European capital markets union, there has been an “endeavour” to make European distribution easier and less expensive, said Veneziano. “There was the cross-border distribution directive that said, for instance, that local facilities agents now can be digital, as opposed to hiring a bank in each country.”

“If you don’t catch up with regulation, as a fund, and if you don’t implement a solution that is in line with current rules, you are incurring a cost that is excessive for your investors,” which would then be undue.

Returning to the cross-border distribution example, say you pay a bank €10,000 a year to be your local agent, said Veneziano. “After the cross-border distribution directive, you no longer need to appoint that facilities agent locally. But you can have a website or a digital provider that offers you this at a fraction of the cost. If you keep on complying with the old rule, and spend more money accordingly, that should be ‘undue.’”

The idea is to make operations “more efficient and less expensive” for clients, said Veneziano. “Successful managers are the ones who are able to do things efficiently.”

This article was published for the Delano Finance newsletter, the weekly source for financial news in Luxembourg. .