The European Securities and Markets Authority (Esma) recently focused its attention to undue costs of Ucits and AIFs and issued an opinion thereon in May 2023. In January 2021, Esma started a Common Supervisory Action (CSA) with the national supervisors on the costs and fees of Ucits across the EU/EEA, in particular referring to charging investors undue costs. The present opinion shows the outcome of the CSA, setting out suggestions for both Ucits- and AIF managers. As the European Commission is currently working on policy proposals in respect of the Retail Investment Strategy, Esma expects that the outcome of this opinion can be taken into consideration therewith.
Legal background
The legal background for the rules on costs are found in Directives 2009/65/EC (Ucits Level 1), 2010/43/EU (Ucits Level 2), 2011/61/EU (AIFMD Level 1) and Commission Delegated Regulation (EU) No. 231/2013 (AIFMD Level 2), all containing rules for fund managers to act honestly and fairly, to act with due skill and not to charge undue costs to participants.
Costs and performance of retail products
As part of the CSA, Esma asked the national supervisors to assess and report the most common approaches used by Ucits managers to prevent that investors are charged with undue costs and also to present a list of costs that the supervisors consider to be “undue” or “due”. Furthermore, Esma asked to report the considerations of Ucits managers when setting the pricing level of a fund. Many of the national supervisors let know that this was difficult due to the lack of specification in current legislation and the fact that there are only non-binding supervisory briefings on that topic. Lack of a firm legal basis causes all supervisors to encounter difficulty with requiring fund managers to compensate their investors for too high costs.
Approach to existing legislation
The outcome from the CSA lead Esma to the conclusion that there should be more specification in respect of due and undue costs in both Ucits Level 1 and AIFMD Level 1. The suggested additions for both directives are similar in scope: the EU member states must require management companies to prevent the charge of undue costs and must impose the obligation to assess the eligibility of costs by referring to the applicable delegated regulation (for both Ucits and AIFs). Furthermore, Esma shall develop draft regulatory technical standards to specify when costs qualify as undue or not eligible, with due notice to the relevant investment policy and specifying under which conditions additional costs are permissible. Generally, Esma believes that where a fund manager has intentionally or negligently committed infringement of the applicable rules, a fine, proportionate to the harm caused to the investors, must be imposed. National supervisory authorities must therefore be granted the power to impose sanctions of a minimum given percentage, all proportionate to the undue costs charged amount. In cases where undue costs have been charged, managers should reimburse or indemnify investors.
Pricing process and related party transactions
Furthermore, the proposed additions relate to the pricing process for funds, being that fund managers must develop and review a structured pricing process that shows all costs charged are due. Also a process allocating clear responsibility to management for determination and review of costs should be in place. The results of the CSA clearly show that the risk of overcharging investors is particularly apparent in related party transactions. Thus, Esma suggests to introduce the obligation to ensure that conflicts of interest are appropriately identified, prevented, managed and monitored to avoid investor downside, in particular in connection with the risk that related parties may charge market standard-exceeding costs.
(No) future for undue costs
Costs of retail investor products have been designated as strategic priorities for supervision in the EU. All market players need guidance on the concept of “undue costs”. All national supervisors indicated in the CSA that the concept of “undue costs” is the same for both Ucits and AIFs. Momentarily, the supervisors’ analysis of undue costs is done on a case-by-case basis, assessment is (generally) made during the licensing procedure only and each national supervisory authority seems to have its own approach.
Both management companies and (retail) investors will benefit from clear guidance on this topic. This must be supported by ongoing monitoring and regular evaluation of policies to avoid undue costs. Deficiencies should be reported immediately to the regulator and on an annual basis disclosed to investors.
The financial markets logic says: “Returns matter a lot, it’s our capital”; don’t let investors see the capital evaporate on undue costs!
Tom Loonen is professor of financial law at Vrije Universiteit Amsterdam and special counsel Pinsent Masons PLC Netherlands, while Jan Saalfrank, partner investment funds at Pinsent Masons PLC Luxembourg. The law firm is an Investment Officer knowledge partner.