www.theaic.co.uk

Investment companies:

Managing risks in a changing environment

Ian Sayers & Guy Rainbird

23 June 2009

www.theaic.co.uk

Who are we?

• The trade body representing closed-ended investment companies

• 349 Members, managing assets of £59bn

• 64 Members based outside UK

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Today’s agenda

• Overview of changing regulatory environment

• Areas to focus on

• AIFM Directive

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Dealing with climate change

• Recent years have been characterised by a temperate climate for

financial services

• Political interest concentrated on potential economic and employment

contribution

• Some clouds on the horizon e.g. trade union concern about private

equity, but no thunderbolts aimed at funds sector

• But in the last twelve months the weather has changed …

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“We have today … pledged to do whatever is necessary to:

restore confidence … repair the financial system to

restore lending; strengthen financial regulation to rebuild

trust; … to overcome this crisis and prevent future ones;

… to underpin prosperity; and build [a] … sustainable

recovery. … We will bring the world economy out of

recession and prevent a crisis like this from recurring in

the future.”

Statement by the Leaders of the G20, 2 April 2009

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“There is no doubt that British regulatory approaches,

European approaches and global approaches are now

outdated … We need fundamental reform of the

international regulatory system. We need tough action to

make sure that the present crisis is not repeated.”

Prime Minister Gordon Brown MP,17 March 2009

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“Without proper financial regulation, there will be no lasting

financial confidence .... and without lasting financial

confidence, there will be no lasting recovery … We

understand that regulation is a vital part of making sure

markets work properly.”

David Cameron MP, Conservative leader, 24 March 2009

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A new environment

• Political scepticism about financial services and the operation of

capital markets has increased exponentially

• This has increased the appetite to intervene through a variety of

avenues

- Corporate governance

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“It falls to Board members to ask searching questions about

the business model of the company on whose Board they

sit. Board members should at times play the role of

“devil’s advocate”, questioning and testing, with some

persistence, the core assumptions on which their

company’s purpose rests”

Lord Myners, Financial Services Secretary, 21 April 2009

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A new environment

• Political scepticism about financial services and the operation of

capital markets has increased exponentially

• This has increased the appetite for intervention

- Corporate governance (Walker and Combined Code reviews)

- Stewardship

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“I want to encourage responsible and engaged

shareholders, not shareholders that act like absentee

landlords.  I want to address the risk of inadequate

engagement leading to weakened accountability.”

Lord Myners, Financial Services Secretary, 21 April 2009

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A new environment

• Political scepticism about financial services and the operation of

capital markets has increased exponentially

• This has increased the appetite for intervention

- Corporate governance (Walker and Combined Code reviews)

- Stewardship (new obligations on shareholders?)

- Enforcement

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“A principles-based approach does not work with

individuals who have no principles … There is a view that

people are not frightened of the FSA. I can assure you

that this is a view I am determined to correct. People

should be very frightened of the FSA.”

Hector Sants, Chief Executive, FSA, 12 March 2009

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A new environment

• Political scepticism about financial services and the operation of

capital markets has increased exponentially

• This has increased the appetite for intervention

- Corporate governance (Walker and Combined Code reviews)

- Stewardship (new obligations on shareholders?)

- Enforcement

- Increased regulation

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“To fill gaps where European or national regulation is

insufficient or incomplete, based on a 'safety first'

approach. The Commission will propose:

– A comprehensive legislative instrument establishing

regulatory and supervisory standards for hedge funds,

private equity and other systemically important market

players (April 2009)”

European Council Spring Statement, 4 March 2009

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A new environment

• Political scepticism about financial services and the operation of

capital markets has increased exponentially

• This has increased the appetite for intervention

- Corporate governance (Walker and Combined Code reviews)

- Stewardship (new obligations on shareholders?)

- Enforcement

- Increased regulation (AIFM Directive, MAD review etc)

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Areas where risks may arise

• Legal and regulatory

• Governance

• Commercial and reputational

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Legal and regulatory

• The last few years has seen the introduction of a substantial body of

new regulation applicable to listed investment companies

• The review of the Listing Rules for Closed-ended Investment Funds

represented a substantial rewrite of the previous rules, on a

principles-based approach

• The Disclosure and Transparency Rules are also ‘bedding in’, and

confusion on certain aspects remain

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Listing Rules

• The cornerstone of the new regime is the introduction of the

requirement for a statement of the company’s investment policy

• Adherence to this policy at all times is critical

• Boards may wish to review policies to ensure that the disclosures in

respect of gearing, diversification and asset allocation reflect reality

• Investment companies considering revising their investment policies

should consider whether these are ‘material’ and require shareholder

approval

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“Markets do sometimes fall by huge amounts and some investment

strategies may not survive in some circumstances. But that is the

market and transparent investment policies should ensure that

collapsing share values and failing companies are distressing rather

than scandalous”

AIC Code – JFSC Statement of support

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Disclosure and Transparency Rules

• Detailed guidance is available on the AIC website (‘Further guidance

on the Disclosure and Transparency Rules’)

• AIC to run further training later this year

• FSA has identified the Interim Management Statement as one area

where “a significant number of issuers…are still failing to meet the

basic requirements”

• Boards may wish to revisit their statement in conjunction with the

AIC’s guidance (‘Interim Management Statements’)

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Going concern

• FRC has highlighted going concern as a key issue for corporate

reporting

• FRC consulting on a revised ‘Going concern and liquidity risk :

Guidance for Directors of UK Companies’

• Listing Rules disclosure does not apply to non-UK companies but….

• ….principles still likely to be regarded as best practice and may also

be relevant for solvency test for distributions

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Internal controls

• Internal controls represent a particular challenge for Boards, as most

operational issues are dealt with externally

• Risk maps should be revisited to see if they remain appropriate (e.g.

asset valuations, liquidity, custody, other counterparty risks etc)

• Guidance available in AIC Directors’ Handbook (Chapter 5 ‘Managing

Risks and Internal Controls’)

• AIC will be providing further guidance on internal controls later this

year

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Governance

• Recent changes to Combined Code are relatively minor

• Further review underway

• AIC would like to see the Combined Code become more principles-based, but

this may not be possible in current environment

• Annual election of directors may be on the agenda, but opposed by the AIC

• Immediate focus is not so much on the role of companies in corporate

governance process, but shareholders

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Shareholder engagement

• The Government is concerned that institutional shareholders are not

sufficiently active in engagement with the companies they invest in

• There is a risk that the Government might be persuaded to introduce

legislation to force institutions to engage more proactively

• The AIC does not believe that mandatory engagement will lead to

better engagement

• All sides of the debate should work together to avert the threat of

legislation

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Commercial and reputational

• Recent markets have tested investment company structures

• The number of companies ‘exiting’ the sector has probably been less

than would have been expected given severity of markets

• Willingness to introduce, and deploy, discount control mechanisms,

has certainly helped

• Some companies are perceived to have ‘abandoned’ their DCMs

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Discount control mechanisms

• Many DCMs provide flexibility to Boards not to apply them

‘mechanistically’ in the face of unanticipated events

• However, trust is a key part of making DCMs work, so it is important

that the ‘spirit’ of the DCM is observed

• AIC believes that Boards have often taken the right decision not to

operate their DCMs slavishly but….

• ….where this is the case, clear communication of the Board’s position

is essential

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Sources of help

• The AIC Code of Corporate Governance (endorsed by the JFSC)

• Technical guides

• The AIC Handbook for Directors

• Directors / company secretary roundtables

• AIC technical team

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The AIFM Directive

• Proposals affect all investment companies regardless of domicile

• Limited exemptions based on manager’s assets under management

• Regulation targeted on ‘Alternative Investment Fund Managers’

• Proposals fail to appreciate characteristics of ‘closed-ended’ vehicles

• Increases compliance obligations (via the manager) in many areas

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Structural issues

• Prevents the issuing of shares

• Creates potential conflict between obligations of the Board and AIFM

• Not clear who AIFM is (administrator or portfolio manager or other)

• Could require redemption on demand

• Prevents retail shareholders from investing in shares (although

individual member states can allow this)

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Operational issues

• Overlapping disclosures and operational obligations

• Requirement for independent depository

• Requirement for independent valuation

• Additional disclosures for private equity portfolio companies

• Leverage limits

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Jersey issues

• Proposals envisage AIFMs will customarily be in EU

• AIFMs will have strict conditions on delegating functions outside EU

• Delegation only allowed where local jurisdictions meet certain

conditions (on prudential and supervision standards, tax-sharing

agreements etc)

• Registration by non-EU domiciled AIMFs will be possible (in theory)

• Passport denied for 3 years after the introduction of the Directive

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AIC objectives

• Priority is ensuring that investment companies can operate at all!

• Protect the existing business model

• Seeking to reduce compliance impact

• Maintain commercial flexibility – including attractions of Jersey

domicile and use of local suppliers

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AIC approach

• Two tier campaign:

- Seek exemption for closed-ended investment companies trading

shares on regulated markets;

- Secure targeted exemptions/modifications where possible

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Prospects for damage limitation

• Regulation of some kind is almost inevitable – UK has no veto/block

• UK authorities have understood the issues at stake

• Exemption is a long-shot

• Amendments of proposals are likely – as legislation is clearly flawed

• Too early to judge how political audiences across Europe will react

• Still all to play for …

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Key areas for consideration

• Investment policies

• IMS

• Going concern

• Internal controls

• Shareholder engagement

• Discount control mechanisms

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Conclusions

• Directors cannot be expected to have foreseen all aspects of the

current economic crisis

• They can, however, be expected to learn the lessons of the current

crisis, and adjust their approach to key risks appropriately

• Assumptions that were valid a few years ago may not be true today

• The AIC is ready to help Boards and their advisers understand the

new rules, and to apply them to a fast changing regulatory

environment

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Investment companies:

Managing risks in a changing environment

Ian Sayers & Guy Rainbird

23 June 2009