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Luxembourg management companies urgently need to review due diligence practices

Thursday, August 18, 2011
Opalesque Industry Update - Laven Legal Services believes that Luxembourg management companies need to review their due diligence practices and has published a white paper on the subject. Under the Ucits legal framework, Luxembourg regulated management companies outsource some important activities for which they remain responsible in the eyes of the law and the CSSF, the report says.

Any accounting or administration activities with one or more banks as well as distribution activities are included, the firm believes. “This clearly results from article 110(1)(f) of the law of 17 December 2010 (previously article 85 of the law of 20 December 2002)”.

Laven says that in order to understand and to be able to monitor the outsourced activities regulated management companies must review the way they do business, not only to be compliant with the law but also to protect themselves from the impact of operational failures.

“This includes the risk of claims for negligence as well as reputational risk.” Directors and conducting persons of regulated companies should remember that legally they have the ultimate responsibility for all delegated activities under article 110(2).

Laven explains that previously, under UCITS III, and before the impact of the 2008 financial crisis, it was common for management companies in Luxembourg to rely on the regulated status or brand recognition of the third parties they worked with. “Companies did not feel the need for in-depth due diligence, notably in terms of covering operational risks. In addition they would rely on the reporting received from the same third parties as evidence of monitoring. This reporting alone, however, falls short of providing the proper checks as was demonstrated during the Madoff fraud. As the industry faces new rules, as well as a tougher regulator and scrutinising investors, this is a good time for regulated companies to plan ahead and review any due diligence process they are using. We will look at the changes that are impacting operations, we will suggest processes for due diligence so that it meets the right standards without imposing too many new administrative costs.”

The firm also points out that the UCITS IV Directive will also be supplemented in many respects by the AIFM Directive which also touches, in a similar way, on other regulated financial companies such as custodians and managers of Special Investments Funds (“SIFs”)

“The rules remain broad and should be of concern for all regulated companies. To date there is little by way of guidance on how operational risk should be managed, although the Association of the Luxembourg Fund Industry (“ALFI”) has summarised the following “best practice measures” to assist in monitoring outsourced functions for management companies. They recommend breaking down the process into three main phases for third party due diligence:

  • The Initial Phase – the stage during which all delegations should be subject to appropriate due diligence prior to the delegation of the activities.
  • Ongoing Monitoring – this stage requires that the board of directors of the management company ensures that an effective ongoing monitoring program is in place for all outsourced functions.
  • The Termination Phase – the stage during which the management company must decide whether to bring the function back in-house, appoint a new delegate, or discontinue the function.
Laven believes that the key to due diligence is the end result, namely the reliable and demonstrable selection and monitoring of third party service providers. To make this workable it takes:
  • a set process which details the items that must be reviewed (including scope and depth) and how it will compare matters identified as against best practice standards; and
  • the investment of time so that the process can be done in full.
“In practice the difficulty lies in setting out a process that will work for third parties that provide different services for which best practice standards may vary. The good news is that there are no particular prescriptive processes and no EU regulator has set in stone what they expect financial institutions to do in detail, only in terms of general practices and ethics. The expectations of the regulator will be high but this principles based approach is likely to be a good thing as it gives regulated companies freedom to determine their own standards and to promote themselves to investors as leaders in the field of operational risk management.” Source

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