This Explanatory Memorandum is intended as an aid to understanding the core Principles of regulating CIS which have been developed by IOSCO Working Group 5. The explanatory text provides a guide concerning the scope of each of the Principles and their interpretation. It also provides examples of how the range of regulatory systems reviewed give effect to the investor protection Principles.

The Explanatory Memorandum is not intended to provide a comprehensive guide to the regulatory systems of all jurisdictions considered by the Working Group; it provides an overview of the range of regulatory approaches and in some cases specific examples are used to illustrate their effect.

For more detailed information on the regulation in various member countries an International Comparative Analysis will be published later.

1. LEGAL FORM AND STRUCTURE

There is a wide range of legal forms and associated structural requirements imposed on CIS under the regulatory regimes of member countries. The lack of compatibility of these structures has contributed significantly to the barriers to CIS entering foreign jurisdictions and marketing internationally. This variability in legal form and structure seems to have resulted from the unique cultural and legal settings of each member country. The legal form and structure of CIS have also influenced the way in which individual jurisdictions address their regulatory responsibilities.

The Principles recognise that a number of structures can be utilised to achieve the same investor protection objectives; there is no single structure which is considered appropriate for effective regulation of CIS. For example, company structures are commonly used in the USA, as well as in several European jurisdictions. Contract and trust based structures are also established under legislation in many European jurisdictions including the United Kingdom, as well as in Hong Kong, Japan, Canada and Australia. In a smaller number of jurisdictions, partnership and other structures may be used to establish CIS.

The main investor protection issues arising from the adoption of a particular structure are reflected in the Principles. These are that the structure should ensure that the assets of the CIS are clearly separated from other assets and that it should not create an unfair disadvantage for investors, such as might arise from the issuing of separate classes of interests.

Umbrella funds have been addressed in this Principle because of the particular regulatory issues that they give rise to. While the Principles refer to umbrella funds as comprising a single legal form, in some countries sub funds are recognised as separate legal entities for tax purposes. In the U.S. such funds are called "series funds", although they are generally treated as separate investment companies, and therefore do not raise many of the issues presented by umbrella funds.

The relationship between sub funds of umbrella funds and their assets and liabilities is an important investor protection issue. While member countries agree that it is best for investors that the assets and liabilities of sub funds always remain separate, it is recognised that there are differences in the legal position in those jurisdictions where umbrella funds exist. While in some jurisdictions, the liabilities contracted by one sub-fund cannot be limited to that sub-fund's assets, unless a contrary agreement with creditors has been made, in others there may be complete segregation of liabilities. Furthermore, in some jurisdictions, such as Australia, the exact legal position under the common law of trusts is not clear.

Consequently the key Principle in relation to umbrella funds is that, where there is not complete segregation of liabilities, the relationships between sub funds and their effect on investors are clearly disclosed, in particular the potential risks faced by investors depending on the segregation of liabilities. Although not required in all jurisdictions, there may also be a common administrator, operator, custodian and auditor of each sub fund of an umbrella fund.

2. CUSTODIAN, DEPOSITARY OR TRUSTEE

The requirement for separation of assets (usually by an independent custodian, trustee or depositary) is a feature common to all regulatory regimes. The primary role of the custodian is to hold the assets of the CIS in safe custody and to keep them separate from any other assets, in particular the assets of management. In some jurisdictions additional functions and duties are carried out by the custodian.

Appointment of Custodian

A custodian is appointed to be responsible for the safekeeping of CIS assets and is held accountable for those assets even though it may entrust the physical deposit of all or part of the assets to a third party. For example, in most jurisdictions the appointment of a sub custodian does not remove the ultimate responsibility of the appointed custodian.

An alternative to the appointment of a formal custodian, but which meets the objective of separation of assets, is the concept of "self custody" as it operates in the USA under the Investment Company Act and also in Canada. Under these arrangements a CIS may maintain custody or otherwise have access to CIS assets if certain additional protective conditions are met. It requires the assets to be deposited in the safekeeping of, or a vault maintained by, a bank or other company whose functions and physical facilities are supervised by federal or state authorities. In the United States these arrangements must be examined by an independent public accountant three times each year.

In Canada, the custodian of a CIS is often different from the trustee who carries out additional responsibilities.

Financial and Other Resources of the Custodian

Because of the importance of the custodian's role in protecting the assets of investors, all regulatory regimes impose certain minimum standards as to who may qualify as a custodian. In some jurisdictions a custodian may be required to be a bank and the regulatory authority relies on its approval as a bank to satisfy itself regarding the suitability of the custodian; in others, the regulatory authority may individually review and approve custodians for their ability (including financial and other resources) to properly carry out its functions. The latter is more likely to be the approach where the custodian fulfils additional responsibilities.

Independence

The independence of the custodian is considered critical to meeting its obligations. In many cases this means that a custodian must be legally independent of and totally unconnected with the operator of a collective investment scheme.

The concept of "independence" varies between jurisdictions, with some insisting upon there being no share holding relationship with the operator of a collective investment scheme, while others allow cross share holdings between the operator and custodian. Instead of restricting share holding relationships, some regulatory systems achieve the required degree of independence by the establishment of a separate corporate structure for the custodian, an independent board and separate lines of reporting to the management of the custodian.

In terms of performance of custodial functions, all regimes seek to ensure that the custodian is independent in the way it performs its obligations. In the Principles this is referred to as "functional independence", so as to distinguish it from absolute, structural independence. "Functional independence" may be achieved in a variety of ways (as described) provided each is appropriate to the broader regulatory framework.

The primary responsibility of a custodian is to ensure safekeeping of CIS assets. In some jurisdictions custodians are fiduciaries under the law and, as such, have direct responsibilities to investors. In other cases, such as the USA, the custodian's responsibilities are under a contract with the operator.

Additional Supervisory Responsibilities

Under some regulatory systems the custodian has additional supervisory responsibilities, although the extent of these responsibilities varies. They include supervision of the purchase and redemption of units in the CIS (including price calculation and settlement), review of the allocation of income and expenses, valuation of CIS assets, the keeping of proper accounts and general oversight of compliance with applicable laws and CIS rules.

While these additional supervisory responsibilities are key features of many regulatory systems, it is not essential that the supervisory role be carried out by the custodian. Instead, this supervision may be carried out by other third parties, such as auditors as is appropriate to the overall framework of regulation in individual jurisdictions. In the USA, for example, while not necessarily having the same role as a supervisory custodian an independent board of directors of an investment company supervises the activities of the operator.

3. ELIGIBILITY TO ACT AS AN OPERATOR

There is a wide range of regulatory systems and a variety of mechanisms for ensuring the suitability and proficiency of CIS operators. The Glossary of Terms defines an operator of a collective investment scheme.

In all jurisdictions operators of CIS are subject to authorisation either prior to, or as part of, authorisation of the CIS. "Authorisation" in this context may mean that an approval process is instituted by the regulatory authority (which assesses the suitability of the operator), or it may simply mean that the authority requires registration of the operator in order for the CIS to market its securities.

In some jurisdictions both the operator and the CIS itself must be registered with the regulators. In the US, for example, CIS are generally operated under an investment company structure (with its own board of directors) and the operator is a separate entity (usually called the investment manager) which is under contract to the investment company. The result is that the operator is licensed as an investment adviser and the CIS as an investment company.

This Principle recognises that eligibility requirements imposed as part of this authorisation process will vary according to the overall context of regulation, in particular where other factors effectively monitor operator conduct. In many European jurisdictions, the regulatory authority reviews the suitability of a CIS manager before authorisation. However, such a detailed review at the point of entry may not be required in the context of a rigorous inspections program and where there is prescriptive regulation of transactions undertaken by the operator.

Under the US system as described, the focus is not upon entry requirements for investment advisers (operators) or investment companies but instead upon prohibitions and other provisions designed to maintain standards of operator conduct on an ongoing basis. In this context, the imposition of substantive eligibility requirements is not necessary.

Specific Suitability Criteria and Standards of Conduct

The management eligibility sub principles identify specific criteria for the standard and conduct generally required of CIS operators. As noted in the Principles, these will not apply in jurisdictions where no substantive eligibility requirements are imposed at the point of entry. They nevertheless reflect the key attributes of operators and the objectives of those regulatory systems that use specific criteria applicable to CIS, at the point of authorisation and as part of a monitoring program.

A range of suitability criteria are imposed by regulatory systems on CIS operators including (but not limited to) the following:

- minimum net capital;

- sufficient human and technical resources;

- "fit and proper" test;

- educational requirements.

In the case of minimum capital requirements, many operators of CIS are subject to specific minimum amounts (such as HK$1 m in Hong Kong, DM5M in Germany) and in many other there is a general requirement to show capital adequacy.

In drafting the Principles, it is acknowledged that not all of these requirements will necessarily be set out in the laws of member countries; instead the Principles express objectives which should be embodied in the overall regulatory framework.

4. DELEGATION

CIS operators often engage third party investment managers or administrators to whom some or all of the functions and duties of the operator (but not overall responsibility) may be delegated. This Principle is concerned with the maintenance of investor protection in the event that delegation occurs.

Although sometimes described as "external management", this situation is different from the concept of "external management" which exists in the USA under the Investment Company Act. In the USA, CIS are legal entities operated by their officers subject to the oversight of a board of directors or trustees. Typically, US investment companies enter into agreements with parties for the provision of all necessary services including operational management and advice. Thus US funds generally do not contemplate delegation of investment authority from a manager to a third party investment adviser. In that regard many of the requirements of this Principle will not apply in the context of the US regulatory system.

There are other jurisdictions, such as Mexico, where delegation of functions by the operator is not permitted.

It is acknowledged that there are limits to the direct control that regulators have over delegates of CIS operators in the current regulatory framework. The Principles recognise these limits and focus on the effect that the use of delegates has on the protection of investors in a collective investment scheme. In some member countries specific approval is required for the use of delegates, while in others there is only a requirement to disclose material information concerning delegates. Where the delegate is an investment manager, generally the same rules will apply to the conduct of its business as an investment manager.

The aim of the Principle is to ensure that a CIS operator has primary and overall responsibility for the proper management of the CIS, and that the operator's accountability is not diminished by the appointment of delegates. Because of the limits on direct regulation of delegates, the Principles are concerned mostly with the ability of the operator to ensure that the functions of the delegate are being performed adequately. Another key role is for the Operator to monitor the delegate's performance and in this regard the means of monitoring will vary according to the overall regulatory framework.

Under the US system, the board of directors must ensure that procedures are in place designed to monitor the behaviour of the investment manager (also called an adviser). That manager has a fiduciary duty with respect to and must always act in the best interests of the fund. CIS may also enter into a separate contract with a sub adviser to manage some or all of the CIS's portfolio. Like the manager any sub adviser has a fiduciary relationship to the CIS and is liable for misconduct or breach of its fiduciary duties. A manager must reasonably supervise the activities of persons acting on its behalf and may remain responsible for the conduct of a sub adviser, depending on the facts and circumstances in each case.

5. SUPERVISION

The regulator's responsibilities in supervising the activities of CIS does not vary greatly, under the law of member countries. Analysis of different regulatory systems indicates that the role of the regulator is paramount and that it holds ultimate regulatory responsibility for CIS. This is reflected in the Principles. The manner in which individual regulatory authorities carry out their responsibilities does, however, vary according to the overall regulatory framework.

Key aspects of a regulator's role as reflected in the Principles are:

- registrations and authorisation;

- inspections and investigations; and

- enforcement powers.

It is recognised that in carrying out their responsibilities regulators may place a different emphasis upon their various powers and activities, and this is something that is likely to change over time depending on the policies of the various regulatory authorities. The role and activities of regulatory authorities is a matter for more detailed consideration by the Working Group in relation to international co-operation issues.

Registration and Authorisation

The activities of member countries in the area of "registration" ranges from the requirement for document filing to undertaking a detailed review of CIS documentation for compliance with the applicable law. The nature of documents lodged may include constituting documents, fund rules, prospectuses and so on. The common element among the various systems is that the regulator has a role in the process of CIS entering the market for the first time, although the level of active involvement of the regulatory authority varies from one jurisdiction to another. In some cases this will depend on the degree of prescription in the applicable law. Another common element is that regulatory authorities, even those that undertake a detailed review prior to CIS approval, do not endorse CIS nor guarantee their performance.

Inspections and Investigations

A further key Principle relating to supervision is the power of the regulatory authority to conduct inspections of CIS and investigations of their activities. Member countries may give effect to their inspection responsibilities in a variety of ways. For example, some aspects of inspections may be delegated to a third party (eg. an auditor) even though the regulatory authority has the power to conduct its own inspection. This is considered to provide an appropriate level of investor protection, provided the regulatory authority maintains overriding control and responsibility for CIS supervision.

Powers of the Regulatory Authority

It is fundamental that a regulatory authority have the powers to take action to enforce the obligations relevant to CIS. This Principle recognises that the nature of enforcement powers and penalties will vary from one jurisdiction to another, and that there are a variety of means to achieve adequate enforcement. The Principles identify the range of powers which might be available to enforce CIS requirements although they may not be exhaustive. The Principles do not imply that an individual regulatory authority must take action in any particular circumstances.

Third Party Supervision

As indicated previously, some systems rely on a third party (such as a custodian or auditor) to carry out some of these supervisory functions. While the regulatory authorities of some member countries rely on the role of third party supervisors, this does not make the regulator's role any less important. Examples of third party supervisors include trustees (with responsibilities additional to that of custodian), auditors, as well as independent directors on the board of an investment company (see Principle 2).

6. CONFLICTS OF INTEREST

There are wide ranging approaches by member countries to regulation of conflicts of interest. In all regulatory systems there is an overriding responsibility for CIS to be managed in the best interests of investors. This duty is variously expressed as

acting exclusively in the interests of investors with the "diligence of an orderly business man";

the duty to exercise good faith in the interest of investors when giving directions relating to a CIS;

exercising powers and duties honestly, in good faith and in the best interests of the CIS;

the duty to act for the sole benefit of the CIS's subscribers.

In some jurisdictions the obligation of an operator to act in the best interests of investors is implicit in their role as a fiduciary under the applicable law, although it may also be an explicit requirement of CIS regulation.

In addition to this general duty of CIS operators, it is essential that all regulators have adequate powers of investigation and enforcement to ensure that where specific circumstances give rise to a conflict of interest the regulator may take appropriate action. These issues are addressed in Principle 5 regarding Supervision.

Beyond these broad principles, the approaches of member countries to conflict of interest situations varies quite significantly. The existence of a general obligation to act in the best interest of investors will often mean that a CIS operator must ensure that CIS transactions are at arms' length and on a commercial basis, that they achieve best execution for the interests of the CIS and that the operator act independently of any other affiliations.

As well as a general obligation, some jurisdictions have adopted a very prescriptive approach to regulation of conflicts of interest. For example, in the US there are also explicit provisions under the Investment Company Act that specify the areas in which conflict occurs and addresses precisely how they must be handled, in some cases requiring that certain transactions be approved in advance.

Other regulatory systems (such as those in Mexico, Australia and many of the European jurisdictions) rely largely on the general obligations to investors, combined with close supervision of activities by the regulatory authorities and other third party supervisors. Another example of how conflict of interest situations may be addressed is by prohibiting the operator of a CIS from carrying out activities other than operation of a CIS.

The aim of this Principle is to ensure that there are proper responses from the regulatory regime to the potential for conflicts of interest. The Principle identifies a number of transactions as examples of situations which raise potential conflict of interest issues It is acknowledged that the list of situations identified in the Principles may not be comprehensive of all potential conflict of interest situations, but they represent the main areas of concern.

The use of the words "capable of dealing with..." in Principle 6.1 reflects the fact that not all regulatory systems explicitly restrict or prohibit these transactions in their applicable law; it also recognises that the response of member countries to these situations may differ.

The Principles use the term "affiliates" in describing a number of potential conflict of interest situations. Broadly, the term refers to those parties who may be affiliated with a CIS, its operator or custodian, or other parties to the CIS's activities. In many jurisdictions, the term "affiliates" or "associates" has a very specific and complex definition and the Working Group has not attempted to provide an all encompassing definition; a comprehensive definition can only be provided in a context of an individual regulatory framework.

The range of responses utilised in a regulatory system to deal with these conflict situations will depend on the overall regulatory framework and whether structural requirements influence the likelihood of the potential conflicts becoming real. The range of possible responses is meant to show that a number of approaches to regulation may be acceptable, and to note that a system of regulation need not embody all such responses in order to be effective. In most cases, member countries employ a number of techniques (direct and indirect) to resolve conflict of interest situations.

7. ASSET VALUATION & PRICING

A fundamental principle of collective investment regulation is the ability of investors to withdraw their funds (liquidate their interest) within a reasonable period. The calculation of unit price and the valuation of CIS assets is an important part of any regulatory system because of the direct interest that investors have in the underlying assets of the CIS. The regularity and accuracy in valuing the underlying assets of a CIS is essential for fairness and accuracy to be achieved in the pricing of interests, for both investors seeking to liquidate their units as well as investors remaining in a fund. These general principles are reflected in the preamble to Principle 7.

The Principles for Valuations, Purchasing and Redemption of Units and Unit Pricing each provide a statement of how the broad Principle applies in the context of CIS within the scope of the Working Group's mandate (ie those investing in transferable securities). The Principles have been drafted so as to cover a range of approaches considered acceptable to achieve the broad objectives.

While many jurisdictions impose specific requirements under the law, there are others that do not embody these Principles in applicable laws. Instead the Principles may operate as rules of best practice and are often embodied in the rules of individual CIS. In some regulatory systems, changes to the system for asset valuation and pricing must be approved by investors.

Provided these Principles are reflected in the rules of a CIS, it is not considered necessary for the laws of member countries to include these detailed requirements for effective regulation to occur.

Valuations

A fundamental Principle of asset valuation and pricing of CIS units is that it is based on the net asset value of the total pool of assets under management according to the market value of those assets, or some other value which is representative of their market value.

Many regulatory systems such as the United Kingdom and USA, provide detailed rules for asset valuation and unit pricing which are consistent with the general Principles but which, at a detailed level, vary in their approach. For example, there is presently a system of dual pricing of assets (bid and offer) operating in the United Kingdom. In the USA and Canada, there is a requirement to price CIS units on a forward pricing basis, although again this may not be common to all regulatory systems. US regulation also permits the use of a non-market prices for certain types of money market instruments and allows their value to be determined at their amortised cost according to a procedure approved by the SEC.

The system for pricing of units is often specified by the law, but in many jurisdictions it may also be set out in the fund rules or the prospectus. In Mexico, the system for pricing units must be disclosed in the prospectus.

Purchasing and Redemption of Units

In relation to redemption requirements, some jurisdictions require CIS to pay out redemptions within a specified amount of time while others (such as Australia) simply require the obligation to be met within a "reasonable" period. This would be judged according to the relevant commercial standards and, in practice, the time frame for payment of redemptions is similar to other jurisdictions notwithstanding the absence of a direct legal obligation.

The Working group has not proposed any specific time periods during which pricing of units must occur or redemption requests met. Specific time limits or periods are arbitrary in nature and will vary according to historical and commercial settings. In many jurisdictions, it is recognised that pricing must occur at least twice a month, although some authorities permit CIS to reduce the frequency to once a month on condition that it does not prejudice the interests of investors. Other jurisdictions require more frequent pricing. In the U.S., for example, a CIS must stand ready to redeem an investor's units