11.2 Scope of this Section

The term collective investment scheme includes authorized open ended funds that will redeem their units or shares, whether on a continuous basis or periodically. It also includes closed end funds whose shares or units are traded in the securities market. It further includes, unit investment trusts, contractual models and the European UCITS (Undertakings for Collective Investment in Transferable Securities) model. ³⁴

The legal form taken by collective investment schemes varies between jurisdictions but in all jurisdictions they are becoming increasingly important as a means for investors to achieve a diversified exposure to investment opportunities.

Proper regulation of collective investment schemes is critical to the objective of investor protection and should ensure that investors have access to a fair market. Investors in collective investment schemes rely upon operators of the schemes to manage their funds and to act in their best interests.

11.3 Eligibility to Act as an Operator

There should be clear criteria for eligibility to operate a collective investment scheme. Investor protection is the key objective and to the extent that a regulatory regime imposes specific requirements, factors that may be considered include:

• Honesty and integrity of the operator;
• Competence to carry out the functions and duties of a scheme operator;
• Financial capacity;
• Operator specific powers and duties;
• Internal management procedures.

11.4 Supervision of Conduct, Conflicts of Interest and Delegation

The regulatory system should require supervision throughout the life of a particular scheme. Supervision of an operator should promote high standards of competence, integrity and fair dealing. There should be clear powers with respect to:

• Registration and authorization of a scheme;
• Inspections to ensure compliance by scheme operators;
• Investigations of suspected breaches;
• Remedial action in the event of breach or default.

These powers should be sufficient to allow action in respect of all supervised entities with responsibilities under the scheme.

To assist in supervision and to promote compliance, there should also be clear responsibilities for maintaining records of the operations of the scheme. The operation of a collective investment scheme raises the potential for conflict between the interests of investors in the scheme and those of scheme operators or their associates. Regulation should ensure that the possibility of conflict arising is minimized and that any conflicts which do arise are properly disclosed. Operators should not benefit to the unfair disadvantage of investors in a scheme. Generally this will require regulation covering topics such as best execution, appropriate trading and timely allocation of transactions, commissions and fees, related party transactions and underwriting arrangements.

It is common for aspects of the operation of collective investment schemes to be carried out by delegates. The use of delegates should not, in any way, be permitted to diminish the effectiveness of the primary regulation of a collective investment scheme. A delegate should comply with all regulatory requirements applicable to the conduct of the principal's business activities.

11.5 Legal Form and Structure ³⁵

The regulatory system should address the legal form and structure of collective investment schemes to enable investors to assess their interests and rights and to enable the pool of investors' funds to be distinguished and segregated from the assets of other entities.

The legal form and structure chosen for collective investment schemes have implications for the nature of the risk of default or breach associated with the scheme. It must be disclosed to investors.

The regulatory system must ensure that these risks to investors are addressed either through statute, conduct rules or mandatory covenants in the constituent documents of a scheme.

11.6 Disclosure to be Made to Investors

There should be a requirement that matters material to the value of the scheme are the subject of disclosure to investors and potential investors. Disclosure about a collective investment scheme should assist investors in understanding the nature of the investment vehicle and the relationship between risk and return, so that investors evaluating scheme performance do not focus solely on return, but also on the risk assumed to produce the return. ³⁶ However, investors should be free to choose the level of market risk to which they are exposed. There should also be clear disclosure of investment policies. The goal of disclosure should be to:

• provide investors with sufficient information to evaluate whether and to what extent the scheme is an appropriate investment vehicle for them;
• provide information on a timely basis, in an easy to understand format, having regard to the type of investor.

One particular aspect of disclosure requiring close attention is the disclosure of all fees and other charges that may be levied under the scheme.

Supervision of an operator of a collective investment scheme should ensure that the stated investment policy or trading strategy of the scheme or any policy required under regulation has been followed and that any restrictions on the type or level of investment have been complied with.

11.7 Client Asset Protection ³⁷

Regulators should recognize the benefits for investor protection and confidence in financial markets of effective mechanisms to protect client assets from the risk of loss and the insolvency of investment firms. Client assets include money, securities and positions, including, in the case of derivatives, accruals thereof or the proceeds thereof, that are held or controlled on behalf of investors in a collective investment scheme.

Regulators should enforce within their jurisdictions those mechanisms which best achieve the overall objective of client asset protection, taking into account their insolvency and investment services laws, regulations and practices, and the needs of market efficiency and investor protection.

Regulators should review the adequacy of arrangements within their jurisdiction to ensure that client securities in the course of settlement are not mixed with those belonging to the investment firm.

11.8 Asset Valuation and Pricing

Regulation should seek to ensure that all of the property of a collective investment scheme is fairly and accurately valued and that the net asset value of the scheme is correctly calculated. ³⁸ Information about asset value and pricing should allow the investor to assess performance over time. The interests of the investor are generally better protected by the use of value based reporting wherever reliable market or fair values can be determined. ³⁹

11.9 Redemption of Interest in a Scheme

The law or rules governing collective investment schemes should enable investors to redeem units upon a basis that is made clear in the constituent documents and should ensure that rights of suspension protect the interest of investors. Regulators should be kept informed of any suspension of redemption rights.

11.10 International Regulatory Cooperation ⁴⁰

An increasing number of collective investment schemes are marketed across jurisdictional boundaries. It is also common for scheme promoters, managers and custodians to be located in several different jurisdictions and they may not be in the same jurisdiction as investors to whom the scheme is promoted. ⁴¹ The approval of schemes should have regard to the possible need for international cooperation. These matters are addressed more generally in Section 9.3.