The Council of Securities Regulators of the Americas ("COSRA") recognizes the importance of effective regulatory oversight of the operation of Collective Investment Schemes (CIS). The provision of investment management services has proliferated throughout the region. As the primary function of CIS is to administer third party funds, it is important that the CIS be operated transparently and fairly, with safeguards for CIS assets.

For this work program, COSRA examined the operation and regulation of CIS. Specifically, COSRA studied:

• general information about CIS;
• conflicts of interest;
• asset valuation and pricing;
• disclosure; and
• safe custody of CIS assets.

This report provides information about the types of mechanisms that regulators in the region use to supervise the activities of CIS, and general trends in regulatory approaches. COSRA recognizes that its members are at different stages of development; and this report is part of COSRA members' continuing efforts to enhance investor protection in CIS regulation.

The report notes that the International Organization of Securities Commissions has previously developed principles in these areas. The IOSCO principles may be particularly useful as a reference for members in various stages of development. The report then demonstrates the variety of approaches COSRA members are using to regulate CIS, without endorsing particular practices. The report provides COSRA members with information about the status of CIS regulation in the region, and a greater understanding of alternative mechanisms for overseeing CIS.

COSRA members reviewed the minimum requisites for entry, and compared the different types of funds in their respective markets.

Before a CIS can operate, the majority of COSRA members require that it register or obtain authorization from a supervisory entity that is specifically authorized for that purpose. Regulators may require CIS to satisfy certain requirements in order to enter the market, including registration and minimum capital requirements. Regulators or other entities with supervisory capacity, such as a central bank or self-regulatory organization (SRO), may assume responsibility for authorizing or regulating CIS. CIS in a single jurisdiction may be supervised by more than one regulator.

COSRA members have different types of CIS in their markets. Below are some of the ways that CIS may differ:

• CIS may issue redeemable or non-redeemable securities (also referred to as open-end or closed-end funds, respectively); 
• CIS differ based on their investment objectives;
• CIS may sell to domestic or overseas investors;
• CIS may or may not be organized as companies; and
• CIS have different types of fund managers.

Depending on the characteristics of the market, the regulator may set limits on the types of instruments that CIS can invest in. Some jurisdictions also regulate the diversification of CIS investments. The regulator should establish mechanisms to ensure compliance with those limits. Regulators also should require that the risks inherent in the investments are disclosed.

Regulators should recognize that an operator of a CIS may have interests that, if exercised without restraint, would conflict in a material way with the interests of investors. Regulators should respond to this risk by ensuring that operators exercise their management responsibilities with full regard to the best interests of investors. Regulators may choose to rely on the concept of "fiduciary responsibility" as interpreted domestically. Detailed regulations designed to monitor and, when possible, prevent potential conflicts between the operator and investors also are recognized as an acceptable regulatory method.

COSRA members discussed:

• the definition of affiliates or connected persons and firms;
• the use of non-public information;
• transactions with connected persons and firms;
• trading by CIS employees; and
• the practice of "softing".

Before studying the transactions or practices that violate statutes or regulations regarding conflicts of interest, it is important to understand which parties are considered to be affiliates or connected persons of CIS. Most COSRA members have a legal definition of affiliates or connected parties. Most COSRA members consider those persons who hold certain positions within a CIS (such as the operator or the CIS's officers and directors), or hold a certain percentage (from 5% to 20%) of a CIS's assets, and their relatives, to be connected or affiliated persons of a CIS. A small number of members also consider second-tier affiliates (that is, affiliates of affiliates) to be affiliates of the CIS. Certain members do not have a legal definition of related persons or companies, but they limit the ability of particular parties to share personnel.

Use of Non-Public Information

To prevent the misuse of non-public information, regulators may prohibit related persons of CIS from using such information in securities transactions for their own advantage. Written procedures established by CIS managers also may be useful to help prevent the misuse of non-public information by CIS managers and their related persons. Regulators may examine the effectiveness of these procedures in inspections of CIS. Requiring CIS, their operators, and employees of the CIS and their operators that have access to non-public information to report their securities holdings and trades also may deter, and assist regulators in detecting, the use of non-public information.

COSRA members regulate the use of non-public information in different ways. Some members have general securities regulations regarding the use of non-public information that are not specific to CIS. Certain members place limitations on CIS and their related persons to prevent the use of non-public information. A small number of members require CIS to maintain written procedures designed to prevent the misuse of non-public information. Several members:

• inspect and audit CIS and their managers to ensure compliance with regulations and any internal control mechanisms; 
• monitor trading of securities;
• analyze transactions; and
• require independent auditors to report on a CIS's internal control mechanisms.

In this area, COSRA members discussed:

• transactions between CIS and their affiliated persons;
• payments by CIS to connected persons and firms for services rendered; and
• ownership by CIS managers and connected persons of the CIS that they manage.

(i)Transactions Between the CIS and their Affiliated Persons

Because related persons of a CIS could potentially use the CIS to benefit themselves at the expense of the CIS and its shareholders, regulators may prohibit or strictly limit the transactions between a CIS and its related persons. Regulators also may create rules that apply to these transactions, and/or require prior review and approval of the transactions.

COSRA members place a wide variety of limits on transactions between CIS and their related persons. Several members generally prohibit transactions between CIS and their managers and other related persons unless they are completed pursuant to a rule, or permission is received from the regulator.

(ii)Payments by CIS to Connected Persons and Firms for Services Rendered

COSRA members also discussed whether related persons and firms of the CIS or the CIS manager may receive payments from the CIS for services rendered, and whether there are any limits on such payments. As part of its fiduciary duties to the CIS, the CIS manager may need to consider whether the fees that it or its related persons charge the CIS for services have a reasonable relationship to the services provided. Requiring the CIS's shareholders to approve the manager's contract with the CIS and any changes to that contract may help to prevent managers from charging excessive fees to the CIS. CIS also should be cautious of paying excessive compensation to related persons for brokerage services.

Approximately half of the COSRA members reporting permit these types of payments, and most of these members regulate the payments. For example, certain members prohibit particular transactions, while others place requirements on the transactions.

(iii)Ownership by CIS Managers and Connected Parties of the CIS that they Manage

One type of related transaction discussed by COSRA members was the ownership by CIS managers and their connected persons of the CIS that they manage. Members discussed whether there were any limits on that ownership, and whether the CIS must maintain a register of its connected persons and firms. By informing their employees of the identity of related persons and of the prohibited or limited transactions between CIS and their related persons and firms, managers may help to prevent violations of laws that prohibit or limit such transactions.

Approximately half of the members that addressed the question limit CIS managers from owning interests in the CIS that they manage. Several members prevent related persons from owning more than a certain percentage (for example, 15% or 25%) of a CIS's shares. In some cases, the limits differ for open-end and closed-end CIS. With respect to maintaining a record of related persons, approximately half of the members that responded to the question have this requirement. Certain members, in their inspections of CIS, review CIS documents and interview personnel to ensure compliance with provisions that apply to related party transactions.

• whether employees of the CIS or the CIS manager are permitted to purchase the same securities that the CIS holds in its portfolio, or securities that the CIS is considering purchasing;
• whether those employees are permitted to purchase securities from and sell securities to the CIS; and
• whether there are limits on such transactions.

• whether personal trades must be approved by or disclosed to CIS management;
• whether the CIS is required to have access to the personal trading records of employees; and
• whether regulators also may obtain access to this information.

Conflicts of interest may arise when CIS employees purchase or sell securities for their personal accounts. For example, CIS employees may have access to information about upcoming CIS transactions that the CIS employees could use for their own benefit. A CIS manager also could profit if the manager causes a CIS to purchase or hold portfolio securities in order to protect or strengthen the manager's personal investments in those securities.

In order to prevent a CIS's employees or other related persons from defrauding the CIS in connection with the purchase or sale of a security held or to be acquired by the CIS, regulators may prohibit personal trading, require a CIS or its manager to adopt a code of ethics, or adopt reporting requirements with respect to personal securities transactions. Regulators also may review personal trading reports during inspections of CIS.

Most COSRA members have reporting requirements with respect to these transactions. A smaller number of members prohibit or otherwise limit them. Certain members require managers to maintain procedure manuals or other internal control mechanisms. Other members require that the transactions be executed on an exchange. Listed below are examples of specific limitations:

• persons who have access to decision-making information regarding CIS investments are prohibited from purchasing securities on their own behalf within the next five business days after the CIS has sold the securities, if the purchase price is lower than the market price before the sale or than the sales price, whichever is higher; and
• CIS may not contract with persons close to the CIS in making purchases or sales of portfolio securities, unless certain requirements are satisfied (for example, in a purchase transaction, the price payable may not exceed the asked price of the securities as quoted by a public quotation).

COSRA members that responded to the question do not require managers to approve transactions carried out by CIS employees or related persons in securities other than those held, or to be acquired or sold by the CIS. Some members require that employees report the transactions to the manager.

Softing

Softing occurs when brokerage commissions or other types of selling compensation are used to obtain research and other services ancillary to the execution of portfolio transactions. Softing may provide an opportunity for managers to use brokerage commissions paid by clients, including CIS, to benefit themselves. This receipt by the manager of a benefit through the use of client commissions raises conflict of interest concerns. When managers use commission dollars to obtain research and brokerage services, it is important that they determine whether the amount of the commission paid is reasonable in relation to the value of the brokerage and research services provided by the broker-dealer.

A majority of COSRA members currently do not regulate softing, but several members have either recently adopted, or intend to adopt, regulations to address concerns raised by softing. One member prohibits managers from promoting trading in securities to obtain brokerage revenue for the managers or third parties and requires managers to disclose annually their brokerage commissions for the last two years.

Another member generally prohibits a CIS manager from receiving any compensation pursuant to a softing arrangement, in connection with the purchase or sale of any property, including securities, to or for the CIS. This prohibition, however, would not apply if the manager used commission dollars to obtain research and brokerage services, so long as the manager determined in good faith that the amount of the commission paid was reasonable in relation to the value of the brokerage and research services provided by the broker-dealer. The manager also must exercise investment discretion over the account, disclose its softing practices to the regulator, and obtain best execution for the account.

Regulators should provide a system for the valuation of CIS assets and the pricing of interests in CIS. Regulators also should ensure that procedures for purchasing and redeeming interests in a CIS are fair to existing and future investors. The price of interests in a CIS should be calculated according to the CIS's net asset value. Net asset value should be determined on a regular basis in accordance with accepted accounting practices.

COSRA members discussed whether a CIS's assets should be valued at market price or based on another standard, who determines a CIS's valuation process, the frequency with which a CIS's assets are valued, and the mechanisms that regulators use to evaluate the fairness of CIS valuations.

Methods of Valuation

If a CIS's portfolio securities are traded actively in a domestic market, market quotations generally provide the best indication of value. Questions may arise regarding the value of illiquid or thinly traded securities. Questions also may arise regarding the value of securities traded on foreign exchanges, when an event occurs after the closing of a foreign exchange that would result in a material change in the market value of a particular security. Under either of those circumstances, a CIS may need to value the security at the amount at which it might reasonably expect to receive upon a current sale.

Most COSRA members require CIS to value their portfolio securities based on the securities' market value, with exceptions for particular types securities or under certain circumstances, as noted below. Some members have specific regulations that apply to different types of assets, and others require that a CIS's valuation method receive regulatory approval. Certain COSRA members are developing regulations regarding valuation.

As stated above, some COSRA members permit valuation based on a price other than market price under specific circumstances and/or if approved by the regulator.

Daily calculation of a CIS's net asset value ensures that a CIS that issues redeemable securities is prepared to redeem those securities at a current price. It may be beneficial for the CIS's pricing procedures to be clearly disclosed to investors and subject to the review of another party, such as the CIS's board, or an auditor.

A large majority of COSRA members require open-end CIS to calculate their net asset values daily, and CIS in other jurisdictions may choose to calculate their net asset values daily. Certain COSRA members require closed-end CIS to calculate their net asset values on another basis, such as weekly, monthly or quarterly. Other COSRA members permit the frequency of calculations of net asset value to be determined by the operator, if disclosed to or approved by investors.

Forward pricing occurs when a CIS sells, redeems or repurchases its securities at a price that is computed after receiving a purchase, sale or redemption request. With backward pricing, the price used is the price that was computed before receiving the request.

An example of forward versus backward pricing is as follows:

An investor places an order to purchase CIS shares on Tuesday morning. If the CIS uses backward pricing, the investor receives the price of the CIS shares that was computed at the end of the day Monday. If the CIS uses forward pricing, the investor receives the price that is computed at the end of the day Tuesday.

Forward pricing addresses certain problems that may characterize backward pricing systems. As shown above, a person who purchases shares of a CIS that uses backward pricing knows the price of the shares before he or she purchases them, which permits a speculator to take advantage of fluctuations in the prices of the CIS's portfolio securities that occurred after the CIS had last calculated its net asset value. For example, when securities prices generally are rising, a speculator could buy a large number of CIS shares at a previously determined price, and then redeem them at a profit after the CIS's net asset value is calculated. Backward pricing can lead to significant dilution in the investments of existing CIS shareholders and can contribute to market volatility. Most members did not address whether they require forward pricing, but a small number of members reported that forward pricing is used by certain types of CIS, or is required for open-end CIS.

Regulators may review a CIS's valuation procedures to evaluate the fairness of those procedures. This review may occur in an inspection of the CIS, and/or in a review of the CIS's disclosure documents.

Of those COSRA members that discussed the review of a CIS's valuation procedures, most stated that they evaluate those procedures in inspections of the CIS. Other COSRA members evaluate the CIS's valuation and pricing methods in their review of the CIS's offering memoranda and other disclosure documents, and rely on CIS compliance with those documents as well as the CIS's internal regulations. Certain members require auditors to audit CIS accounts or verify valuation criteria periodically. Although, some COSRA members only use one compliance method, most of them combine two or more methods.

Regulators should impose a disclosure requirement on CIS to ensure that there is full, accurate and timely disclosure to prospective investors of all of the information that is necessary for an investor to make an informed investment decision. Financial data and other information relating to the management and operation of a CIS must be provided on a regular (for example, annual or semi-annual) basis for the benefit of existing and prospective investors in the CIS. Compliance with these requirements must be monitored by the regulator to ensure that the information that is provided meets the required standards.

COSRA members discussed how regulators ensure that full, accurate and timely disclosure is made, the procedures that regulators use to make information available to the public, and the requirements that apply to CIS advertisements.

By specifying the types of disclosure that must be made by CIS, regulators may help to ensure that complete disclosure is made to investors. Complete, accurate and timely disclosure enhances investor's decision making process. Regulators may require CIS to file their prospectuses and other periodic reports to allow the regulators to review the filings for misstatements or omissions of information. When reviewing these documents, regulators also may identify questionable practices in which the CIS or its manager may be engaging.

Most COSRA members require CIS to make certain information available periodically. The particular information that must be provided, and the frequency with which the information must be made available, vary among members. Disclosure requirements also may vary based upon the type of CIS (that is, open-end or closed-end). Certain members require that the information be filed with the regulator, while others require that the information be displayed in offices, published in newspapers or sent to investors.

Regulators may require CIS to file information with them so that the information will be available to the public. Once information has been filed, regulators may need to determine how to make the information easily available to the public in a timely and cost-effective manner. Regulators may seek or promote mechanisms that facilitate the wide disclosure of CIS information to the public. The regulator may establish, for example, its own publication which provides consolidated market information periodically. It may also designate personnel or an office responsible for answering questions from the public and providing investor education materials. With the increasing use of electronic media, regulators may choose to require that CIS information be filed and made available electronically. These mechanisms may assist regulators in increasing the amount of information that is available to the public about CIS, which may improve market transparency.

Certain COSRA members make CIS filings available at the regulator's office, distribute the information in newspapers, and sell historical information to the public on computer diskettes. Several COSRA members have established or are developing their own Internet web sites. Of those members that have web sites, some provide information upon request, while others place certain information on their web sites. A small number of COSRA members require CIS to file information with them electronically.

CIS Advertisements - General Regulatory Requirements

To prevent materially misleading information from being included in CIS advertisements, regulators may require CIS advertisements to meet certain requirements and may require advertisements to be reviewed by the regulator or by another entity chosen by the regulator. Advertisements may be materially misleading if they include untrue statements of material fact, or if they omit to state facts necessary in order to prevent the statements made in the advertisements from being materially misleading.

Below are examples of some of the standards that COSRA members apply to CIS advertisements:

• must be accurate and not misleading;
• must only include information that is contained within:

- the CIS's bylaws;
- the CIS's prospectus;
- documents filed with the CIS's prospectus;
• may not include:

- incorrect or improper information;
- misleading promises or statements; and
- guarantees of investment results.

Approximately half of the COSRA members that submitted reports require CIS advertisements to be reviewed by the regulator or its delegate, although most of these members do not review the advertisements until after publication. Of those members that do not require formal review, some review publications in which the advertisements typically appear, and some require approval of advertisements under certain circumstances. Under certain circumstances, regulators may require CIS to cease publishing an advertisement that contains false or misleading information.

Required Legends and Other Information in CIS Advertisements

Requiring legends in a standardized format or other information in CIS advertisements may highlight for investors information that is particularly relevant to the information in the advertisement and relevant to investing in CIS.

Most COSRA members require legends in advertisements. In some cases, the legends apply only to particular types of CIS, and only under certain circumstances (for example, in advertisements that include performance information).

In addition to legends, certain COSRA members require that a CIS include in its advertisements information regarding the CIS's characteristics, classification, guarantees, responsibilities, as well as information regarding the availability of the CIS's prospectus.

Certain CIS include performance information, such as return or yield figures, in their advertisements. Establishing requirements that apply to the calculation of all performance information assists investors in making meaningful comparisons among CIS.

Not all COSRA members regulate performance advertising, but several members have established procedures regarding the calculation of the CIS's yield and return. Other members check the performance information in advertisements with that submitted to the regulator. Specific legends may be required in advertisements with performance information, as discussed above.

COSRA members discussed the types of entities that may act as custodians of CIS assets, the regulation of custodians, whether a custodian must be independent from the CIS's manager, whether the CIS may retain custody of its assets, the use and regulation of foreign custodians, and practices that govern the disbursement of CIS assets.

CIS use custodians to protect CIS assets against loss, theft or misappropriation. To further protect CIS assets, custodians and custodial arrangements should be regulated.

Many parties within the financial services industry act as custodians.

Certain COSRA members permit only one category of custodian, such as financial institutions, while others permit several types of custodians.

The regulation that applies to a particular type of custodian should address the potential risks to CIS assets associated with that type of custodian. Custodians such as banks, stock exchanges, and depositories frequently are regulated by either the COSRA member's central bank or its securities regulator. Some COSRA members have other requirements, including minimum capital, shareholders' equity, licensing, and reporting requirements.

Requiring a custodian to be independent of the CIS and the CIS's manager may help to ensure the safekeeping of a CIS's assets. A slight majority of COSRA members that submitted reports require custodians to be independent of the CIS manager, or they require a degree of independence, such as restrictions on common directors or agents. Some members are considering requiring custodians to be independent.

Self-Custody

Self-custody is an alternative to the appointment of a formal custodian. Under self-custody, the CIS, or an entity close to the CIS, such as its manager, may be permitted to have custody of the CIS's assets, if additional protective requirements are in place. These safeguards could include:

• holding the CIS's assets in the safekeeping of a bank or other company that is supervised by regulatory authorities;
• physically segregating CIS assets from the assets of others;
• designating certain persons who can access the CIS's assets; and
• requiring an independent public accountant (a) to verify the assets held by the self-custodian, and (b) conduct a certain number of examinations without giving prior notice to the CIS.

A slight majority of the members submitting reports do not permit self-custody. Some members permit self-custody but require that the CIS's assets be handled separately. Other members are considering additional requirements for self-custodians, such as additional capital requirements.

With the increased investment opportunities for CIS in foreign markets, it may be necessary for CIS to use foreign custodians. In deciding whether to use a particular foreign custodian, the following considerations may be useful:

• the custodian's practices, procedures, and internal controls;
• whether the custodian has the necessary financial strength to provide reasonable care for CIS assets;
• the custodian's general reputation and standing; and
• whether the CIS will have jurisdiction over and be able to enforce judgments against the custodian.

A slight majority of COSRA members that submitted reports permit CIS to use foreign custodians. Certain members that permit the use of foreign custodians require foreign custodians to receive regulatory approval. Other members have specific requirements that apply to foreign custodians, but do not require foreign custodians to obtain regulatory approval.

Disbursement of Assets

Many types of transactions occur in the operation of a CIS, including purchases and sales of securities, and payments of expenses. In order to minimize the possibility that CIS assets will be lost, stolen, or misused, the following practices may be useful:

• prohibiting the CIS manager from having access to the CIS assets; 
• requiring the CIS manager to provide written instructions, signed by designated CIS officers, to the CIS's custodian to complete each movement of assets; and
• requiring the custodian to effect securities transactions in the CIS's portfolio only on a payment-on-delivery or collect-on-delivery basis. This means that the custodian does not release CIS cash to pay for a purchase until it receives a confirmation that the securities have been transferred into the CIS's name. For the sale of CIS assets, the custodian does not release the security until it has received cash. This process minimizes the possibility that CIS assets may be lost through theft or default by those in the settlement chain.

COSRA members currently use a variety of mechanisms designed to minimize the risk of loss due to the movement of CIS assets. Several members limit the disbursement of CIS assets by specifying the expenses that may be deducted, or by limiting CIS disbursements to those that the CIS has listed in a particular document. Other members require physical and financial settlement of a securities transaction to occur a specified number of business days after the transaction. Some members require that the CIS manager maintain separate bank accounts exclusively for the CIS.