In this issue:-
- European Commission's Draft Directive on Alternative Investment Fund Managers
- Class level assets within Irish funds
- New Issues
- Interest Rate Hedging
- Undertakings for Collective Investment in Transferable Securities (UCITS) – collateral passed by UCITS to OTC derivative counterparties
- Disclosure in Complex UCITS Funds
UPDATE ON THE EUROPEAN COMMISSION'S DRAFT DIRECTIVE ON ALTERNATIVE INVESTMENT FUND MANAGERS
The EU Parliamentary committee for economic and monetary affairs has delayed its vote on the Alternative Investment Fund Managers Directive (the "AIFM Directive") for a third time. The vote, due to take place on May 10 was delayed so amendments proposed by the EU Parliament's legal affairs committee can be taken into account.
The Spanish EU Presidency published three new EU Council compromise texts for the proposed AIFM Directive in March, 2010. The Spanish presidency reinstated Article 35 which had been removed by the Swedish Presidency. It stipulates that non-EU managers and funds may only be able to access the EU market if there is a cooperation agreement in place between the jurisdiction where they are based and the EU jurisdiction they wish to market in. Potentially this could mean that the EU market could be effectively closed to non- EU funds and managers.
Two further amendments to the AIFM Directive were proposed by the EU Parliament's legal affairs committee on 28 April, 2010. These amendments will allow national private placement regimes to continue operating under reasonable conditions. The EU Council's group of finance ministers is due to vote on the AIFM Directive on May 18, having also delayed its vote from March due to continued disagreement over key points.
For detailed information on AIFM, please refer to your usual contact in Dillon Eustace.
CLASS LEVEL ASSETS WITHIN IRISH FUNDS
The Irish Financial Regulator has issued a Policy Update (February 9, 2010) in relation to class level assets within Irish funds clarifying the circumstances in which:
- financial derivative instruments may be used at share class level to provide for standard class level distinctions (currency and interest rate hedging, different distribution policies and fee structures) but, more importantly, to provide different levels of participation in the performance of the underlying portfolio;
- investment in New Issues can be carried out at share class level; and
- interest rate hedging can be carried out at share class level.
Background
For many years Irish funds have been permitted to issue multiple share classes in respect of a single portfolio of assets, with the differentiating features between the different classes usually being currency hedging at class level and different class level distribution policies, management fees and front end/exit fees.
The core principles underpinning the Financial Regulator's approach to multiple classes in respect of a single portfolio of assets (a "Fund") are that:
- each Fund must consist of a single common pool of assets;
- assets may not be allocated to individual share classes; and
- the capital gains/losses and income arising from that pool of assets must be distributed and/or must accrue equally to each shareholder, relative to their participation in the Fund.
These principles are themselves founded on a general "equality of treatment" principle and legitimate concerns that to allow allocation of assets to individual classes could result in "cherry picking" of assets and other potential abuses.
Over the years some exceptions or variations have been permitted, most notably hedged currency share classes where the costs of and gains/losses on the hedging contract are allocated solely to the hedged class. Similar exceptions have allowed interest rate hedging at class level where derivatives have been used to provide different interest rate exposures on different classes in respect of, for example, a diversified bond portfolio.
More recently, allocation of assets to side pockets has been allowed for non-UCITS as a measure to deal with portfolio illiquidity, subject to quite specific rules set down by the Financial Regulator.
Following a number of industry submissions, the Financial Regulator has now formalised a series of welcome changes to its approach which will facilitate the engineering of different returns on different classes and a more suitable approach to investing in New Issues. The opportunities offered by this Policy Update are explained below.
Financial Derivative Instruments used at Share Class Level
The Financial Regulator notes in its Policy Update that it will permit the use of financial derivative instruments at share class level where their purpose is to effect currency and interest rate hedging (subject to the principles set out in Guidance Note 3/99) or different distribution policies or fee structures at share class level. This is really a statement of current practice.
However, the Policy Update also provides that the Financial Regulator will consider proposals where financial derivative instruments may be used at share class level to enable a different level of participation in the performance of the underlying portfolio or different levels of capital protection, subject to the following conditions:
- the financial derivative instrument for each share class must be based on the same underlying portfolio or index;
- the transactions cannot result in a leveraged return per share class (i.e. the participation rate can be up to but not exceeding 100% of the relevant share class' performance of the underlying portfolio);
- the issue of segregated liability between share classes must be addressed.
With regard to point (c) above, the Financial Regulator will require: (i) a legal opinion that the OTC counterparty's recourse to the Fund is limited to the relevant share class' participation in the assets of the Fund; and (ii) confirmation from the board of the Fund/management company that it has reviewed and is satisfied that the proposal will, as a result of the agreement between the Fund and the OTC counterparty, not result in any prejudice for investors in one class over another. The board must also confirm that there will be no cross liability between share classes.
In practice, amendment of the Fund's constitutional document may be required as may contractual agreement between the parties that the recourse of the OTC counterparty be limited to the assets [attributed to] the relevant share class.
Professional and Qualifying Investor Funds
In the case of professional and qualifying investor funds, the Financial Regulator will also consider proposals for use of financial derivative instruments at share class level with different features, for example to provide an additional add-on exposure to that generated from the underlying portfolio, or to generate a leveraged return at share class level or where the underlying of the derivatives are different versions of the same underlying, e.g. two classes with different swap instruments based on sub-indices derived from the same initial index.
This may be of significant interest to many investors and asset managers, the key being the capacity to ring-fence the class level liabilities.
Other arrangements similar to these examples will be considered by the Financial Regulator on a case-by-case basis, subject to demonstrating segregated liability between share classes in the manner described above.
General Conditions
Key requirements for utilising this opportunity include that:
- the Fund's constitutional document makes specific provision for the creation of share classes and contains clear provisions for the charging of any resultant gains/losses on the transaction to the relevant share class;
- the prospectus contains a clear description of the strategies being pursued at share class level and the effect this will have on investors in each share class;
- the use of financial derivative instruments at share class level creates positive benefits for investors and does not prejudice the interests of holders in other share classes.
NEW ISSUES
Another regulatory hurdle which certain Funds have faced is how to deal with Rule 5130 of the U.S. Financial Industry Regulatory Authority, Inc. ("FINRA"), which imposes restrictions on the participation by certain persons involved in the securities industry ("Restricted Persons") in equity securities issued in initial public offerings. In summary, the Rule prohibits the sale of equity securities issued in initial public offerings through FINRA member firms (so called, "New Issues") to accounts in which Restricted Persons have a significant beneficial interest (a 10% de minimis exemption applies).
FINRA Rule 5130 defines "Restricted Persons" as including FINRA members or other broker dealer personnel (officers, directors, general partners etc.), immediate family members thereof, finders or persons acting in a fiduciary capacity to the managing underwriter of a New Issue, portfolio managers, or persons owning a broker dealer.
The Irish Financial Regulator has issued a Policy Update (February 9, 2010) which provides that the Financial Regulator will now permit professional and qualifying investor funds to establish a separate class within a Fund where any gains/losses on investment in "New Issues" can be allocated for the benefit of investors not deemed to be Restricted Persons in accordance with Rule 5130 of FINRA. The constitutional documents and prospectus must clearly provide for these arrangements.
This is a welcome development as in the past an Irish Fund either had to have two subfunds (one for Restricted and one for Unrestricted), not accept Restricted Persons or avoid New Issues entirely.
INTEREST RATE HEDGING
The Irish Financial Regulator has issued a Policy Update (February 9, 2010) which clarifies that Financial Regulator will permit interest rate hedging at share class level where the benefits and costs of such hedging may be accrued and attributed solely to investors in a hedged share class.
This is not an entirely new development as the Financial Regulator previously allowed interest rate hedging within UCITS where one class of shares offered an unhedged exposure to a long bond asset class and a second class provided investors with the same opportunity but sought to hedge (80% - 100%) against interest rate risk thereby allowing investors to limit downside asset risk through the use of derivatives. In that example, the allocation of gains or costs involved with the derivatives (including relevant unwinding costs) were charged to the second class only.
Such arrangements must be effected in accordance with the principles set out in Guidance Note 3/99, namely:
- clear disclosure of the exchange rate hedging strategy, the risks associated therewith and the implications of the strategy to be set out in the prospectus;
- unambiguous valuation and allocation provisions to be set out in the constitutional document of the Fund;
- an indication of how the hedging transactions have been utilised to be included in the periodic reports of the Fund; and
- the valuation systems operated by the Fund or its delegate must be capable of processing and identifying the relevant hedge transaction at share class level.
UNDERTAKINGS FOR COLLECTIVE INVESTMENT IN TRANSFERABLE SECURITIES (UCITS) – COLLATERAL PASSED BY UCITS TO OTC DERIVATIVE COUNTERPARTIES
Regulation 18 of the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations 2003 ("the Regulations") provides that the assets of a unit trust and the assets of a common contractual fund shall be entrusted to a trustee for safe-keeping. Regulation 37 makes the same provision in relation to the assets of an investment company.
Regulation 45(g) of the Regulations permits UCITS to invest in financial derivative instruments, including OTC derivatives. This note addresses the passing of collateral by a UCITS to an OTC derivative counterparty.
The Committee of European Securities Regulators ("CESR") issued advice on Level 2 measures related to the UCITS management company passport to the European Commission in October 2009. This advice addressed, inter alia, matters related to OTC derivatives, including the passing of collateral by a UCITS to an OTC counterparty or broker in respect of financial derivative instruments.
The advice noted that market practice may require collateral or margin to be passed by the UCITS to an OTC counterparty or broker in respect of OTC financial derivative instruments. As such these arrangements do not offend Regulations 18 and 37 of the Regulations.
The CESR advice also noted that:
- collateral passed must be taken into account in calculating risk exposure to the OTC counterparty as referred to in Article 52(1) of the UCITS Directive;
- collateral passed may be taken into account on a net basis only where there is a legally enforceable netting arrangement in place.
CESR work in relation to risk measurement, including the calculation of counterparty risk for UCITS, is ongoing with the intention to provide detailed Level 3 guidelines in these areas. The UCITS Notices and related Guidance Notes issued by the Financial Regulator will be amended in due course to reflect the provisions of Directive 2009/65/EC, the implementing measures required under that Directive and any guidelines issued by CESR.
DISCLOSURE IN COMPLEX UCITS FUNDS
The Financial Regulator is proposing changes to Guidance Note 3/07 "Structured Products and Complex Trading Strategies – Prospectus Disclosure Requirements" in 2010, whereby the following disclosures should be provided upfront in a prospectus:
- The underlying exposure. This should give an indication of the underlying asset class or trading strategies. It should also state whether the exposure is leveraged and will result in a long/short exposure. An example would be "the fund has a direct and/or indirect leveraged exposure to {asset class x} and/or to the following trading strategies".
- The expected risk-return profile (high level) which is normally expressed in terms of volatility or a volatility range.
- The investment opportunity. This will normally follow along the lines of "the investment strategy supporting this is as follows...". There was some discussion as to whether and where this should be disclosed. It should be disclosed where it is not obvious to a reader what the investment rationale is. Asset managers will generally express this in terms of some sort of "alpha" and how they think they can extract it from the exposures and strategies previously disclosed above.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
