On 5 October 2015, the Central Bank of Ireland (the “Central Bank”) published new regulations setting out the Central Bank requirements applicable to undertakings for collective investment in transferable securities (“UCITS”). The Central Bank (Supervision and Enforcement) Act 2013 (Section 48(1)) (Undertakings for Collective Investment in Transferable Securities) Regulations 2015 (the “CB UCITS Regulations”) supplement existing legislative requirements (in particular, the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations 2011) and, together with guidance published on the Central Bank website and the UCITS Q&A, replace the rules and guidance previously set out in the Central Bank’s UCITS Notices and Guidance Notes. The publication of the CB UCITS Regulations follows a consultation issued by the Central Bank in January 2014 and is accompanied by a feedback statement summarising the responses received.
Following the introduction of the AIF Rulebook as part of the implementation of the Alternative Investment Fund Managers Directive (“AIFMD”), the Central Bank indicated that it would adopt a similar approach in respect of UCITS and would consolidate into one document all of the conditions which the Central Bank imposes on UCITS, their management companies and depositaries. The Central Bank consulted on this proposal in its “Consultation on Publication of UCITS Rulebook” (CP77) which outlined the Central Bank’s approach, included a draft of the new proposed UCITS Rulebook, and raised specific queries in relation to proposals regarding the promoter regime, Central Bank approval of regulated markets and semi-annual reporting for UCITS management companies.
The Central Bank has decided to publish the requirements applicable to UCITS in the form of a statutory instrument rather than a “UCITS Rulebook” under relatively new regulation-making powers conferred on the Central Bank by the Central Bank Supervision and Enforcement Act 2013. This new procedure has been adopted for implementation of regulation in other financial sectors and the Central Bank has indicated that using regulations is its preferred approach, as it is intended to assist fund providers by bringing additional clarity and certainty to the rules applied by the Central Bank. The Central Bank has indicated that it will shortly commence a review of the Central Bank’s AIF Rulebook to see whether it should also be issued as Central Bank regulations.
Amendments to Central Bank Conditions
The CB UCITS Regulations introduce a number of amendments to the conditions previously set out in the UCITS Notices. The key changes are as follows:
Codification of Existing Derogations
One of the most significant changes effected by the CB UCITS Regulations is the codification of any derogations previously granted by the Central Bank in relation to individual requirements. The Central Bank believes that its review process has allowed it to identify any such derogations and to ensure that they are included. If a particular derogation has not been included in the CB UCITS Regulations, the relevant UCITS will need to re-apply for such derogation. The Central Bank has emphasised on a number of occasions that it retains the authority to grant derogations from the provisions of the CB UCITS Regulations.
While the Central Bank has endeavoured to ensure that all existing derogations are provided for in the CB UCITS Regulations, each UCITS will now need to consider its current offering documents and operating procedures, together with its authorisation file, in order to determine whether any derogations were obtained which are not provided for in the CB UCITS Regulations and to re-apply for such derogation if necessary. Matheson are of course happy to assist our clients with this analysis and any such applications.
Removal of Promoter Approval Requirement
Following the approach adopted in respect of alternative investment funds in the AIF Rulebook, the requirement for UCITS to have approved promoters has been removed. The Central Bank will instead place reliance on the regulatory regimes for UCITS management companies and it has elaborated on the obligations of directors in circumstances where a UCITS gets into difficulties. This is a welcome development and follows the approach adopted by the Central Bank in implementing the AIFMD.
Guidance on Regulated Markets
The Central Bank has withdrawn Guidance Note 1/96, which set out its approach to the determination of whether a market met the criteria for “regulated markets” upon which transferable securities or financial derivative instruments must be listed or traded in order to be an eligible investment for a UCITS. This withdrawal is on the basis that there is a degree of overlap between that guidance note and the UCITS eligible assets directive. The Central Bank will no longer review submissions on proposed regulated markets and will no longer publish a list of permitted markets for UCITS. It will therefore be for the UCITS to determine whether a particular market meets the relevant criteria set out in the CB UCITS Regulations, which may provide additional flexibility to UCITS.
Financial Reporting Requirements
The Central Bank has extended the financial reporting requirements by requiring UCITS management companies and depositaries to submit half-yearly management accounts covering the second six months of the financial year (in addition to the requirement to submit half yearly management accounts covering the first six months of the financial year, as applied to date). The Central Bank is of the view that this change will provide it with more complete and timely information, allowing it to compare and analyse reports from the first six months of the year with the second six months and providing more timely key risk indicators and alerts on PRISM, the Central Bank’s risk-based framework for the supervision of regulated firms.
The CB UCITS Regulations contain provisions which reflect the outcome of the Central Bank’s July 2014 consultation on the adoption of the European Securities and Markets Authority (“ESMA”) revised guidelines on ETFs and other UCITS issues (“CP84”). ESMA’s revised guidelines provide for a derogation from the collateral diversification requirement where collateral consists of securities issued or guaranteed by a member state, one or more of its local authorities, a third country or public international body to which one or more member states belong. The derogation applies to all UCITS, subject to additional disclosure requirements applicable to the prospectus and periodic reports of UCITS who avail of the derogation.
The CB UCITS Regulations include provisions designed to mitigate the risks the Central Bank perceives in applying the derogation to all UCITS and builds upon the existing obligation on UCITS management companies to perform a credit assessment set out in the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations 2011 by identifying a specific credit quality threshold.
The CB UCITS Regulations provide that collateral received should be of “high quality”. In assessing whether collateral is of high quality, the UCITS management company must ensure that, where the issuer was subject to a credit rating by an agency registered and supervised by ESMA, that rating must be taken into account. Where an issuer is downgraded below the two highest short-term credit ratings by the credit rating agency, the management company must conduct a new credit assessment of the issuer without delay. This revised rule is based on the formulation set out in ESMA’s opinion on the review of the ESMA guidelines on a common definition of money market funds, meaning that the threshold applied by a UCITS in its credit assessment of collateral issuers is the standard which applies to investments by a UCITS MMF.
Further guidance in relation to the matters which should be taken into consideration in a credit assessment process and also practice which should be followed when there is a deterioration in credit quality have been incorporated in the UCITS guidance published on the Central Bank’s website.
US OTC Derivative Counterparties
The UCITS Notices set out a list of entities which are eligible to act as counterparties to a UCITS in OTC derivative trades. This list includes credit institutions and MiFID firms and goes on to capture any US entities by referring to an entity subject to regulation as a Consolidated Supervised Entity (“CSE”) by the Securities and Exchange Commission in the US. However, due to changes in the US regulatory framework, the CSE test has become inapplicable to broker-dealers in the US. Accordingly, during the consultation period, industry engaged with the Central Bank to amend this list. The CB UCITS Regulations refers, in addition to credit institutions and MiFID firms, to a group company of an entity issued with a bank holding licence from the Federal Reserve, where that group company is subject to consolidated supervision by the Federal Reserve.
The CB UCITS Regulations address the status of clearing houses, where central clearing is mandated under the European Market Infrastructure Regulation (“EMIR”), by providing that, where an OTC derivative is subject to novation, the counterparty after the novation must be one of the three entities referred to in the preceding paragraph, a central counterparty authorised or recognised under EMIR or, pending recognition by ESMA under EMIR, an entity classified by the SEC as a clearing agency or by the Commodities Futures Trading Commission as a derivatives clearing organisation.
It is worth noting that the CB UCITS Regulations do not provide for a higher limit in respect of counterparty exposure to a clearing house. In this regard, the Central Bank has stated in its feedback statement on CP77 that ESMA has addressed this point in its Opinion 2015/ESMA/880 dated 22 May 2015 and considered that an amendment to the UCITS Directive may be required in order to raise the relevant exposure limit.
Investment in Indices through Financial Derivative Instruments
The Central Bank currently permits a UCITS to hold a financial derivative instrument (“FDI”) in respect of a financial index comprised of eligible assets with concentration levels in excess of those permitted under the UCITS Regulations, provided that, by applying a look-through approach, the consolidated holdings held through the index, together with direct holdings, comply with the risk spreading requirements of the UCITS Regulations. This position is amended by the CB UCITS Regulations so that each individual underlying financial index will need to be assessed against UCITS concentration limits.
The Central Bank has consolidated in the CB UCITS Regulations all of the rules relating to the prospectus, which are now located together whereas in the UCITS Notices these rules were located across a number of different Notices. One change introduced is a new requirement that where a UCITS proposes to take short positions, it must disclose in its prospectus, in relation to each of the categories of assets in which it may invest, whether it will take long or short positions or both. It must also disclose the percentage of its assets which it anticipates will be invested in long positions and short positions. This disclosure requirement is more detailed than was previously the case and it will remain to be seen how investment managers will be required to address this level of detail in fund documents.
Reporting of Non-Material Breaches
The CB UCITS Regulations introduce a new requirement for depositaries to report to the Central Bank non-material breaches which remain unresolved for four weeks, on the basis that this is a reasonable period within which to resolve any breach and it would be concerned to be aware of instances where this is not the case. The Central Bank will keep the operation of this rule under review to ensure that it is workable and proportionate.
Next Steps and Transitional Provisions
The CB UCITS Regulations will apply from 1 November 2015. There are transitional provisions in respect of certain requirements dealing with redemption gates so that those requirements will not apply until 2 November 2016. The prospectus disclosures required where a UCITS enters into short positions as part of its investment policy should be included in the prospectus when it is next updated.
The consolidation of the Central Bank requirements applicable to UCITS into a single document is a practical and welcome development, together with the removal of the promoter approval requirement and the clarification relating to US OTC counterparties. UCITS managers will need to consider whether they need to apply for permission to retain existing derogations and to ensure that the current prospectus disclosures, some of which may be in place for an extended period, meet the updated disclosure requirements. As part of our continuing engagement with the Central Bank through industry and directly on behalf of our clients, we will seek further clarity on the timeline for filings, if any, required as a result of this analysis. We are happy to share relevant feedback with clients as it is made available.