On 23 December 2014, ESMA issued a short discussion paper (2014/1577) on what constitutes a share class in a UCITS and which classes should be permitted. The impact of any resulting proposals will be limited for UK managers. The paper is, however, worth noting for those directly affected with ranges domiciled outside the UK especially, and also more generally given the principles set out for the first time at a European level, and the restrictions on more innovative class propositions that may follow. Responses should be submitted to ESMA by Friday 27 March 2015.
This topic is an example of where ESMA sees divergences in permissible practices for UCITS between different member states. It wants to develop a common position, without having to wait for the next formal amendment of the UCITS Directive.
In this case, the issue is that the Directive recognises the possibility of a UCITS offering more than one share class in a fund. But it does not define the term ‘class’, as opposed to a sub-fund or compartment of a UCITS, or the way in which one class may differ from other classes. The issue applies to classes of units in common funds, or unit trusts, as well as to shares in corporate UCITS. In this briefing, we also use the term ‘shares’ to cover both units and shares.
What is a share class?
The paper sets out a sensible basic distinction between a compartment (the term the Directive uses for sub-fund in an umbrella) and a class:
- In a compartment: investors share the same investment strategy, and this strategy is not shared by the investors in other compartments. There will also usually be legal segregation between compartments.
- In a class: these are categories of shares which allow subsets of investors some customisation – but they all share the common pool of assets of their compartment, and there is no legal segregation between classes. Customisation examples relate to the distribution of revenues, a particular tax treatment under national law or a different minimum investment amount.
Principles developed by ESMA in assessing the legality of different classes
The principles ESMA has developed are as follows:
- Share classes of the same UCITS should have the same investment strategy.
- Features that are specific to one share class should not have a potential (or actual) adverse impact on other share classes of the same UCITS.
- Differences between share classes of the same UCITS should be disclosed to investors when they have a choice between two or more classes.
ESMA concludes that if management companies want to offer different investment strategies between classes they should do so at fund level, and create a separate UCITS for each strategy.
What is permitted?
Applying these principles, the paper discusses some clearly permissible types of share classes. The list is non-exhaustive but includes characteristics relating to different investment minima, investors, charges and currencies of denomination, to the allocation of revenues and to currency hedging where the class has a different denomination to the base currency – in other words, the type of customisation which is normal in the UK.
And not permitted?
There is also a non-exhaustive list of types of share classes that do not appear to be compatible with the principles. Some of these are not surprising:
- Classes exposed to different pools of underlying assets (e.g. where two share classes in a sub-fund track different indices).
- Classes where the same underlying portfolio is swapped against different portfolios of assets.
- Classes exposed to the same pool of assets but with different levels of capital protection and/or pay off.
Another example is, however, very relevant to the more innovative classes that we have recently been seeing and discussing – classes that offer differing degrees of protection against some market risk such as interest rate risk or volatility risk.
As the paper says, interest rate hedging at class level can be distinguished from currency hedging because it modifies the investment strategy of a class. The same would be true for a class changing the duration of a portfolio.
By contrast, currency class hedging, where a class is differently denominated to the base currency, is intended to ensure investors receive as nearly as possible the same results of the investment strategy, albeit through a different currency. In effect ESMA is saying that a limited exception to the principle that all classes in a compartment are exposed to the same investment strategy should be confirmed, but not be extended.
For UK funds, this confirms principles as to a sub-fund’s shareholders all sharing exposure to one strategy and sharing in one pool of assets. These are already reflected in and derived (if not always so explicitly) from the COLL Sourcebook, the OEIC Regulations and trust law, and the rules allowing currency class hedging have always been a limited exception for pragmatic and policy reasons.
What is the likely impact for UK and non-UK UCITS?
The paper indicates that caution is appropriate for UK UCITS looking to extend the exception to more innovative classes akin to those identified by ESMA as not permissible.
Non-UK UCITS are likely, depending on ESMA’s final position, to have to use a transitional period to change their class arrangements, and move to separate compartments and sub-funds instead.