On 30 January 2017 ESMA published its long-awaited opinion on UCITS share classes. The opinion follows its consideration of responses to the second consultation of April 2016 and provides ESMA's final opinion on the nature of share classes and the establishment of a regulatory framework comprising a set of high-level principles and certain operational principles with which all UCITS share classes should comply. A copy of the opinion can be downloaded from: https://www.esma.europa.eu/sites/default/files/library/opinion_on_ucits_share_classes.pdf ESMA Share Class Opinion.
It should be noted that ESMA has confirmed that hedging arrangements at the share class level with overlays that are not linked to currency (such as interest rate risk, duration risk or volatility risk hedged share classes) are not compatible with the high-level principles and these should be set up as separate funds.
The opinion is addressed to the national regulators and we would expect the Central Bank of Ireland to confirm that it will require UCITS to comply with the requirements set out in the opinion.
KEY ELEMENTS OF SHARE CLASSES
As part of the second consultation ESMA set out four high-level principles, supplemented by a set of operational principles, that should be followed when setting up different share classes within a UCITS. This approach has been retained in the final opinion.
Common investment objective
Share classes of the same fund should be linked by a common investment objective which is realised through investment in a common pool of assets. Share classes which differentiate between groups of investors (such as retail vs institutional) or means of investment (such as management fees, minimum investment amounts, voting rights or currency) are permitted as they share a common investment objective.
ESMA confirmed that hedging arrangements at the share class level are not compatible with the requirement for a fund to have a common investment objective. However there is an important exception - ESMA considers currency risk hedging which allows investors to mitigate currency risk to be compatible with the principle of a common investment objective. The opinion acknowledges that currency risk hedging is a way to support a single market as well as a means to level the playing field for investors from across the EU by allowing them to mitigate currency risk. The opinion specifically refers to the type of currency risk hedging where the currency of the hedged share class is different from the base currency of the fund. However, the opinion does not refer to currency hedging that may be carried out at the level of the fund's portfolio holdings. Hopefully the Central Bank may clarify that the currency risk hedging permitted in the ESMA opinion covers both share class and portfolio level hedging.
A key issue addressed by ESMA in the opinion is to ensure that derivative overlays which systematically hedge out currency risk do not disadvantage investors in other share classes. ESMA has stated that it is paramount that any additional counterparty and operational risk introduced to a UCITS through the use of a derivative overlay for a given share class should be mitigated, monitored appropriately and the costs only borne by the investors in the currency hedged share class. In order to ensure that any derivative overlay used to hedge currency risk does not lead to spill-over risk to other share classes ESMA is of the view that the following operational principles should be observed at a minimum:
- the notional of the derivative should not lead to a commitment to deliver or receive securities with a value which cannot be serviced by that portion of the common pool of assets on which the share class unitholders have a claim;
- the UCITS should put in place a level of operational and accounting segregation;
- the UCITS should implement stress tests to quantify the impact of losses on all of its share classes; and
- the derivative overlay should be implemented according to a detailed, pre-defined and transparent hedging strategy.
The opinion also acknowledges the difficulty in attaining a perfect hedge within a share class and sets out additional requirements that need to be monitored in this regard. These requirements relate to calculating the exposure of a hedged share class to a derivative counterparty and ensuring that the levels of under-hedged and over-hedged positions are in the range of 95% to 105% of the net asset value of the hedged share class. Hedged positions must be kept under review on an ongoing basis and hedging arrangements which exceed the permitted position levels should be rebalanced and not carried forward from month to month. For the most part these requirements already apply to currency hedged share classes in Irish funds.
ESMA is of the opinion that all the features of a share class should be pre-determined before the share class is set up in order to allow potential investors in a UCITS to gain a full overview on the rights and/or features attributed to their investment. Notwithstanding this, and in an improved positon from the second consultation, ESMA is of the opinion that this requirement neither limits the discretion of the UCITS management company as to the type of derivative instrument used to hedge the currency risk, nor its operational implementation.
It is important that the existence and nature of all the share classes of a fund are disclosed to all investors, whether participants in the other share classes or not. ESMA proposes that three operational principles be observed in order to achieve a common level of transparency as a minimum requirement:
- the information about existing share classes should be provided in the fund prospectus;
- a list of share classes with contagion risk should be kept readily available and current; and
- stress test results should be made available to the national competent authorities on request.
As already mentioned, we expect the Central Bank to confirm that the requirements in the opinion will apply to UCITS and will replace the current Central Bank guidance on share classes insofar as they relate to UCITS and we will update our clients on any further developments on the Central Bank's policy.
ESMA noted that the issue of its opinion will have a considerable impact on the investment fund markets in Member States where share class arrangements have been set up which do not comply with these principles. To mitigate negative effects for investors in such share classes, ESMA is of the view that these share classes should be allowed to continue to operate. However, in order to level the playing field across the EU, ESMA has stated that these share classes should be:
- closed for investment by new investors within six months of publication of this opinion, i.e. by 30 July 2017; and
- closed for additional investment by existing investors within eighteen months of publication of this opinion, i.e. by 30 July 2018.
The timing specified in the transitional provisions is helpful for those UCITS that have established interest rate risk, duration risk or volatility risk hedged share classes which are incompatible with the principles set out in the opinion as it provides time to allow these arrangements to be restructured.
UCITS with currency hedged share classes will need to ensure that the four high-level principles are met in respect of its currency hedged share classes and in particular will need to ensure that the operational and accounting segregation is achieved and that the stress tests are carried out.
This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.