Following the recent downgrading of credit ratings of financial
institutions by Moody's Investor Services and in the light of
the potential impact this might have on regulated investment funds,
the Central Bank of Ireland ("the Central Bank") has
clarified its policy regarding inadvertent breaches of its
requirements relating to credit ratings.
By way of background, the Central Bank's UCITS and Non-UCITS
Series of Notices and Guidance Notes prescribe minimum credit
rating requirements for counterparties to:
OTC derivative transactions
prime brokerage arrangements
efficient portfolio management techniques including stock
lending and repurchase transactions
Minimum Credit Rating Requirements
In the case of UCITS, OTC derivatives counterparties which are
not banks and all counterparties to repo or stock lending
arrangements must have a minimum credit rating of A-2 or equivalent
or be deemed by the UCITS to have an implied rating of A-2 or
equivalent. Alternatively, an unrated counterparty will be
acceptable where the UCITS receives from an entity which has and
maintains a rating of A-2 or equivalent an indemnity or guarantee
in respect of losses suffered as a result of the failure by the
In the case of non-UCITS qualifying investor funds (QIFs), prime
brokers must have a minimum credit rating of A-1 or equivalent. If
a QIF enters into collateral arrangements with an OTC derivatives
counterparty other than a prime broker, whereby assets of the QIF
are passed outside of the control of the QIF's custodian and
may be pledged, lent, rehypothecated or otherwise used by the
counterparty for its own purposes, that counterparty must have a
minimum credit rating of A-2 or equivalent or be deemed by the QIF
to have an implied rating of A-2 or equivalent.
The credit ratings referred to in the Central Bank's Notices
are Standard and Poors short term ratings. An equivalent rating for
the purposes of the Notices is one which has been provided by an
internationally recognised rating agency and which is deemed
equivalent by the investment fund to the rating stipulated in the
Notice. An implied rating arises, in the normal course, where a
decision on an unrated entity is made by the investment fund on the
basis of the relationship between an issuer and its rated parent,
or where an issuer has a senior debt/long term rating but no short
Breaches of Rating Requirements
In the light of recent credit rating downgrades by Moody's
Investor Services, the Central Bank notes that it is possible that
some regulated funds may inadvertently breach the Central
Bank's requirements. In these circumstances, the directors of
the investment company/management company and the trustee must
consider the issues arising, including their obligations to act in
the best interests of the unit holders. They should, as is required
in the case of an inadvertent breach of any regulatory requirement,
adopt as a priority objective the remedying of that situation over
a reasonable timeframe, taking due account of those interests. The
director/management company or trustee must continue to actively
monitor the credit worthiness of the counterparty by conducting
internal ratings assessments on behalf of the investment fund. A
decision to remain contracted to a counterparty inadvertently in
breach of the Central Bank's rating requirements should be
supported by an internal rating assessment undertaken on behalf of
the investment fund. The Central Bank expects to be informed of any
breach and of the remediation plan made necessary by a counterparty
downgrade and the rationale for that proposed approach.
Prime Brokerage Arrangements
In the context of prime brokerage arrangements, without any
intention to pre-empt the decision of the directors/management
company or trustee, the Central Bank would, in principle, and
taking the provisions of the Central Bank's Prime Broker
Guidance Note into account, be prepared to permit that, in the
event of a downgrade of the credit rating to not below A-2, or
equivalent, the relationship between the prime broker and the
investment fund remain in place where net exposure of the fund to
the prime broker is maintained at less than 40% of net asset value
in the case of a qualifying investor fund (QIF) (or 20%/30% in the
case of a professional investor fund).
Application to New Transactions
Finally, the Central Bank has confirmed that investment funds
entering into new OTC derivative transactions, efficient portfolio
management techniques or prime brokerage arrangements must adhere
to the requirement of the Central Bank's Notices and Guidance
Notes. Accordingly, it would not be permissible to enter into new
transactions or arrangements with counterparties which have been
downgraded to below the prescribed minimum credit rating.
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.
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