On November 20, 2012 the European Securities and Markets Authority (ESMA) published a formal opinion on its interpretation of Article 50(2)(a) of the UCITS Directive (2009/65/EC) ( "UCITS Directive") which may have implications for UCITS which hold units or shares of collective investment schemes within the 10% limit provided for in Article 50 (2)(a), commonly referred to as the "trash bucket".

Article 50(2)(a) of the UCITS Directive provides that UCITS may not invest more than 10% of their assets in transferable securities and money market instruments which do not meet the UCITS eligibility requirements as detailed in Article 50(1) (i.e. they are not admitted to or dealt in on a regulated market which operates regularly and is open to the public).

ESMA's opinion states that UCITS may only invest in units or shares of collective investment undertakings as defined in Article 50(1)(e) of the UCITS Directive, being other UCITS and other collective investment undertakings, whether or not established in a Member State, which meet the following criteria:

(i) they are authorised under laws which provide that they are subject to supervision considered by the competent authority of the UCITS home Member State to be equivalent to that laid down in EU law, and that co-operation between authorities is sufficiently assured;

(ii) the level of protection for unit holders is equivalent to that provided for unit holders in a UCITS, and in particular the rules on asset segregation, borrowing, lending and uncovered sales of transferable securities and money market instruments are equivalent to the UCITS Directive requirements;

(iii) the business is reported on in half yearly and annual reports; and

(iv) no more than 10% of the assets of the UCITS or other collective investment undertakings can, according to their constitutive documents, be invested in aggregate in units of other UCITS or other collective investment undertakings.

ESMA's opinion points to the fact that Article 50(2)(a) refers only to investments in transferable securities and money market instruments and not to units or shares of collective investment undertakings, and accordingly it follows that the derogation provided in Article 50(2)(a) does not extend to units or shares of collective investment undertakings.

ESMA expects that any portfolio adjustments required to ensure compliance with this opinion will be made taking into account the best interest of investors and at the latest by 31 December 2013.

ESMA's competence to deliver an opinion is based on Article 29(1) (a) of Regulation (EC) No 1095/2010. Whilst such opinions are not binding, there is an expectation that such opinions will be adopted by competent authorities into local rules. Where a competent national authority does not comply with an opinion issued by ESMA, ESMA does have authority to initiate further procedures to ensure common, uniform and consistent application of EU law by national competent authorities. Accordingly, we await the Central Bank's official position in respect of ESMA's opinion.

There are at least two areas of concern with this opinion. Firstly, it appears to create a potential conflict between ESMA's opinion and the Eligible Assets Directive (Directive 2007/16/EC) insofar as it relates to closed-ended collective investment schemes. The Eligible Assets Directive has made it clear that certain closed-ended funds will fall within the definition of "transferable securities" and therefore be eligible for investment by UCITS subject to meeting certain criteria. In other words, they are funds but they qualify as transferable securities.

Secondly, ESMA's opinion suggests that the treatment of certain Non-UCITS ETFs (including those from outside the EU) as transferable securities – which Investment Managers are permitted to do – would not be acceptable. That could exclude them entirely from a UCITS investment menu as they might not qualify with the collective investment scheme category but be excluded from the "transferable securities" category.

These areas may warrant further consideration of this opinion.

In conclusion, ESMA's opinion calls for limits on the scope of the "trash bucket". UCITS portfolio managers may need to carefully consider the composition of their portfolios in future, particularly holdings of units or shares in collective investment undertakings which do not meet the criteria outlined in Article 50(1)(e).

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.