The European Securities and Markets Authority published on January 9 its latest guidelines on ETFs and other UCITS issues for regulators and UCITS management companies.
The guidelines, published in Q&A format and based on questions posed by both regulatory authorities and members of the industry, are designed by ESMA to encourage harmonisation of supervisory approaches and practices in the application of the UCITS directives and their implementing measures.
The latest additions to the guidelines deal with financial derivative instruments and collateral management. ESMA says that in cases where the role of a counterparty to a derivative instrument only involves implementing a set of rules agreed in advance with the UCITS management company and does not allow the exercise of any discretion, the counterparty should not be considered to have any discretion over the composition of the underlying assets of the instrument.
This contrasts with cases where the counterparty to the derivative can decide on the composition of the underlying of the derivative instrument or the UCITS investment portfolio without the prior consent of the management company.
ESMA says a counterparty offering advice to the management company on the composition of the underlying of the derivative or the UCITS’ investment portfolio should not be considered to have discretion over the composition of the underlying of the derivative provided that the management company expressly approves any investment decision in advance.
With regard to collateral, ESMA says that when a UCITS reinvests cash collateral in short-term money market funds subject to paragraph 43 (j) of the guidelines, the funds must comply with the requirements of Article 50(e)(iv) of the UCITS directive, stipulating that short-term money market funds should not invest more than 10 per cent of their assets in aggregate in other money market funds.
The ESMA guidelines may be consulted at: http://www.esma.europa.eu/system/files/2015-12_qa_etf_guidelines_january_update.pdf. Please also see our article on CSSF Circular 14/592, issued on August 1 last year and implementing into Luxembourg’s regulatory framework earlier ESMA guidelines on ETFs and other UCITS issues for regulators and management companies, at: https://www.cs-avocats.lu/legal-news/investment_management/cssf-circular-etf-collateral-restrictions/.

Luxembourg’s Financial Sector Supervisory Authority According has published Circular 14/591 on July 22, addressed to all open-ended UCITS funds governed by the grand duchy’s legislation of December 17, 2010, regarding the protection of investors in the event of a material change to an open-ended undertaking for collective investment.

The CSSF says that according to well-established supervisory practice, in the event of such a material change to investors’ interests in an open-ended fund under the 2010 law, the regulator requires that they be given sufficient time to take an informed decision, and that if they do not wish to accept the proposed change, they should be able to redeem or convert their shares or units free of charges. The circular formally enshrines and clarifies this existing administrative practice, with immediate effect.

Under the 2010 law, a fund’s prospectus should include information necessary for investors to make an informed judgement on the proposed investment. In the event of any change proposed to the prospectus, the CSSF assesses this requires additional measures to protect the interests of the fund’s investors in the UCI. Although this is not the case for every change, since fund investment is predominantly retail investors, the CSSF believes they need time to make an informed decision about any change significant enough potentially to affect the their interests and possibly alter the basis on which they originally made the investment.

When considering a material change to their structure, organisation or operations, funds should consider the likelihood of it being such as to prompt investors to reconsider their investment, and compare their interests or situation before and after the change, then submit the proposed change, with any appropriate explanations, to the CSSF, well before the change is due to take effect.

The CSSF says it may assess proposed changes on a case-by-case basis, decide whether they should be deemed material, and where necessary request notification of investors. As a rule, such changes may not be put into effect until after the expiry of the notification period, which under current practice should be one month.

During this notification period, investors are entitled to request the repurchase or redemption of their shares or units without charge. At its discretion, the fund may also offer investors the option to investors to switch their investment into another fund, or sub-fund of the same fund structure, without conversion charges.

The CSSF may agree on request not to impose a notification period in cases such as where all investors in the fund in question agree to the proposed change. It may also agree to impose a notification period only to inform investors of the change before it becomes effective, without offering the ability to redeem or convert holdings free of charge.

The notification period is without prejudice to notice periods required by law for investors to pre-approve such changes, nor to specific requirements of regulators in other jurisdiction, both within and outside the EU, where the UCI is registered for distribution.

Luxembourg’s financial regulator, the Financial Sector Supervisory Authority (CSSF), has published on June 24 a series of Frequently Asked Questions about master-feeder structures under the UCITS IV legislation, which came into effect in July 2011.
The issues raised cover both master and feeder funds domiciled in Luxembourg. The regulator says the FAQs will be regularly updated and that it may if need be change its approach or position with regard to some of the issues they deal with.
The questions dealt with by the document cover:
• The identification and disclosure of matters to be treated as irregularities in the audit reports of master and feeder UCITS.
• How and where the combined charges of the master and feeder funds should be disclosed in the feeder’s fund’s annual report.
• How to assess the combined charges of the master and feeder UCITS when the funds have different financial year-ends, how audits should be prepared in this situation, and how the costs of such ‘ad hoc’ audit reports should be allocated.
• The languages in which the annual reports of master funds are made available.

The CSSF has published on February 18 Circular 13/559 implementing the guidelines published by European Securities and Markets Authority on 18 December 2012 for EU regulators and UCITS management companies on exchange-traded funds and other UCITS issues.
The guidelines set out the information that such funds must publish in their prospectus, key investor information document and annual report, including monitoring of tracking error, the index replication method and leverage policy.
For leveraged funds, the requirements include information on global risk calculation and management. For ETFs that engage in some sort of active management, how the investment policy is implemented must be specified.
The key provisions of ESMA’s guidelines on ETFs and other issues include the requirement that UCITS that are defined as exchange-traded funds must carry the identifier ‘UCITS ETF’ in their name.
ESMA says UCITS ETFs will have to ensure appropriate redemption conditions for secondary market investors by opening the fund for direct redemptions when liquidity in the secondary market is inadequate.
UCITS engaging in efficient portfolio management techniques such as securities lending must inform investors clearly about these activities and the related risks, and all revenues net of operating costs generated by these activities should be returned to the UCITS. UCITS should be able at any time to recall any securities lent or terminate any lending agreement.
The guidelines say UCITS that conclude derivative transactions such as total return swaps must ensure their underlying exposure complies with diversification criteria
UCITS receiving collateral to mitigate counterparty risk from OTC derivative transactions or efficient portfolio management techniques should ensure that the collateral complies with strict qualitative criteria and diversification requirements.
In addition, UCITS investing in financial indices must ensure that investors are provided with the full methodology used to calculate the indices. They may invest only in indices that respect criteria including the frequency of rebalancing and diversification.
The guidelines were finalised following the publication by ESMA of a discussion paper on guidelines for UCITS ETFs and structured UCITS in July 2011 and a consultation paper on ETFs and other UCITS issues in January 2012 (see below under related documents our article, ‘ESMA refines proposed framework to deal with complexity of ETFs and other Ucits’ of February 3, 2012).
The ESMA guidelines came into force on February 18 this year following translation into the EU’s official languages and apply immediately to any new UCITS created after that date, but funds already in existence are subject to transitional arrangements.
Existing UCITS generally have 12 months to comply with the guidelines, with various exceptions: they must comply with the UCITS ETF label requirement if they change their name earlier for another reason; any reinvestment of cash collateral after February 18 should comply with the guidelines immediately; and information requirements apply whenever the documents, prospectus, KIID or other marketing communications are next revised even if before the 12-month deadline. However, existing UCITS ETFs must comply with the provisions related to the treatment of secondary market investors as of the application date.
Structured UCITS that exist before the application date are not required to comply with the guidelines if they do not accept any new subscriptions, but they may actively manage their financial contracts to be able to continue offering the underlying payoff to existing investors.

ESMA has published on 4 December 2012 its guidelines on repurchase and reverse repurchase agreements for UCITS funds intended to complement the ETF guidelines. They stipulate that UCITS should only enter into repo and reverse repo agreements if they are able to recall at any time any assets or the full amount of cash.
However, when cash is recalled on a mark-to-market basis, the mark-to-market value of the reverse repurchase agreements should be used for the calculation of the net asset value of the UCITS.
ESMA says that fixed-term repo and reverse repo agreements that do not exceed seven days shall be considered automatically as arrangements that allow the assets to be recalled at any time by the UCITS.
The guidelines are now being translated into all EU languages and will be incorporated into ESMA’s Guidelines on ETFs and other UCITS issues, which were first published in July 2012 and came into force on February 18 this year.
The repo and reverse repo guidelines will enter into force two months after the publication of the translations. ESMA says the result will be a single comprehensive rulebook for UCITS that increases transparency and investor protection as well as helping to safeguarding the stability of financial markets.

The European Securities and Markets Authority has published on January 30 a consultation paper proposing future guidelines for exchange-traded funds established as Undertakings for Collective Investment in Transferable Securities and other issues related to the Ucits regime.
The Esma proposals cover both physical ETFs, which replicate the performance of stock, bond, commodity, currency or other indices by holding shares or other securities in the proportions that make up the index in question, or a sample thereof, and synthetic ETFs, which use swap transactions to obtain the economic performance of the index, using a basket of securities as collateral.
The consultation paper, ESMA/2012/44, proposes regulatory requirements covering Ucits ETFs, other index-tracking UCITS, efficient portfolio management techniques, total return swaps and strategy indices, which seek to replicate a quantitative or trading strategy.
The proposals envisage additional obligations regarding collateral where any Ucits funds, not just ETFs, use total return swaps, tighten the eligibility criteria for investment by Ucits in strategy indices, oblige Ucits ETFs to identify themselves as such, and seek to facilitate the redemption of ETF shares by investors directly with the fund’s provider or on a secondary market.
A Ucits ETF is defined as “a Ucits, at least one unit or share class of which is continuously tradeable on at least one regulated market or multilateral trading facility with at least one market maker which takes action to ensure that the stock exchange value of its units or shares does not significantly vary from their net asset value.”
According to chairman Steven Maijoor, Esma has drawn up the proposals in response to concerns about the increasing complexity of ETF products marketed to retail investors, which involve investment strategies and risks far removed from the simple replication of well-known indices covering highly liquid markets.
Regarding a mooted distinction between complex and non-complex Ucits, Esma says it will wait for the outcome of negotiations on the revised MiFID directive, on which the European Commission has proposed removing structured Ucits from the scope of instruments automatically categorised as non-complex.
The guidelines have been broadened to reflect 65 responses to a discussion paper issued by Esma in July 2011, which urged the authority to cover not only ETFs but all Ucits engaged in securities lending or tracking an index.
The discussion paper on policy orientations on Ucits ETFs and Structured Ucits (ESMA/2011/220) examined possible measures to mitigate the risk of highly complex products that might be difficult to understand and evaluate being made available to retail investors, the potential systemic risk such funds might cause, and their impact on financial stability.
Esma proposes that all Ucits exchange-trade funds be obliged to use ‘ETF’ in their name as an identifier, and that investors should be provided with additional information about the investment policy and valuation of actively-managed ETFs that do not track an index or seek to outperform one.
It is also seeking feedback on an appropriate regime for secondary market dealings in ETF shares. For example, one option is that that a Ucits ETF or its management company should replace the market-maker if it is no longer willing or able to act as such, and if necessary make arrangements for investors to sell shares directly back to the fund or manager if redemption in the marketplace is disrupted. Alternatively, investors could be given the right to redeem their shares directly with the ETF at any time.
The consultation paper proposes that index-tracking ETFs disclose through their prospectus the index being tracked and details of its components, the means by which it replicates the index and its implications, for example counterparty risk in the case of synthetic ETFs, the degree of tracking error exhibited by the fund and the factors likely to affect this, such as transaction costs, liquidity and dividend reinvestment.
Esma says index-tracking leveraged ETFs should disclose their leverage policy, its costs and risks, and the impact of short exposure combined with leverage.
Esma recommends that collateral posted to mitigate counterparty risk in securities lending transactions should comply with the criteria set out in the July 2010 guidelines of the Committee of European Securities Regulators on Risk Measurement and Calculation of Global Exposure and Counterparty Risk for UCITS (CESR/10-788), as well as the strengthening of diversification and haircut criteria.
These requirements would also apply to repo and reverse repo activities. This is designed to ensure that collateral posted in the context of efficient portfolio management techniques should respect the Ucits diversification rules, and that Ucits should have a documented and appropriate haircut policy for each category of assets received as collateral.
Esma proposes that all Ucits investing in total return swaps be subject to the same obligations on collateral management as with securities lending. On Ucits investing in strategy indices, it mostly follows the proposals in the 2011 discussion paper on eligibility of indices, including the 20/35 per cent diversification requirement, disclosure to investors and due diligence to be carried out by the Ucits.
The authority also reiterates the need to tackle issues such as the sale of complex ETFs to retail investors and the absence of harmonised regulation on the manufacturing and management of these products.
Esma also says it will consider whether and how guidelines agreed for Ucits can be applied to regulated non-Ucits funds established or sold within the EU and the establishment of harmonised definitions covering all exchange-traded products.
The consultation paper calls for industry members and other stakeholders to submit comment on the draft guidelines by March 30. The final guidelines should be ready for adoption by mid-2012 and apply to any new investment made, collateral received, or document or marketing communication issued after that date. Requirements relating to information to investors and the general public, including a fund’s Key Investor Information Document, will take effect at the latest 12 months after the guidelines are adopted.

Esma proposes measures to handle problems arising from non-implementation of Ucits IV
The European Securities and Markets Authority (Esma) has published proposals on October 13 to deal with the fact that the majority of European Union member states have not yet approved legislation implementing the Ucits IV directive, even though the deadline to do so passed on July 1.
The European regulator says the proposals are designed to avoid difficulties, where this is possible, arising from the fact that in some cases the legislative framework for proper implementation of the directive, including cross-border regulatory measures, are not yet in place.
Without prejudice to any measures taken by the European Commission with regard to the late transposition of Ucits IV, Esma says it aims to “address the situation at an operational level in order to minimise, as far as possible, the impact on industry and investors” resulting from failing to bring the directive into national law, and is putting forward practical arrangements for cross-border operations involving one member state that has not yet transposed the directive.
According to PricewaterhouseCoopers, as of September 29 the EU member states that had not yet implemented the directive included Belgium, Finland, Greece, Hungary, Italy, Lithuania, Poland, Portugal, Romania and Spain.
Esma has identified a number of issues that could be handled by arrangements between regulators. Ucits management companies in a member state where the directive has passed into national law may not be able to benefit from the management company passport if the country where it wants to establish a fund has not transposed the directive.
Regulators in member states that have transposed the directive may have difficulties delivering notification of the marketing of Ucits established in their jurisdictions to their counterparts in countries that have not done so, while the regulator of a member state that has transposed the directive may receive a notification for marketing of a Ucits from its counterpart in a country that has not.
In addition, Esma notes that a management company in a member state where the directive has not been transposed cannot create a feeder fund to a master fund established in another EU jurisdiction, nor can it merge one of the Ucits it manages with a Ucits domiciled in another jurisdiction.
The European regulator notes that not all situations arising from failure to transpose the directive can be accommodated through practical arrangements that are “legally sound”.
It says the practical arrangements proposed are based on the jurisprudence of the EU Court of Justice on the direct applicability of self-executing provisions contained in EU directives.
Ucits IV “unequivocally” gives Ucits management companies and investment companies the rights to market Ucits units on a cross–border basis and to provide services that for management companies include the management of collective portfolios on a cross-border basis, Esma says.
It argues that European primary law obliges member states to transpose directives into their national law, leaving them the choice of form and methods, and to create a legal framework in which “the rights and obligations arising from the directive can be recognised with sufficient clarity and certainty to enable citizens to invoke them.”
In other words, member states have an obligation to reconcile their legislation with the objectives of a directive at the end of the transposition period. The European court has held that they are liable to pay damages where loss results from their failure to transpose a directive in whole or part.
Esma is proposing that regulators should not be able to refuse a valid notification for the marketing of a Ucits on their territory under the directive on the ground that their member state has not yet implemented the directive.
However, the regulator of a country that has not transposed the directive cannot deliver new notifications for the marketing of Ucits unless they can satisfy Esma that their national legislation, while not fully implementing Ucits IV, does at least comply with articles 12, 14, 15 and 51 of the directive – governing prudential provisions, rules of conduct, investor complaints and risk management – and where applicable their related implementing measures.
The regulator in the non-transposing country should also able to fulfil its obligations on access to documents under the directive. If these conditions are satisfied, notification can take place on a regulator-to-regulator basis as if both countries had transposed the directive, using a template that Esma will draw up.
Even if the legislation of the non-transposing member state does not comply with the articles in question, this procedure remains possible on condition that the management company and its home regulator certify that the management company complies with these provisions on a voluntary basis.
Esma says management companies in a member state that has implemented Ucits IV should be able to create a fund via the management company passport in a country where the directive has not been transposed, since it says the relevant provisions of the directive are of a self-executing nature. Any existing local rules to the contrary will not be valid.
However, management companies in a country that has not transposed the directive can make use of the passport only if its national legislation already materially complies with articles 12, 14, 15 and 51, and their regulators can provide the co-operation required by Article 101 and implementing measures in the case of remote management.
Esma considers the case of a merger between two Ucits established in the same member state that has not transposed the directive, where at least one Ucits is marketed in other EU countries.
Since the directive requires that both Ucits involved in a merger provide information to their investors, including those in different member states, the merger may take place where the national legislation of the non-transposing fund domicile nevertheless materially complies with the Ucits IV merger rules contained in articles 40, 41, 42, 43 and 45 and their implementing measures –otherwise not.
Due to the “inherent complexity of the operation”, Esma believes that cross-border mergers involving Ucits established in different member states, one of which has not transposed the directive, are not possible on the sole basis of the direct applicability of the directive.
The European regulator also believes that master-feeder structures should not be permitted if one of the two member states in which the Ucits are established has not transposed the directive because this issue also cannot be addressed solely on the basis of the direct applicability of the directive.
Nor, it says, should master-feeder structures be permitted if both the proposed master and feeder Ucits are domiciled in a member state that has not transposed the directive and the proposed feeder Ucits is the subject of a notification of marketing in another member state.

On December 17, 2010, the legislation implementing the latest European Union directive on Undertakings for Collective Investment in Transferable Securities – known to the world as Ucits IV – was signed into Luxembourg law, upholding the proactive, pace-setting approach that over the past two decades has enabled the grand duchy to carve out a position of leadership in the European investment fund industry and one second worldwide only to the United States.
The early passage of the law by Luxembourg, the first EU member state to adopt the Ucits IV rules, has given the country’s fund industry the maximum time to prepare for the entry into effect of the directive on July 1, 2011. However, it also offered the opportunity to amend other aspects of Luxembourg’s fund legislation including measures affecting vehicles not subject to the Ucits regime for the cross-border distribution of retail funds across Europe.
The legislation clarifies a number of areas relating to the regulation and tax treatment of Luxembourg funds and investment management entities. For example, it abolishes the subscription tax on fund assets in the case of exchange-traded funds, which are Ucits funds, as well as non-Ucits funds whose strategy involves investment in microfinance, an area in which the grand duchy has carved out a leading role.
Ucits IV was formally approved by the EU on July 13, 2009 under the designation of Directive 2009/65/EC. Rather than introducing sweeping changes to investment rules, as did its 2002 predecessor, the directive mostly involves changes designed to improve the efficiency of the European fund market, as well as strengthening the safeguards for investors that have been a key factor in the success of Ucits funds not only in Europe but elsewhere in the world.
These include notably facilitating cross-border fund mergers, simplifying and shortening notification procedures required to sell funds in other EU member states, authorising master-feeder structures under the Ucits regime and creating a ‘passport’ for management companies established in one member state to provide services to funds in another. In addition, the directive has created the Key Investor Information Document (KIID) to help retail investors understand the investment goals, risk and performance of Ucits funds. For more information about Ucits IV, please see our guide to the directive, Removing barriers to Europe’s single fund market.
This guide is designed to help fund industry participants and investors understand the changes made to the Luxembourg fund industry as a result of the law of December 17, 2010 as well as the new opportunities available to establish both Ucits and non-Ucits funds in the grand duchy for marketing across Europe and beyond.
Please find below a link to the guide: [download id=”61″ format=”3″]

The European Union’s latest directive on undertakings for collective investment in transferable securities, known as Ucits IV, which was formalised on July 13, 2009, will take effect from July 1 this year, the deadline for transposition of the directive into the national law of EU member states. Luxembourg became the first member state to do so on December 17, 2010.

Over the past year and a half the European Commission has drawn up subsidiary legislation in the form of directives and directly applicable regulations that add detail to the legislative framework of the Ucits IV directive.

The introduction of the revised directive is intended to improve the efficiency of the European fund industry by making it easier to merge funds into bigger, more cost-effective vehicles, enabling management companies in one jurisdiction to run funds domiciled in another, and to operate master-feeder structures within the Ucits framework, as well as speeding up authorisation procedures for cross-border distribution. In addition, it aims to ensure investors are better informed through the introduction of the Key Investor Information Document.

We will continue to cover new developments in the implementation of the directive and subsidiary legislation across Europe and analyse key aspects of the new rules and their practical application in our Ucits IV blog. In the meantime, please contact us if you would like to discuss in greater detail elements any issues regarding the directive and how it may affect your business.
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