Clarification of Definitions concerning Eligible Assets for Investments of UCITS

Transcription

1 Clarification of Definitions concerning Eligible Assets for Investments of UCITS 1 Clarification of Definitions concerning Eligible Assets for Investments of UCITS Updated June 2009 kpmg.lu

2 Clarification of Definitions concerning Eligible Assets for Investments of UCITS 1 Background The UCITS 1 Directive creates a harmonised framework for investment funds. It specifies the core features of this financial product such as risk-diversification, redemption of units at the request of unit-holders, regular valuation, and oversight by a depositary. The also contains detailed provisions setting out the assets which are eligible. Revision of the () has expanded this list beyond transferable securities to include money market instruments, units of UCITS and other collective investment undertakings as well as banking deposits. The amendments also allow UCITS managers to manage index-replicating UCITS and to make greater use of derivatives. Financial derivative instruments may not only be used for the purposes of hedging, but also to increase return. The is not a Lamfalusy Directive. However Article 53a of the confers delegated powers to the European Commission to clarify definitions in the in order to ensure its uniform application throughout the European Union. In this context, the Commission decided to make use of its powers in Article 53a to clarify the meaning and the scope of the definitions included in the Directive as regards transferable securities, money market instruments and other liquid financial assets as well as how these definitions apply to certain financial instruments. In 2004, the Commission mandated the Committee of European Securities Regulators (CESR) to assist in the preparation of technical implementing legislation. After two rounds of market consultation, CESR communicated its final advice to the Commission in January This advice was divided into level 2 advice, requiring enacting legislative action from the Commission and level 3 guidelines, reflecting common understanding amongst European regulators. Based on CESR level 2 advice, the European Securities Committee ( ESC ) finalised a draft directive in January 2007, adopted by the Commission on 19 March Member States will have 12 months to transpose this Directive. The short deadlines as well as the absence of grand-fathering clauses reflect the Commission s view that the clarifications contained in this Directive will not impose any new behavioral or operational obligations for competent authorities or market participants. CESR also published its final level 3 guidelines on 19 March CESR members should bring into effect the implementing Directive and CESR s guidelines as a single package of measures by March 2008 at the latest. On July 2007, the CESR published a guideline in relation with the classification of hedge fund indices as financial indices, following a specific consultation on this matter. 1 Undertakings for Collective Investment in Transferable Securities

3 2 Clarification of Definitions concerning Eligible Assets for Investments of UCITS Clarification of Definitions concerning Eligible Assets for Investments of UCITS 3 In, the Directive was transposed on February 8, 2008 in the form of a règlement grand-ducal. It strictly transposes the directive and is immediately applicable for new UCITS. Existing UCITS have been granted a delay up until July 23, Transferable securities On February 19, 2008, the regulator, CSSF, issued a circular requiring the UCITS to follow relating to eligible assets together with the application of the règlement grand-ducal. CESR level 3 guidelines were updated in September 2008 and the CSSF issued an updated circular requiring the UCITS to follow accordingly. This publication is based in the following texts: CESR s Advice to the European Commission on Clarification of Definitions concerning Eligible Assets for Investments of UCITS, January 2006 ( CESR advice ) European Directive 2007/16/CE as well as the background note ESC/44/2006 REV 2 (January 2007) (the implementing Directive ) CESR s guidelines, March 2007 ( CESR s guidelines ). : the classification of hedge fund indices as financial indices July 2008 Règlement grand-ducal relatif à certaines définitions de la loi modifiée du 20 décembre concernant les organismes de placement collectif February 8, 2008 CSSF Circular 08/339 : CESR s guidelines for UCITS February 19, 2008 CSSF Circular 08/380: CESR s guidelines for UCITS - November 26, 2008 The provisions contained in the implementing Directive aim at clarifying the formal criteria to define eligible transferable securities, taking into consideration the obligation for the UCITS to redeem or repurchase its units at the request of unitholders and to calculate its net asset value any time units are issued or redeemed. These criteria include: limitation of potential loss to the amount paid liquidity reliable valuation information available to the public and to UCITS negotiability acquisition consistent with investment policy of UCITS risk management There is a presumption of liquidity and negotiability for instruments traded on a regulated market but this presumption is not absolute. CESR s guidelines provide guidance on how to assess liquidity.

4 4 Clarification of Definitions concerning Eligible Assets for Investments of UCITS Clarification of Definitions concerning Eligible Assets for Investments of UCITS 5 Closed end funds Units of closed end funds, whether constituted in the form of investment companies, unit trusts or common funds may be considered as transferable securities provided that: they fulfil the criteria applicable to transferable securities as mentioned above they are subject to corporate governance mechanisms equivalent to those applied to companies they are managed by a regulated entity. CESR s guidelines provides guidance on how to assess whether the corporate governance mechanisms are equivalent to those applied to companies. CESR s view, as expressed in its advice to the European Commission, is that UCITS are allowed to invest in real estate and private equity funds, provided Structured products and embedded derivatives that they meet the above-mentioned criteria but that hedge funds may not necessarily make sufficient information available to the market to meet the criteria applicable to transferable securities. The implementing Directive clarifies that structured products, even if backed by or linked to assets that are themselves ineligible under the UCITS Directive (e.g. oil price, commodities, ), are eligible, provided that they meet the transferable securities criteria mentioned earlier. This is based on the consideration that the does not require a look-through approach, unless these products embed a derivative. The definition of embedded derivatives retained by CESR and the Commission inspires itself from IAS A host contract (i.e. redeemable at par) whose cash flow, economic characteristics and risk profile can be modified by a variable is deemed to embed a derivative. Not all forms of linkage to other assets should be construed as embedding a derivative element but the definition of embedded derivatives as mentioned above would capture several structured financial instruments. CESR s guidelines provide examples of instruments which could be deemed to embed derivatives: leveraged or insufficiently diversified CDO s, credit linked notes, convertible bonds, exchangeable bonds, structured financial instruments whose performance is linked to the performance of a bond index or a basket of shares. It also clarifies that if an instrument embeds a derivative, the following has to apply: reflect the contribution of the derivative in the global risk management process; include the embedded derivative in the global exposure calculation; apply look through principles to the underlying in order to include the underlying in the risk spreading compliance check; ensure that they are not used to circumvent the Directive rules. The CSSF circular further indicates that in their view, it is up to the UCITS to determine whether a transferable security or a money market instrument embeds a derivative. 2 International Accounting Standards

5 6 Clarification of Definitions concerning Eligible Assets for Investments of UCITS Clarification of Definitions concerning Eligible Assets for Investments of UCITS 7 Money Market instruments The implementing Directive clarifies money market definition elements such as dealt in on the money market, liquid instruments with a value which can be accurately determined at any time as well as the requirements applicable to money market instruments not dealt in on the money market, depending on the type of issuers. The combination of all the definitions and criteria to be met leads to a quite long and complex decision tree to be followed in order to determine the eligibility of a money market instrument. Derivatives The implementing Directive clarifies the categories of eligible underlyings for derivatives instruments. Credit derivatives are allowed, provided that they meet the eligibility criteria applicable to OTC derivatives, are settled in cash or by the delivery of eligible assets and their particular risks (asymmetry of information) are captured by the risk management process. Derivatives on commodities are not eligible. CESR s guidelines also indicate under which circumstances UCITS may use the amortisation method to value money market instruments: Money Market Instruments with a residual maturity of less than 3 months and no specific sensitivity to market parameters, including credit risk or; UCITS investing solely in high-quality instruments with as a general rule a maturity or residual maturity of at most 397 days or regular yield adjustments in line with the maturities mentioned before and with a weighted average maturity of 60 days. The requirements that the instruments be high-quality instruments should be adequately monitored, taking into account both the credit risk and the final maturity of the instrument; These principles along with adequate procedures should avoid the situation where the difference between the fair value of the instrument and the value calculated according to the amortisation method would become material whether at the level of the individual instrument or at the level of the UCITS. When the derivative underlying is a financial index, the implementing Directive also enumerates the criteria to be met by financial indices in order to be considered as a financial index (diversification, benchmark, publication). If these criteria are not met, the index is to be considered as a basket or combination of assets and the look-through principle has to apply. CESR is of the view that indices based on financial derivatives on commodities and property indices may be eligible. Regarding derivatives on hedge fund indices, CESR conducted an in-depth consultation and finally issued specific guidelines in July In addition to the requirements applicable to financial indices and to derivatives, it is required that the UCITS conducts appropriate due diligence on the quality of the index. Index that would not have rules on selection of components, would accept payments from potential index components or would apply backfilling are not eligible. The implementing Directive also requires that OTC derivatives be priced in accordance with either a reliable up-to-date market price or a pricing model using a recognised methodology. This value must be verified either with a third party or by a department of the UCITS independent from the asset management. Reliance solely on counterparty quotation is not sufficient.

6 8 Clarification of Definitions concerning Eligible Assets for Investments of UCITS Clarification of Definitions concerning Eligible Assets for Investments of UCITS 9 Techniques and instruments Derivative instruments can now either be considered as an eligible asset class (under article 19(1)(g)) or be used for efficient portfolio management (article 21(2)). In this context, the implementing Directive defines the concept of efficient portfolio management (EPM) which means an economically appropriate and cost effective transaction aiming at either: reducing the risk or; reducing the costs or generating additional capital or income for the UCITS with an appropriate level of risk taking into consideration the risk profile of the UCITS and the provisions of the Directive. This extended definition of EPM now encompasses the previous definition of hedging. As a consequence, we have moved from a model where derivatives and techniques and instruments could be used either for hedging or EPM purposes to a model where they can be used either as an asset class or for EPM purposes as illustrated below: UCITS 1 EPM Hedging Derivatives Derivatives on currency Techniques and instruments (repos, securities lending ) Conclusion Clarification on eligible assets should materially reduce the scope of divergences in interpretation and implementation of the definition of the and will thus help to improve the functioning of the product passport. Clarification on the eligibility of closed end funds, credit derivatives and derivatives on property or commodity indices is particularly welcomed by the market. Definition of clear criteria to define eligible instruments will also help product design and compliance monitoring. While the recital to the implementing Directive indicates that these clarifications do not of themselves give risk to any new behavioral or operational obligations, market participants should review their process in order to ensure that they are in line with these requirements. Particular care should be given to: pricing of transferable securities for which a market price is not available, money market instruments priced in accordance with amortised costs and OTC derivatives pricing; compliance monitoring of the criteria applicable to transferable securities and money market instruments (decision tree), identification and measurement of embedded derivatives; risk monitoring of embedded derivatives, credit derivatives and other techniques and instruments. UCITS 3 Asset class EPM (includes hedging) Derivatives (incl. currency) Techniques and instruments (repos, securities lending )

7 10 Appendix : Overview of ESC/43/2006 Appendix : Overview of ESC/43/ Transferable securities Article 1(8) For the purposes of this Directive, transferable securities shall mean: shares in companies and other securities equivalent to shares in companies ( shares ), bonds and other forms of securities debt ( debt securities ), any other negotiable securities which carry the right to acquire any such transferable securities by subscription or exchange, excluding the techniques and instruments referred to in Article 21. Article 1, 22) Article 2, 1 The reference in Article 1(8) of Directive to transferable securities shall be understood as a reference to financial instruments which fulfil the following criteria: (a) the potential loss which the UCITS may incur with respect to holding those instruments is limited to the amount paid for them; (b) their liquidity does not compromise the ability of the UCITS to comply with Article 37 of (*); (c) reliable valuation is available for them as follows: (i) in the case of securities admitted to or dealt in on a regulated market as referred to in points (a) to (d) of Article 19(1) of Directive, in the form of accurate, reliable and regular prices which are either market prices or prices made available by valuation systems independent from issuers; (ii) in the case of other securities as referred to in Article 19(2) of, in the form of a valuation on a periodic basis which is derived from information from the issuer of the security or from competent investment research; (d) appropriate information is available for them as follows: (i) in the case of securities admitted to or dealt in on a regulated market as referred to in points (a) to (d) of Article 19(1) of Directive (**), in the form of regular, accurate and comprehensive information to the market on the security or, where relevant, on the portfolio of the security; (ii) in the case of other securities as referred to in Article 19(2) of Directive (***), in the form of regular and accurate information to the UCITS on the security or, where relevant, on the portfolio of the security; (e) they are negotiable; (f) their acquisition is consistent with the investment objectives and/or policy of the UCITS pursuant to ; (g) their risks are adequately captured by the risk management process of the UCITS. For the purposes of points (b) and (e), and unless there is information available to the UCITS that would lead to a different determination, Article 2, 1(a) A partly paid security must not expose the UCITS to loss beyond the amount to be paid for it. Article 2, 1(g) The security s risks and their contribution to the overall risk profile of the portfolio must be assessed on an ongoing basis. Article 2, 1 Where information is available to the UCITS that would lead it to determine that a transferable security could compromise the ability of the UCITS to comply with Article 37 of, the UCITS must assess its liquidity risk. The liquidity risk is a factor that the UCITS must consider when investing in any financial instrument in order to be compliant with the portfolio liquidity requirement to the extent required by Article 37. In taking this prudent approach, the following are examples of the matters a UCITS may need to consider: the volume and turnover in the transferable security; i f price is determined by supply and demand in the market, the issue size, and the portion of the issue that the asset manager plans to buy; also evaluation of the opportunity and timeframe to buy or sell; where necessary, an independent analysis of bid and offer prices over a period of time may indicate the relative liquidity and marketability of the instrument, as may the comparability of available prices; in assessing the quality of secondary market activity in a transferable security, analysis of the quality and number of intermediaries and market makers dealing in the transferable security concerned should be considered. In the case of transferable securities which are not admitted to trading on a regulated market as defined in Article 19(1) of, liquidity cannot automatically be presumed. The UCITS will therefore need to assess the liquidity of such securities where this is necessary to meet the requirements of Article 37. (*) Article 37(1): A UCITS must repurchase or redeem its units at the request of any unit-holder. (**) Article 19(1): The investment of a unit or of an investment company must consist solely of: (a): transferable securities and money market instruments admitted to or dealt in on a regulated market within the meaning of Article 1(13) of the ISD and/or; (b) transferable securities dealt in on another regulated market in a Member State which operates regularly and its recognized and open to the public and/or; (c) transferable securities admitted to official listing on a stock exchange in a non-member State or dealt in on another regulated market in a non-member State which operates regularly and is recognized and open to the public provided that the choice of stock exchange or market has been approved by the competent authorities or is provided for in law or the fund rules or the investment company s instruments of incorporation and/or; (d) recently issued transferable securities, provided that: - the terms of issue include an undertaking that application will be made for admission to official listing on a stock exchange or to another regulated market which operates regularly and is recognized and open to the public, provided that the choice of stock exchange or market has been approved by the competent authorities or is provided for in law or the fund rules or the investment company s instruments of incorporation; - such admission is secured within a year of issue. (***) Article 19(2): A UCITS may invest no more than 10% of its assets in transferable securities other than those referred to in paragraph 1. Closed-end funds --- Money Market Instruments Article 1(9) For the purpose of this Directive money market instrument shall mean: instruments normally dealt in on the money market; --- Article 1, 14) financial instruments which are admitted or dealt in on a regulated market in accordance with points (a), (b) or (c) of Article 19(1) of (**) shall be presumed not to compromise the ability of the UCITS to comply with Article 37 of (*) and shall also be presumed to be negotiable. Article 2, 2 Transferable securities as referred to in Article 1(8) of include the following: (a) units in closed end funds constituted as investment companies and unit trusts which fulfil the following criteria: (i) they fulfil the criteria set out in paragraph 1; (ii) they are subject to corporate governance mechanisms applied to companies; (iii) where asset management activity is carried out by an other entity on behalf of the closed end fund, that entity is subject to national regulation for the purpose of investor protection; (b) units of closed end funds constituted under the law of contract which fulfil the following criteria: i) they fulfil the criteria set out in paragraph 1; (ii) they are subject to corporate governance mechanisms equivalent to those applied to companies as referred to in point (a)(ii); (iii) they are managed by an entity which is subject to national regulation for the purpose of investor protection. Article 3, 1 The reference in Article 1(9) of Directive 85/611/ EEC to money market instruments as instruments shall be understood as a reference to the following: (a) financial instruments which are admitted to trading or dealt in on a regulated market in accordance with points (a), (b) and (c) of Article 19(1) of (**); (b) financial instruments which are not admitted to trading. If the security is assessed as insufficiently liquid to meet foreseeable redemption requests, the security must only be bought or held if there are sufficiently liquid securities in the portfolio so as to be able to meet the requirements of Article 37. In the case of transferable securities which are not admitted to trading on a regulated market as defined in Article 19(1), negotiability cannot automatically be presumed. The UCITS must assess the negotiability of securities held in the portfolio, with a view to ensuring compliance with the requirements of Article 37. Article 2, 2 UCITS may not make investments in closed end funds for the purpose of circumventing the investment limits provided for UCITS by Directive. Article 2, 2(b)(ii) In assessing whether the corporate governance mechanisms for funds in contractual form are equivalent, the following factors are indicators which can be used as a guidance: Unit holders rights. The contract on which the fund is based should provide for: right to vote of the unit holders in the essential decision making processes of the fund (including appointment and removal of asset management company, amendment to the contract which set up the fund, modification of investment policy, merger, liquidation); right to control the investment policy of the fund through appropriate mechanisms. It is understood that the assets of the fund should be separate and distinct from that of the asset manager and the fund will be subject to liquidation rules adequately protecting the unit holders. Article 3, 1 CESR s view is that there is no scope for gaining exposure to precious metals through investment in money market instruments. CESR s view is that Article 42 of Directive prohibits the short selling of money market instruments by a UCITS. CESR s view is that money market instruments referred to in Article 19(2)(a) of are those instruments that comply with the definition of

8 12 Appendix : Overview of ESC/43/2006 Appendix : Overview of ESC/43/ liquid instruments Article 3, 2 The reference in Article 1(9) of Directive 85/611/ EEC to money market instruments as instruments normally dealt in on the money market shall be understood as a reference to financial instruments which fulfil one of the following criteria: (i) they have a maturity at issuance of up to and including 397 days; (ii) they have a residual maturity of up to and including 397 days; (iii) they undergo regular yield adjustments in line with money market conditions at least every 397 days; (iv) their risk profile, including credit and interest rate risks, corresponds to that of financial instruments which have a maturity as referred to in points (i) or (ii), or are subject to a yield adjustment as referred to in point (iii). Article 4, 1 The reference in Article 1(9) of Directive 85/611/ EEC to money market instruments as instruments which are liquid shall be understood as a reference to financial instruments which can be sold at limited cost in an adequately short timeframe, taking into account the obligation of the UCITS to repurchase or redeem its units at the request of any unit holder. a money market instrument as set out by Article 1(9) of (i.e. are normally dealt in on the money market and fulfill the requirements of liquidity and accurate valuation), but do not, however, fall in the categories defined by Article 19(1)(a) to (d) or (h). Article 3,2 Treasury and local authority bills, certificates of deposit, commercial papers, and banker s acceptances will usually comply with the criterion normally dealt in on the money market. Article 4, 1 When assessing the liquidity of a money market instrument (MMI), the following cumulative factors have to be taken into account: - at the instrument level: frequency of trades and quotes for the instrument in question; number of dealers willing to purchase and sell the instrument, willingness of the dealers to make a market in the instrument in question, nature of market place trades (times needed to sell the instrument, method for soliciting offers and mechanics of transfer); size of issuance/program; possibility to repurchase, redeem or sell the MMI in a short period (e.g. seven business days), at limited cost, in terms of low fees and bid/offer prices and with very short settlement delay; - at the fund level, the following relevant factors should be considered in order to ensure that any individual MMI would not affect the liquidity of the UCITS at the fund level: unit holder structure and concentration of unit holders of the UCITS; purpose of funding of unit holders; quality of information on the fund s cash flow patterns; prospectuses guidelines on limiting withdrawals. with a value which can be accurately determined at any time Money Market instruments dealt in on a regulated market Article 19(1)(a) to (d) Article 41(1)(a) to (d) Article 4, 2 The reference in Article 1(9) of Directive 85/611/ EEC to money market instruments as instruments which have a value which can be accurately determined at any time shall be understood as a reference to financial instruments for which accurate and reliable valuations systems, which fulfil the following criteria, are available: (i) they enable the UCITS to calculate a net asset value in accordance with the value at which the financial instrument held in the portfolio could be exchanged between knowledgeable willing parties in an arm s length transaction; (ii) they are based either on market data or on valuation models including systems based on amortised costs. Article 4, 3 The criteria referred to in paragraphs 1 and 2 shall be presumed to be fulfilled in the case of financial instruments which are normally dealt in on the money market for the purposes of Article 1(9) of and which are admitted to or dealt in on a regulated market in accordance with points (a), (b) or (c) of Article 19(1) (**) thereof, unless there is information available to the UCITS that would lead to a different determination. The fact that some of these conditions are not fulfilled does not automatically imply that the financial instruments should be considered as non-liquid. These elements must ensure that UCITS will have sufficient planning in the structuring of the portfolio and in foreseeing cash flows in order to match anticipated cash flows with the selling of appropriately liquid instruments in the portfolio to meet those demands. Article 4, 2 With respect to the criterion «value which can be accurately determined at any time», if the UCITS considers that an amortization method can be used to assess the value of a MMI, it must ensure that this will not result in a material discrepancy between the value of the MMI and the value calculated according to the amortization method. The following UCITS/MMI will usually comply with the latter principles: MMI with a residual maturity of less than three months and with no specific sensitivity to market parameters, including credit risk; or UCITS investing solely in high-quality instruments with as a general rule a maturity or residual maturity of at most 397 days or regular yield adjustments in line with the maturities mentioned before and with a weighted average maturity of 60 days. The requirement that the instruments be high-quality instruments should be adequately monitored, taking into account both the credit risk and the final maturity of the instrument. These principles along with adequate procedures defined by the UCITS should avoid the situation where discrepancies between the value of the MMI as defined at Level 2 and the value calculated according to the amortization method would become material, whether at the individual MMI or at the UCITS level. These procedures might include updating the credit spread of the issuer or selling the MMI. Article 4, 3 Where the presumption of «liquidity» and «accurate valuation» cannot be relied upon, the MMI should be subject to an appropriate assessment by the UCITS.

9 14 Appendix : Overview of ESC/43/2006 Appendix : Overview of ESC/43/ Money Market instruments other than those dealt in on a regulated market Article 19(1)(h) if the issue or the issuer of such instruments is itself regulated for the purpose of protecting investors and savings Article 41(1)(h) Article 5, 1 The reference in Article 19(1)(h) of Directive to money market instruments, other than those dealt in on a regulated market, of which the issue or the issuer is itself regulated for the purpose of protecting investors and savings shall be understood as a reference to financial instruments which fulfil the following criteria: (a) they fulfil one of the criteria set out in Article 3(2) and all the criteria set out in Articles 4(1) and 4(2); (b) appropriate information is available for them, including information which allows an appropriate assessment of the credit risks related to the investment in such instruments, taking into account paragraphs 2, 3 and 4; Article 5, 1 It remains the responsibility of the UCITS to ensure whether a money market instrument (MMI) that is not dealt in on a regulated market is an eligible asset. (3) issued or guaranteed by an establishment subject to prudential supervision, on accordance with criteria defined by Community law, or by an establishment which is subject to and complies with prudential rules considered by the competent authorities to be at least as stringent as those laid down by Community law; Article 6 The reference in the third indent of Article 19, 1, (h) of to an establishment which is subject to and complies with prudential rules considered by the competent authorities to be at least as stringent as those laid down by community law shall be understood as a reference to an issue which is subject to and complies with prudential rules and fulfills one of the criteria: (a) it is located in the European Economic Area; (b) it is located in the OECD countries belonging to the Group of ten; (c) it has at least investment grade rating; (d) it can be demonstrated on the basis of an in-depth analysis of the issuer that the prudential rules applicable to that issuer are at least as stringent as those laid down by community law. Article 5, 3 (c) they are freely transferable. Appropriate information shall consist in: and provided they are: (1) issued or guaranteed by a central, regional or local authority or central bank of a Member State, the European Central Bank, the European Union or the European Investment Bank, a non-member State or, in case of a Federal State, by one of the members making up the federation or by a public international body to which one or more Member States belong or; (2) issued by an undertaking any securities of which are dealt in on a regulated markets Article 5, 2 Appropriate information For those that are guaranteed by a Member State, appropriate information shall consist in information on the issue or issuance programme or on the legal and financial situation of the issuer prior to the issue of the money market instruments. For those that are not guaranteed by a Member State, appropriate information shall consist in the following: (a) information on both the issue or the issuance programme and the legal and financial situation of the issuer prior to the issue of the money market instrument; (b) up-dates of the information referred to in point (a) on a regular basis and whenever a significant event occurs; (c) verification of the information referred to in point (a) by appropriately qualified third parties not subject to instructions from the issuer; (d) availability of reliable statistics on the issue or issuance programme. Appropriate information shall consist in the following: (a) information on both the issue or the issuance programme and the legal and financial situation of the issuer prior to the issue of the money market instrument; (b) up-dates of the information referred to in point (a) on a regular basis and whenever a significant event occurs; (c) verification of the information referred to in point (a) by appropriately qualified third parties not subject to instructions from the issuer; (d) availability of reliable statistics on the issue or issuance programme. Article 5, 2(b) CESR s view is that regular updates should normally occur on an annual basis. Article 5, 2(c) Such third parties should specialise in the verification of legal or financial documentation and be composed of persons meeting professional standards of integrity. (4) issued by other bodies belonging to the categories approved by the UCITS competent authorities provided that investments in such instruments are subject to investor protection equivalent to that laid down in the first, the second or the third indent and provided that the issuer is a company whose capital and reserves amount to at least EUR 10 million and which presents and publishes its annual accounts in accordance with Directive 78/660/ EEC, is an entity which, within a group of companies which includes one or several listed companies, is dedicated to the financing of the group or is an entity which is dedicated to the financing of securitization vehicles (a) information on the issue or issuance programme or on the legal and financial situation of the issuer prior to the issue of the money market instrument; (b) up-dates of the information referred to in point (a) on a regular basis and whenever a significant event occurs; (c) availability of reliable statistics on the issue or issuance programme or other date enabling an appropriate assessment of the credit risks related to the investment in such instruments. Article 5, 2 Appropriate information shall consist in: (a) information on both the issue or the issuance programme and on the legal and financial situation of the issuer prior to the issue of the money market instrument; (b) up-dates of the information referred to in point (a) on a regular basis and whenever a significant event occurs; (c) verification of information referred to in point (a) by appropriately qualified third parties not subject to instructions from the issuer; (d) availability of reliable statistics on the issue or issuance programme. Securitisation vehicles which benefit from a banking liquidity line (Article 7) 1. The reference in the fourth indent of Article 19(1)(h) of to securitisation vehicles shall be understood as a reference to structures, whether in the corporate, trust or contractual form, set up for the purpose of securitisation operations. 2. The reference in the fourth indent of Article 19(1)(h) of Directive /611/EEC to banking liquidity lines shall be understood as a reference to banking facilities secured by a

10 16 Appendix : Overview of ESC/43/2006 Appendix : Overview of ESC/43/ which benefit from a banking liquidity line. Financial derivatives Underlying (article 19(1)(g), first indent) The underlying consists of instruments covered by this paragraph, financial indices, interest rates, foreign exchange rates or currencies, in which the UCITS may invest according to its investment objectives as stated in the UCITS fund rules or instruments of incorporation. Article 41(1)(g) financial institution which itself complies with the third indent of Article 19(1)(h) of Directive. Article 8, 1 Their underlying consist of one or more of the following: (i) assets as listed in Article 19(1) of Directive including financial instruments having one or several characteristics of those assets; (ii) interest rates; (iii) foreign exchange rates or currencies; (iv) financial indices. the UCITS corresponding to the fair value as referred to in paragraph 3, which does not only rely on market quotations by the counterparty and which fulfils the following criteria: (a) the basis for the valuation is either a reliable up-to-date market value of the instrument, or, if such a value is not available, a pricing model using an adequate recognised methodology; (b) verification of the valuation is carried out by one of the following: (i) an appropriate third party which is independent from the counterparty of the OTC-derivative, at an adequate frequency and in such a way that the UCITS is able to check it; (ii) a unit within the UCITS which is independent from the department in charge of managing the assets and which is adequately equipped for such purpose. the value of OTC derivatives» means: regarding the accurate assessment of the value of the over-the counter (OTC) derivative: a process which enables the UCITS throughout the life of the derivative to value the investment concerned with reasonable accuracy at its fair value on a reliable basis reflecting an up-to-date market value; organization and means allowing for a risk analysis realized by a department independent from commercial or operational units and from the counterparty or, if these conditions cannot be fulfilled, by an independent third party. In the latter case, the UCITS remains responsible for the correct valuation of the OTC derivatives. Lastly, this organization of the UCITS implies that risk limits are to be defined. Article 8,4(b)(i) Credit derivatives --- Reliable and verifiable valuation - Article 19(1)(g) (3rd indent) The OTC derivatives are subject to reliable and verifiable valuation on a daily basis and can be sold, liquidated or closed by a offsetting transaction at any time at their fair value at the UCITS initiative. --- Article 41(1)(g) (3rd indent) Article 8, 2 Financial derivative instruments as referred to in Article 19(1)(g) of shall include instruments which fulfil the following criteria: (a) they allow the transfer of the credit risk of an asset as referred to in point (a) of paragraph 1 of this Article independently from the other risks associated with that asset; (b) they do not result in the delivery or in the transfer of assets including cash other than those referred to in Article 19(1) and (2) of ; (c) they comply with the criteria for OTC-derivatives laid down in the second and third indents of Article 19(1)(g) of and in paragraphs 3 and 4 of this Article (see below); (d) their risks are adequately captured by the risk management process of the UCITS, and by its internal control mechanisms in the case of risks of asymmetry of information between the UCITS and the counterparty to the credit derivative resulting from potential access of the counterparty to non-public information on firms referenced by credit derivatives. Fair value (Article 8, 3) For the purposes of the third indent of Article 19(1)(g) of, the reference to fair value shall be understood as a reference to the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm s length transaction. Reliable and verifiable information (Article 8, 4) For the purposes of the third indent of Article 19(1)(g) of, the reference to reliable and verifiable valuation shall be understood as a reference to a valuation, by Article 8, 2(d) A UCITS must undertake the risk assessment with the highest care when the counterparty to the derivative is a related party of the UCITS or the credit issuer. Article 8, 4(a) For the purpose of applying Article 21(1) of in conjunction with Article 19(1)(g) third indent of Directive, the criteria «process for accurate and independent assessment of Derivative on commodities --- Derivatives on financial indices Article 19(1)(g) see above --- Article 41(1)(g) Article 8, 5 The reference in Article 1(2) and 19(1)(g) of to financial liquid assets shall be understood as excluding derivatives on commodities. Article 9, 1 The reference in point (g) of Article 19(1) of to financial indices shall be understood as a reference to indices which fulfil the following criteria: The UCITS remains responsible for the correct valuation of OTC derivatives and must, inter alia, check that the independent third party can adequately value the types of OTC derivatives it wishes to conclude. Article 8,4(b)(ii) CESR s view is that «independent» and «adequately equipped» in this context mean a unit which has the adequate means (both human and technical) to perform this valuation. This implies that the UCITS use its own valuation systems, which can however be provided by an independent third party. This excludes the use of valuation models provided by a party- related to the UCITS (such as a dealing room with which OTC derivatives are concluded) which have not been reviewed by the UCITS. This also excludes the use of data (such as volatility or correlations) produced by a process which has not been qualified by the UCITS. Article 8,5 CESR s view is that eligible assets exclude non-financial indices. Article 9, 1 Indices based on financial derivatives on commodities or indices on property may be eligible provided they comply with the criteria set down for financial indices.

11 18 Appendix : Overview of ESC/43/2006 Appendix : Overview of ESC/43/ (a) they are sufficiently diversified, in that the following criteria are fulfilled: (i) the index is composed in such a way that price movements or trading activities regarding one component do not unduly influence the performance of the whole index; (ii) where the index is composed of assets referred to in Article 19(1) of Directive, its composition is at least diversified in accordance with Article 22a of that Directive (****); (iii) where the index is composed of assets other than those referred to in Article 19(1) of, it is diversified in a way which is equivalent to that provided for in Article 22a of that Directive; (b) they represent an adequate benchmark for the market to which they refer, in that the following criteria are fulfilled: (i) the index measures the performance of a representative group of underlyings in a relevant and appropriate way; (ii) the index is revised or rebalanced periodically to ensure that it continues to reflect the markets to which it refers following criteria which are publicly available; (iii) the underlyings are sufficiently liquid which allows users to replicate the index, if necessary. (c) they are published in an appropriate manner, in that the following criteria are fulfilled: (i) their publication process relies on sound procedures to collect prices and to calculate and to subsequently publish the index value, includind pricing procedures for components where a market price is not available; Article 9, 1(a)(ii) If the composition of the index is not at least as diversified under the ratios of Article 22a of, its underlying assets have to be combined with the other assets of the UCITS according to Article 21(3) and Article 22 of in order to avoid undue concentration. Article 9, 1(a)(iii) Where derivatives on an index composed of non-eligible assets are used to track or gain high-exposure to the index, in order to avoid undue concentration the index should be at least as diversified as set out under the diversification ratios according to Article 22a of. If derivatives on the index are used for risk-diversification purposes, provided that the exposure of the UCITS to the individual indices complies with the 5/10/40% ratios, there is no need to look at the underlying components of the individual indices to ensure that they are sufficiently diversified. with the requirements of this Article. a component which fulfils the following criteria: (a) by virtue of that component some or all of the cash flows that otherwise would be required by the transferable security which functions as host contract can be modified according to a specified interest rate, financial instrument price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, and therefore vary in a way similar to a stand-alone derivative; (b) its economic characteristics and risks are not closely related to the economic characteristics and risks of the host contract; (c) it has a significant impact on the risk profile and pricing of the transferable security. 2. Money market instruments which fulfil one of the criteria set out in Article 3(2) and all the criteria set out in Articles 4(1) and 4(2) (******), and which contain a component which fulfils the criteria set out in paragraph 1 of this Article shall be regarded as money market instruments embedding a derivative. 3. A transferable security or a money market instrument shall not be regarded as embedding a derivative where it contains a component which is contractually transferable independently of the transferable security or the money market instrument. Such a component shall be deemed to be a separate financial instrument. they are leveraged, i.e. the CDOs or asset backed securities are not limited recourse vehicles and the investors loss can be higher than their initial investment; or they are not sufficiently diversified. Where a product is structured as an alternative to an over-the-counter (OTC) derivative, its treatment should be similar to that of the OTC derivative instrument, if the consistency of the Directive provisions is to be ensured. This will be the case for tailor-made hybrid instruments, such as a single tranche CDO structured to meet the specific needs of a UCITS, which should be considered as embedding a derivative from the Directive point of view. Such a product offers an alternative to the use of an OTC derivative, for the same purpose of achieving a diversified exposure with a pre-set credit risk level to a portfolio of entities. CESR s view is that the following list of SFIs, which is illustrative and non-exhaustive, could be assumed by a UCITS to embed a derivative: credit linked notes; SFIs whose performance is linked to the performance of a bond index; SFIs whose performance is linked to the performance of a basket of shares with or without active management; SFIs with a nominal fully guaranteed whose performance is linked to the performance of a basket of shares, with or without active management; convertible bonds; and (ii) material information on matters such as index calculation, rebalancing methodologies, index changes or any operational difficulties in providing timely or accurate information is provided on a wide and timely basis. exchangeable bonds. UCITS using SFIs embedding derivatives must respect the principles of the Directive. Embedded derivatives Article 21(3) When a transferable security or money market instrument embeds a derivative, the latter must be taken into account when complying Article 42(3) 2. Where the composition of assets which are used as underlyings by financial derivatives in accordance with Article 19(1) of Directive does not fulfil the criteria set out in paragraph 1 of this Article, those financial derivatives shall, where they comply wih the criteria set out in Article 8(1) of this Directive, be regarded as financial derivatives on a combination of assets referred to in points (i), (ii) and (iii) of Article 8(1)(a). Article The reference in the fourth subparagraph of Article 21(3) of to transferable securities embedding a derivative shall be understood as a reference to financial instruments which fulfil the criteria set out in Article 2(1) of this Directive (*****) and which contain Article 10 Collateralized debt obligations (CDOs) or asset backed securities using derivatives, with or without an active management, will generally not qualify as structured financial instruments (SFIs) embedding derivatives, except if: These include: - embedded derivatives may never be used to circumvent the principles and rules set out in the Directive (Recital 13 of Directive 2001/108/EC); - in compliance with the third indent of Article 21(3) of, «when a transferable security or money market instrument embeds a derivative, the latter must be taken into account when complying with the requirements of (Article 21)». As a consequence, the UCITS must: employ «a risk-management process which enables it to monitor and measure at any time the risk of the positions and their contribution to the overall risk profile of the portfolio» (Article 21(1)); have a global exposure relating to (****) see below paragraph on index replicating UCITS (*****) see above paragraph on transferable securities (******) see above paragraph on money market instruments

12 20 Appendix : Overview of ESC/43/2006 Appendix : Overview of ESC/43/ Techniques and instruments Article 21(2) The Member States may authorise UCITS to employ techniques and instruments relating to transferable securities and money market instruments under the conditions and within the limits which they lay down provided that such techniques and instruments are used for the purpose of efficient portfolio management. Article 42(2) Article 11 1.The reference in Article 21(2) of Directive to techniques and instruments related to transferable securities for the purpose of efficient portfolio management shall be understood as a reference to techniques and instruments which fulfil the following criteria: (a) they are economically appropriate in that they are realised in a cost-effective way; (b) they are entered into for one or more of the following specific aims: (i) reduction of risk; derivative instruments that does not exceed the total net value of its portfolio (Article 21(3)); comply with all the investment limits set by Article 22 and Article 22a of Directive : «A UCITS may invest... in financial derivative instruments provided that the exposure to the underlying assets does not exceed in aggregate the investment limits laid down in Article 22» (Article 21(3)). More specifically: - UCITS using SFIs embedding derivatives should refer to the Commission Recommendation 2004/383/EC of 27 April 2004 on the use of financial derivative instruments by UCITS in order to comply with the risk spreading rules required by Article 22 of the Directive, as this Recommendation sets out how the underlying assets of financial derivative instruments should be taken into account when assessing compliance with the risk limits set by the above-mentioned article; and - embedded derivatives will generally not be taken into account when calculating counterparty limits, except if these products enable the issuer of the hybrid instrument to pass the counterparty risk of underlying derivatives to the UCITS. It is the responsibility of the UCITS to check that investment in hybrid instruments embedding derivatives complies with these requirements. The nature, frequency and scope of checks performed will depend on the characteristics of the embedded derivatives and on their impact on the UCITS, taking into account its stated investment objective and risk profile. Where the UCITS considers that this impact is not significant, controls can be tailored accordingly. In such cases, the UCITS may for instance rely on predefined investment limits to ensure compliance with the above mentioned principles. Article 11 Techniques and instruments relating to transferable securities and money market instruments include, but are not limited to, collateral under the provisions of Directive /47/EC on financial collateral arrangements, repurchase agreements, guarantees received, and securities lending. The requirement to comply with the provisions of Article 21 of imply in particular that if UCITS are authorized to use repurchase agreements or securities lending to generate leverage through the re-investment of collateral, these operations must be taken into account to calcu- When these operations concern the use of derivative instruments, these conditions and limits shall conform to the provisions laid down in this Directive. Index replicating UCITS Article 22a(1): Without prejudice to the limits laid down in Article 25, the Member States may raise the limits laid down in Article 22 to a maximum of 20% for investment in shares and/or debt securities issued by the same body when, according to the fund rules or instruments of incorporation, the aim of the UCITS investment policy is to replicate the composition of a certain stock or debt securities index which is recognized by the competent authorities, on the following basis: its composition is sufficiently diversified; the index represents an adequate benchmark for the market to which it refers; it is published in an appropriate manner Article 44(1) (ii) reduction of cost; (iii) generation of additional capital or income for the UCITS with a level of risk which is consistent with the risk profile of the UCITS and the risk-diversification rules laid down in Article 22 of ; (c) their risks are adequately captured by the risk management process of the UCITS. 2. Techniques and instruments which comply with the criteria set out in paragraph 1 and which relate to money market instruments shall be regarded as techniques and instruments relating to money market instruments for the purpose of efficient portfolio management as referred to in Article 21(2) of. Article The reference in Article 22a(1) of Directive to replicating the composition of a stock or debt securities index shall be understood as a reference to replication of the composition of the underlying assets of the index, including the use of derivatives or other techniques and instruments as referred to in Article 21(2) of and Article 11 (see above) of this Directive. 2. The reference in the first indent of Article 22a(1) of to an index whose composition is sufficiently diversified shall be understood as a reference to an index which complies with the risk diversification rules of Article 22a(1) of that Directive. 3. The reference in the second indent of Article 22a(1) of to an index which represents an adequate benchmark shall be understood as a reference to an index whose provider uses a recognized methodology which generally does not result in the exclusion of a major issuer of the market to which it refers. 4. The reference in the third indent of Article 22a(1) of to an index which is published in an appropriate manner shall be understood as a reference to an index which fulfils the following criteria: (a) it is accessible to the public; (b) the index provider is independent from the index replicating UCITS. Point (b) shall not preclude index providers and the UCITS forming part of the same economic late the global exposure of the UCITS. Regarding the coherence between Article 19 and Article 21(2) of Directive, CESR notes that currently only financial derivative instruments are subject to both articles. Therefore, in accordance with the wording of Article 21(2), financial derivative instruments used under Article 21(2) must comply simultaneously with the provisions of Article 19. However, financial derivative instruments used under provisions of Article 19 are not automatically subject to the «efficient portfolio management» requirement of Article 21(2). Article 28 of defining the obligations concerning the information to be supplied to unit holders by UCITS implies that techniques and instruments relating to transferable securities and money market instruments can not result in a change of the fund s declared investment objective or add substantial supplementary risks in comparison to the concerned fund s general risk policy as described in its applicable sales documents. Article 12, 2 A UCITS should provide appropriate information for the subscribers in the simplified prospectus, if the limit for investment in shares and/or debt securities issued by the same body is raised above 20% and to a maximum of 35% for a single issuer, in compliance with Article 22a(2) of Directive, in order to justify exceptional market conditions.

13 22 Appendix : Overview of ESC/43/2006 Appendix : Overview of ESC/43/ Other Collective Investment Undertakings Article 19(1)(e) Units of UCITS authorised according to this Directive and/or other collective investment undertakings, within the meaning of the first and second indent of Article 1(2), should they be situated in a Member State or not, provided that: - such other collective investment undertakings are authorised under laws which provide that they are subject to supervision considered by the UCITS competent authorities to be equivalent to that laid down in Community law, and that cooperation between authorities is sufficiently ensured; - the level of protection for unit-holders in the other collective investment undertakings is equivalent to that provided for unitholders in a UCITS, and in particular that the rules on assets segregation, borrowing, lending and uncovered sales of transferable securities and money market instruments are equivalent to the requirements of this Directive; - the business of the other collective investment undertakings is reported in half-yearly and annual reports to enable an assessment to be made of the assets and liabilities, income and operations over the reporting period; - no more that 10% of the UCITS or the other collective investment undertakings assets, whose acquisition is contemplated, can, Article 41(1)(e) group, provided that effective arrangements for the management of conflicts of interest are in place. --- In CESR s view, the following matters can be used by the competent authorities to assess whether a collective investment undertaking is subject to supervision «equivalent to that laid down in Community law», as provided in Article 19(1)(e), first indent of. These factors can be used to guide a decision on equivalence: Memoranda of Understanding (bilateral or multilateral), membership of an international organization of regulators, or other co-operative arrangements (such as an exchange of letters) to ensure satisfactory cooperation between the authorities; the management company of the target collective investment undertaking, its rules and choice of depositary have been approved by its regulator; and authorisation of the collective investment undertaking in an OECD country. In CESR s view, the following matters can be considered in deciding whether the level of protection of unit holders is «equivalent to that provided for unit holders in a UCITS», as referred to in Article 19(1)(e), second indent. These factors can be used to guide a decision on equivalence: rules guaranteeing the autonomy of the management of the collective investment undertaking, and management in the exclusive interest of the unit holders; the existence of an independent trustee/custodian with similar duties and responsibilities in relation to both safekeeping and supervision. Where an independent trustee/custodian is not a requirement of local law as regards collective investment schemes, robust governance structures may provide a suitable alternative; availability of pricing information and reporting requirements; redemption facilities and frequency; restrictions in relation to dealings by related parties; the extent of asset segregation; and the local requirements for borrowing, lending and uncovered sales of transfer- according to their fund rules or instruments of incorporation, be invested in aggregate in units of other UCITS or other collective investment undertakings. Hedge Fund indices able securities and money market instruments regarding the portfolio of the collective investment undertaking. concerning eligible assets : the classification of hedge fund indices as financial indices. For the purposes of Article 19(1)(g) of, to fall under the classification of a financial index, a hedge fund index must comply with the conditions laid down in Article 9 of Directive 2007/16/EC. For the purposes of Article 19(1)(g) of, a hedge fund index will not fall under the classification of a financial index unless the methodology of the index provides for the selection and the re-balancing of components on the basis of pre-determined rules and objective criteria. For the purposes of Article 19(1)(g) of, a hedge fund index will not fall under the classification of a financial index if the index provider accepts payments from potential index components for the purpose of being included in the index. For the purposes of Article 19(1)(g) of, a hedge fund index will not fall under the classification of a financial index if the methodology of the index allows retrospective changes to previously published index values ( backfilling ). When gaining exposure to a hedge fund index by means of an OTC derivative, a UCITS must comply with the relevant requirements laid down in Directives and 2007/16/EC. These include: requirements about counterparties (Article 19(1)(g) of ); requirements about valuation and the ability to close a position (Article 19(1)(g) of ) and Article 8 of Directive 2007/16/EC); requirements about risk management and valuation processes (Article 21(1) of ); and requirements about risk exposure (Article 22 of ). When gaining exposure to a hedge fund index, a UCITS must carry out appropriate due diligence. This includes consideration

14 24 Appendix : Overview of ESC/43/2006 by the UCITS of the quality of the index. In assessing the quality of the index, the UCITS must take into account at least the following factors.the UCITS must keep a record of its assessment. (a) the comprehensiveness of the index methodology, including - whether the methodology contains an adequate explanation of subjects such as the weighting and classification of components (eg on the basis of the investment strategy of the selected hedge funds), and the treatment of defunct components; - whether the index represents an adequate benchmark for the kind of hedge funds to which it refers; (b) the availability of information about the index, including - whether there is a clear narrative description of what the index is trying to represent; - whether the index is subject to an independent audit and the scope of the audit (eg that the index methodology has been followed, that the index has been calculated correctly); - how frequently the index is published and whether this will affect the ability of the UCITS to accurately calculate its net asset value (NAV); (c) matters relating to the treatment of index components, including - the procedures by which the index provider carries out any due diligence on the NAV calculation procedures of index components; - what level of detail about the index components and their NAVs are made available (including whether they are investable or non-investable); - whether the number of components in the index achieves sufficient diversification.

15 Contacts Nathalie Dogniez Partner T: E: Gabrielle Jaminon Senior Manager T: E: Dee Ruddy Senior Manager T: E: The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation KPMG S.à r.l., a private limited company, is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. Printed in.