UCITS fair value

A matter of some debate and heartache. Should counterparties to derivatives transactions with UCITS funds have to agree to give them a daily termination right at a fair value?

Things have recently changed.

The New Regime

Valuation of OTC Derivatives

A key change has been made to UCITS Notice 10 (the “Notice”) in the context of the valuation of OTC derivatives.

Whereas previously the central bank notice said that:

A UCITS must be be satisfied that:

• Its counterparty will value the derivative with reasonable accuracy and on a reliable basis; and that
• The derivative can be sold, liquidated or closed by an offsetting transaction at fair value, at any time at the UCITS initiative

The UCITS must subject its OTC derivatives to reliable and verifiable valuation on a daily basis and ensure that it has appropriate systems, controls and processes in place to achieve this. The valuation arrangements and procedures must be adequate and proportionate to the nature and complexity of the OTC derivative concerned and should be adequately documented.
Reliable and verifiable valuation shall be understood as a reference to a valuation, by the UCITS, corresponding to fair value which does not rely only on market quotations by the counterparty and which fulfils the following criteria:

• 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
• Verification of the valuation is carried out by one of the following:
  • 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; or
  • 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

These requirements were typically satisfied by the inclusion of the following wording in the valuation provisions of the Prospectus of each UCITS that could invest in derivatives:

The value of any OTC FDI contract shall be the quotation from the counterparty provided that such quotation is provided on at least a daily basis and is approved or verified at least weekly by a person independent of the counterparty.

The Central Bank recently revised the Notice to delete the wording in (a), (b) and (c). The rationale for this deletion was that EMIR requires that counterparties value outstanding non-centrally cleared OTC derivatives contracts on a daily basis on a mark to market basis or, where market conditions determine otherwise, a “reliable and prudent marking to model” may be used. It is not yet clear whether the Notice will be further updated to insert the requirement under EMIR. Novation of OTC Derivatives The Notice has also been amended by the insertion of a requirement that in the case of the subsequent novation of a OTC derivative contract, the counterparty is: • A credit institution authorised in the European Economic Area (EEA) (European Union Member States, Norway, Iceland, Liechtenstein), a credit institution authorised within a signatory state, other than a Member State of the EEA, to the Basle Capital Convergence Agreement of July 1988 (Switzerland, Canada, Japan, United States) or a credit institution authorised in Jersey, Guernsey, the Isle of Man, Australia or New Zealand or an investment firm, authorised in accordance with the Markets in Financial Instruments Directive in an EEA Member State, or is an entity subject to regulation as a Consolidated Supervised Entity (“CSE”) by the US Securities and Exchange Commission; or • A central counterparty (CCP) authorised, or recognised by ESMA, under EMIR or, pending recognition by ESMA under Article 25 of EMIR, an entity classified as a derivatives clearing organisation by the Commodity Futures Trading Commission or a clearing agency by the SEC

The old regime

Background

UCITS fair value comes from Article 19(1)(g) of Council Directive 85/611/EEC (EUR Lex) (the original UCITS Directive.

That in turn is dealt with in Article 8(3) of Commission Directive 2007/16/EC (also known as "The Commission Directive implementing Council Directive 85/611/EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) as regards the clarification of certain definitions"), or even more elegantly, the UCITS Eligible Assets Directive:

3. For the purposes of the third indent of Article 19(1)(g) of Directive 85/611/EEC, 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.

Obligations concerning the investment policies of UCITS

Article 19

1. The investments of a unit trust 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 and money market instruments dealt in on another regulated market in a Member State which operates regularly and is recognized and open to the public and/or;

(c) transferable securities and money market instruments 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 and/ or;

(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 than 10 % of the UCITS' or the other collective investment undertakings' assets, whose acquisition is contemplated, can, according to their fund rules or instruments of incorporation, be invested in aggregate in units of other UCITS or other collective investment undertakings and/or;

(f) deposits with credit institutions which are repayable on demand or have the right to be withdrawn, and maturing in no more than 12 months, provided that the credit institution has its registered office in a Member State or, if the registered office of the credit institution is situated in a non-Member State, provided that it is subject to prudential rules considered by the UCITS' competent authorities as equivalent to those laid down in Community law and/or;

(g) financial derivative instruments, including equivalent cash-settled instruments, dealt in on a regulated market referred to in subparagraphs (a), (b) and (c); and/or financial derivative instruments dealt in over-the-counter (‘OTC derivatives’), provided that:

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;

the counterparties to OTC derivative transactions are institutions subject to prudential supervision, and belonging to the categories approved by the UCITS' competent authorities and;

the OTC derivatives are subject to reliable and verifiable valuation on a daily basis and can be sold, liquidated or closed by an offsetting transaction at any time at their fair value at the UCITS' initiative, and/or;

(h) money market instruments other than those dealt in on a regulated market, which fall under Article 1(9), if the issue or issuer of such instruments is itself regulated for the purpose of protecting investors and savings, and provided that they are:

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 the 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;

issued by an undertaking any securities of which are dealt in on regulated markets referred to in subparagraphs (a), (b) or (c), or;

issued or guaranteed by an establishment subject to prudential supervision, in 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 or;

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 (EUR Lex) (1), 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 securitisation vehicles which benefit from a banking liquidity line.

2. However:

(a) a UCITS may invest no more than 10 % of its assets in transferable securities and money market instruments other than those referred to in paragraph 1;

(c) an investment company may acquire movable and immovable property which is essential for the direct pursuit of its business;

(d) a UCITS may not acquire either precious metals or certificates representing them.

4. Unit trusts and investment companies may hold ancillary liquid assets.

2014|91|EU