UCITS share classes will be subject to a number of new principles according to a recently published ESMA opinion (the ‘opinion’). UCITS managers will need to ensure that any new share classes conform with these principles. In particular, the opinion states that hedging arrangements at share class level, aside from currency risk hedging, should no longer be permitted.
Share classes are categories of shares which belong to the same UCITS, but which allow subsets of investors in the UCITS to achieve some level of customisation which accommodates their specific needs (for example, the distribution of revenues, different fees, a particular tax treatment or a different minimum investment amount). However, notwithstanding the ability to issue share classes with different characteristics, all investors in UCITS, no matter which share class, share an exposure to the same pool of assets.
The UCITS Directive recognises the possibility for UCITS to offer more than one share class to investors. However, according to ESMA, it does not prescribe whether, and to what extent, share classes of a given UCITS can differ from each other. In view of diverging national practices as to the types of share class that are permitted, ESMA published a discussion paper in December 2014 with a view to developing a common understanding of what constitutes a UCITS share class and the extent of share class differentiation. This was subsequently followed by a consultation paper in April 2016.
Opinion on share classes of UCITS
On 30 January ESMA published an opinion, ‘Share classes of UCITS’ in which it identifies four high-level principles that must be followed when setting up different share classes, namely: a) common investment objective, b) non-contagion, c) pre-determination, and d) transparency.
Common investment objective
Share classes of the same fund must have a common investment objective reflected by a common pool of assets. Share classes that differentiate between groups of investors (for example, retail vs. institutional investors) comply with this principle, as do share classes which differentiate on the commercial terms applicable to investors’ investments (for example, as regards management fees, minimum investment amounts, voting rights or currency).
In contrast, with the exception of currency risk hedging, ESMA has determined that share classes which differentiate between groups of investors on the basis of hedging arrangements are not compatible with the common investment objective. ESMA sees currency risk hedging as an acceptable basis for differentiating a share class as it supports the single market and provides a means to level the playing field across the EU. According to ESMA, it is ‘a means to ensure that investors participate to the maximum extent possible in the same performance of the common pool of assets as other investors, even though their exposures to the fund is obtained through a different currency from the base currency of the fund.’
This principle is aimed at ensuring that features specific to one share class do not have adverse consequences for other share classes in the same fund. UCITS managers should implement appropriate procedures to ensure that this is not the case. Consequently, if a UCITS manager uses a specific derivative overlay for currency risk hedging purposes at share class level, he or she should ensure that the overlay is scaled and managed appropriately. In particular, the UCITS manager must observe a number of operational principles, including limitation of potential loss, counterparty risk limits, operational and accounting segregation and stress tests.
All features of a share class must be determined before the share class is set up. This is to allow a potential investor in the fund to gain a full overview on the rights and/or features attributed to his or her investments.
In share classes with currency risk hedging arrangements, the pre-determination also applies to the currency risk being hedged. However, this requirement does not limit the UCITS manager’s discretion as to the type of derivative instrument used to hedge the currency risk, nor its operational implementation.
UCITS managers must ensure that a fund with share classes provides a common level of transparency for all its investors by:
New and existing investors must be informed about the creation and existence of share classes in a timely fashion, including updates in periodic reports.
In order to allow investment funds sufficient time to comply with the new principles, the opinion sets out transitional arrangements for share classes that were established prior to 30 January 2017 and which do not comply with the principles. Specifically, pre-existing share classes that do not comply with the principles can continue to operate subject to two conditions, namely such share classes must be closed for:
For the most part, the principles set out in the opinion are in line with the current regulatory treatment of share classes by the Central Bank of Ireland (CBI). One key difference lies in the treatment of interest rate hedging at share class level, which, while currently permitted by the CBI subject to the fulfilment of certain conditions, are likely to be prohibited following the release of the opinion.
UCITS managers with share classes customised on the basis of interest rate risk (and other non-currency risk) will need to take measures to restrict access to those share classes over the coming months. In future, when establishing a new UCITS, a UCITS manager will not be able to achieve hedging at share class level (other than currency risk hedging) and will probably need to set up a separate fund (or sub-fund) if he or she wishes to offer investors exposure to the same pool of assets, but with the option of certain risks (interest rate risks) being hedged.