3 minute read 8 Oct 2020

CSSF FAQ on CSSF Circular 02/77

Authors
Kerry Nichol

EY Luxembourg Wealth & Asset Management Partner

Provider of wealth and asset management services. Connecting clients to EY globally. Team player.

Jean-Marc Cremer

EY Luxembourg Wealth and Asset Management Partner

Independent auditor of Wealth and Asset Management clients. Having strong knowledge of the investment fund industry and Luxembourg regulations. Passionate about gardening. Father of two boys.

3 minute read 8 Oct 2020

On 7 July 2020, the CSSF issued a Frequently Asked Questions document describing how CSSF Circular 02/77 should  be applied by investment fund managers

Background

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SSF Circular 02/77 (the “Circular”) issued on 27 November 2002 concerns the protection of investors in case of NAV calculation error and the compensation of the consequences resulting from non-compliance with the investment rules applicable to undertakings for collective investment (“UCI”).

Primary Change

On 7 July 2020, the CSSF issued a Frequently Asked Questions document (“FAQ”) describing how CSSF Circular 02/77 should  be applied by investment fund managers (“IFMs”, i.e. UCITS management companies, authorized alternative investment fund managers, self-managed UCITS and internally-managed AIFs).

The FAQ clarifies the scope of application of the Circular, the process to select the method of correction for NAV errors and  the circumstances in which tolerance thresholds are applicable.

Key Points

1. General clarifications on the scope of the Circular
  • In the case of an active investment breach that corrects itself through market evolution or new subscriptions, the unrealized loss generated by the holding of the excess security position during the breach period should be compensated to the UCI.
  • Intraday active investment breaches and breaches that occur between two official NAVs should be notified to the CSSF and compensated in accordance with the provisions of the Circular.
  • CSSF notification or remedial action plan are not required in case of investment breaches beyond the control of the UCI (“passive breaches”)  but the remediation of the investment breach should be a priority for the IFM.
  • In cases where (i) there are no subscriptions and redemptions occurring during the NAV error period, or (ii) the corrective action resulted in a gain for the UCI, only a notification including the financial impact calculation, and not a Remedial Action Plan, is required to be sent to the CSSF. However, the notification should include corrective measures to avoid the recurrence of the same type of error/breach and the external auditor of the UCI has to review the correction process during its annual audit of the UCI and provide the related results in the Long Form Report and/or the Management letter.
  • In case of an active investment breach where the compensation amount for the UCI exceeds EUR 25,000 and no compensation is due to investors, both the notification and the Remedial Action Plan are required. The external auditor of the UCI has to report on the Remedial Action Plan pursuant to the Circular.
  • When the UCI makes use of the de minimis amount for compensating the investors which are financially impacted by a material NAV error calculation, prior approval from the CSSF is not required but the CSSF may request  the UCI, on an ex-post basis, to provide documentary evidence that such amount represented the bank charges necessary to transfer the compensation amount to investors (notably where the “de minimis” amount  exceeds EUR 25). The IFM’s internal policy should provide for the use and the level of the “de minimis”  amount.
  • The FAQ clarifies that the CSSF will not confirm in writing closure of an incident based on the action taken   as disclosed in  the notification, but may , on an ex-post basis, raise additional questions or require further remedial action if the corrective actions are not deemed sufficient or compliant with the Circular.
  • The FAQ also clarifies that a breach of UCITS and AIFs leverage limits does not need to be notified to the CSSF in the context of the Circular. However, adequate monitoring and correction in accordance with applicable internal procedures is expected.
  • The CSSF clarifies that specialized investment funds (“SIFs”) may either opt for the application of the Circular or set specific internal rules. In the absence of specific internal rules, the Circular applies. All material NAV errors and active investment breaches have to be notified to the CSSF, whether the SIF applies the Circular or specific internal rules. When SIFs opt for the application of the Circular, a remedial action plan is not required but the external auditor has to review the correction process and the related compensation and confirm in the management letter that they complied with the provisions of the Circular.
2. Clarification on certain types of investment rules
  • In case of a breach of compliance with the UCITS 5/40% rule [1], the UCITS does not necessarily have to sell the securities that caused the breach. The FAQ describes three acceptable methods (impact by reference to security which caused the breach (use of accounting method), impact by reference to other security sold to correct the breach (use of accounting method) or impact by reference to the performance of the reference portfolio (economic method)). However, where the method is not laid down in writing in the internal policy of the IFM, the impact should be calculated by reference to the security which caused the breach, by applying the accounting method in proportion to the amount in breach.
  • A breach of the UCITS 20% deposit limit is considered to be active every time the event which caused the breach, such as a settlement date mismatch (between the capital activity and the portfolio transactions or between several portfolio transactions) or the maturity of security, is predictable and avoidable. The organization of the portfolio management function by the IFM at the level of the UCITS (i.e the investment operations, the cash management and subscription/redemption flows) should provide for ongoing compliance with the 20% deposit  limit.
  • Where the UCITS 20% deposit limit is breached and the deposit returns negative interest, the UCITS should be indemnified in  relation to the interest rate and other charges borne by the UCITS. Financial impact cannot be derived from a comparison with interest rates between different bank accounts.
  • The CSSF also confirmed that the Circular applies in case of breach of the UCITS collateral diversification rules and other criteria that the collateral has to observe, but a financial impact calculation is only necessary in case of a counterparty default.
3. Governance and organizational requirements
  • The CSSF considers that the organization of IFMs managing Luxembourg domiciled UCIs  should provide for robust policies, processes and procedures governing the treatment of NAV calculation errors and investment breaches and, in particular a detailed policy approved by the Board of Directors of the IFM and, if applicable, by the Board of Directors of the UCI. 
  • The policy and related procedure should cover, inter alia:
    • The governance process, together with the different stakeholders involved, applied in relation to NAV calculation errors and investment breaches
    • The oversight of the delegates where NAV calculation and investment compliance are delegated
    • The definition of active vs. passive investment breaches and applicable criteria (considering notably which events are or are not beyond the control of the UCI)
    • The different steps and the timeline in relation to the correction of errors and breaches
    • The NAV error threshold applicable for each sub-fund
    • The use and the level of de minimis amounts
    • The methodology used by the sub-fund for the financial impact calculation: accounting (e.g. Average Weighted Cost, LIFO, FIFO) vs. economic method (setting the comparative reference index to be used by sub-fund)
    • The application of the compound or non-compound method used by the sub-fund for the financial impact calculation
    • The periodic review of the adequacy and the effectiveness of the policy, processes and procedures.

SIFs which are not managed by an AIFM should also establish and implement such a policy. The CSSF also recommends UCIs subject to Part II of the Law of 17 December 2010 which are not managed by an AIFM to establish and implement such a policy.

4. Conditions required for the application of the economic method to determine the financial impact
  • As per Circular CSSF 02/77 the economic method calculates the  compensation  by  reference  to  the  performance  which  would  have  been  realised in case the non-compliant investments would have had the same  fluctuations as the portfolio invested in compliance with the investment policy  and the investment restrictions provided for by law or the prospectus
  • The use of the economic method is only permitted if it is defined in the internal policy that governs the UCI, approved by the Board of Directors of the IFM and, if applicable, by the Board of Directors of the UCI. This policy must include the reference benchmark index used to measure the comparative performance against the non-eligible asset. The reference benchmark index should be a fair representation of the investment policy, or a part thereof laid down in the UCI prospectus. IFMs should be able to demonstrate and to evidence with necessary documentation that the comparative performance and the method does not prejudice the investors and has not been selected with the objective of minimizing compensation payments. 
  • The CSSF confirmed that it is not acceptable to compare the performance of the non-eligible asset with a  corresponding eligible asset having the same characteristics 
  • In case of an umbrella fund, the choice of the methodology is possible at the entity level or at sub-fund level. 
  • It is possible, within the same UCI, to use different methods (accounting/economic) for different types of active investment breaches if this is formally laid down in the internal policy of the IFM and applied on a consistent basis. 
  • Any change of the method used to correct investment breaches is only possible if there is an adequate justification and if it has been approved by the Board of Directors of the IFM and, if applicable, by the Board of Directors of the UCI. It is in principle not permitted to change the correction method applied when it has been previously determined to use a given method for a certain type of breach. It is only possible, upon approval by the Board of Directors of the IFM and, if applicable, the Board of Directors of the UCI, to change the method prospectively, i.e. for the next investment breach of the same type.
5. Tolerance thresholds
  • The over charging of  fees/costs to the UCI have to be reimbursed to the UCI in all cases, irrespective of the materiality threshold laid down in the Circular. However, the recalculation of NAV is only necessary where the reimbursed fees/costs exceed the materiality threshold.
  • Where no tolerance threshold is applied by an UCI or the tolerance threshold defined in the internally approved policy is lower than the threshold laid down in the Circular, NAV calculation errors should be notified to the CSSF and all provisions of the Circular apply based on the lower thresholds as determined for  the UCI
  • In order to determine the materiality threshold applicable to a fund of funds, an index tracker or a feeder fund, a UCI should consider the investment policy of the target investments on a look-through basis, i.e. the investment policy of  the target funds or master fund or the investment policy  of the assets/funds in the tracking index.
Practical considerations

IFMs should assess their current governance, policies, processes and procedures to make sure they match the CSSF’s expectations in terms of correction of NAV errors and investment breaches.

[1] The total value of the transferable securities and money market instruments  held by a UCITS in the issuing bodies in each of which it invests more than 5% of its net assets shall not exceed 40% of the value of its net assets

Summary

About this article

Authors
Kerry Nichol

EY Luxembourg Wealth & Asset Management Partner

Provider of wealth and asset management services. Connecting clients to EY globally. Team player.

Jean-Marc Cremer

EY Luxembourg Wealth and Asset Management Partner

Independent auditor of Wealth and Asset Management clients. Having strong knowledge of the investment fund industry and Luxembourg regulations. Passionate about gardening. Father of two boys.