The European Securities and Markets Authority (ESMA) has issued a second consultation on the types of share classes that may be created within any one UCITS (Undertakings for Collective Investments in Transferable Securities) or sub-fund of an umbrella UCITS. It is an ongoing example of ESMA dedicating time to the objective of consistency of approach as between the national regulators, despite its very heavy workload in dealing with hundreds of Level 2 measures.
Consistency of regulatory interpretation and supervisory approach is viewed as especially important for UCITS given its retail passport. UCITS managers will need to review their fund ranges across their fund domiciles and to adjust or restructure any share classes that fall on the wrong side of the line.
Further to its Discussion Paper of last year, in which ESMA commented on examples of appropriate and inappropriate share classes, in its view, it has now issued a second consultation proposing four principles which should be met: common investment objective, non-contagion, pre-determination and transparency. This differs from its original example-based approach, but, as we predicted last year, ESMA’s view remains that hedging (other than of currency risk) does not generally meet the first principle. The deadline for response is 6 June.
There are various business reasons why share classes are preferred over sub-funds (as set out in the paper) and there are divergent national regulatory approaches.
Each sub-fund of a UCITS differs from other sub-funds in its investment strategy or other characteristic. Commonly, the assets of one sub-fund are legally separated from the assets of the others, so a liability arising in one cannot be offset by the assets of another.
Share classes of the same UCITS or sub-fund allow subsets of investors to achieve some level of customisation, such as the distribution or accumulation of income or a particular tax treatment. There is no legal segregation of the assets of one share class from another.
Common investment objective means that all share classes share the same pool of assets. ESMA notes that some respondents argue that derivative overlays hedge out some of the risk factors of that common pool of assets, while others believe that common investment objective also mean a common risk profile.
Non-contagion: There should be appropriate procedures in place to minimise the risk that features specific to one share class cannot have a potentially adverse impact on others. Again, ESMA believes that derivative overlays create spill-over risk, so do not meet this principle.
Pre-determination: All features a share class should be determined before it is set up.
Transparency: Differences between share classes should be disclosed to investors who have a choice of class.
National competent authorities will need to review their national rules and approach and firms will need to review their existing share classes. In some jurisdictions, this might result in certain types of share classes being allowed, but the greater impact will be in those fund domiciles where the rules or approach have to date been more liberal than ESMA’s proposal. Some share classes may have to be adjusted and others withdrawn or merged. This will require an assessment of the impact on investors in those share classes and a clear communication strategy. And all managers will need to review procedures for minimizing contagion between share classes of any features.