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News on Eligible Assets for UCITS in Germany
by
Ingo Heinen* and Kai-Uwe Steck**

For asset managers it is crucial to distinguish between harmonized funds – so-called UCITS (Undertakings for Collective Investment in Transferable Securities) – which have to comply with the relevant EU laws and regulations and enjoy, for example, a European passport, and non-harmonized collective investment schemes – such as hedge funds and private equity funds. The EU legislative framework for UCITS comprises binding Council Directive 85/611/EEC ("UCITS Directive") and its two amendments, 2001/107/EC and 2001/108 EC (together "UCITS III") and non-binding European Commission Recommendations on the use of derivatives (2004/383/CE), the simplified prospectus (2004/384/CE) and the recent advice from the Committee of European Securities Regulators ("CESR") on eligible assets (CESR/06-005)). The CESR Advice was requested to assist the European Commission in developing a legal text in the form of either a regulation or a directive. Indeed, most recently (September 2006), a draft Commission directive implementing the UCITS Directive on the clarification of definitions related to eligible assets for UCITS was published, together with a background note (Working Document ESC/44/2006). Implementation is expected in January 2007.

Since its implementation UCITS III has been interpreted differently by the various Member States. In particular, different rules have been enacted to govern eligible assets. In general, UCITS III allows UCITS to invest not only in listed securities and bonds, but also in bank deposits, money market instruments, financial derivatives, units of other UCITS and other undertakings for collective investment that do not qualify as UCITS. UCITS III do not allow, for example, instruments which refer to commodities.

To determine whether the assets of a UCITS are permissible, the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht - "BaFin") as well as the financial supervisory authorities in Luxembourg, Austria and France, use a so called "look-through" approach. As such, the BaFin identifies the assets which back, or provide performance to, structured financial instruments and assesses whether these are in line with UCITS requirements. This is critical for issuers, who want to use backing or linked assets which are not eligible under UCITS III, e.g. instruments referring to oil price or to commodities. Indeed, if a special purpose vehicle issuing such certificates directly invests into such a commodity, the "looking through" approach will almost certainly prevent this asset from being used for a UCITS. As a result, certificates have been synthetically linked to a gold index while the issuer invested in gold through, for example, another entity of its group. In these cases it is not possible for the BaFin to identify the assets which back the respective structured product as described above. Additionally, another reason for choosing this structure is driven by the desire to tax optimize the structured financial instruments.

In this context, CESR has published its final advice to the European Commission on the eligible assets of UCITS on 26 January 2006. CESR’s advice focuses among other topics on the clarification of definitions concerning eligible assets for investments of UCITS:

CESR specifically accepts that an index of commodity derivatives could qualify as an eligible asset for UCITS whereas a commodity derivative itself would not be permissible. Indeed, this is not seen as a circumvention of the restrictions on eligible assets. In CESR’s view, in addition to indices based on financial commodity-based derivatives, indices on property may be eligible too, provided they comply with the criteria developed, e.g. that the index is sufficiently diversified and represents an adequate benchmark for the market to which it refers. Based on this, CESR doubts that an index of property would meet these tests for an eligible index but expressly accepts the case for an index of shares investing in property. Given the complexities of hedge fund indices and the fact that they are still developing, CESR at this stage does not recommend allowing hedge fund indices to be considered as financial indices for the eligibility of UCITS.

Subsequently, in September 2006, the Commission published the above-mentioned draft directive in order to "clarify uncertainties among competent authorities and market participants as to whether certain instruments might qualify under the definitions of UCITS III". Through the draft directive, which is subject to change, the Commission follows CESR’s view and one can see the following trends emerging:

• The "look-through" concept as used by the BaFin will come to an end, if the working paper remains as it is in its final form, and provided that the structured financial instrument does not embed a derivative;
• Likewise, financial indices are admissible (under certain conditions), even if their underlying assets are not eligible. While CESR allowed this for at least commodities and property indices (see above), the current draft directive by the Commission also permits indices on hedge funds or other previously prohibited assets; and
• The draft directive excludes derivatives on commodities.

  Kai-Uwe Steck

The Commission chose its draft implementing measure in the form of a directive although originally the legal form was supposed to be that of a regulation. Accordingly, the Member States will be given the freedom to transpose the draft measure into their legal framework. By choosing the less appropriate legal form, the Commission has missed the opportunity to ensure a universally harmonized approach. But it will definitely increase the necessity of - as the Commission put it in its background note - "further coordination between competent authorities through the CESR network towards common approaches on practical day-to-day implementation".

Nevertheless, one can envisage a future scenario in which, following the recent CESR Advice, the draft directive of September 2006 could enable asset managers once more to invest via sophisticated structures into a widened range of assets. This would mean that the European regulators continue to allow the European funds industry to grow by supporting innovation, by having appropriate and strong regulations while still being able to facilitate new products. There is no doubt that, in this respect, this move from the Commission will be welcomed by many, in particular providers of structured products.

*) Ingo Heinen is Director, Product Development and Fund Derivatives at Nomura International plc. in London.
**) Dr. Kai-Uwe Steck is Partner and Head of the German Desk in London at Dewey Ballantine.

Dr. Kai-Uwe Steck
Dewey Ballantine LLP
Taunusanlage 1
60329 Frankfurt
Germany

T: 49 (0) 69.3639.3390
F: 49 (0) 69.3639.3333
E: ksteck@deweyballantine.com
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