How are Warrants Accounted for Within UCITS Schemes

Saturday August 20 2011

Relevant Directive Rule

The criteria dealing with this issue are set out in Article 57 (1)

UCITS IV

Overview

A Fund Manager wishing to invest in warrants must ensure the warrants themselves comply with investment limits at the time set out in the UCITS IV Directive at the time that they are acquired, but is not obliged to take into account the effect they would have if exercised at that point in time. The caveat to this is that it applies to proper warrants and not to the many structured products now called warrants / covered warrants which are more akin to listed futures or options.

If the warrant was exercised, and the exercising of the warrant subsequently put the fund into breach, then the fund would have to take corrective action to rectify the breach within a reasonable time frame and with investors interests in mind.

An example of the Financial Services Authority of the UK (“FSA’s”) interpretation of this is set out below for further information.

The attached FSA CP from 2007 at http://www.fsa.gov.uk/pubs/cp/cp07_18.pdf has the following comments:

Exercise of warrants

7.56 Article 26 of the Directive permits a UCITS operator to exceed investment limits when it exercises subscription rights attaching to transferable securities, provided that it corrects any resulting breach as a matter of priority, taking account of unitholders’ interests. We implement this provision through COLL 6.6.14R, which allows an AFM six months in which to correct any such breach, provided it was reasonably foreseeable at the time of the acquisition that no breach would occur. However, if the breach was foreseeable, it must be corrected as soon as reasonably practicable.

7.57 This means that an AFM wishing to invest in warrants must ensure the warrants themselves comply with investment limits at the time they are acquired, but is not obliged to take into account the effect they would have if exercised at that point.

However, in practice the rule provides the AFM with an appropriate incentive to review the exercise terms of the warrants, to be able to take advantage of the six-month correction period if it subsequently proves necessary.

7.58 For this reason, we do not consider that 5.2.17R (1) adds any benefit in terms of investor protection and we propose to delete it. We are aware that some AFMs and depositaries have interpreted this rule as requiring them to monitor continuously the impact of exercising holdings of warrants. We do not consider this necessary, and indeed it would be impossible for a fund that seeks to invest substantially in warrants to comply with such a requirement. When checking compliance with investment limits, AFMs must continue to assess holdings in warrants in the same way as for any other transferable security, based on their current valuation.

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