IRELAND: IFSRA Policy Change on UCITS and Physical Short Selling

Friday October 5 2007

The Irish Regulator has published a Policy Change to the effect that UCITS should be able to enter into physical short selling arrangements even where this creates leverage within the scheme provided that certain requirements are met. The previously accepted wisdom was that UCITS could only short sell synthetically through the use of finanical derivative instruments.

This policy change is an important development as regards long / short funds and 130/30 strategies as Managers will now be able to physically short sell and use the proceeds from the short sales to invest in the additional long positions, rather than synthetically short selling through the use of financial derivative instruments.

This Policy Change follows on from the Eligible Assets Directive and CESR Guidelines on Eligible Assets and is the latest in a recent flurry of publications from the Irish, Luxembourg and German Regulators which give us a much greater understanding of the regulations in respect of UCITS eligible assets, derivatives usage, gearing, leverage and coverage.

Policy Change

On the basis of their review the Financial Regulator will now permit UCITS to engage in physical short strategies, provided that:

* The strategy only involves covered short sales, in accordance with the Regulations;

* Leverage generated, as measured by global exposure, falls within permitted limits;

* The strategy is subject to the submission of a risk management process in accordance with the requirements of Guidance Note 3/03, (UCITS-Financial Derivative Instruments), in particular in relation to the calculation of global exposure. As part of this submission the UCITS must demonstrate expertise and prior experience in relation to the use of short selling strategies; and

* The strategy is appropriately disclosed in the prospectus.

As regards `covered short sales, in accordance with the Regulations`, the IFSRA policy change acknowledges that where a stock is borrowed before entering into a short sale of that stock, this would be regarded as a covered short sale. A key issue for future discussion will be how much further that concept of `coverage` can be extended!

Disclosure

The Policy Change publication also requires that a UCITS which intends to engage in covered short selling will be expected to include the following in the prospectus:

* A clear description of the covered short-sale strategy including the stock borrowing arrangement;

* A statement, under risk factors, to the effect that shorting involves the risk of a theoretically unlimited increase in the market price of the short security positions and therefore the risk of unlimited loss;

* A statement to the effect that leverage is expected to be generated and an indication of the level of such leverage; and

* A statement that leverage will be measured in accordance with the requirements of the Financial Regulator and will be added to any exposure created through the use of financial derivative instruments.

This IFSRA policy change will require an amendment to Notice UCITS 12 and to Guidance Note 3/03. These changes will be effected as soon as possible.

Final thoughts

Whilst Funds-Axis strongly welcome this development, we would also note that this again demonstrates the significant differences that exist in the stances of the Member State Regulators, notwithstanding all the work that has been performed on eligible assets of UCITS by CESR and the European Commission.

Also, for UK Managers hoping to be able to prevail similarly of an ability to physically short sell there will be other challenges to be overcome; for example whether the trustee will be able to give a charge over the assets of the UCITS in connection with any stock borrowing.