The Central Bank of Ireland has clarified its position on breaches of contract of the minimum rating requirement that financial institutions are required to have when transacting in UCITS and non-UCITS funds.
The clarification follows the regulators July publication of services of notices and guidance notices, which prescribe minimum credit rating requirements for counterparties to OTC derivative transactions, prime brokerage arrangements and efficient portfolio management techniques including stock lending and repo transactions.
In the case of UCITS, OTC derivatives counterparties which are not banks and all counterparties to repo or stock lending arrangements must have a minimum credit rating of A-2 or equivalent or be deemed by the UCITS to have an implied rating of A-2 or equivalent. Alternatively, an unrated counterparty will be acceptable where the UCITS receives from an entity, which has and maintains a rating of A-2 or equivalent an indemnity or guarantee in respect of losses suffered as a result of the failure by the counterparty.
In the case of non-UCITS qualifying investor funds (QIFs), prime brokers must have a minimum credit rating of A-1 or equivalent. If a QIF enters into collateral arrangements with an OTC derivatives counterparty other than a prime broker, whereby assets of the QIF are passed outside of the control of the QIFs custodian and may be pledged, lent, rehypothecated or otherwise used by the counterparty for its own purposes, that counterparty must have a minimum credit rating of A-2 or equivalent or be deemed by the QIF to have an implied rating of A-2 or equivalent.
In the event of a breach of the Central Banks requirements, directors of the investment company/management company and the trustee must remedy that situation over a reasonable timeframe, taking due account of those interests. The director/management company or trustee must continue to actively monitor the credit worthiness of the counterparty by conducting internal ratings assessments on behalf of the investment fund. A decision to remain contracted to a counterparty inadvertently in breach of the Central Banks rating requirements should be supported by an internal rating assessment undertaken on behalf of the investment fund.
The Central Bank would consider that in the event of a downgrade of the credit rating to not below A-2, or equivalent, the relationship between the prime broker and the investment fund remain in place where net exposure of the fund to the prime broker is maintained at less than 40% of net asset value in the case of a qualifying investor fund (QIF) (or 20%/30% in the case of a professional investor fund).
Finally, the Central Bank has confirmed that it would not be permissible to enter into new transactions or arrangements with counterparties, which have been downgraded to below the prescribed minimum credit rating.