Reform of Circular CSSF 02/77 on NAV calculation errors and investment breaches

Introduction

The CSSF published Circular CSSF 24/856 on investor protection in the event of a NAV calculation error, non-compliance with investment rules, and other errors (“Circular 24/856”) on 29 March 2024.Circular 24/856 will replace Circular CSSF 02/77 on NAV calculation errors and investment breaches (“Circular 02/77”) as of 1 January 2025. Circular 24/856 contains provisions for managers of undertakings for collective management (“UCI”) in relation to net asset value (“NAV”) calculation error, non-compliance with investment rules, as well as incorrect application of swing pricing, non-compliant payment of costs/fees at UCI level, incorrect application of cut-off rules, and investment allocation errors (“Other Errors”). Circular 24/856 codifies general legal and regulatory developments, administrative practice, and evolutions in the Luxembourg fund industry over the last two decades.

Circular 24/856 will be an essential element of the Luxembourg regulatory framework for the in-scope UCIs as of 1 January 2025. Circular 24/856 is presently only available in French.

Circular 02/77 continues to apply to any errors and non-compliance that will occur until 1 January 2025.

On a general note, attention should be drawn to the fact that prospectuses of in-scope UCIs that are either issued for the first time or updated before 1 January 2025 must contain the following provision: “the rights of final beneficiaries may be affected when compensation is paid in the event of errors/non-compliance occurring at UCI level when they have subscribed to UCI units through a financial intermediary”. This provision is mandatory for UCITS, Part II UCIs, MMF, and ELTIFs. It also applies to SIFs and SICARs issuing new shares or units to new investors. In other cases, the in-scope UCIs must communicate the required information to investors via the official and common communication channels provided for in the constitutional documents and/or the prospectus.

Scope of Application and general principles

Circular 24/856 directly applies to UCITS, Part II UCIs, SIFs, SICARs, including UCITS, Part II UCIs and SIFs set up as money market funds (“MMF”), and Part II UCIs, SIFs and SICARs set up as ELTIF, EuVECA, or EuSEF.

Circular 24/856 directly applies to all Luxembourg ELTIF and Luxembourg MMFs subject to the supervision of the CSSF, and all Luxembourg EuVECA and EuSEF. Unregulated alternative investment funds, including RAIFs, do not fall directly within the scope of the Circular. Some provisions of Circular 24/586 do, however, apply indirectly to alternative investment funds, including RAIFs, that qualify as Luxembourg MMF, ELTIFs, EuVECA, or EuSEF.

The management body of the UCI, or the IFM, under the supervision of the management body of the UCI, when applicable, are responsible for, among other things, preventing the occurrence of errors/non-compliance at the UCI level, handling such errors/non-compliance, and compliance with Circular 24/856. It entails ensuring that the relationships with the service providers involved are covered by adequate arrangements including contractual arrangements. The IFM must make sure that the error is corrected, and that any loss suffered by the UCI and/or its investors is compensated.

The persons who have caused the error/non-compliance due to a failure to comply with their obligations and resulting in prejudice to the UCI and/or its investors shall also ensure appropriate reparation.

Circular 24/856 also provides for specific provisions applicable to the management body of the UCI, the IFM (Luxembourg IFM, cross-border IFM, and EuVECA or EuSEF managers), the fund administrator, and the depositary.

NAV Calculation errors

Circular 24/856 provides for materiality thresholds expressed as a percentage of NAV for MMFs (0.2%), UCITS (0.5% to 1%), and Part II UCIs and ELTIF open to retail investors (0.5% to 1%).

For Part II UCI and ELTIF reserved for well-informed or professional investors, SIFs, SICAR, EuVECA, and EuSEF, the management body and the IFM may determine the applicable threshold in accordance with an analysis based on specific criteria which must be properly documented. Such a threshold shall not exceed 5% and shall not be set at 5% by default as such a threshold must be the result of a specific analysis (whether the UCI is closed-ended or not, risk profile, investment policy, etc). If such threshold exceeds 0.5%, or 1% accordingly, investors must be informed.

UCIs may set lower materiality thresholds subject to a consistent and continuous application and compliance with any stricter thresholds imposed in countries where the UCI is marketed, as the case may be. Policies and procedures relating to the NAV calculation errors must be in place for the UCI.

Non-compliance with investment rules

The investment rules to comply with are listed in Circular 24/856. They are the rules on asset eligibility, portfolio management techniques, and investment restrictions in the regulations applicable to UCIs, rules defined in the constitutional documents and/or the prospectus, assets authorised by the investment policy, and quantitative or qualitative investment restrictions.

Circular 24/856 differentiates between active breaches and passive breaches. Although active breaches must be notified to the CSSF, such a requirement does not apply to passive breaches.

The thresholds relating to the materiality of NAV calculation errors do not apply to non-compliance with investment rules.

In case of an active breach of the investment rules, the necessary measures must be decided without delay in order to regularise the situation of the UCI. The time necessary for the implementation of the regularisation action varies according to the type of UCI, its investment policy, and the assets held in the portfolio. For UCITS and UCIs investing in liquid assets, the implementation of the regularisation action must take place directly after the detection of active non-compliance. For UCIs other than UCITS which invest in less liquid or illiquid assets (e.g. SIFs, SICARs, Part II UCIs), the regularisation decision must also be taken without delay, but the implementation of this decision may take longer.

Policies and procedures relating to non-compliance with investment rules must be in place for the UCI.

Other Errors

Circular 24/856 deals with Other Errors at the UCI level and provides detailed rules for each Other Error.

In case of a swing pricing error, the UCI must be compensated for the loss it suffered, and the investors must be compensated according to rules applicable to material NAV errors. The rules applicable to swing pricing errors also apply mutatis mutandis to other liquidity management tools.

Where a UCI has paid too high an amount of costs/fees compared to the amount provided for in the constitutional documents and/or the prospectus, this error must be corrected, and the UCI must be compensated for the amount of the costs/expenses paid in excess. Where a UCI underpaid costs/fees when compared to the amount provided for by the constitutional documents and/or the prospectus, any correction of this error shall not prejudice investors who should not have borne these costs/fees. Any such correction must not cause prejudice to investors as a result of the ex-post charging of costs/charges to the UCI when such investors have not benefited from the related services.

In case of incorrect application of cut-off rules, the UCI must take the necessary measures to rectify the prejudice suffered by the UCI and/or the investors as a result of the investors having obtained a different NAV than the one they were entitled to. Where the investor who has unknowingly benefited from such an error in the incorrect application of cut-offs qualifies as a sophisticated/professional investor, the UCI may ask such an investor to reimburse the sums from which he has unduly benefited. For investors who are not sophisticated/professional investors, it is not, in principle, appropriate to ask them to reimburse the sums from which they have unduly benefited.

In case of investment misallocations, the UCI must be compensated for the loss incurred on the investments allocated in error. If the erroneously allocated investments have generated a profit, this profit must be retained by the UCI.

Indemnification or reimbursement

The UCI or the IFM, if applicable, must ensure that the indemnification is made without delay and that the compensation due to the UCI and/or investors is paid to them after quantification. The UCI must ensure that the final beneficiaries, who have subscribed/purchased via financial intermediaries, receive the compensation due to them as a result of the error/non-compliance. If it cannot do so, the UCI must nevertheless ensure that all the necessary information relating to the error/non-compliance is provided to the financial intermediaries, so that these financial intermediaries can assume their responsibilities and make the necessary compensation payments to the final beneficiaries.

The UCI may apply the de minimis rule for the payment of compensation to which investors are entitled, but the de minimis rule does not apply to compensation payable to the UCI.

Independent Auditor

Circular 24/856 distinguishes the separate report under Circular CSSF 21/790 and the new special report under Circular 24/856. When preparing the separate report under Circular CSSF 21/790, the independent auditor shall verify the errors and non-compliance matters to ensure compliance with Circular 24/856. A material NAV calculation error in a closed-ended UCI (Part II UCI) does not require any separate report. The new special report is required when the error/non-compliance concerns a UCITS or a Part II UCI, and the total amount of compensation is greater than EUR 50,000 or the amount to be compensated to a single investor is greater than EUR 5,000. The additional verifications to be mentioned in the new special report relate to compliance with the rules about financial intermediaries, adequacy of the notification to CSSF, the de minimis rule, and the origin of the error/non-compliance and related corrective measures.

Notification of errors/non-compliance to the CSSF

Circular 24/856 provides for the notification of any material NAV calculation errors, active non-compliance with investment rules, and Other Errors to the CSSF through the relevant notification form to be available from the website of the CSSF. When an error or non-compliance issue requires a special report from the auditor, such special report must be transmitted to the CSSF within 3 months following the submission of the complete notification. The notification period is a maximum of 4 to 8 weeks after the date of detection of the error/non-compliance. The CSSF must be informed of the progress of compensation payments or the special report, as the case may be, on a monthly basis.

The CSSF does not approve corrective measures notified to it, but it may at any time, on an ex-post basis, carry out specific supervisory actions. The competent authorities of the other countries where the UCI is marketed must be duly informed about the errors/non-compliance according to applicable local rules.

Documents yet to be published before 1 January 2025

The CSSF will make available to the industry, sufficiently in advance, an adjusted notification form.

New FAQs are expected in relation to Circular CSSF 24/856 to replace the FAQs relating to Circular CSSF 02/77.

The procedures of the separate report of Circular CSSF 21/790 will also be updated, in order to take into account, the provisions of Circular 24/856.

Author: Thomas Wurtz

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