On 19 March 2007, following over two years of cooperation and consultation with the Committee of European Securities Regulators (CESR), the European Commission adopted its Directive on eligible assets for UCITS (Council Directive 2007/16/EC of 19 March 2007 implementing Council Directive 85/611/EEC of 20 December 1985 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) as regards the clarification of certain definitions).

The UCITS Directive of 1985, as amended, created the first European retail financial product. By harmonising the features of collective investment undertakings, the UCITS Directive paved the way for effective cross-border competition and uniformly high level of protection of investors in the EU.

The UCITS Directive defines transferable securities exclusively from a formal-legal point of view. Accordingly, the definition of transferable securities is applicable to a wide range of financial products with differing features and different levels of liquidity. Since the adoption of the UCITS Directive, the variety of financial instruments traded on financial markets has increased considerably, leading to uncertainty in determining whether categories of financial instruments are encompassed by those definitions. Such uncertainty gives rise to divergent interpretations of the UCITS Directive and subsequently compromises uniformity in the application of these legislative provisions.

In order to ensure uniform application of the UCITS Directive, help member states to develop a common understanding as to whether a given asset category is eligible for a UCITS and to ensure that the definitions are understood in a manner consistent with the principles underlying UCITS Directive, the Commission recognised the necessity to provide regulators and market participants with more certainty in this respect.

In October 2004, the European Commission issued a mandate to CESR requesting its technical advice, in its capacity as an independent advisory group, regarding clarification of definitions relating to what financial instruments a UCITS can invest in, that is, eligible assets. Article 1 of the UCITS Directive defines these, at a high level, as being 'transferable securities and… other liquid financial assets'. Other articles, in particular Article 19, set out rules in more detail.

Availing of Article 53a, which provides that technical amendments may be made to the UCITS Directive to clarify definitions 'in order to ensure uniform application of the Directive throughout the Community', CESR embarked on a period of consultation before publishing its final advice prepared by its expert group on investment management to the Commission in January 2006, together with a feedback statement. The advice set out suggested measures that could be adopted at 'level 2' and 'level 3'. (Under the Lamfulussy process, a four-level procedure is applied to financial services legislation. Level 1 constitutes framework legislation; level 2 covers implementing measures for level 1 legislation; level 3 consists of supervisory committees facilitating the convergence of regulatory practice and level 4 concerns enforcement of EU measures.)

On 19 March 2007, following consideration of CESR's advice, the European Commission adopted the final implementing Directive with regard to eligible assets for UCITS. The clarifications provided by Directive 2007/16/EC 'do not of themselves give rise to any new behavioural or operational obligations for competent authorities or market participants'. Rather than establishing exhaustive and finite lists of financial instruments and transactions, it sets out basic criteria as an aid in assessing whether or not a class of financial instrument is covered by the various definitions. These measures are aimed at removing uncertainty as to whether UCITS can properly invest in the following financial instruments:

• asset backed securities
• listed closed-ended funds
• Euro commercial paper
• index based derivatives, and
• credit derivatives.

It is clear that the eligibility of an asset for a UCITS must now be assessed not only with regard to the requirements of the UCITS Directive but also with regard to whether it falls within the scope of the definitions as clarified by the text of Directive 2007/16/EC.

The Directive on eligible assets for UCITS lays down rules clarifying, for the purposes of their uniform application, the following terms:

1. transferable securities, as defined in Article 1(8) of Directive 85/611/EEC
   
   
2. money market instruments, as defined in Article 1(9) of Directive 85/611/EEC
   
   
3. liquid financial assets, as referred to in the definition of UCITS laid down in Article 1(2) of Directive 85/611/EEC, with respect to financial derivative instruments
   
   
4. transferable securities and money market instruments embedding derivatives, as referred to in the fourth paragraph of Article 21(3) of Directive 85/611/EEC
   
   
5. techniques and instruments for the purpose of efficient portfolio management, as referred to in Article 21(2) of Directive 85/611/EEC, and
   
   
6. index-replicating UCITS, as referred to in Article 22a(1) of Directive 85/611/EEC.

The following may be regarded as key developments in the categorisation of eligible assets for UCITS:

• closed-end funds are regarded as transferable securities provided that they are subject to certain corporate governance mechanisms
  
  
• credit derivatives are regarded as eligible for a UCITS provided that they are in compliance with the criteria applicable to OTC derivatives
  
  
• derivatives on a single commodity remain forbidden, and
  
  
• financial indices, whether or not comprised of eligible assets, can be considered as eligible financial indices once they are sufficiently diversified, represent an adequate benchmark for the market to which they refer and are published in an appropriate manner.

CESR has compared the text of the implementing Directive with the advice it provided to the Commission, and has decided to adopt, at level 3, guidelines covering the text which was not included in the implementing Directive.

There is one area of potential level 3 material which remains outstanding, relating to the classification of hedge fund indices as eligible assets for investment by UCITS. CESR is currently consulting on this issue, and if appropriate, will issue additional level 3 guidelines in mid-2007.

Member states will bring the implementing Directive into effect as a single package of measures by adopting and publishing, by 23 March 2008 at the latest, the laws, regulations and administrative provisions necessary to comply with Directive 2007/16/EC and shall apply those provisions from 23 July 2008.

The Directive on eligible assets and the accompanying CESR guidelines represent a constructive and positive step in this area providing for the consistent, uniform and standardised application of these rules relating to eligible assets for UCITS.

May 2007.

For further information please contact David Williams.