CSSF CIRCULAR 24/856: Tolerance Threshold Analysis and Corrective Actions – What is The Impact on Open-Ended vs. Closed-Ended UCIs? 

On 28 March 2024, the CSSF issued Circular 24/856 (the “Circular”) to establish a new regulatory framework for investor protection concerning NAV calculation errors and non-compliance with investment rules at the UCI level. Effective from 1 January 2025, this Circular replaces the previous CSSF Circular 02/77. Its objectives are to modernize regulations, enhance transparency, and strengthen governance within the asset management industry. This change will necessitate significant operational adjustments for fund managers and UCI stakeholders. As private equity (PE) fund managers prepare for these changes, a crucial question arises: how will the impact differ for open-ended versus closed-ended UCIs?

Objectives and Impact of Circular 24/856

The Circular consolidates previous regulatory provisions into a single, comprehensive document, refining the regulatory environment for asset managers. The CSSF aims to enhance investor protection by clearly outlining the roles and responsibilities of stakeholders involved in UCI management, administration, and control. A key requirement of the Circular is the mandatory establishment of internal policies and contractual arrangements with service providers, delegates, and sub-delegates.

By streamlining these elements, the CSSF seeks to ensure that governance structures are robust and compliant with up-to-date regulatory standards. Additionally, the Circular introduces provisions to address various types of errors at the UCI level, with the goal of creating a cohesive and efficient system for managing potential risks. As a result, fund managers will need to update their compliance frameworks, risk management practices, and internal procedures to meet the new requirements, ensuring better protection for investors.

NAV Calculation and Tolerance Thresholds

The NAV calculation process for each UCI is influenced by several factors, including structural complexities, asset liquidity, market characteristics, and the availability of information. Historically, these factors led the regulator to define different tolerance thresholds to identify errors relevant to the specific features of each UCI. As per the new Circular (paragraph 4.2), only errors that result in NAV deviations above these thresholds must be reported to the CSSF, with the notable exception of closed-ended UCIs, which are excluded from the guidelines set out in Chapter 4 of the Circular.

The Circular does not impose mandatory thresholds for SIFs, SICARs, or UCIs Part II and ELTIFs intended for professional investors. Instead, it requires that the UCI or the IFM management body conduct a "well-documented analysis" that meets several specific criteria. This analysis must take into account the UCI's characteristics, including its subscription and redemption frequency (whether it is open-ended or closed-ended), investment and valuation policies, risk profile, and the liquidity and volatility of the markets in which the investments are made. Additionally, the analysis must consider the thresholds set for UCIs Part II and ELTIFs reserved for non-professional investors. Importantly, this analysis cannot bypass the 5% NAV threshold and must be available to the CSSF upon request.

Within the alternatives industry, closed-ended UCIs typically engage in less liquid or illiquid investment strategies, or a mix of both. These types of UCIs appear to be excluded from the general provisions in Chapter 4 of the Circular. There is no obligation to notify the CSSF in the event of NAV errors for these products. The Circular refers only to a general compliance requirement with the UCI’s laws or by-laws and the need for internal policies and procedures to ensure compliance, including corrective measures. This exclusion is further confirmed by the provision stating that the REA will not intervene in cases of significant NAV calculation errors, except to verify that the valuation of the UCI’s assets and liabilities complies with its by-laws during statutory audits.

Implications for Closed-Ended UCIs and Timing of Remedial Actions

While closed-ended UCIs were initially excluded from the notification obligations for NAV errors under Chapter 4 of the Circular, the Circular does seem to suggest that these UCIs must still consider a documented threshold analysis. This analysis could be simplified and embedded into the general policies and procedures of each UCI, particularly for newly established UCIs. The Circular indirectly links closed-ended UCIs to the tolerance threshold analysis by referencing the "open/closed-ended" nature of these products as a key factor when drawing up the analysis. As a result, further provisions in Chapter 4 of the Circular might still apply to closed-ended UCIs, depending on the specific circumstances. For example, UCI/IFM managers of closed-ended products will likely need to ensure information sharing among all stakeholders (including the management body, administrator, and depositary) and make timely decisions on the implementation of corrective actions.

Timing of decisions and the implementation of remedial actions are also crucial elements, as highlighted in Chapter 5 of the Circular, which addresses non-compliance with investment rules. These rules affect investment and capital activities and are outlined in laws, EU regulations, constitutive documents, and prospectuses. In contrast to NAV errors, no tolerance thresholds apply here, except when breaches of investment rules result in NAV errors. However, the Circular makes no distinction between open-ended and closed-ended funds when defining the response to active or passive non-compliance, but makes direct reference to the liquidity of the UCI’s investments when establishing the response to active and passive compliance breaches. In the case of passive non-compliance, both open-ended and closed-ended UCIs may choose whether or not to implement corrective measures, provided they do so in the best interests of investors. In the case of active non-compliance, less liquid or illiquid UCIs are allowed more time to implement corrective actions, whereas more liquid UCIs must act without delay. Regardless of the UCI type, any corrective action must be decided promptly according to the UCI’s internal policies and procedures, which must be established at the time of incorporation.

Unified Framework for UCI Management

The Circular aims to streamline regulatory practices for UCIs, providing clear guidance on the tolerance threshold analysis and corrective measures required in cases of NAV errors or non-compliance with investment rules. While the Circular creates a unified framework for open-ended and closed-ended UCIs, differences in the implementation timing of corrective actions reflect the liquidity and investment strategy of the UCI. Both types of UCIs must comply with these regulations, ensuring that tolerance threshold analyses are conducted, and remedial actions are implemented as part of their internal policies and procedures. These measures contribute to a more robust and transparent regulatory environment, benefiting both investors and asset managers.

The Circular has significant implications for the PE sector in Luxembourg, embracing certain products that were typically excluded from the application scope of such prudential supervision. As a consequence, implementing the Circular's requirements could increase the operational burden on PE fund managers dealing with closed-ended/illiquid products, which might need to invest in new systems, enhance existing procedures, and allocate more resources to comply with the new provisions. Additionally, PE players will face an increased level of transparency in their initial and periodic communication towards the investors about errors and corrective actions, starting from the offering documents and internal manuals’ update. Last but not least, closed-ended/illiquid products might represent a strong incentive for the PE firms to enhance their valuation processes and ensure they have robust procedures in place to handle potential discrepancies.

Conclusion

These changes, while ambitious, represent a pivotal moment to strengthen the industry’s core frameworks and build a more resilient and forward-looking ecosystem, with their full potential unfolding over time. The Circular introduces significant operational adjustments for both open-ended and closed-ended UCIs regarding tolerance thresholds and corrective actions. While closed-ended UCIs are partially exempt from certain obligations, they must still implement robust internal policies to comply with the new requirements. Fund managers, particularly in the private equity sector, will need to invest in new systems and enhance their governance processes to meet the increased demands for transparency, compliance, and risk management.