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



On 29 March 2024, the Luxembourg Commission de Surveillance du Secteur Financier (CSSF) published its long-awaited Circular 24/856 (the Circular) on investor protection in the event of net asset value (NAV) calculation error, non-compliance with investment rules and other errors at the level of the undertaking for collective investment (UCI). The Circular replaces the well-known Circular 02/77, whose reform was, according to the CSSF, necessary to reflect the numerous regulatory developments observed in the Luxembourg fund sector since its publication in 2002. One can notably mention the various updates to the undertaking for collective investment in transferable securities directive (UCITSD), the implementation of the alternative investment fund managers directive (AIFMD), the introduction of the specific product regulations (ELTIF, EuVECA, EuSEF, Money Market Funds), and the enactment of the laws relating to investment companies in risk capital (SICARs) and to specialised investment funds (SIFs). The CSSF finally advocates a need to consolidate in one single document the guidance given over the past years through various means such as CSSF FAQs and activity reports.

Key takeaways of the Circular

Extended scope of application

Besides undertaking for collective investment in transferable securities (UCITS) and UCIs Part II, the scope of application of the Circular has been extended to cover:

- specialised investment funds (SIFs);

- investment companies in risk capital (SICARs);

- UCITS, UCIs Part II and SIFs qualifying as money market funds (MMFs);

- UCIs Part II, SIFs and SICARs qualifying as European long-term investment funds (ELTIFs), European venture capital funds (EuVECA), and European Social Entrepreneurship Funds (EuSEFs);

- unregulated alternative investment funds, including reserved alternative investment funds (RAIFs), qualifying as MMFs, ELTIFs, EuVECAs, or EuSEFs, to the exception of rules on external auditors covered by Chapter 8 of the Circular.

Identification of stakeholders dealing with errors/non-compliance

In Chapter 3 of the Circular, the CSSF clarifies the roles of identified stakeholders dealing with errors/non-compliance. It starts by reminding that it is the responsibility of the UCI’s governing body to ensure that a sound organisation is in place to prevent as far as possible the occurrence of errors/non-compliance.

The Circular includes dedicated sections on the roles and responsibilities of (i) UCI managers; (ii) investment fund managers (IFMs); (iii) UCI administrators; and (iv) depositaries.

NAV calculation errors

The Circular also aims at defining a dedicated approach for the different types of funds concerning tolerance thresholds governing NAV calculation errors. In that context and similarly to Circular 02/77, the CSSF recalls that it is common practice that only NAV calculation errors whose percentage in relation to the NAV reaches or exceeds a certain threshold, called the tolerance threshold (referred to as "significant NAV calculation errors"), must be reported to the CSSF and corrected in accordance with the provisions of the Circular in order to safeguard the interests of the UCI and investors.

The following tolerance thresholds (in % of the NAV) apply to the different types of UCIs covered by the Circular, depending on the types of investors:

- UCI qualifying as MMF: 0.20% (as opposed to 0.25% under Circular 02/77)

- If offered to retail investors: UCITS, UCIs Part II and ELTIFs (except MMFs)

  • Bond UCIs: 0.50%
  • Mixed UCIs: 0.50%
  • UCIs in shares and other financial assets: 1%
  • UCIs investing primarily in other assets (e.g., unlisted stocks, eligible investments for ELTIFs): 1% (newly introduced)

- If offered to professional/well-informed investors: UCIs Part II, ELTIFs, SIFs, SICARs, EuVECAs and EuSEFs (except MMFs)

  • The tolerance threshold is to be determined by the UCI’s governing body, with the IFM to the extent applicable, and shall consider some of the key aspects of the UCI (e.g., investment policy, risk profile…).
  • The above-mentioned thresholds should be used as a reference and the CSSF expects UCIs Part II, ELTIFs or SIFs having similar investment policies to use similar thresholds.
  • If using a higher threshold, investors should be informed accordingly, but the tolerance threshold shall not exceed 5%.
  • Lower thresholds can be used if applied on a continuous and coherent basis.

The CSSF further provides methods for determining the financial impact of NAV errors and guidelines that should be observed when determining and applying the tolerance threshold. It introduces new guidelines regarding the correction of significant NAV calculation errors, whereby the administration and the depositary shall be informed right away. Compensation is only required when issuance and redemption of units have been made on the basis of significantly erroneous NAV and the UCI or IFM must notably ensure that all necessary measures are taken to correct and remedy the situation.

Non-compliance with investment rules

In principle, the UCI has to comply with investment rules (rules relating to eligibility of assets, portfolio management techniques and investment restrictions) set out in European regulations, sector-specific laws, grand-ducal regulations and CSSF regulations and circulars issued by the CSSF.

The Circular introduces the distinction between:

Active breaches: situations of non-compliance that are the result of (i) voluntary acts/operations, in particular investment or divestment decisions at UCI level, leading to non-compliance with a given investment rule; or (ii) the absence of acts/operations or decisions at UCI level when non-compliance with an investment rule was foreseeable and avoidable; and

Passive breaches: situations of non-compliance that are the result of acts or events beyond the control of the UCI, such as, for example, non-compliance resulting from fluctuations in the market price of the investments held by a UCI, which reduces the NAV used as a reference for calculating the use of a given investment restriction.

Passive breaches do not need to be reported to the CSSF, but corrective measures need to be taken within a reasonable period of time, taking into account the interests of investors.

The Circular sets out two corrective methods:

The accounting method: calculating the gain or loss realised in the UCI's accounts in relation to a breach of investment rules. It is the default approach used by UCIs; and

The economic method: comparing the financial impact of non-compliance calculated according to the accounting method with the performance that would have been achieved had the irregular investments been subject to the same fluctuations as the portfolio invested in accordance with the investment policy and investment restrictions laid down by the applicable regulations and the constitutional documents and/or the prospectus. This method may only be used if it is formally provided for in the internal policy in place for the UCI.

Other errors at UCI level

The Circular clarifies the guidelines to be followed by the industry, by notably consolidating in one single document all guidance given by the CSSF over the past years and market practice, in case of four other types of errors at the level of the UCI:

- incorrect application of swing pricing;

- error in the payment of fees and costs;

- incorrect application of cut-offs; and

- erroneous allocation of investments.

Correction of errors/non-compliance and indemnification

The Circular further clarifies that, when having recourse to financial intermediaries, the compensation scheme requires the UCI (along with distributors/financial intermediaries) to have the necessary arrangements in place to be able to move up the intermediation chain to ensure a compensation payment that takes into account the individual situation of each final beneficiary and therefore the loss he or she has suffered over the period of the error/non-compliance.

The Circular reiterates the de minimis rule according to which UCIs may not pay compensation to investors if these amounts do not exceed a certain amount, known as the de minimis amount, which is generally set at a flat rate. It also recalls the possibility of allocating additional units (or fractions of units, as the case may be) in lieu of a compensation payment.

Involvement of the external auditor

The external auditor must carry out specific checks as part of the preparation of the separate report under CSSF Circular 21/790, as fully described in Chapter 8.2 of the Circular.

However, an additional control should be performed when (i) the error/non-compliance concerns a UCITS or a Part II UCI, and (ii) the total amount of compensation exceeds EUR 50,000 or the amount to be compensated to a single investor exceeds EUR 5,000. Such additional control must be carried out directly after detection of the error/non-compliance at UCI level and must give rise to the issuance of a special report by the external auditor addressed to the UCI managers and the CSSF.

Notification of errors/non-compliance to the CSSF and other competent authorities

Any error/non-compliance must be notified to the CSSF, using the specific notification form made available on the CSSF website, within 4 to 8 weeks maximum after the date of detection of the error/non-compliance. Corrective measures performed by the UCI are not subject to prior approval by the CSSF, but the CSSF may at any time, on an ex-post basis, carry out specific monitoring actions in relation to notifications received.

Next step?

The Circular will come into force with effect from 1 January 2025, date on which the old Circular 02/77 will be repealed.

New rules of Chapter 8 on external auditors will start applying for fiscal years closing from 1 January 2025, and current rules laid down in Circular 02/77 should still be observed until that date.

Feel free to reach out to our experts, Julia Bruzzese, Aurélien Hollard or Benjamin Bada if you wish to further discuss the impact of the Circular on your business.