Following the recent downgrading of credit ratings of financial institutions by Moody's Investor Services and in the light of the potential impact this might have on regulated investment funds, the Central Bank of Ireland ("the Central Bank") has clarified its policy regarding inadvertent breaches of its requirements relating to credit ratings.

By way of background, the Central Bank's UCITS and Non-UCITS Series of Notices and Guidance Notes prescribe minimum credit rating requirements for counterparties to:

  • OTC derivative transactions
  • prime brokerage arrangements
  • efficient portfolio management techniques including stock lending and repurchase transactions

Minimum Credit Rating Requirements

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 QIF's 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.

The credit ratings referred to in the Central Bank's Notices are Standard and Poors short term ratings. An equivalent rating for the purposes of the Notices is one which has been provided by an internationally recognised rating agency and which is deemed equivalent by the investment fund to the rating stipulated in the Notice. An implied rating arises, in the normal course, where a decision on an unrated entity is made by the investment fund on the basis of the relationship between an issuer and its rated parent, or where an issuer has a senior debt/long term rating but no short term rating.

Breaches of Rating Requirements

In the light of recent credit rating downgrades by Moody's Investor Services, the Central Bank notes that it is possible that some regulated funds may inadvertently breach the Central Bank's requirements. In these circumstances, the directors of the investment company/management company and the trustee must consider the issues arising, including their obligations to act in the best interests of the unit holders. They should, as is required in the case of an inadvertent breach of any regulatory requirement, adopt as a priority objective the remedying of 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 Bank's rating requirements should be supported by an internal rating assessment undertaken on behalf of the investment fund. The Central Bank expects to be informed of any breach and of the remediation plan made necessary by a counterparty downgrade and the rationale for that proposed approach.

Prime Brokerage Arrangements

In the context of prime brokerage arrangements, without any intention to pre-empt the decision of the directors/management company or trustee, the Central Bank would, in principle, and taking the provisions of the Central Bank's Prime Broker Guidance Note into account, be prepared to permit 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).

Application to New Transactions

Finally, the Central Bank has confirmed that investment funds entering into new OTC derivative transactions, efficient portfolio management techniques or prime brokerage arrangements must adhere to the requirement of the Central Bank's Notices and Guidance Notes. Accordingly, 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.

This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.