In broad terms, counterparties permitted to engage in OTC derivatives with French funds must be alert to two broad categories of issues: (i) the legal capacity and authority of the relevant type of French fund to enter into the particular type of derivative and (ii) compliance with the provisions of French Decree 89-623 applicable specifically to OTC derivatives with French funds. In each case, the relevant issues may be addressed effectively, first, by knowing the type of French fund entering into the transaction and, second, by appropriate tailoring of contractual provisions in master agreements.
Know Your Fund
The names used for the various French collective investment funds present a maze of acronyms. Generally, French funds are called organismes de placement collectif (collective investment vehicles) of which two principle types are active in the OTC derivatives markets: (i) organismes de placement collectif en valeurs mobilières (OPCVMs) also known as UCITS and (ii) fonds commun de créance (FCCs).
An OPCVM can take the form of a SICAV (sociétés d'investissement à capital variable) or an FCP (fond commun de placement). A SICAV is a limited liability company that functions in many respects in the same manner as an ordinary company. Unlike a corporate entity, however, a SICAV may issue or repurchase and cancel its shares at any time at the request of its shareholders and the net asset value of the SICAV varies accordingly. SICAVs may either act on their own behalf or appoint a fund manager to manage the SICAV's assets and negotiate and enter into contractual arrangements on behalf of the SICAV.
An FCP, on the other hand, does not have a separate legally-recognized identity. Unit holders in an FCP have co-ownership rights in a pool of assets constituted and managed by a fund manager and a custodian in accordance with the FCP's constitutive documents and French law. The fund manager of an FCP is authorized by law to act on behalf of and in the name of the FCP and may execute agreements in the name of the FCP.
OPCVMs: The Basic Requirements
In any OTC derivative with a French OPCVM, French law imposes four key requirements.
Limited Purpose
French OPCVMs entering OTC derivatives are subject to an overarching "purpose" requirement. Specifically, OTC derivatives must either be used to hedge the fund's asset position or employed in connection with the fund's disclosed investment strategy. The latter purpose is cast broadly and in effect contemplates that a fund may trade OTC derivative positions or engage in synthetic portfolio investments through credit derivatives. If a fund intends to use derivatives as part of its investment strategy, the fund's constitutive documents must expressly contemplate such activity.
Permitted Counterparties
Under the French statutory framework, funds may enter into derivative transactions only with counterparties which fall within one of three statutorily enumerated categories of permitted counterparties: (i) custodians of collective investment funds, (ii) credit institutions based in the Organisation for Economic Co-operation and Development and (iii) investment companies situated in the European Economic Area which are authorized to act as securities depositories and have capital of at least EUR3.8 million. A transaction with an unauthorized counterparty would be unenforceable.
Unilateral Termination Rights
French law specifically provides that a fund must have the contractual right to unwind or liquidate any or all of its derivative transactions at any time at market value or at a value previously agreed by the parties. This requirement is designed to ensure fund liquidity since fund unit holders are typically entitled to redeem their units at any time during the life of the fund. Counterparties will usually seek to provide mutual unilateral termination rights. As mutual termination rights are not necessarily required by law, a counterparty's success on this issue will often turn on pricing and related commercial considerations. As a fall-back position in cases in which mutual unilateral termination rights cannot be agreed, the non-fund counterparty should at least seek protection against "cherry-picking" by the fund.
Standard Documentation
French law specifies that any derivative transaction with a French fund must be entered into "in conformity with" a French or international master agreement. Transactions documented under the International Swaps and Derivatives Association or French Banking Federation master agreements would satisfy this requirement. Market participants generally interpret the words "in conformity with" as covering confirmations which incorporate a master agreement by reference even when the master agreement has not yet been executed.
Authority & Capacity Issues
At the heart of an OTC derivative transaction with a French fund is the authority and capacity of the relevant fund, and its signatory, to enter into the transaction. Comfort is generally provided on these issues through the representations and warranties of the fund and by delivery of supporting documentation with respect to the structure and organization of the fund.
In the relevant master agreement between the parties, the fund should provide, in addition to the conventional ISDA or FBF representations and warranties, representations expressly declaring that (i) the funds' governing documents (règlement for an FCP or by-laws for a SICAV) permit the fund to enter into and perform its obligations under the master agreement and each further transaction. In addition to the usual language regarding compliance with laws, the fund should also declare that it will manage its assets and its affairs in compliance with all laws and regulations, including European Community directives, French laws and regulations, and instructions issued by the Autorité des Marchés Financiers previously known as the Commission des opérations de bourse.
French law provides that an FCP must be represented in dealings with third parties by its société de gestion, a statutorily-mandated asset management company or fund manager. Hence, a counterparty entering into OTC derivatives with an FCP (or a SICAV using a fund manager) should verify the identity of the société de gestion for the FCP. This may be accomplished by examining the internal rules or by-laws (règlements) of the FCP or by consulting an independent database. Additionally, the due authorization of the individual executing agreements on behalf of the société de gestion should be confirmed.
For all FCPs as well as SICAVs which are represented by a fund manager, the fund itself will generally represent that the fund manager is authorized to enter into the master agreement and the transactions and to execute all the fund's obligations on behalf of the fund, and that each transaction is entered into by the fund manager in the name and on behalf of the fund, and not in the name of the fund manager.
As an added measure of precaution, the fund manager may be added as a signatory to the documentation. In such cases, the fund manager should also represent, in its own capacity, that the fund complies with all applicable laws and the fund's regulations or by-laws and that it will at all times ensure that the fund has sufficient assets to execute its obligations under the master agreement. The fund manager should also represent that it is a duly organized and statutorily-mandated asset management company.
Given the structure of OPCVMs and the importance of the relevant fund manager to the financial health of the fund, non-fund counterparties will often seek additional termination events. Frequently added termination events include (i) termination or resignation of the fund manager; (ii) termination or resignation of the fund's custodian; and (iii) withdrawal of authorization by the AMF of the fund manager or SICAV or other disciplinary action by the AMF against the fund or its investment management parties. Additionally, since the net asset value of any fund is usually regarded as the best indicator of the financial health of the fund, it is not uncommon for the parties to specify that if the net asset value drops by a certain percentage over a defined time period, a termination event would occur.
Specific Requirements For Credit Derivatives
Since December 2002, French funds have been authorized to both buy and, more importantly, sell credit protection as credit derivatives. The statutory term "credit derivatives" has been broadly defined and includes any type of credit derivative which can be documented under a French or internationally recognized master agreement.
However, French funds are permitted to buy and sell credit protection only in respect of certain types of entities. Using ISDA terminology, "Reference Entities" are limited to sovereign states, international public organizations of which one or more states of the European Community are members, municipalities located within Europe or legal entities which have publicly listed shares or publicly issued debt instruments.
It is also important to note that since regulated financial institutions have exclusive authority to make loans under French banking law, French funds are not permitted to accept physical delivery of loan assets in settlement of credit derivatives. This is also consistent with statutory investment guidelines which preclude OPCVMs from holding loan assets in their portfolios. Nevertheless, cash settlement of credit derivative transactions on loan assets is permitted.
Derivatives With FCCs
The Fonds Commun de Créance, or FCC, is a type of French special purpose vehicle used for securitizing assets. FCCs are more restricted in their use of derivatives than OPCVMs. In particular, an FCC may only use derivatives for hedging purposes. This is described in the law as "ensuring that the amounts the FCC receives and the amounts the FCC pays out correspond". Typically, the FCC will hedge with the originator of the assets used in the securitization transaction but it is permitted to enter into hedging transactions with other credit institutions or the Caisse des Dépôts et Consignations.
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| Edward Nalbantian |
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| Cecilia Poullain |
This week's Learning Curve was written by Edward Nalbantian, a partner and head of Jones Day's European lending and structured finance practice, and Cecilia Poullain, an associate at Jones Day in Paris.
