With less than a week remaining to respond to the FCA’s recent consultation paper on rules to allow Authorised Fund Managers (“AFMs”) to create separate unit classes (“side pockets”) for assets in retail investment funds affected by the invasion of Ukraine, we take a look at the FCA’s proposals (the “Proposals”) and their implications.
Why is this relevant to fund managers?
The Russian invasion of Ukraine has resulted in some investments and securities becoming illiquid or untradeable (“affected investments”). Normal mechanisms for determining the accurate and reliable valuation of some of these affected investments are no longer operating. In many cases the value of the affected investments has had to be written down to zero or near-zero as a prudent measure, reflecting, in part, the inability to deal in assets subject to sanctions. This means that AFMs may not be able to accurately produce unit prices, and unitholders may not be treated fairly.
Summary of the Proposals
For the first time in the context of UK authorised funds, the FCA proposes to allow AFMs of UK UCITS and non-UCITS retail schemes (other than regulated money market schemes) to create side pocket unit classes, to which the affected investments would be allocated. This has the effect of enabling AFMs to separate the affected investments from the relevant fund’s other investments. This is notable – normally, a unit class will reflect the proportionate value of all the scheme’s assets, rather than just a subset of the assets. The fund’s existing classes of units would no longer include the value of affected investments, whereas the value of units in the new side pocket unit class would be determined only by reference to the affected investments. The existing unitholders at the time the side pocket is created would receive units in the side pocket class. New investors coming into the fund after the creation of the side pocket class(es) would not be allocated any units in the side pocket class. This means that any side pocket classes will be categorised as “limited issue”.
Benefits of the Proposals
Side pockets therefore could allow:
- new investors to enter the fund without sharing in the exposure to the affected investments;
- existing investors to sell the units which relate to assets that are not affected investments;
- some funds to end their current suspension of dealing.
The intent is that AFMs should manage the side pocket class with the aim of terminating it as and when this could be done in the best interests of investors. The FCA notes that the affected investments may not ever recover their lost value but, if there is recovery of value, investors holding units in the side pocket class would benefit.
AFMs will not be compelled to use side pockets; the FCA are clear that they consider that it is up to the AFMs themselves (presumably in conjunction with the depositary) to determine whether a side pocket would be the best way to deal with its fund’s exposure to affected investments. However, we note that there is a suggestion that funds will need to consult with auditors, which will have the effect of driving costs up.
The FCA have also proposed waiving the requirement for AFMs to treat the introduction of side pocket classes as a fundamental or significant change. This is a stay on normal amendment provisions. Ordinarily, one might expect empowering an AFM to create a side pocket class might be regarded as a fundamental change, as it changes the nature of the fund and alters its risk profile. Similarly, one might expect that a change affecting unitholders’ ability to exercise rights in relation to their investments would be a significant change – the side pocket class would appear to impact on those rights. COLL 4.3 will ordinarily govern how funds engage with unitholders when such changes are made. Instead, the FCA proposes that:
- The AFM need not treat the introduction of side pocket unit classes as a fundamental change, provided it is satisfied on reasonable grounds that the foreseeable costs of this course of action are not disproportionate to the benefits. The AFM must explain, in the information it is required to send unitholders, the basis on which it has reached this conclusion.
- If the AFM determines that implementing side pocket unit classes should be treated as a significant change, the requirement to give prior notice is disapplied. The AFM must inform unitholders in a timely way of what is happening. It may do this by announcing its decision in advance, or after the change has been implemented.
Although the Proposals will disapply the usual rules under COLL 4.3, the FCA expects that AFMs communicate their actions in a timely way to unitholders, and prepare a written notification that fully explains the reasons for their decision including the expected benefits and costs, the effect on unitholders’ ability to exercise their rights, the main features of the side pocket class and the practical information unitholders will need about the changes to their investment.
Under the Proposals, the AFM must confirm to each unitholder individually in writing the number and type of units they hold in the fund as a result of the action taken. AFMs should also take care to avoid using excessively legalistic language, and consider setting out the key points on a summary page. Finally, the document should be published in a durable medium, and AFMs should ensure it is accessible, such as by publishing a copy in a prominent location on their website.
Additionally, the FCA considers that the issue of units in a side pocket class does not fall within the requirement to make a UCITS key investor information (KII) document, or a NURS-KII document available to investors.
Limitations of the Proposals
The proposed rules on side pockets are intended only to be a limited emergency measure. Accordingly, the FCA Proposals apply only to investments:
- that are subject to financial sanctions relating to Russia under the applicable regimes in the United Kingdom, other G7 countries and the European Union; or
- for which there are no accurate, reliable and regular prices.
A key concern arising from the Proposal is that there could be a “run” on a fund with affected investments. Investors may not fully understand the operation of the side pocket class and seek to exit the fund as soon as possible. This would leave the AFM with the cost of continuing to operate a fund comprising of largely affected investments.
Further down the line, one can envision a scenario where an investor receives side pocket units, but then subsequently redeems the rest of their units. That investor could easily become a “gone-away” client, storing up future issues for the AFM if value returns to the affected investments once more.
It is also unclear from the Proposals whether side pocket classes can be held within an ISA structure but it is hoped that ongoing discussions between the FCA and HMRC will provide some clarity.
Other implications of the Proposals
AFMs will need to have regard to the distribution strategy of the fund and the investor-base before deciding to create side pocket classes. If the fund is largely sold through platforms, then there may be a need to engage with the platform services provider (“PSP”) prior to making such a decision - the PSP may not be able or willing to support the move given need to continue communication with the underlying investors and administrative difficulties in fairly allocating the side pocket units amongst these investors.
The creation of a side pocket class will also entail changes to the fund documentation, including to both the instrument of incorporation and the prospectus. Ordinarily, any change to the instrument will require FCA Approval with a statutory 1-month period of review. However, the FCA touts the possibility of fast-tracking approval in the context of side pocket applications at paragraph 4.21 of the consultation. We query whether this will come at the cost of delays to other fund applications – the Proposals make no mention of this.
Relatedly, the FCA also suggests that “it is the AIFM’s responsibility to decide whether creating a side pocket class is in unitholders’ best interests, so the approval process would not entail the FCA expressing a view on that matter”. We note that all proposed changes to a fund are subject to the over-arching requirement that the AFM act in the best interests of unitholders – regardless, the FCA still take an active role in probing and impacting the facets of change applications. In other words, it seems strange to us that the principle that the AFM act in the unitholders’ best interests for the creation of side pocket classes should affect the speed of the approval process, given that this principle is always present.
With regards to investment and borrowing, the AFM must, in respect of side pocket units, continue to comply with as much of COLL 5.1 as is possible in the circumstances. For UCITS, the AFM must also comply with COLL 5.2 and 5.3 to the extent possible; for NURS, the applicable requirements are set out in COLL 5.6. Class hedging transactions are also permitted under the Proposals.
Consideration will also need to be given to the costs of operating the side pocket class and how this cost is absorbed. The FCA would not prevent the AFM from charging an annual management fee for managing the side pocket, but considers that any fee should fairly reflect the AFM’s activities as agent for investors. The FCA has proposed that the AFM should not be able to make any preliminary charge when issuing units in the side pocket class, nor receive payment from any charge if it redeems units (although the FCA notes that a charge permitted by COLL 6.3.8R may be applied to a redemption if necessary to protect the interests of remaining unitholders). The FCA also proposes that the AFM should not be able to charge a performance-related annual management fee, as it does not consider this to be appropriate in these circumstances.
Finally, the FCA has proposed requiring the AFM to take legal advice on the implications of sections 235(4) and s236(3) of FSMA. We consider this an unnecessary burden on AFMs. If the FCA are to permit side pocket classes, then we would expect that the legislative framework supports this, and the FCA ought to be satisfied that this is the case as well.
How we can help
With less than a week remaining of the very curtailed consultation period, we can help you to formulate your response to the FCA. Once the rules are made, we can work with you to help you decide whether to implement side pockets and document the outputs.