The FCA has published their response (the “Response”) in the form of a policy statement (the “Policy Statement”) 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. In our previous article, we looked at the FCA’s proposals and their implications. Here, we consider the final form of these rules and review the approaches of other jurisdictions in implementing side pockets in the context of the invasion of Ukraine.
In general terms, the FCA’s proposals met with general agreement and support from the respondents to the consultation. This means that the main proposals are to be implemented as follows:
- AFMs of UK UCITS and NURS (other than regulated money market schemes) will be allowed to create side pocket unit classes, to which investments affected by the war in Ukraine will be allocated. These will be valued purely by reference to the sanctioned and untradeable assets and not the remaining tradeable investments in the fund. Existing unitholders at the time the side pocket is created will receive units in the side pocket class, and new investors coming into the fund after the creation of the side pocket class(es) will not be allocated any side pocket class units (any side pocket classes will be categorised as “limited issue”).
- Provided it is satisfied on reasonable grounds that the foreseeable costs of this course of action are not disproportionate to the benefits, the requirement for AFMs to treat the introduction of side pocket classes as a fundamental or significant change has been waived. Instead, the AFM must provide justification in the notice to unitholders; if the AFM determines that implementing side pocket unit classes should be treated as a significant change, the requirement to give prior notice will be disapplied (although unitholders must still be given some form of timely notification).
- The FCA will not prevent the AFM from charging an annual management fee for managing the side pocket, but any fee should fairly reflect the AFM’s activities as agent for investors. The AFM will 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). AFMs will also not be able to charge a performance-related annual management fee.
- Although changes will be required to the fund constituting instrument and prospectus, a key investor information document will not be required for the new side pocket class. The FCA will be putting in place a fast-track process to review and approve changes to fund documentation. Once AFMs have decided to establish a side pocket class, they should contact the FCA fund authorisations team at [email protected] to obtain further information on the approval process. AFMs will need to submit the relevant fund approval form (forms 251/21/261Q), and the FCA will aim to expedite the review of the application and give a decision as soon possible.
The FCA has made the following minor clarificatory amendments, including:
- widening the definition of “sanctioned investment” to cover any asset or investment subject to a relevant sanctions regime and held in a retail authorised fund;
- enhancing the risk warnings to be set out in the prospectus and in the information to be sent to existing investors when they receive units in the side pocket class (for example, regarding contagion risk of fees and charges to other share classes);
- adding rule and guidance about how voting rights for side pocket units may be exercised at a unitholder meeting;
- adding a rule and guidance clarifying expectations of how AFMs should carry out the assessment of value required by COLL 6.6.20R, in relation to a fund with a side pocket class;
- clarifying some provisions around the ability of AFMs to effect redemptions and transfers of title to units in a side pocket class; and
- adding guidance that AFMs should consider the operational needs of distributors before deciding to set up a side pocket class (amongst other things, on the basis that the AFMs will need to time unitholder notifications and fund dealing changes carefully to avoid creating opportunities for new investors to enter the fund ahead of the side pocket being created, and to manage the risk of other unitholders seeking to exit the fund).
As part of the responses, there were strong representations on the belief that AFMs should have a choice in how to structure the side pockets, whether through alternative unit classes or schemes of arrangement.
The alternative scheme of arrangement model would involve establishing a clone authorised fund, into which the AFM would transfer the majority of the scheme property of the existing fund – all the tradeable assets and most of the uninvested cash – to become the first property of the newly‑created fund, under a scheme of arrangement. The existing fund would then be put into winding up, to be completed as soon as the market allows. The Response noted that the CSSF allows both the share class and the scheme of arrangement side pocket models. Respondents who showed interest in the alternative model wanted it to be made generally available.
The Response emphasised that the question concerning the wider use of side pockets, as a liquidity management tool (“LMT”) to be made generally available for UCITS and NURS, was not within the scope of the Policy Statement. The FCA is engaging internationally with the International Organisation of Securities Commissions (“IOSCO”) on LMTs, but remains cautious, noting that the current scenario should remain distinct from one caused by a poor investment decision (similarities may be identified with ESMA’s Public Statement, see below). The FCA left open the possibility of using the scheme of arrangement model, asking that interested firms contact them directly.
Impact on ISA Eligibility
The FCA has also worked closely with HM Treasury and HMRC to assess whether a side pocket class created under these rules will remain ISA‑eligible; the Treasury and HMRC are of the view that the ISA Regulations look to the qualifying status of a UCITS or NURS at the level of the FCA’s recognition or permission, not the unit class or the underlying assets and the creation of a side pocket class will therefore not impact the ISA eligibility of either the fund as a whole or the side pocket class. This is a welcome clarification, although it is noted that there may be implications where an investor wishes to transfer their ISA, particularly in the current tax year.
How do the UK’s side pocket rules compare with the main EU Jurisdictions?
ESMA Public Statement
On 16 May 2022, ESMA issued a Public Statement (the “Public Statement”) to promote convergence on actions taken to manage the impact of the Russian invasion of Ukraine on investment fund portfolios exposed to Russian, Belarusian and Ukrainian assets. In general, ESMA supports the concept of side pockets, as it allows investors in need of liquidity to cash in the liquid part of the investment fund’s portfolio at, presumably, little liquidation cost; the approach also protects the interests of investors who wish to remain in the investment fund, since the fund manager is not forced to liquidate assets at or under market prices.
ESMA flags similar issues as those raised by the FCA, including the potential for ‘moral hazard’ problems (i.e. that side pockets should not be used by fund managers to correct errors in investment decisions or initial asset valuations), and that illiquid assets that are transferred to side pockets do not necessarily become liquid or gain value again in the future. ESMA also emphasises the need for fund managers to conduct a comprehensive analysis of any side pocket arrangements, and reflect any necessary risk disclosures in the fund documentation. Ultimately, however, ESMA is of the view that side pockets in UCITS could be permissible (and indeed preferable, from an investor protection perspective) where the liquid and illiquid assets are segregated by way of transferring the liquid assets to a new UCITS (as in the scheme of arrangement model currently rejected by the FCA – see above) or to a new compartment of the initial UCITS.
On 16 May 2022, the Central Bank of Ireland (“CBI”) also issued a notice (the “Notice”) expressing its intention to permit, subject to certain conditions, UCITS to implement a side pocket arrangement for certain securities impacted by the Russian invasion of Ukraine and/or the consequential sanctions imposed as a result.
Importantly, the CBI states that it will permit only a UCITS side pocket arrangement by way of establishment of a clone fund into which liquid assets may be transferred. This stands in clear contrast to the alternative unit class stance taken by the FCA.
Helpfully, the Notice states that there will be a streamlined authorisation/approval process for the side pocket arrangement, which is aligned to the FCA’s intentions for the prompt approval of applications to establish side pockets. The CBI strongly emphasises that side pocketing of UCITS assets is only available in the current context – by way of comparison, the FCA’s language was somewhat more circumspect, noting the possibility (subject to further careful and diligent consideration) for these side pocket models to be used in different scenarios.
The CSSF published their FAQs (the “FAQs”) on the application of LMTs by funds in the context of the invasion of Ukraine in March 2022. Their approach is more liberal than the other regulatory bodies, noting that it remains the responsibility (and prerogative) of the governing body of the fund to ascertain whether the side pocket is a tool that could be implemented, and is in the best interest of investors in the fund.
The CSSF presents three options for funds looking to segregate their assets: (1) segregation by unit class; (2) implementing a clone fund whereby the initial sub-fund retains the illiquid assets, and the liquid assets are transferred to a new sub-fund; and (3) in a reversal of (2), implementing a clone fund whereby the initial sub-fund retains the liquid assets, and the illiquid assets are transferred to a new sub-fund.
We note that the CSSF document is prefaced with a bold and underlined preliminary remark that the segregation options they present are “only applicable for illiquid assets resulting from the current situation” and should “under no circumstance” be interpreted such as creating a precedent. The different attitudes of the various regulators are noteworthy, and should be considered in any future dealings with them.
How we can help
The rules are set to come into effect today, Monday 11 July. Our UK authorised funds team has a Tier-One ranking in the UK’s Legal 500 Guide and has significant experience and expertise in setting-up all forms of UK authorised funds across all asset classes, effecting all forms of changes to existing funds, and extensive experience of liaising and working with the FCA’s CIS Authorisations Team. We can help support you in deciding whether to implement side pockets, document the outputs, draft the necessary amendments and engaged with the FCA to obtain their approval.