On 28 September 2007 an interim regime was introduced to regulate investment entities. In summary, Chapter 15 of the Listing Rules has been substantially deregulated and a new Chapter 16 has been introduced for open-ended investment companies.1 This follows extensive consultation by the Financial Services Authority (“FSA”) on proposed changes to the Listing Rules as they impact on investment entities.2 This interim regime will remain in force until the first quarter of 2008, when the FSA is expected to implement further deregulatory changes to the Listing Rules and create a unitary regime for all listed investment entities regardless of domicile.
This briefing focuses on the implications of a revised Chapter 15 (the “New Rules”) for those listed investment entities previously regulated under the Listing Rules as a ‘property investment company’. It reminds these issuers of their duties and obligations as ‘closed-ended investment funds’ under the New Rules, and provides guidance on the practical steps to be taken to ensure compliance with the New Rules in the months ahead. For an overview of the New Rules for investment entities in general, please see the Norton Rose LLP briefing “Investment entities listing review”.
Summary of September 2007 rule changes
Overview of New Rules
One of the continuing aims of the FSA’s listing review is to create a single, principles-based, listing regime that applies to all types of investment entity, regardless of domicile or the assets it invests in. Prior to the implementation of the New Rules, a property investment company was subject to specific restrictions on gearing, restrictions on the proportion of leasehold property that could be held and rules requiring diversification of tenancies and assets. Under the New Rules, property investment companies are no longer differentiated from other closed-ended investment companies and, aside from a requirement to include a property valuation in their annual report, will no longer be subject to any separate rules.
Under the New Rules, all types of investment entity now fall within a more general definition – there is no longer a specific definition of a ‘property investment company’. The New Rules apply to any investment entity (a) which is an undertaking with limited liability, including a company, limited partnership, or limited liability partnership; and (b) whose primary object is investing and managing its assets in property of any description with a view to spreading investment risk. An investment entity satisfying this criteria is defined as a ‘closed-ended investment fund’ under the New Rules.
Removal of investment restrictions
Under the New Rules, a property-focused closed-ended investment fund will, like all other closed-ended investment funds, be required to invest and manage its assets in a way which is consistent with the objective of spreading risk and in accordance with a published investment policy (see below for information on publishing an investment policy). As a result of these changes, there are no longer any formal risk spreading limits on the percentage of a property-focused closed-ended investment fund’s assets that may be represented by a single investment.3 Instead, the New Rules create a general requirement on all closed-ended investment funds to spread risk without specific restrictions on how this should be done. Moving the objective of spreading risk from the regulator to the closed-ended-investment fund now means that risk is a matter of analysis for each closed-ended investment fund. This ‘purposive approach’ is intended to retain a similar standard of investor protection to that which existed prior to the implementation of the New Rules, while removing the mechanistic and prescriptive approach to risk spreading which existed previously.
Publication of an investment policy
Contents of an investment policy
The requirement to publish an investment policy is a key component of the New Rules and furthers the FSA’s stated intention that a closed-ended investment fund’s own investment policy should become the key control mechanism for shareholders in place of the prescriptive and inflexible rules previously applied.
The New Rules provide that the information contained in an investment policy must be ‘sufficiently precise and clear’ to enable an investor to: (a) assess the investment opportunity; (b) identify how the objective of risk spreading will be achieved; and (c) assess the significance of any proposed future change of investment policy. Further, and as a minimum, the investment policy must provide details relating to asset allocation, risk diversification and gearing, and must also include maximum permitted exposures. This ‘quantification’ is intended to enable a closed-ended investment fund to draft its investment policy with the requisite level of precision and clarity to enable it to demonstrate that it can invest and manage its assets in a way which is consistent with the objective of spreading risk. The New Rules also retain the requirement to seek shareholder approval for any ‘material change’ to an investment policy.
Time-frame for publishing an investment policy
Given that the New Rules involve a significant change from existing practice and recognising a need to avoid a disproportionate impact on listed investment entities, the FSA has indicated in consultation papers 06/21 and 07/12 that existing listed closed-ended investment funds will be able to publish their investment policies for the first time ‘in the ordinary cycle of publication’ (i.e. in their next annual report). The FSA has also stated that when a closed-ended investment fund first publishes its investment policy, there will not be a ‘material change’ requiring shareholder approval if the policy fairly reflects existing practice and adopts existing limits in place (or more conservative ones) at the time the New Rules came into force.
Although the New Rules might initially have appeared to have removed the old Listing Rule 15.5 investment restrictions by deleting references to specific ratios and limits, FSA guidance in CP06/21 and CP07/12 indicates that property focused closed-ended investment funds will de facto have to continue to comply with investment restrictions on gearing, the proportion of leasehold property that can be held and rules requiring diversification of tenancies and assets, unless shareholder approval is sought for the adoption of less onerous restrictions.
Removal of requirement for shareholder approval for major acquisitions or disposals of property
Prior to the implementation of the New Rules, a property investment company was required to comply with the class test provisions in Chapter 10 as if such a company was a trading company, even if that transaction fell within its investment policy. This meant, for example, that shareholder approval was required for the purchase of new property assets where any percentage ratio exceeded 25 per cent. or more of various class tests. The need to gain shareholder approval before making an acquisition or disposal was a costly and time consuming process, considered by many to be a barrier to growth in the listed property funds sector.
Under the New Rules, there is now no requirement for a property-focused closed-ended investment fund to comply with Chapter 10 and seek shareholder approval for acquisitions or disposals of property that fall within the scope of its stated investment policy.4
The deregulatory nature of this change means that the investment policy will now become the key control for shareholders. This could of course mean that any shareholders who are concerned about any risks that the removal of this restriction creates, might respond by investing only in those property-focused closed-ended investment funds whose publicly stated investment policy does not authorise major acquisitions or disposals of property without first obtaining shareholder approval.
Experience of directors and investment managers
It was previously a requirement for the directors, the investment manager and the property manager of a property investment company to be able to demonstrate ‘sufficient and satisfactory experience’ in property investment over a 3 year period involving the management of a portfolio of a similar type and size to that of the property investment company.
This requirement remains under the New Rules but has been re-phrased to provide that, collectively, the directors and investment managers (this will also include property managers) must have ‘sufficient and appropriate experience’. This test will be passed if such persons are FSA authorised to manage investments or have a three-year track record of managing a portfolio of assets comparable to the closed-ended investment fund’s portfolio.5
Removal of prohibition on taking controlling positions
Under the New Rules there is no restriction on closed-ended investment funds taking controlling positions. However, to ensure that there is a spread of investment risk, a closed-ended investment fund should avoid cross financing between group companies and the operation of common treasury functions between the closed-ended investment fund and investee companies.
The New Rules retain the requirement for quarterly disclosures of a closed-ended investment fund’s 10 largest investments and of investments which represent more than 5 per cent. of the closed-ended investment fund’s total assets. However, the New Rules now require quarterly disclosures of cross holdings in place of the previous requirement for monthly disclosures.
The New Rules still require a closed-ended investment fund to provide a statement in its annual report (including a quantitative analysis) explaining how it has invested its assets in accordance with its investment policy and with the objective of spreading risk.
Practical implications of the New Rules
To assist in compliance with the New Rules, directors and investment managers of property-focused closed-ended investment funds should have regard to the following key points:
There is now a requirement to publish an investment policy. This can be done in line with the ordinary cycle of publication (i.e. in the annual report).
- The old Listing Rule 15.5 which contained investment restrictions in relation to gearing, the proportion of leasehold property that can be held and rules requiring diversification of tenancies and assets will be regarded as the investment policy by default. As a result, any change to this ‘default’ investment policy will constitute a ‘material change’ requiring shareholder approval to be obtained either at the annual general meeting or at a specially convened extraordinary general meeting.
- When analysing the scope of any proposed new investment policy, it is important to note that there is no longer a requirement to comply with Chapter 10 and seek shareholder approval for acquisitions or disposals of property that fall within the scope of a stated investment policy.
- There will be a need to consult with institutional shareholders in drafting a new investment policy, given that the investment policy will now become the key control mechanism for shareholders governing their exposure to, and appetite for, investment risk.
- The directors (in consultation with investment managers) must ensure that, when drafting a new investment policy:
- it is sufficiently precise and clear so as to enable an investor to assess the investment opportunity, identify how the objective of risk-spreading will be achieved and assess the significance of any proposed future change of investment policy; and
- it provides details of asset allocation, risk diversification and gearing, and includes maximum permitted exposures.
- The articles of association of a property investment company commonly prohibit borrowings from exceeding 65 per cent. of gross assets. Any change to this gearing restriction would require shareholder approval for an amendment to the articles of association. As the New Rules require a closed-ended investment fund’s gearing restrictions to be set out in its investment policy, directors (in consultation with their advisers) should consider removing all references to gearing restrictions from the articles of association (since depending on the domicile of the fund, a change to the articles of association would usually require shareholders to pass a special resolution).
Reporting and disclosure requirements
The annual report must include:
- a summary of the valuation of the property portfolio if more than 20 per cent. of assets are invested in property; and
- a statement of how the closed-ended investment fund has invested its assets in accordance with its investment policy and with the objective of spreading risk.
- Quarterly disclosures of a closed-ended investment funds 10 largest investments and of investments which represent more than 5 per cent. of the closed-ended investment fund’s total assets must still be made.
- Quarterly, as opposed to monthly, disclosures of cross holdings must now be made.
From 28 September 2007 until the final unitary regime is put into effect and further amendments are made to Chapter 15 of the Listing Rules in 2008, a modified super-equivalent regime for closed-ended investment funds will operate alongside the existing directive-minimum regime in Chapter 14 of the Listing Rules. During this interim period, the key challenge for property-focused closed ended investment funds will be to review the scope and flexibility of their existing investment policies. In preparing an investment policy for publication, property-focused closed-ended investment funds will therefore need to weigh up the potential commercial benefits of departing from the old Listing Rule 15.5 investment restrictions, with the need to consult with their shareholders to ‘set’ an acceptable level of investment risk having regard to investment opportunities in the relevant market.