The Financial Conduct Authority (FCA) published its Policy Statement (PS19/24) on 30 September 2019, outlining new rules for certain types of open-ended funds, known as non-UCITS retail schemes (NURSs) that invest in inherently illiquid assets. Our Financial Services Regulatory team explore the key changes which will be relevant to anyone with an interest in open-ended investment funds that are likely to hold illiquid assets.
Who do these new rules affect?
The new rules are relevant to anyone with an interest in open-ended investment funds that are likely to hold illiquid assets. This includes:
- operators and investment managers of these funds;
- ancillary service providers;
- intermediaries, such as platform service providers, or those, like wealth managers or financial advisers, whose retail clients invest in funds holding illiquid assets;
- firms communicating financial promotions to retail clients for funds investing mainly in illiquid assets; and
- investors, whether institutional, professional or retail, who have direct or indirect exposure to these funds.
Why the new rules?
The final rules follow on from, and are broadly in line with, the FCA's proposals in its consultation paper ("CP18/27"), which it published following suspensions in dealing of NURSs in 2016. These were largely implemented in the wake of Brexit uncertainty and pressures on the retail sector. These suspensions effectively froze investor cash and caused concern amongst investors about their ability to unlock their investments in funds invested predominantly in property.
The use of suspensions had therefore raised questions regarding how best to strike a fair balance between the interests of investors wishing to redeem holdings and those wishing to remain invested. While such suspensions were generally found to prevent further market disruption in stressed conditions, improvements in contingency planning and disclosure, particularly for retail investors, were considered due by the FCA.
The FCA's aim is to increase awareness amongst investors regarding liquidity risks associated with property funds, reduce the risk of investors losing out due to wrongly priced units in a fund and improve liquidity contingency planning.
- FIIAs - A New Category of Funds. The FCA's new rules will
apply to a new category of fund: funds investing in inherently
illiquid assets ("FIIAs"). A fund will be classed as a
FIIA in one of two circumstances:
- NURSs which have disclosed to their investors that they are aiming to invest at least 50% of their scheme property in inherently illiquid assets; or
- NURSs which have invested at least 50% of the value of their scheme property in inherently illiquid assets for at least three continuous months in the past 12 months, whether or not they have disclosed their intention to do so.
It should be noted that NURSs that apply limited redemption arrangements will be excluded from the new requirements imposed on FIIAs and the definition of 'FIIA'. Despite some opposition in the consultation period, the FCA held the view that reduced dealing frequency helps to mitigate the liquidity mismatch in these funds. If a NURS applies limited redemption arrangements that reflect typical time needed to dispose of its assets, the fund will be less exposed to liquidity issues at times of market turbulence than is the case for funds dealing more frequently. As such, the FCA found the additional measures associated with classification as a FIIA were not necessary for funds with limited redemption arrangements in place.
- Inherently Illiquid Assets. To aid the correct
interpretation of FIIAs the FCA has also defined
'inherently illiquid assets' which, in summary, comprise
- an immovable;
- an investment in an infrastructure project;
- a transferable security that is not a readily realisable security;
- any other security or asset that is not listed or traded on an eligible market and has particular features that make the process of buying or selling difficult or time consuming; and
- a unit in a FIIA or another fund with substantially similar features.
- Mandatory suspensions due to material
uncertainty. The new rules introduce a requirement for
authorised fund managers to temporarily suspend dealing in units of
a NURS where the standing independent valuer ("SIV") has
expressed material uncertainty about the value of immovable that
account for at least 20% of the scheme property. If there is
material uncertainty about the valuation of a significant
proportion of the assets in an open-ended fund, there is potential
for investors to be treated unfairly. For example, uncertainty in
the value of the underlying assets may mean an investor exiting the
fund receives a unit price significantly lower or higher than its
underlying value. Those investors who remain invested in the fund
might then see the value of their investments go up or down once
the underlying value of the assets in the fund becomes
However, due to fears that the SIV may be unwilling to state that there is material uncertainty because of the potential consequences for the fund, the new rules grant the fund manager the discretion to continue to deal if they have a reasonable basis to believe suspension would not be in the best interests of investors. In these circumstances, the depositary must give agreement and the decision to continue dealing would need to be taken as soon as possible and in any event by the end of the second business day after the day on which material uncertainty applies to at least 20% of the scheme property.
- Improving quality of liquidity management.
Sound liquidity management ensures that investors are treated
fairly by enabling them to redeem their investments as expected and
with certainty about the amount due to them. With this in mind, the
rules introduce the following measures intended to improve
- Enhanced contingency planning
The current rules already require fund managers to have liquidity management systems and procedures in place, and to identify when these tools should be used in both normal and exceptional circumstances. Nevertheless, shortcomings were identified in how this rule was being adhered to in practice. The FCA is therefore introducing a new rule to require managers of FIIAs to draw up and maintain contingency plans for exceptional circumstances with regards to their liquidity management. Such plans should:
- describe how the fund manager will respond to liquidity risks crystallising;
- set out the range of liquidity tools and arrangements available which they may deploy in such circumstances, any operational challenges associated with such tools and consequences for investors;
- include communication arrangements for internal and external concerned parties; and
- explain how the fund manager will work with the depositary, intermediate unitholders, third party administrators and others as necessary to implement the contingency plan.
In addition, fund managers will be required to obtain written confirmation from any third party on which they intend to rely for the delivery of the contingency plan that such reliance is permitted.
- Rapid sales The new rules introduce additional safeguards to be put in place that would require fund managers wishing to sell assets more quickly than usual to meet significant redemption demand, at a price below the full open market value of the asset, to disclose this intention in the fund prospectus, and come to an agreement with the SIV regarding a fair and reasonable price.
- Depositary oversight While current rules require authorised funds' depositaries to monitor cash flow, they do not prescribe clear responsibilities as to how this should be done in practice. As such, the new rules will extend and clarify depositaries' duties with regard to oversight of liquidity management processes.
- Enhanced contingency planning
- Increased disclosure. The new rules will
impose more stringent disclosure requirements on funds in order to
make investors aware of the unique liquidity risks associated with
open-ended funds investing in illiquid assets. The two key ways
this will be achieved are through:
- standard risk warnings in financial promotions to retail clients; and
- additional requirements for a FIIA's prospectus to disclose how the fund manager will manage the fund should liquidity risks crystallise.
While there already exist requirements for relevant liquidity risks to be disclosed under the Packaged Retail and Insurance-Based Investment Products Regulation, the additional requirement for FIIAs will emphasise these risks further. Similarly, the prospectus disclosure measures will supplement existing requirements under the Alternative Investment Fund Managers Directive.
When will the new rules apply?
The new rules in respect of NURSs will come into force on 30 September 2020.
In June 2019 (after the FCA's consultation period had closed) two high-profile UCITS funds, the LF Woodford Equity Income Fund ("WEIF") and the M&G Property Fund ("M&GF"), also saw suspended dealing which caused concern amongst investors about their ability to unlock their investments. While the FCA's new rules apply only to NURSs, the WEIF and M&GF suspensions raise questions regarding the need for broader application of such rules. The FCA has committed to considering whether the remedies set out in PS19/24 should apply more widely than NURSs and also whether it should be exploring a wider range of potential remedies, both for NURSs and for other types of fund. The FCA is working with the Bank of England's Financial Policy Committee to assess how funds' redemption terms might be better aligned with the liquidity of their assets to minimise financial stability risks without compromising the supply of productive finance.
In anticipation of the new rules, firms affected by these changes might wish to consider what measures they are currently taking to ensure liquidity is managed effectively and in particular how they can work with the depositary, intermediate unitholders, third party administrators and others as necessary to implement revised contingency plans.
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