The Russian invasion of Ukraine has affected financial markets in many ways. Sanctions have been imposed in response to Russia’s invasion, and the Russian government has applied trading restrictions. Some securities, including some Ukrainian assets, have become illiquid or untradeable. Normal mechanisms for determining accurate and reliable valuation for some securities have stopped operating. The FCA’s recent consultation paper CP22/8 (“CP22/8”) outlines the 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…
The FCA is consulting on rules to give AFMs a way to deal with this situation, whereby they will be able to use separate new unit classes to hold the affected investments.
Before deciding whether to create the side pockets class and determining the arrangements under which the class is to operate, the AFM will need to understand the legal requirements and obligations that apply under the relevant financial sanctions regimes and be satisfied that the class and the operational arrangements will comply.
BENEFITS OF THE SIDE POCKETS
Side pockets would allow AFMs to separate affected investments from the fund’s other investments. This would then:
- enable new investors to enter into the fund without taking on the risk of being exposed to the affected investments;
- enable existing investors to sell their units which relate to assets that are not affected investments; and
- facilitate the ability for funds to end their current suspension of dealing.
The proposed rules within the CP22/8 are a limited emergency measure to deal with the impact of the Russian invasion of Ukraine. The FCA is not considering allowing the wider use of side pockets in authorised funds. The side pockets would only be available for:
- UK UCITS and non-UCITS retail schemes; and
- holding affected investments,
and would be subject to sanctions (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.
The proposed rules and guidance in the CP22/8 should not be interpreted as meaning that the FCA will allow the side pockets in retail funds for any other current or future situations.
The creation of the side pockets 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 has mentioned the possibility of fast-tracking approval in the context of the side pockets applications, however this has not yet been confirmed.
COLL 4.3 (Approvals and notifications) sets out rules for engaging with unitholders when a change is made to the way an authorised fund is operated or managed. Changes are categorised into three types and the AFMs must decide which category a change falls into, according to how material its impact will be on an individual fund:
- fundamental changes require prior approval by unitholders;
- significant changes require adequate prior notice to be given to unitholders’; and
- notifiable changes can be notified to unitholders at a later date.
The FCA proposes that the AFMs need not treat the introduction of the side pockets 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 (COLL 7.8.14R). The AFMs must explain, in the information it is required to send unitholders, the basis on which it has reached this conclusion.
COSTS AND CHARGES
The FCA considers that it is fair for unitholders in the side pockets to bear a proportionate share of the costs which arise and are incurred for their benefit and the CP22/8 proposals include guidance on this. However, the FCA does not expect AFMs to charge unitholders a preliminary charge (on issue of units in the side pocket class), an exit charge for selling units in the side pockets, or a performance fee. The FCA’s proposed rules will prohibit these charges in relation to the side pockets class.
With respect to the introduction of any side pocket class, the AFMs should continue to take account of the information needs of investors with whom it does not have a direct relationship, by ensuring that communications are clearly presented and can be easily passed on by firms that manage the customer relationship.
Once the AFM has decided that establishing the side pockets class is appropriate, it should consider how to manage the process to protect the interests of all investors. In particular, it should consider how the timing of an announcement of its intention might impact investor behaviour.
The AFMs may conclude that the safest way to deal with these risks would be to make no announcement until the point at which it is ready to launch the new class, having obtained clearance from the FCA and made all the necessary operational preparations.
Alternatively, the AFMs may decide to make an earlier announcement, in which case it must consider whether to suspend dealing from the point at which the announcement is made. This is likely to be the surest way to protect the interests of all investors by preventing inappropriate decisions to buy or sell units, even though it might be inconvenient and commercially unattractive from the AFMs’ point of view.
The FCA will consider all feedback and, depending on responses received, will aim to publish a final policy statement and final Handbook rules and guidance as soon as possible.
The FCA is not proposing to set any time limit on when AFMs may elect to create the side pocket under these rules, since it is too early to know how the situation in Ukraine might develop. The FCA intend to keep matters under review and consult further when it is appropriate to withdraw this emergency measure. Any future decision to end the power to create a new side pocket would not affect any arrangement already set up under the CP22/8 rules.
For more information, and any guidance or advice on the use of side pockets, Cleveland & Co external in-house counselTM, are here to help.
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