In August 2020 the Financial Conduct Authority (“FCA”) consulted on proposals to reduce the potential for harm to investors from the liquidity mismatch in open-ended property funds (the “Consultation”,”CP20/25”). In particular, the FCA consulted on suggesting a new notice period for redemption in these funds and also asking for alternative proposals.
Following this consultation, the FCA has published a follow up statement and its feedback (FS21/8) on the Consultation and its next steps (the “Feedback”).
To view our previous article covering the FCA’s consultation last year, please click here.
The Feedback is relevant for, amongst others, managers of UK authorised property funds, depositaries of these property funds, feeder funds that invest in these property funds, master funds that invest in property (which these property funds invest in) and other professional or institutional investors. This will also interest consumers who invest in UK authorised property funds, or who are exposed to these and funds through their pension contributions or their long‑term life assurance policies.
Open-ended funds let investors pool their contributions so they can invest efficiently. Investors can request to be issued new units and redeem units on demand. The issue highlighted by the FCA in its Consultation is that the underlying property in which the funds invest cannot be bought and sold at the same frequency as investors can buy and sell units. This in turn creates a liquidity mismatch and potential harm to investors.
To address this potential liquidity mismatch, the FCA considered in its Consultation whether property funds should be required to have notice periods before an investment can be redeemed and suggested a notice period of between 90 and 180 days for these funds.
The FCA’s view was that this notice period would have a number of benefits including reducing the risks to fund investors and the wider economy of pressure to sell fund assets at speed, rather than maximum price, in order to meet redemption requests. It would also allow funds to be more efficient, enabling them to hold less cash to manage the liquidity mismatch, and therefore boost investors’ returns.
The FCA received 70 responses from a wide range of stakeholders, including fund managers and depositaries, life assurance providers, and those involved in the distribution chain (transfer agents, platforms, advisers, wealth managers, property valuers and pensions specialists), as well as individual investors. The FCA commented that respondents expressed a range of views. Although many defended the utility of open-ended property funds as a component of an investment portfolio,
only a small number of respondents agreed with the proposal of notice periods as consulted on.
The feedback is summarised under three key themes within the Feedback, namely: (a) whether to require notice periods for property funds (addressed in Chapter 2); (b) consequences of introducing mandatory notice periods (addressed in Chapter 3); and (c) feedback on further points for discussion (addressed in Chapter 4).
WHETHER TO REQUIRE NOTICE PERIODS FOR PROPERTY FUNDS
The FCA commented that those respondents who supported the proposals believe that notice periods would improve consumer protection and encourage long-term thinking amongst investors.
However, the FCA indicated that just over half of respondents, who expressed a clear position, supported the proposals ‘in principle’ but subject to the following conditions:
- the need for the whole ‘ecosystem’ that supports and distributes investment funds (including platforms’ and advisers’ systems) being able operationally to support notice periods; and
- investments in funds with notice periods continuing to be eligible assets for Individual Savings Account (“ISA“) purposes.
Opposition to notice periods
In terms of opposition, firms argued a variety of reasons against the adoption of notice periods, supporting, for example, that the notice period may substantially reduce investor and adviser demand for open-ended property funds, eliminating an important element of consumer choice and reducing diversification in retail investors’ portfolios. Additionally, another concern raised was that the mandatory notice period would not take account of substantial differences between the different investor’s needs, and liquidity profile in each of the different property funds. These respondents believe that a blunt “one size fits all” solution is not appropriate.
Additionally, it was pointed out that the notice period would not actually lead to a substantial reduction in the level of cash which property funds would need to hold in order to manage the fund’s liquidity.
The FCA responses to these concerns are that open-ended property funds are unlikely to be suitable for investors with short-term investment horizons and a need for immediate liquidity. As such, the FCA does not believe that a relatively short notice period would fundamentally undermine the investment rationale for investors with a longer-term investment horizon.
The FCA emphasised that the infrastructure should evolve to support a wider range of investment funds, including funds that deal less frequently. According to the FCA, the lack of operational investment to support a wider range of fund structures, including funds that deal less frequently, is reducing consumer choice and preventing innovation. Given the concerns raised about the operational complexities, as well as to mitigate the risk of substantial outflows within a short period, the FCA will allow a suitable implementation period before rules come into force.
In respect of alternative proposals to structural liquidity mismatch, the FCA highlighted that current rules already permit Authorised Fund Managers (“AFMs”), managing Non-UCITS retail funds (“NURS”), to manage the liquidity mismatch through limited redemptions and notice periods.
In consideration of the proposed dealing structure, the FCA proposes that should investors change their mind about redeeming shares, the investor will be able to re-subscribe for the same amount on any dealing day.
The FCA disclosed that almost three quarters of respondents supported a shorter notice period of 90 days (as opposed to 180 days), with a number of respondents arguing that between 60 and 90 days is a reasonable timeframe in which to sell commercial property at market value. In consideration of these feedbacks, the FCA highlighted a number of factors to take into account in determining the length of the notice in order to strike the right balance between addressing liquidity mismatch and providing investors with the speed of access to investment. Finally, the FCA commented that a notice period of 180 days would be more effective in reducing liquidity risk but will consider the evidence further before making a final decision.
CONSEQUENCES OF INTRODUCING MANDATORY NOTICE PERIOD
The FCA’s consultation recognised that the potential introduction of the proposed notice periods may cause property funds to be treated differently under other regulations, affecting other market participants, as well as investors.
SIPP provider capital rules
The FCA acknowledged that a transitional rule relating to Self-Invested Pension Plan (“SIPPs”) provider capital rules could help reduce redemption pressure on property funds and reduce the chance of additional costs being passed on to investors.
Accordingly, the FCA have stated that if they proceed with the notice periods, a long implementation period would be required to smooth the overall transition.
Stocks and shares ISAs
Under current tax legislation, units of NURS can be qualifying investments for the stocks and shares component of an ISA if account holders are able to access the funds or transfer them to another ISA within 30 days of making an instruction to their account manager. Therefore, the FCA has noted, that if notice periods were introduced, and no change was made to ISA eligibility and transfer rules, property funds would no longer be qualifying investments for a stocks and shares ISA.
The FCA has stated that it will take the situation of ISA investors into account in their final decision, noting that if Treasury and HMRC were to take the proposals forward, current retail investors will continue to benefit from ISA eligibility for funds they already hold in ISAs.
The FCA have launched a consultation for a Long-Term Asset Fund (“LTAFs”) and given the cross over between the FCA’s LTAF proposals and the possible introduction of notice periods for property funds, the FCA will not take a final decision on any policy positions on property funds until Q3 2021 at the earliest, so that it can also take feedback to the LTAF consultation into account.
Moreover, in light of the feedback received and points for further discussions, and given the complexity of the policy and the crossover with the LTAF work, the FCA will continue to work with stakeholders to weigh up the benefits and drawbacks of the alternative proposals that have been put forward (such as an introduction of optional notice periods).
The FCA has confirmed that they continue to work with industry stakeholders, including through the Productive Finance Working Group set up by the FCA, Bank of England and HM Treasury to overcome operational barriers in respect of property funds.
Notably, the FCA has confirmed that if they do proceed with applying mandatory notice periods for property funds, they will allow a suitable implementation period before the rules come into force, approximately 18 months to 2 years, to allow firms to make operational changes. As such, property funds will need to keep track of any update in this area to ensure they are not caught unawares.
For a copy of the FCA Feedback, please click here.
For more information, and any guidance or advice on open-ended property funds, Cleveland & Co External in-house counsel™, your specialist outsourced legal team, are here to help.