FCA rule changes ahead for NURS investing in illiquid assets

The changes, which are set out in the FCA’s policy statement, PS 19/24, focus, in particular, on

• when the authorised fund manager (AFM) should suspend dealing
• improving the quality of the NURS’s liquidity risk management and
• enhanced disclosure requirements.

The FCA consulted on these measures in October 2018 (in CP 18/27) but postponed publication of the PS while it considered the fall-out from the Woodford case.

The FCA has compromised in certain aspects of its original proposals but has remained steadfast in its core requirements of greater certainty around the use of powers, improved liquidity risk management and enhanced disclosure to investors.

We await with interest to see how these themes may find their way into other policy developments for UCITS and other authorised funds, as flagged in the PS.

The new rules that PS 19/24 brings in won’t come into force until 30 September 2020 – the FCA feels that this gives firms time to make the necessary changes to their fund documentation as part of their annual review.

The FCA has also introduced a new category of NURS, ie, the ‘fund investing in inherently illiquid assets’ or ‘FIIA’. While some of the new rules (summarised in the first section below) apply to all NURS, others apply only to FIIAs (see the section below entitled, “Rule changes which apply only to FIIAs”).

This, though, isn’t the end of the FCA’s interest in this area. Although the changes in PS 19/24 only affect NURS, managers of UCITS should also pay attention to the FCA’s follow up work – in an additional chapter in the PS, written in light of Woodford, the FCA highlights the other avenues (summarised in the section below entitled, “Further work on open-ended funds investing in illiquid assets”) that it intends to explore before possibly publishing a further consultation paper in due course.

Rule changes which apply to all NURS

Rules concerning suspension of trading

Mandatory suspension due to material uncertainty

In CP 18/27, the FCA proposed a new rule to require an AFM to suspend dealing temporarily in units of a NURS where the fund’s standing independent valuer (SIV) had expressed material uncertainty about immovables accounting for at least 20% of the value of the scheme property.

This proposal encountered (in the FCA’s words) ‘substantial resistance’ from those who responded to the CP.

To take this into account, the final rules will now allow an AFM to continue to deal where it has agreed with the fund’s depositary that doing so is in the best interests of investors.

The result is that:

• where the SIV expresses material uncertainty about the value of immovables making up more than 20% of the scheme property*, the AFM must

  • suspend dealing as soon as possible (by the end of the second business day after the SIV’s assessment at the latest) and
  • notify the depositary of its decision

• however, the fund can continue to deal provided the AFM and depositary

  • both agree to this
  • have a reasonable basis for determining that a suspension is not in the investors’ best interests and
  • do not rely solely on fair value pricing as their ‘reasonable basis’ for keeping the fund open, as this would fail to address the issue of uncertainty around the value of the fund’s assets.

• dealing must restart as soon as reasonably practicable once

  • the SIV’s assessment of material uncertainty applies to less than 20% of the scheme property and
  • the depositary has given approval to ending the suspension.

The phrase ‘as soon as practicable’ already appears in COLL 7.2.1R (4) and the FCA considers that it is broad enough to allow an AFM discretion, for example, to keep a fund closed so it can rebuild the liquidity position before recommencing dealing. Doing this should ensure that the fund has enough cash to meet anticipated redemption demands and can avoid having to re-suspend dealing shortly after re-opening.

*The requirement to suspend dealing also applies to a NURS that has invested at least 20% of the value of its scheme property in one or more funds which have suspended trading because of material uncertainty.

Rules on improving the quality of liquidity risk management

The rapid sales of immovables

New guidance provides that, where it needs to sell an immovable quickly to meet redemption requests as they fall due, an AFM should consult the SIV and agree a fair and reasonable value for it. The FCA feels that, by ensuring that there is external input from a qualified professional into the price-setting process, investors’ interests will be protected.

The AFM can, however, only agree a fair and reasonable price for an immovable to reflect a rapid sale where the prospectus says it can do so.

The use of anti dilution measures

Anti dilution measures are commonly used when a fund is experiencing strong in- or outflows to help ensure that transaction costs of investors dealing in the fund’s units are borne largely by those entering or exiting the fund, rather than by other investors.

In light of responses to CP 18/27, the FCA has concluded that no further rules or guidance are needed to clarify how anti dilution mechanisms are to be used. However, given the capacity for retail investors to misunderstand such measures, it reminds AFMs of the existing obligation to disclose details of what is meant by dilution in the fund prospectus, along with any policies the AFM is adopting to deal with it.

Liquidity buffers (not taken forward)

The FCA was concerned that the accumulation of large liquidity buffers may increase the first mover advantage that exists in funds that invest in illiquid assets (ie, investors who are quick to redeem their holding can gain an advantage over those who are ‘loyal’ or less informed).

In CP 18/27, it proposed guidance for NURS and UCITS to the effect that cash, and cash-like investments, retained in funds should not be accumulated or held for a significant duration in anticipation of unusually high and unpredictable volumes of redemption requests.

However, following ‘clear opposition’ to this proposal from respondents, the FCA has decided not to proceed with such guidance.

Rule changes which apply only to FIIAs

Scope and definitions

Funds investing in inherently illiquid assets

The FCA has decided to go ahead with its proposal to introduce a new category of NURS - the ‘fund investing in inherently illiquid assets’ or ‘FIIA’.

It falls to the AFM to determine which, if any, of its funds is a FIIA and to take appropriate steps to comply with the new requirements.

A NURS will be an FIIA where it has:

• disclosed to its investors that it is aiming to invest at least 50% of its scheme property in inherently illiquid assets (see below) or
• invested at least 50% of the value of its scheme property in inherently illiquid assets for at least three ‘continuous’ (by which we assume the FCA means ‘consecutive, without a break’') months in the last twelve months, whether or not it has disclosed its intention to do so.

NURS that provide for limited redemption arrangements have been excluded from the definition of a FIIA since their reduced dealing frequency helps to mitigate the liquidity mismatch in them.

The FCA accepts that some feeder funds, multi asset funds or funds of funds will meet the definition of a FIIA, due to their holdings in other funds.

“Inherently illiquid assets”

An asset is inherently illiquid where it is (among other things)

• an immovable
• an investment in an infrastructure project
• a transferable security that is not listed or traded on an eligible market
• any other security or asset that is not listed or traded on an eligible market and has particular features that make buying or selling it difficult or time consuming or
• a unit in a FIIA or another fund with substantially similar features

FCA guidance also provides a non exhaustive list of asset types that are inherently illiquid, including

• property and real estate
• shares in a special purpose vehicle (SPV) investing in infrastructure projects
• shares not officially listed on, or admitted to, a recognised investment exchange
• units in a property authorised investment fund (PAIF)

The FCA notes that it will “be giving further consideration to the definition of liquid and illiquid assets in respect of a range of fund types. As part of that review, we will consider the most appropriate rules and guidance around those listed securities that are less liquid in practice because there is not also an active market in the securities”.
 
Rules regarding suspensions

Guidance on the use of suspensions by FIIAs

In addition to the requirement (discussed above) that a NURS must suspend dealing when the SIV has expressed material uncertainty about the value of immovables, the FCA has included guidance noting that, for FIIAs, there may be other circumstances – albeit exceptional ones - where suspension is genuinely in the best interests of unitholders.

Such instances could include, for example, where the fund cannot meet redemption requests without significantly depleting the fund’s liquidity or selling off scheme property at a substantial discount.

Rules on improving quality of liquidity risk management

Contingency planning

AFMs are already required to have liquidity management systems and procedures in place and must identify when these tools and arrangements are to be used, in both normal and exceptional circumstances.

The FCA is introducing an additional rule that requires the AFM of a FIIA to draw up and maintain contingency plans for exceptional circumstances.

These plans must:

• describe how the AFM would respond where a liquidity risk crystallises
• set out
• the range of liquidity tools and arrangements which could be deployed in such exceptional circumstances
• any operational challenges associated with their use and
• the consequences for investors
• include communication arrangements for concerned parties and explain how the AFM will work with others (including the FCA, the depositary and third-party administrators) to implement the contingency plan.

Where the AFM of a FIIA relies on a third party to deliver the contingency plan, it must obtain written confirmation from it that the AFM can place such reliance on the third party.

These contingency plans must be disclosed in the FIIA’s prospectus (see below). The FCA points out that these requirements are in addition to existing rules by which an authorised fund has to disclose in its prospectus the circumstances in which redemptions of units may be suspended.

Depositary oversight of liquidity risk management processes

The FCA considers that fund depositaries are ‘generally’ effective in checking that managers are meeting their responsibilities. Nevertheless, since AFMs of FIIAs will be required to draw up detailed contingency plans (see immediately above), the FCA has decided that it would be appropriate to specify that the duties of a depositary of an FIIA also include oversight of the fund manager’s liquidity management systems and processes.

The depositary of a FIIA will, therefore, be required to assess regularly the liquidity profile and liquidity risks presented by the FIIA’s scheme property. The FCA’s new rule also sets out the parts of its Handbook over which an FIIA’s depositary will have to take reasonable care to oversee the AFM’s compliance.
 
Rules on enhanced disclosure

Flagging the fund’s liquidity risks

Recognising that the fund name is not, perhaps, the most appropriate place for a risk warning, the FCA has decided against implementing its proposal to require the words ‘ – a fund investing in inherently illiquid assets’ to be added to the end of the FIIA’s name.

It has, instead, decided to require the following enhanced disclosures:

Risk Warning

FIIAs will need to include the following risk warning in financial promotions to retail clients other than the fund’s prospectus or NURS KIID:

‘[Name of fund] invests in assets that may at times be hard to sell. This means that there may be occasions when you experience a delay or receive less than you might otherwise expect when selling your investment. For more information on risks see the prospectus and key investor information document.’

This warning will apply to the firms’ MiFID business as well as its non-MiFID business.

It will also apply when other firms approve financial promotions in relation to FIIAs, not merely in relation to promotions produced by the FIIA’s manager.

Other firms, such as intermediaries and platforms, which promote a FIIA to retail investors must also provide the above risk warning.

Prospectus disclosures

As mentioned above, the prospectus of a FIIA must include:

• an explanation of the risks associated with the fund investing in inherently illiquid assets and how these might crystallise
• a description of the tools and arrangements the AFM would propose to use
• details of the circumstances in which these tools and arrangements would typically be deployed and the likely consequences for investors.

Further work on open-ended funds investing in illiquid assets

In June 2019, after the consultation period for CP 18/27 had closed, the LF Woodford Equity Income Fund (the WEIF) suspended dealing.

The Woodford case showed the FCA that

• liquidity considerations are not confined to open-ended funds with an exposure to property or other immovables but can extend to UCITS and other open-ended funds, where these have holdings in less liquid assets (including listed equities if there is not a liquid market in them) and
• many retail investors didn’t understand the liquidity risk to which they were exposed and the impact this could have on their ability to realise their investments on demand.

As a result, the FCA delayed publication of its findings under CP 18/27 while it considered what lessons it needed to read across between NURS and UCITS.

Some of the issues that the FCA identified were essentially the same as those it hopes to remedy through the new rules for NURS outlined above (eg, ensuring effective investor disclosure and the appropriate use of suspensions).

So, the FCA is now considering whether the rules in PS 19/24 should apply more widely than just to NURS and also whether it should be looking at a wider range of remedies, both for NURS and for other types of funds.

Areas that the FCA is looking at include:

• the possibility of using notice periods and reduced dealing frequency as liquidity management tools for open-ended funds which invest in illiquid or less liquid assets (especially where they are offered to retail investors)
• liquidity risk stress testing (taking into account ESMA’s recent guidelines) and the appropriate regulatory implications for funds that fail these tests
• the role of intermediaries and product distribution channels in providing investors with appropriate risk information
• the role of alternative product structures in managing risks associated with illiquid underlying investments, including possible new fund types (such as the Investment Association’s suggestion of a new ‘Long Term Asset Fund’)
• how other international regulatory liquidity regimes could be applied to authorised funds in the UK

If the FCA proposes to change its rules as a result of its findings, it will publish a consultation paper in due course.

In related work, the FCA has been working since July 2019 with the Bank of England’s Financial Policy Committee (FPC) on a review of how an open-ended fund’s redemption terms can best be aligned with the liquidity of its assets, with the FPC warning that the mismatch between the two 'has the potential to become a systemic risk'.

A statement issued jointly by the FCA and Bank of England in December 2019 noted that, if greater consistency is to be achieved between the liquidity of a fund’s assets and its redemption terms, the following principles should apply:

• the liquidity of fund assets should be assessed either (a) by reference to the discount in price that would be needed for a quick sale of a representative sample of those assets or (b) the time frame needed to achieve a sale which avoided a material price discount;

• to ensure an outcome that is fair for both redeeming and remaining investors, those investors who want to redeem their units should receive a price that reflects the discount which would be needed to sell the required portion of the fund’s assets in the specified redemption notice period; and

• redemption notice periods should reflect the time that would be needed to sell the required portion of a fund’s assets without a discount beyond that captured in the price which redeeming investors would receive.

The review will now go on to consider how these principles might be implemented in a way that is both proportionate and effective. The FCA will use the conclusions of the review (which will be published in 2020) in the development of its rules for open-ended funds.