UCITS and side pockets – the Central Bank of Ireland provides guidance

As we reported yesterday, ESMA has provided guidance to AIFMs and UCITS ManCos on how to approach the issue of side pocketing Russian, Belarusian and Ukrainian assets that have been affected by the Russian invasion of Ukraine.

The Central Bank of Ireland (the Central Bank) has also set out its expectations with specific reference to UCITS in a statement (the Statement) published, like the ESMA guidance, on 16 May 2022.

What does the Central Bank’s Statement cover?

The Statement

• notes that the Russian invasion has left some securities illiquid or difficult to value accurately, with certain asset classes being subject to pronounced devaluation
• confirms that the Central Bank will allow a UCITS to implement a side pocket arrangement by establishing a clone fund into which liquid assets can be transferred
• sets out the conditions for such a step and the approval process to be followed and
• makes clear that side pocketing of UCITS assets is only available in the context of “Affected Securities” (see below) and “should not be interpreted as creating a precedent by the Central Bank for any other current or future situations”.

Affected Securities are defined in the Statement as being:

“Russian, Belarusian and Ukrainian assets that are directly and/or indirectly impacted by the Russian invasion into Ukraine and/or impacted by sanctions that have been imposed as a result of Russia’s invasion of Ukraine”.

How would side pocketing work?

Where a side pocket is set up:

• a new clone UCITS is established.
• the liquid assets of the original UCITS are transferred into this clone, with Affected Securities which have become illiquid or difficult to value remaining in the original UCITS.
• shareholders in the new clone UCITS hold shares in that fund pro-rata to their holdings in the original UCITS. Investors in the original UCITS maintain a pro-rata holding in the original UCITS.
• over time, as assets can be realised, the original UCITS will be wound down with realised value being paid out to shareholders.

Conditions for establishing a side pocket

An original UCITS can establish a side pocket via a new clone UCITS subject to the following conditions:

1. The proposal must be in the best interests of unitholders.

2. Investors must have approved the transfer into the newly established clone UCITS side pocket.

3. The UCITS must have obtained the Central Bank’s prior written approval for the proposal (see below).

4. The UCITS must provide unitholders with a clear description to unitholders of the costs and fees associated with establishing the side pocket, as well as providing details of the ongoing costs and fees payable in its prospectus.

5. The original UCITS must be placed in wind-down mode at the same time as the creation of the new clone UCITS

6. The original UCITS must have established written policies in relation to management of the Affected Securities – these would include polices on the costs and fees associated with maintaining the original UCITS

7. The original UCITS must report annually to the Central Bank

   • to confirm whether or not these parameters and policies are still being respected and
   • to outline the prospects and/or plans for the side pocketed assets and liquidation of the original UCITS.

Approval Process

Since side pockets can only be set up by establishing a new fund/sub-fund, which will require the Central Bank’s authorisation or approval, the Statement sets out a process for obtaining this.

Any application for authorisation/approval of a new fund/sub-fund should be made in the normal manner and should be accompanied by:

1. confirmation from the fund directors that the new fund/sub-fund is identical to the original UCITS

2. a copy of the Resolution which approves the establishment of the new fund/sub-fund and

3. a copy of the investment objective and policy marked up against that of the original UCITS.

Timing and notification

Complete applications will be processed within five working days.

Applications which do not include the directors’ confirmation (see point (1) above) will be processed “within normal time-frames”.

Managers should note that the Central Bank requires advance notice of an application to be made to fundsauthorisation@centralbank.ie and onlineauthorisation@centralbank.ie.

Overarching expectations

Finally, the Statement underlines that

“it is the responsibility of fund management companies to take all necessary steps to ensure that the valuation of fund assets are fair and proper and in accordance with the relevant fund valuation policies and rules”.

What happens next?

The Central Bank will continue to monitor the impact of the Russian invasion of Ukraine and related sanctions on investment funds.

Further communications may be published in due course, where necessary.