The FCA has published its Policy Statement PS19/24 on illiquid assets and open-ended funds and feedback to its October 2018 Consultation Paper CP18/27. The overall aim is to reduce the potential for harm to investors in funds that hold illiquid assets, particularly under stressed market conditions. The rules relate to Non-UCITS Retail Schemes (NURS), ie those authorised open-ended funds available to the retail market that can invest substantially in illiquid assets, and will not be extended to Qualified Investor Schemes (QIS) with more knowledgeable investors. However, in the wake of the June 2019 suspension of the high profile UCITS fund, LF Woodford Equity Income Fund, a broader consideration by the FCA and the Bank of England is underway: both of extending the remedies set out in this Policy Statement beyond NURS as well as exploring a wider range of potential remedies, both for NURS and for other types of funds. Depending on the outcome of this work, additional changes may be consulted on in the future.

The final rules set out in the Policy Statement broadly follow those proposed in the FCA’s October 2018 consultation paper: improvements in the use of suspensions and other liquidity management tools, contingency planning, oversight arrangements and disclosure to retail clients. The FCA has made some important adjustments to reflect industry feedback: in particular, allowing discretion for authorised fund manages (AFMs) to keep a fund open despite meeting the material uncertainty test about the value of immovables (which would otherwise trigger a mandatory suspension).

The new Handbook rules and guidance will come into force on 30 September 2020, but the FCA suggests that AFMs and depositaries may wish to consider adopting some of the measures earlier (eg increased disclosure and improved liquidity management) where it would be in customers’ interests and the changes do not conflict with existing rules.

We have set out below a summary of the key points in the new rules, including where there are changes to the original proposals consulted on. These are divided into four areas: scope, suspension, liquidity management and disclosure. We conclude with three takeaway points.

Scope

A new classification of funds investing in inherently illiquid assets (FIIA)

Despite broad industry opposition, the FCA is introducing a new category of fund, a FIIA, as originally proposed - a fund structured as a NURS that intends to invest at least 50% of its scheme property in inherently illiquid assets (or those that have infact invested at least 50% of the value of their scheme property in inherently illiquid assets for at least three continuous months in the last twelve months, whether or not they have disclosed their intention to do so).

NURS with limited redemption mitigate liquidity mismatch and are out of scope

Many industry respondents also objected to the proposal that NURS that invest in real estate or other immovables where the prospectus and constitutional instrument provide for limited redemption arrangements (at least once every six months) appropriate to its aims and objectives would not be within scope of a FIIA. But the FCA has not changed its view and the definition of FIIA will exclude these funds (along with funds being wound up) on the basis that their less frequent dealing means that they are less exposed to liquidity risk.

We would note therefore that pure property funds structured as NURSs with limited redemption rights are likely to be excluded from the ambit of the FIIA regime (albeit the mandatory suspension rule summarised below will still apply).

Adapting the definition of inherently illiquid assets

Illiquid assets include real assets (eg property and infrastructure), a transferable security that is not listed or traded on an eligible market, units in another FIIA or in a QIS or unregulated fund with similar features. For example, a FIIA will include both an investment in a specialist real asset fund that is unregulated or holding units in a PAIF. It is up to the AFM to identify and monitor their FIIA.

On the basis that funds with comparable indirect exposure to illiquid assets should be subject to the same requirements as funds investing directly, feeder funds, multi asset funds or funds of funds may also be within scope.

Note that this definition may be re-visited in the future (or another definition of “less liquid assets” crafted), for instance to account for listed securities or bonds that are less liquid in practice because there is not an active market in them.

Suspension

Carve out to mandatory suspension due to material uncertainty of the value of at least 20% of the scheme property

The FCA’s proposed new rule that an AFM of a NURS holding immovables such as property (whether or not it is a FIIA) must suspend the issue, cancellation, sale and redemption of units when there is ‘material uncertainty’ about the valuation of at least 20% of the scheme property was met with substantial resistance by industry. Industry was concerned that this could result in more frequent and unnecessary suspensions, a run on the fund once the suspension was lifted and increased power of valuers in determining material uncertainty. They also argued that the existing liquidity management toolkit worked well.

The FCA has tailored its rules in response, so that although the blanket mandatory suspension rule still applies, an AFM will be able to continue to deal where it has agreed with the fund’s depositary that this is in the investors’ best interests (and this must be based on more than solely setting a fair value price adjustment). This decision must be taken within two business days of the fund being subject to the material uncertainty test and it must be reviewed at least every two weeks. Where the depositary disagrees with the AFM, or fails to agree within the time limit, dealing in the fund must be suspended.

Funds with indirect exposure to immovables still caught

The Policy Statement confirms that the mandatory suspension rule described above extends to NURS that have at least 20% of the value of their scheme property invested in one or more underlying funds which have suspended trading due to ‘material uncertainty’. The FCA states that this ensures fairer treatment of investors, as otherwise the non-redeemers in the feeder fund could inadvertently end up with increased illiquid asset exposure in the underlying portfolio. It dismisses the suggestions raised in the consultation feedback that this rule should be applied on a look-through basis; and points out that AFMs will still be able to use their discretion to continue to deal by way of the carve out outlined above, where for instance suspension would not be in the interests of all the investors due to limited exposure.

Role of depositary in mandatory suspensions

The depositary’s consent is not needed for mandatory suspensions due to material uncertainty. The depositary must be informed of a temporary suspension and it must agree to the suspension being lifted. The Policy Statement says that the timing of resumption of dealing can be broadly interpreted to give the AFM discretion, for example, to keep a fund closed for long enough to rebuild the liquidity position.

Liquidity Management

Liquidity contingency plans and third party reliance to deliver

The FCA seeks to repair reported shortcomings by requiring AFMs of FIIAs to produce (and disclose in each fund’s prospectus) contingency plans for dealing with liquidity risks. The revisions are in line with those originally proposed: setting out details on how an AFM will respond to a liquidity risk crystallising; the range of liquidity tools and arrangements which it may deploy in such exceptional circumstances (along with operational challenges and consequences for investors of using such tools); how arrangements should be communicated internally and to third parties, as well as how the AFM will work with the depositary and other third parties to implement contingency plans. These rules also address some of the disclosure obligations under AIFMD.

In addition, FIIA managers will have to gain written confirmation from any third party on which they rely to deliver a contingency plan, that they are able to place this reliance on them.

Fire sales and cash buffers both allowed (in theory)

An AFM can anticipate selling assets quickly to meet demand for redemptions, provided its intentions are disclosed in the prospectus. The FCA has adapted the rules to reflect some concerns raised by RICS, in particular to allow more flexibility around pricing methodology in the context of what may be achieved in a rapid sale.

The FCA has dropped its proposal that would bring to an end the practice of using cash buffers for long periods in order to meet high levels of redemption requests. It noted the various issues that could make the proposals counter-productive or ineffective - including exacerbating first mover advantage and removing an AFM’s discretion. However, it also notes that holding a large cash buffer to meet the needs of a minority of investors wanting immediate liquidity is unlikely to be in the best interest of investors as a whole.

Depositary oversight of liquidity management

Depositaries have been criticised for not fully considering how to fulfil their responsibilities under stressed market conditions. As a result, depositaries of FIIAs will have an increased function in overseeing processes and systems to manage liquidity. The FCA is making these functions more explicit, and a depositary will also be obliged to establish an escalation procedure for potential non-compliance in this area (and inform the FCA where significant).  This is likely to increase the depositary fees, hence fund costs, even though in some cases the depositary may already be fulfilling this function.

Disclosure

No mandatory identifier in fund name for FIIAs

The rules include a package of measures around increased disclosure for FIIAs. The FCA has dropped the requirement which formed part of the consultation for a mandatory identifier/signpost in the name of the fund. The FCA agreed with industry feedback that in isolation this could lead to misinformed investor conclusions about relative risk and could be better disclosed elsewhere rather than in the fund name.

Risk warning and other disclosures for FIIAs

Unchanged from the original proposals are a standard risk warning in financial promotions to retail clients and fuller disclosure of liquidity risk and how this will be managed in the prospectus (for instance the tools the AFM will use and the potential impact of anti‑dilution mechanisms on investors). The FCA has provided updated, clearer language for the new standard risk warning to help promote investor protection, which may also need to be used by firms in the course of their MiFID business. It also notes that the disclosure rules are not intended to be prescriptive for AFMs.

Conclusion

We would summarise with three takeaway points:

• The FCA points out that risks of suspension can be reduced by better aligning redemption terms with the liquidity of assets – for example by avoiding offering daily dealing where this may not be sustainable without loss of value; or by choosing to operate as a closed-ended or listed fund instead. Fund managers should continue to explore the full spectrum of fund options that may fit their model.
• A call to action to consider adopting some of the new rules before they become mandatory in a year’s time. Prudent AFMs should explore the opportunities presented.
• The industry should continue to monitor developments as policy makers make progress in their scrutiny of regulatory regimes and fund regimes in a broad and international context.

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