The closing of redemption gates in several open-ended property funds after the Brexit referendum, followed by the 2019 Woodford saga, has shone a spotlight on the risk to investors of funds holding illiquid assets in stressed markets.
The Financial Conduct Authority (FCA) recognised the need for more transparency and has introduced new rules, applicable from 30 September 2020, for open-ended funds falling within the non-UCITS retail scheme (NURS) - imposing a mandatory redemption suspension and more stringent liquidity risk management obligations on fund managers.
Furthermore, the FCA and the Bank of England (BoE) are currently considering wider reforms to all open-ended funds (both NURS and UCITS) to ensure redemption terms are better aligned with liquidity of assets.
New rules for NURS: Which funds are affected?
1. NURS that have disclosed to their investors that they are aiming to invest at least 50% of their portfolio in inherently illiquid assets.
2. NURS that have invested at least 50% of their portfolio in inherently illiquid assets for at least three continuous months in the past 12 months - whether or not they have disclosed their intention to do so.
If a fund falls within the above, the new rules classify it as a "fund investing in inherently illiquid assets, or "FIIA".
It is clear FIIA managers will need to actively scrutinise fund portfolios and investment strategies, determine the potential liquidity risks and outline possible tools and arrangements proposed for each liquidity risk.
This must all be properly conveyed to investors, so they are aware of the risks and can make an informed decision about whether the product is right for their needs.
Fund managers should bear in mind if a liquidity issue did crystallise, the contingency plan and its disclosure will be scrutinised, and any failings could lead to FCA enforcement against them.
Suspension: What are the rights of investors?
The introduction of a mandatory suspension leads to the question of whether investors have any other recourse to force the redemption.
In short, no - there is no legal recourse to force the fund to honour a redemption request.
The new rules should be a reminder to all of the risks that come with investing in illiquid assets.
2020 outlook: Further changes to redemption terms for NURS and UCITS?
While the new rules target NURS, the regulator highlighted how UCITS (such as Woodford) can also face the same liquidity issues.
The FCA is working jointly with the BoE to determine whether the new rules should apply to UCITS, as well as exploring other changes for both types of funds.
The initial findings of the joint review (published in December 2019) focused on the "mismatch" between redemption terms and funds' liquidity, which leads to unfair advantages for investors who redeem first.
The regulators found that to achieve better consistency, the following three principles need to be implemented:
• A fund's liquidity should be assessed based on either the price discount needed for a quick sale of a representative sample of the fund (including liquid and illiquid parts) or the time period needed for a sale to avoid a material price discount.
• Removing the incentive to redeem ahead of other investors via "swing pricing" - investors who ask for their assets first (within 24 hours, for example) would receive a lower price for their units compared to investors who gave a longer notice period.
• Redemption notice periods should last for the period needed to sell the required portion of a fund's assets without discounts beyond those captured in the price by redeeming investors.
The joint review is still ongoing with the regulators expected to release the findings in 2020, which will then inform the FCA's development of further rules for all open-ended funds.
While the shape of those additional rules are still unclear, the initial findings suggest big changes particularly on investors' rights to redeem, potentially putting a question mark on the future of daily trading for illiquid assets.
What do the new rules mean for fund managers of FIIAs?
Must suspend dealing when there is "material uncertainty" about the valuation of at least 20% of the scheme property.
Exception: If the fund manager has agreed with the fund's depositary that remaining open is in the best interests of investors. This exception can only be utilised if the decision to continue dealing is taken within two business days from when the material uncertainty arises.
Liquidity risk management
While current rules require fund managers to have liquidity management systems in place, the new rules additionally require fund managers to:
• Implement and maintain an "adequate" liquidity management contingency plan for exceptional circumstances, including outlining communication arrangements with the FCA, investors and the media.
• Obtain written confirmation from any "relevant" third parties identified in their contingency plans that they can comply with the contingency plan.
The rules require:
• Additional disclosure in the prospectus of the details of their liquidity risk management strategies, including the tools they will use and the potential impact on investors.
• A standard risk warning in financial promotions to retail clients: including "…there may be occasions when you experience a delay or receive less than you might otherwise expect when selling your investment".
Robin Henry is partner and head of dispute resolution services, and Anna Battams is an associate at Collyer Bristow