FCA consults on allowing side pockets for UK authorised funds

On 28 April 2022, the FCA published CP 22/8 (the CP), setting out proposals to protect investors by allowing UK authorised funds to use side pockets for their Russian, Belarusian and Ukrainian exposures following Russia’s invasion of Ukraine. This move would be a “limited emergency measure” only.

As we reported at the time, the likelihood of a CP was flagged on the FCA’s website in mid-March.

Not surprisingly, the timeframe for the consultation and resultant rules is tight – the CP closes on 16 May 2022 and the FCA intends to publish final Handbook rules and guidance in a Policy Statement “as soon as possible”.

What is the CP about?

The impact on the financial markets of Russia’s invasion of Ukraine has meant that authorised fund managers (AFMs) need to decide how to deal with affected investments in their funds. Many AFMs have written down the value of the affected investments to zero (or near-zero) to reflect their inability to deal in assets which are subject to sanctions.

For the purposes of the CP, the FCA defines ‘affected investments’ as including:

• equities and fixed-income securities issued by governments, public authorities and corporates in Russia, Belarus and Ukraine and securities listed, offered or placed in those countries
• assets listed and traded on other stock exchanges and backed by such securities, for example depositary receipts
• securities issued by companies whose operations are particularly severely affected by the current situation, or which are owned or controlled by individuals who are the subject of UK or international sanctions relating to Russia
• units in other collective investment schemes that have suspended dealings because of exposure to such assets.

What is the CP proposing?

In the current situation, AFMs may not be able to obtain accurate, reliable and regular prices for affected investments, so may be unable to produce an accurate unit price for the fund. This can make it difficult for AFMs to comply with their duty to treat unitholders in their funds fairly.

Some funds, where affected investments form a significant proportion of the fund’s assets, have suspended dealing, which means that their investors can neither invest more in the fund or redeem their existing units.

So, the CP proposes changes to Chapter 7 of the Collective Investment Schemes sourcebook (COLL), which would allow UK authorised funds to use side pockets for their Russian, Belarusian and Ukrainian exposures, thereby separating these from the fund’s other investments.

• Taking the decision. The AFM will be responsible for deciding whether using a side pocket would be in the best interests of investors (although they must consult with the depositary). AFMs will have to consider the particular circumstances for a fund carefully, with the FCA setting out a list of conditions that must be satisfied.
• Amendments to scheme documents. The instrument and prospectus must be amended to allow side pockets, which requires FCA approval. The FCA has stated that it is willing to work on a fast track process to consider such applications.
• Investor consent. Investor approval will not be needed under these proposals, unless the foreseeable costs are disproportionately large compared to the potential benefits. The usual notification requirements will also not apply.
• Costs and charges. The FCA accepts that the side pocket class should bear a proportionate share of the costs, which may include the AFM receiving some remuneration from the side pocket class.
• Other considerations. The FCA have left it to AFMs to consider whether the side pocket will be a single collective investment scheme for the purposes of s235(4) of the Financial Services and Markets Act 2000. The FCA are also engaging with HM Treasury and HMRC in relation to the ISA Regulations.

Under the proposals, existing classes of units in the fund would no longer reflect the value of affected investments - the value of units in the side pocket would be determined only by reference to the affected investments. Existing unitholders at the time when the side pocket is created would receive units in the side pocket class, giving them the right to a portion of the affected investments.

The advantage of this is that it could then allow

• some suspended funds to reopen, allowing investors access to part, at least of their investment (which would otherwise remain locked up, possibly for a long period).
• new investors to enter the fund without sharing in the exposure to the affected investments
• existing investors to sell the units which relate to assets that are not affected investments

The proposals would require the AFM to manage the side pocket class with the aim of terminating it as and when this could be done in the best interests of investors.

Noting that the affected investments are subject to financial sanctions not only by the UK but also the EU and other G7 nations, AFMs would have to “understand the legal requirements and obligations that apply under the relevant financial sanctions regimes and be satisfied that the class and the operational arrangements will comply” before deciding to create a side pocket class. The AFM would have to base its decision on whether a side pocket would be in the best interests of each fund it manages and of the unitholders in those funds.

The FCA’s proposals deliberately do not include any time limit for an AFM to elect to create a side pocket while it remains uncertain how the situation in Ukraine might develop. Instead, it will consult further when it feels the time is right to end the emergency measure. The FCA does, though, confirm that any decision to end the power to create a new side pocket would not affect any arrangements already set up under the proposed rules.

What happens next?

The consultation period ends on 16 May 2022. The FCA intends to publish its final rules as soon as possible thereafter, along with a Policy Statement with feedback received to the CP.

Hopefully, this will offer some clarity on the position for UK firms that manage EU-based UCITS funds, given that different EU Member States take different approaches on the use of side pockets by retail products.

It is important to note that the FCA specifically notes that the side pocket proposals are a “limited emergency measure” to deal with the impact of the Russian invasion of Ukraine and would only be available for UK UCITS and NURS holding affected investments which are subject to sanctions, or for which there are no accurate, reliable and regular prices.

The FCA has a specific mandate in this regard and is not currently considering allowing the wider use of side pockets in authorised funds and its current proposals should not be taken to mean that it will allow side pockets in retail funds “for any other current or future situations”.

Further information

For our note on the impact on asset managers more generally of the recent EU sanctions on Euro denominated securities see our article here.

For further information or advice, please see our online resource here or speak to our Financial sanctions and trade controls team; Alexandra Webster, Etienne Kowalski, Sascha Kuhn and David Schreuders.