Ukraine – ESMA provides guidance on the use of side pockets

ESMA has today published a public statement, "Actions to manage the impact of the Russian invasion of Ukraine on investment fund portfolios".

In an associated development, the Central Bank of Ireland has also published a regulatory update, supporting the ESMA stance and setting out a streamlined approval process for side pocketing arrangements for affected funds. Our separate note on the Central Bank’s update will be published shortly.

Who does this affect?

• AIFMs subject to the AIFMD

• EuVECA managers

• EuSEF managers and

• UCITS management companies and self-managed UCITS investment companies (together 'UCITS ManCos')

What is the aim of the Statement?

ESMA is seeking to promote convergence in the management of investment fund portfolios which have exposure to Russian, Belarusian and Ukrainian assets, given the material valuation uncertainties and adverse impacts on the liquidity of such assets.

In particular, the Statement looks at managers' obligations to

• manage investment funds in the best interest of investors

• have adequate liquidity management systems in place and

• ensure the fair valuation of assets.

At the moment, rules around the use of liquidity management tools (LMTs) and on asset valuation and fund accounting are still largely subject to national law.

The Statement also considers where the use of LMTs - specifically side pockets - may be warranted, both by AIFs and by UCITS.

General principles in case of material liquidity issues and valuation uncertainties

Managers of investment funds which have exposure to assets ('exposed assets') facing liquidity issues must

• assess whether a fair value of exposed assets can still be determined and

• adapt the valuation without undue delay.

A one-size-fits-all approach (e.g., writing all exposed assets down to zero without due consideration to the specificities of each asset) would not be appropriate.

Where the manager concludes that it's not possible to determine a fair value, it should consider a number of measures, such as

• immediate temporary suspension of both subscriptions and redemptions

• the total write-off of the relevant assets

• liquidation of the fund or

• segregating assets that have become illiquid or non-tradable following the invasion of Ukraine from the liquid assets in the portfolio.

The appropriate course of action will depend on a case-by-case assessment (how much value could be recovered, how many assets are affected, their importance in the overall portfolio etc).

Side pockets

The Statement looks principally at the use of side pockets in respect of exposed assets

(a) General principles - benefits and risks of side pockets

ESMA sees two main advantages to using side pockets:

• they allow investors who need liquidity to cash in the part of the fund portfolio that is still liquid

• it protects the interests of investors who wish to remain in the investment fund, as the manager does not have to liquidate assets at or under market prices if faced with high redemption demand.

In particular, using side pockets might prevent the need to suspend all subscriptions and redemptions and provide initial investors with protection against potential dilution effects.

On the other hand:

• side pockets can carry risk as illiquid assets transferred into a side pocket may not become liquid again in the future - writing off exposed assets at the outset may save investors the costs of creating the side pocket

• some fund distribution platforms also have potential operational problems with the creation of side pockets.

The use of side pockets (including by UCITS) forms part of the debate in the context of the AIFMD/UCITS review and ESMA emphasises that the clarifications provided in the Statement relate to the specific situation around the Russian invasion and are without prejudice to any potential future legislative amendments that the EU may adopt.

(b) Side pockets in AIFs

The AIFMD framework recognises the ability to use side pockets and, subject to more restrictive requirements in relevant national law or in the fund's constitutional documents, an authorised AIFM may consider creating a side pocket where this is in the best interest of investors.

In principle, registered managers of EuVECA and EuSEF should apply the same considerations as other AIFMs, though ESMA accepts that, in practice, the closed-ended nature of these funds makes the issue less relevant.

(c) Side pockets in UCITS

Again, subject to national law and any future guidance that the European Commission may provide, ESMA's view is that, to manage the impact of the Russian invasion of Ukraine on the fund's portfolio, side pockets in UCITS "could be permissible" where the liquid and illiquid assets are segregated by transferring the liquid assets to a new UCITS or into a new compartment of the original UCITS. This would mean that

• existing investors would receive shares or units of the new UCITS (or new compartment) pro rata to their existing investment

• new investors would only subscribe to the new UCITS (or new compartment) holding the liquid assets.

ESMA does, though flag that using a side pocket

• should be in the best interest of investors and

• cannot result in a transformation of the UCITS into a non-UCITS in contravention of Article 1(5) UCITSD.

UCITS ManCos are required to inform investors and their home NCA of their planned use of side pockets and to do so in a timely, clear and comprehensive manner.

They must also keep investors informed on a regular basis both of the illiquid and the liquid part of the original UCITS portfolio.

Comprehensive analysis

The manager must perform a comprehensive analysis to ascertain, whether and which of the permissible side pocket arrangements could be implemented (and under what circumstances and conditions) and to weigh up the advantages and disadvantages for all investors wishing to subscribe, redeem or remain invested in the fund.

The analysis should also take into account other relevant regulatory requirements - for example, the evolving EU sanctions regime and potential adverse tax implications under applicable national rules

In respect of a UCITS, this includes demonstrating that the liquid part of the portfolio is sufficiently diversified to operate in accordance with the UCITS risk diversification requirements. If this means that the risk profile or constitutional documents of the UCITS have to be changed, this should be reflected in the prospectus.

As there is no legal segregation of assets between different UCITS share classes (and even the legal segregation between different UCITS compartments might be uncertain in some Member States) there may be the risk that liability arising in the future in one compartment impacts assets and investors in other compartments.

Next steps

ESMA will continue to closely monitor the situation and take or recommend any measures necessary to mitigate the impact of the Russian invasion of Ukraine on investment funds.

It will also reassess, as necessary, the need to either supplement the guidance provided in the Statement or provide additional guidance on other issues arising from the crisis.

Where can I find out more?

See also our articles on:

• the FCA's consultation on allowing Authorised Fund Managers (AFMs) of retail UK authorised funds (UK UCITS and NURS) to create side pockets to get through some the problems arising from the Russian invasion of Ukraine and

• the EU's restrictions on the sale of euro denominated transferable securities issued after 12 April 2022 or units in collective investment undertakings which provide exposure to such securities

For more information on the ESMA statement, please speak to your usual Simmons contact.

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