Posted by Michael McKee and Chris Whittaker on 13 July 2022
Tagged to FCA, Funds, Investors, Russia, sanctions, Ukraine

On 6 July 2022, the Financial Conduct Authority (FCA) published its Policy Statement in response to its Consultation on the use of side pockets for authorised fund managers (AFMs) who have been affected by the Russian invasion of Ukraine. These new rules and guidelines have applied from 11 July 2022.

Illiquid and untradeable assets  

The invasion of Ukraine has resulted in the UK and other jurisdictions – including the EU, Japan, Canada and the US – imposing financial sanctions on individuals and corporate entities in Russia. In addition, the Russian government has itself applied trading restrictions, leading to challenges for investors and funds.

The sanctions and trading restrictions have led to Ukrainian assets becoming illiquid and untradeable. Consequently, the assets cannot be sold and purchased, because they are not freely transferable. Potential purchasers are also unwilling to acquire assets connected with Russian sanctions due to their risk and reputational issues. In addition, the procedure for assessing accurate and reliable valuations of these assets has been a particular challenge.  

The FCA has sought to tackle these challenges in a timely and cost-effective way by authorising the use of side pockets in this limited circumstance by AFMs as a temporary solution.

A regulatory solution: using side pockets

Following questions in the Consultation, the FCA has provided guidance and support for AFMs when dealing with this situation. The regulator has proposed ring-fencing the illiquid assets in side pockets away from the remainder of the fund that is not subject to sanctions or restrictions. These assets are referred to as “affected investments.”

The side pockets give the AFMs the option to separate the affected investments from the fund’s other investments as a separate unit class. This means the existing class of units would no longer reflect the value of the affected investments. Instead, these ring-fenced affected investments would only be valued by reference to the sanctioned and untradeable assets.

As a result, original unitholders will be entitled to receive proportionate units of the affected investments, however, there is no certainty in the valuation of these affected investments, due to the unpredictability of the current situation. New investors to the fund would not receive any portion of the proceeds if the assets in the side pocket were sold as they are entirely separate from the other assets.

Benefits of the side pocket option

The FCA proposes the use of the side pocket mechanism will enable:

  • new investors to enter the fund without sharing in the exposure of the affected investments;
  • existing investors to sell the units that relate to assets that are not affected investments; and
  • some funds to end their current suspension of dealing.

This is a temporary strategy for AFMs, but the regulator understands this structure may last for a longer duration due to the uncertain circumstances. With this in mind, the AFMs are encouraged to manage the side pocket class with the aim of terminating it when the best interests of the unitholders can be met.

The FCA warns of the uncertainty of these affected investments and the unpredictability of whether the affected investments will ever recover their lost value. If the assets in the side pocket are sold and realise a gain, the investors holding units in the side pocket class would benefit.

Outcomes and updates of the Policy Statement

In response to the Consultation, the Policy Statement set out to clarify several issues:

  • the definition of “sanctioned investment”
  • the disclosure of enhanced risk warnings in the prospectus alongside any information sent to investors when they receive units in the side pocket class
  • rules and guidance regarding how voting rights for side pocket units may be exercised at a unitholder meeting
  • rules and guidance on the expectations of how AFMs should carry out the Assessment of Value (AoV) required by COLL 6.620R
  • rules and guidance that AFMs should consider in relation to the operational needs of distributors before deciding to set up a side pocket class
  • the provisions around the ability of AFMs to effect redemptions and transfers of title to units in a side pocket class

Sanctioned investment

Affected investments includes reference to a “sanctioned investment.” The Policy Statement has extended this definition to cover assets or investments subject to any relevant sanctions regime and held in the retail authorised fund, making it broader in nature. Alternatively, the asset must be linked to one of the “affected countries” – Russia, Belarus or Ukraine – for it to fall under the definition of “affected investments.”

Disclosure of enhanced risk warnings

Disclosure of enhanced risk warnings must be outlined in the prospectus document. This should include any risks associated with the side pocket such as the possibility of costs and charges attributable to the side pocket class. The regulator requires that care be taken when making these disclosures to ensure it is capable of being understood by the investors.

Voting rights

At a unitholder meeting, it must be clear whether the discussion relates to all classes of unit in the fund or the side pocket class only. Votes will relate to the individual unitholder’s portion of the specified class or classes. Unitholders with units in both a standard class and a side pocket class should not receive any undue advantage from the arrangement.

Assessment of value

AFM should review the side pocket class as part of the annual AoV process in line with COLL 6.6.20R. The AFM of a fund with a side pocket class should consider the whole fund, including the side pocket class, as part of the AoV process. The AFM should adopt a proportionate approach to the specific assessment of the side pocket class.

Operational needs

Before announcing the intention to create a side pocket class, the AFM should have regard to the reasonable operational needs of the intermediate unitholders and any reasonable periods of time they need to establish their processes, procedures and communications to clients. This is relevant to platform providers.

Redemptions and transfers of title

The regulator offers suspension as a tool for managing the liquidity of the side pocket class. In addition, the FCA allows the AFM at its discretion to specify special non-standard dealing terms for the side pocket class in the prospectus. This includes the possibility of an extended time period for the proceeds to be paid to the unitholder.

Next steps

Those AFMs intending to use the option of a side pocket are encouraged to engage with the FCA directly before applying to modify the scheme documentation. The FCA itself has committed to undertaking reviews of authorisation applications as quickly as possible.

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