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Six month notice periods for property funds? A closer look at CP20/15

  • United Kingdom
  • Financial services and markets regulation
  • Real estate investment
  • Financial services

02-10-2020

Introduction

After several months’ hiatus the Financial Conduct Authority (“FCA”) has returned to its pre-pandemic focus on open-ended fund liquidity.  On 3 August 2020 the regulator published a new consultation paper CP20/15: Liquidity mismatch in authorised open-ended property funds (“CP20/15”) which proposes steep notice periods for any redemption requests made to UK authorised funds investing in property.

In this briefing we explore the immediate impacts for fund managers and anticipate the regulator’s next steps.

Background

The June 2019 suspension of Neil Woodford’s flagship fund was one of the biggest financial stories of the year and gave renewed urgency to calls for the FCA to examine the so-called “structural mismatch” between many open-ended funds and the liquidity of their target assets.  The FCA then published PS19/24: Illiquid assets and open-ended funds (“PS19/24”) on 30 September 2019.  PS19/24 introduced significant reforms, including:

  • new suspension rules for NURS investing in immovable property;
  • new guidance and disclosure requirements for daily dealing NURS funds investing in illiquid assets; and
  • the introduction of a regulatory sub-category – funds investing in inherently illiquid assets (“FIIA”) – for NURS.

In our briefing on PS19/24, we wrote that the FCA was also considering “introducing notice periods and reduced dealing frequencies for open-ended funds investing in illiquid or less liquid assets”. CP20/15 represents a clear step in this direction, though it is clear that events over recent months have also played a role.  Following the outbreak of COVID-19 almost all UK authorised funds that invest in property suspended dealings.

In addition to this focus on suspensions, the FCA has also raised concerns about the large cash holdings many open-ended property funds hold as a precautionary buffer.  In the FCA’s view this ‘cure’ may be as bad as the disease, providing inadequate defence against underlying risk while adding an unwelcome drag on investor returns.  It is hoped that notice periods will allow property funds to maintain leaner cash asset ratios.

Who does this cover?

CP20/15 is directed at the managers and depositaries of any open-ended UK non-UCITS retail schemes (“NURS”) which qualifies as a “fund predominantly investing in property” (“FPIP”).  At least 50% of a NURS’ holdings must be in property related assets for it to be considered a FPIP.  ‘Open-ended’ is less clearly defined at this stage as the scope of the new rules will depend on the length of the notice period (see below). 

There is a proposed exemption for existing funds which offer limited redemption and offer dealing no more frequently than monthly. No such exemption is proposed for new funds.

Fund-of-funds, or master funds investing in eligible funds, may also be subject to the new rules.

Summary

Under the new rules, investors in relevant funds would be expected to give notice ahead of any withdrawal.  No payment would be processed by the fund until the end of this notice period and the value of the withdrawal would be based on the unit price following the end of their notice period, not the point at which the investor made the initial request.

The dealing frequency for subscriptions would not be affected.  The analogy the FCA makes is that a daily dealing fund would thus in this respect operate similarly to a deposit account with a notice period.

Withdrawal requests would be irrevocable, which means that investors will be subject to a degree of uncertainty as the market may move after they process their initial request.  The FCA acknowledges these drawbacks and relevant fund managers would be required to “ensure that warnings are given to retail investors covering the market risk they would be exposed to during the notice period, the length of the notice period associated with their investment, and the irrevocable nature of the redemption requests.”  There is no suggestion that the FCA will consider allowing investors to cancel requests once they have been made.

The length for the notice period is one of the key areas of debate in CP20/15.  The FCA’s proposed range stretches from 90 days – this being an “acceptable timeframe” for the consumer to plan financial affairs – all the way up to six months (180 days).  As the FCA notes, the longer timeframe would allow “more time to sell property at the best price which can be obtained”, but it would have a clear impact on consumers, who would be exposed to more of the “market risk” previously discussed.  The FCA has also indicated that it might consider using multiples of seven (i.e., a 182 day limit) which could be broken down into a set number of weeks.

The notice period will determine the final scope of the new rules, as only funds which provide for more frequent dealing in units than the notice period would qualify as FPIPs.  As NURS must redeem investors at least once every 185 days, a longer notice period would effectively capture all NURS funds which meet the asset qualifications.

ISA eligibility and other consequences of the proposals

One major issue surrounding CP20/15 is the possible impact on FPIP tax status.  While NURS currently benefit from ISA status under certain conditions, it is likely that the new FPIP sub-category would be ineligible investments for a Stocks and Shares ISA.

The FCA is in currently in talks with the Treasury and HMRC on the future status of these funds for ISAs.

The CP also discusses the possible impact of the proposals on advisers, distributors, unit-linked funds investing in property funds and SIPP providers.

‘Fundamental’ or ‘significant’ change?

Any changes made to the dealing terms will require amendments to the fund’s constitutional documents along with the prospectus.  Written notice of the proposed changes must be provided to the FCA and the fund will be obliged to take account of any fund specific requirements. That said, the regulator has indicated that changes associated with CP20/15, as they are driven by a regulatory requirement, will not be regarded as ‘fundamental’; this means investors will not be called on to grant prior approval by extraordinary resolution.

The changes would still be regarded as ‘significant’, however, and as such investors will be entitled to a 60 day notice period under COLL 4.3.6R(3).

Interaction with PS19/24’s FIIA rules

As discussed in greater depth in our briefing on PS19/24  the FCA established a similar sub-category of fund to the FPIP last year: a ‘fund investing in inherently illiquid assets’ (“FIIA”).  To qualify as an FIIA a NURS must disclose its intention to invest at least 50% of the scheme property in inherently illiquid assets, or have invested 50% of the scheme property in inherently illiquid assets for at least three continuous months in the last twelve.  FIIAs are subject to a number of additional liquidity management and disclosure requirements. 

Assets that are immovable (i.e. real estate) are obviously captured by the FCA’s definition of ‘inherently illiquid assets’ and as such there will be some overlap between the FIIA and FPIP sub-categories.  The FCA has confirmed that FPIPs which meet the definition of a FIIA will be considered FPIPs, but remain subject to all of the FIIA requirements, with the exception of the FIIA-specific risk warning to retail investors. Managers of FPIPS will have to include their own warnings covering the risks noted above, but in this case the exact wording can be determined by the FPIP manager.

Next steps

The consultation window for CP20/15 closes on 3 November 2020, and the FCA is looking for responses to  a number of open questions  around possible measure that could be taken to meet the issues the paper identifies and the wider consequences of the proposals, as well as in relation to the proposals themselves.   A policy statement and final rules will follow as soon as possible in 2021. 

How Eversheds Sutherland can help

Eversheds Sutherland is widely recognised as one of the leading advisers to the investment funds industry, with one of the leading fund, asset management and regulatory teams. We have over 40 years' experience of investment funds work and, in particular, authorised funds.

If you would like further guidance on the impact of the consultation paper on your business, please get in touch.