Funds Legal Update | 26 May 2021

Following the UK's departure from the European Union (EU), investment fund managers have had to deal with a considerable amount of change and uncertainty. However, as the UK takes firms steps to shape its own financial services regulation outside of the EU, there are lots of reasons for the industry to remain optimistic. While we look forward to seeing the detailed proposals coming out of HM Treasury's review of the UK funds regime, we also have the recently enacted Financial Services Act 2021. This promises (among other things) to improve the UK's regulation of investment firms, promote access to UK markets and address the ambiguities that have long cast a shadow over aspects of the Packaged Retail Investment and Insurance-based Products (PRIIPs) Regulation.

There are also changes on the horizon for property funds, as the Financial Conduct Authority (FCA) considers the next steps in its proposal to apply mandatory notice periods to property funds. Will 2021 also see the introduction of a new authorised fund regime for investing in long term assets?

Separately, the FCA has published a discussion paper regarding its proposals to strengthen its financial promotion rules for high-risk investments, and for authorised firms which approve financial promotions.

Financial Services Act 2021 becomes law

After a long and arduous journey through the parliamentary process, HM Treasury reported on 29 April 2021 that the Financial Services Bill had received Royal Assent and the Financial Services Act 2021 is now law The following provisions will be of interest to the investment funds industry:

1. Prudential regulation of investment firms: As reported in our previous Legal Update, HM Treasury recently moved into the second phase of consultation regarding the creation of a new prudential regime for investment firms, known as the Investment Firms Prudential Regime (IFPR). This regime, which is due to be introduced in the UK by 1 January 2022, will be based on the EU's Investment Firms Regulation ((EU) 2019/2033) and the Investment Firms Directive ((EU) 2019/2034), with certain aspects tailored to reflect the UK's interests. The Act sets out the legislative framework for the IFPR, in particular, the FCA's role in making rules concerning the prudential regulation of FCA investment firms (for capital, liquidity, exposure to concentration risk, reporting, public disclosure, governance arrangements and remuneration policies).
2. Overseas Funds Regime: The establishment of a new Overseas Funds Regime (OFR) will allow overseas collective investment schemes to be marketed to all investors, including retail investors, in the UK market on appropriate terms. The OFR will introduce two new mechanisms: one for retail collective investment schemes, and one for money market funds, and HM Treasury will have the power to grant equivalence to a specified category of schemes from an overseas country or territory.
3. Gibraltar Authorisation Regime: The establishment of the Gibraltar Authorisation Regime is intended to provide a long-term post-Brexit legislative framework for mutual market access and aligned standards in financial services between the UK and Gibraltar. The aim is ensure that Gibraltarian financial services firms can access the UK’s wholesale and retail markets on the basis of alignment of relevant law and practice, and close co-operation between the UK and Gibraltarian governments and regulators. It is also intended to facilitate the access of UK-based firms to the Gibraltarian market.
4. Amendments to UK PRIIPs regulation: The amendment of the UK's version of the PRIIPs regulation will enable the FCA to clarify its scope through its own rules, which will allow it to address existing and future ambiguities relating to investment product. The changes will also enable the regulator to clarify what information on performance should be provided in a key information document, and delegate power to HM Treasury to further extend the exemption for UCITS (undertakings for collective investment in transferable securities) for up to five years.

Liquidity mismatch in authorised open-ended property funds

The FCA has published (7 May 2021) the Feedback Statement (FS21/8) to its consultation paper on liquidity mismatch in property funds. These are open-ended UK authorised funds that invest in property that are constituted as non-UCITS retail funds (NURS) and offer investors daily, monthly and quarterly opportunities, or "valuation points’", to buy and redeem units.

Property funds tend to hold a significant cash balance. Otherwise, they might not have time to sell properties to pay investors who can request their money back at short notice. If a fund runs out of cash, this can cause it to suspend dealings, which can in turn cause investors to request their cash back in anticipation of such suspensions (thereby exacerbating the problem).

In August 2020, the FCA consulted on whether property funds should be required to have notice periods between 90 and 180 days before an investment can be cashed. However, finding the optimal notice period length is no easy task –a balance needs to be struck between lowering the risks of fund suspensions by addressing the liquidity mismatch and providing retail investors with speed of access to their investment. The market risk borne by the investors during the notice period also needs to be considered. A majority of respondents preferred a notice period of 90 days rather than 180 days.

Taking into account the operational work necessary for fund managers to support notice periods, the FCA has said it will not take a final decision on its policy position until the third quarter of 2021 at the earliest. The regulator has indicated that a suitable implementation period will be given (reflecting feedback that 18 months to two years would be an appropriate period).

Given the crossover between the FCA's Long Term Asset Fund (LTAF) proposal (see below), and the possible introduction of notice periods for property funds, the FCA will also take account of feedback to its LTAF consultation paper and wider progress on the LTAF before finalising its policy on notice periods for property funds.

A new authorised fund regime for investing in long term assets?

The FCA has published its consultation paper (CP21/12) ( 7 May 2021) on a regime to enable UK-authorised open-ended funds to invest more efficiently in long-term, illiquid assets.

Investors can already invest in these types of assets through closed-ended structures or a range of private structures. But some investors prefer investing in open-ended funds that offer opportunities to put in or take out money at the net asset value of the assets. However, as is the case with property funds, open-ended structures that invest in illiquid assets can face problems if daily dealing to investors is offered.

The FCA is, therefore, proposing that LTAF rules embed longer redemption periods, high levels of disclosure, and specific liquidity management and governance features. These would take account of the types of risk to which LTAFs might be exposed and help give investors confidence that they are being managed appropriately and in their interests.

Aside from offering an alternative investment opportunity to experienced retail investors, the LTAF would also be aimed at defined contribution (DC) schemes which may be interested in investing part of their assets into an LTAF, in line with their investment horizons and risk appetite. This consultation also, therefore, proposes amending the permitted link rules to enable pensions schemes to consider the proportion of illiquid assets across their investment portfolios, rather than to restrict the proportion of illiquid assets in each underlying fund in which they invest.

Initially, the regulator is proposing to restrict distribution of the LTAF to professional investors and sophisticated retail investors. The FCA is also looking for feedback on whether, and how, it could safely permit future wider retail access to these funds than its proposed rules would permit.

The deadline for comments is 25 June 2021.

FCA sets out proposals to strengthen its financial promotion rules for high-risk investments

On 29 April 2021, the FCA published Discussion Paper 21/1: Strengthening our financial promotion rules for high-risk investments and firms approving financial promotions (DP21/1).

The issues that the FCA discusses in DP21/1 primarily relate to financial promotions for high-risk investments. The FCA considers any investment which is subject to marketing restrictions under its rules to be a "high-risk investment". This includes non-readily realisable securities, peer-to-peer agreements, non-mainstream pooled investments and speculative illiquid securities.

The FCA focuses on the following three areas where changes could be made to address harm to consumers from investing in inappropriate high-risk investments:

• Classification of high risk investments (chapter 3 of DP21/1). The FCA’s classification determines the level of marketing restrictions that apply to an investment.
• Further segmenting the high-risk investments market (chapter 4 of DP21/1). The FCA is concerned that despite its existing marketing restrictions, too many consumers are still investing in inappropriate high risk investments which do not meet their needs.
• The role of a section 21 approver (chapter 5 of DP21/1). Section 21 approvers approve financial promotions for unauthorised persons and check for compliance with FCA rules.

The deadline for comments on DP21/1 is 1 July 2021.

Signatories to the UK Stewardship Code 2020

The UK Stewardship Code 2020 sets high standards for those investing money on behalf of UK savers and pensioners, and those that support them. It applies to:

• Asset owners such as pension schemes, insurers, foundations, endowments, local government pension pools and sovereign wealth funds.
• Asset managers who manage assets on behalf of UK clients or invest in UK assets.
• Service providers such as investment consultants, proxy advisors, data and research providers that support asset owners and asset managers to exercise their stewardship responsibilities.

Signatories must submit a stewardship report to the Financial Reporting Council (FRC) explaining how they have applied the code’s principles in the previous 12 months, demonstrating the responsible allocation, management and oversight of capital to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society.

Stewardship Code applications for the first list of signatories closed on 31 March 2021 for asset managers and service providers and 30 April 2021 for asset owners. The FRC is expected to announce the first tranche of signatories to the code in the third quarter of2021. The deadline for applications to the second round will be 31 October 2021.