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7 April 2020
Over the past few weeks, the Covid-19 epidemic led to a significant decrease in the value of listed securities, to high price volatility and to a liquidity dry-up on several market segments.
These market events entail major challenges for UCITS and open-ended AIFs in which investors are entitled to request the redemption of their units or shares at any time, such redemptions being made on the basis of the funds assets and of their net asset value. Indeed, during such market events, valuating the assets (whether listed or unlisted) of the funds may prove difficult. This situation is also likely to compromise the establishment of the net asset value of the funds, which is used to calculate the redemption price of the units. Furthermore, the dry-up of the secondary market for the assets held in the portfolios of funds may limit the possibility of selling them at non-discounted prices. On top of these two difficulties, if investors submit significant redemption requests, investment funds may face a liquidity mismatch between their assets and liabilities. This mismatch entails a liquidity risk, which the AMF defines as the risk that a line in the portfolio cannot be sold, liquidated or closed-out at a limited cost and within a sufficient short period of time, thereby compromising the ability of the UCITS or AIFs to comply at all times with the requirement to issue and redeem units at the request of investors.
These issues are totally identified by management companies of UCITS and AIFs. Indeed, they must anticipate, control and remedy the occurrence of the liquidity risk in the funds they manage. They are required by applicable regulations to define the liquidity profile of the funds when designing them and to run liquidity stress tests in normal market situations and in crisis situations, which can lead to adjustments in the composition of portfolios. ESMA published guidelines on the conduct of these stress tests ("Guidelines on liquidity stress testing in UCITS and AIFs", 2 September 2019) which will be applicable starting 30 September 2020. In addition, management companies may specify in the legal documentation of their funds that several instruments allowing for a gradual management of liquidity risk could be used, depending on the magnitude of this risk.
In this context, this newsletter provides for an overview of:
Swing pricing consists in adjusting upwards or downwards the net asset value of a fund depending on the net balance of subscriptions and redemptions requests so that investors exiting the fund are the ones to bear the costs deriving from the readjustment of the portfolio of the fund which is made necessary to meet their redemption requests. The same effect can be obtained, without adjusting the net asset value, but by charging fees payable to the fund to the investors entering or exiting the fund, such fees corresponding to the selling or purchase costs incurred when adjusting the portfolio of the fund.
Usually, these measures are solely implemented when the net balance of subscription and redemption requests exceeds a threshold. Such mechanisms are referred to as partial swing or partial adjustable fees.
The legal documentation of the funds must detail how these mechanisms can be implemented. Management companies must also put in place an up-to-date internal procedure which shall notably specify the methodology for calculating the readjustment costs of the portfolio in accordance with the AFG's Charter of Good Conduct for Swing Pricing and Adjustable Entry and Exit Fees for Funds (updated in 2016) (“Charte de bonne conduite pour le swing pricing et les droits d’entrée et de sorties ajustables acquis aux fonds”). In its Q&A, management companies are reminded that this policy may be monitored by the AMF.
Triggering swing pricing mechanisms and applying adjustable fees, which can also be used in normal market conditions, are often the first steps taken by a management company to deal with a temporary liquidity problem. The AMF approves in its Q&A the use of these mechanisms in the context of the current crisis, due to the low liquidity profile of several underlying assets of investment funds and to the high costs that are sometimes incurred when readjusting portfolios.
Several investment funds have already started to use these tools in the context of the current crisis. However, for investment funds whose legal documentation does not yet indicate the possibility for their management company to use these tools, or for funds that need to amend their legal documentation to change their swing pricing system, the AMF specifies in the Q&A that the introduction of these changes is not subject to the prior authorisation of the AMF but must be disclosed to unitholders by any means. In addition, the AMF indicates that it authorizes, on an exceptional and temporary basis (until 24 June 2020), management companies to introduce adjustable exit fees involving an increase in redemption fees without any obligation to offer unitholders the possibility to exit the funds free of charge and to provide them with a specific disclosure on this change. However, the AMF specifies that these fees must be justified, non-confiscatory and non-dissuasive, and that investors must be properly informed of this measure.
Redemption in kind consists in transferring assets of the portfolio to investors in order to pay the price of redemption requests. However, it is difficult to implement this mechanism for non-professional funds, since French regulations require the prior approval of the redeeming unitholder, or even of all unitholders when the management company is unable to transfer a representative portion of the total assets in the portfolio of the fund. Also, a specific report on the valuation of the assets from the statutory auditors is required.
In the event that the first-level liquidity risk management measures are not sufficient to deal with a crisis situation, management companies may implement two types of exceptional measures on a temporary basis as well as an exceptional measure to implement the extinctive management of the illiquid portion of a fund's assets.
Management companies may decide to set up a gating mechanism on redemption requests in UCITS, as well as in open-ended AIFs such as retail AIFs (fonds d'investissement à vocation générale (FIVG)).
This measure, which allows to allocate temporarily the execution of redemption requests for units on several successive net asset values, when such redemption requests exceed a threshold computed on the basis of the fund's net assets, must be provided for in the funds legal documentation.
AMF Instruction 2017-05 on "Conditions for setting up redemption gate mechanisms", which applies to retail investment funds (FIVG), private equity funds (FCPR, FCPI and FIP), professional private equity investment funds (FPCI), or employee investment schemes, govern the implementation of gating mechanisms. More specifically, the legal documentation of these investment funds must provide for a triggering threshold and for the maximum time period during which the gating mechanism can be applied, which must both be defined with respect to the frequency of calculation of the net asset value, the management policy and the liquidity profile of the underlying assets of the funds. The procedures for delaying the execution of redemption orders on subsequent net asset values must also be detailed in the funds documentation, it being specified that orders that are carried forward shall not benefit from a priority right to be executed on the basis of the next net asset values.
A management company has the option to activate a gating mechanism provided for in the legal documentation of an investment fund. Its decision must be justified each time it is actually made. The activation of a gate on the execution of redemption requests must be communicated to the AMF and to the unitholders of the funds.
In its Q&A, the AMF emphasizes that management companies must provide for the possibility to activate gates in the governing documentation of CIUs, which shall notably include details on the triggering threshold, the maximum duration for sequencing the execution of redemption requests and the procedures for managing remaining non executed orders (postponement or cancellation, at the investor’s discretion or not), that these amendments are subject to the prior approval of the AMF (for authorized CIUs), and that investors must have been granted the opportunity to exit the CIUs free of charges during a minimum period of 30 calendar days when such change is made.
In both UCITS and open-ended AIFs, management companies may decide to suspend the redemption of units or shares under two cumulative conditions: (i) when exceptional circumstances so require, and (ii) if the interests of investors and the public demand it. The conditions for implementing a temporary suspension of redemption requests must be provided for in the funds documentation.
The decision to suspend redemption requests is a last resort measure taken during very difficult events. The AMF pointed out in its Q&A that this measure should only be contemplated, given the current exceptional circumstances, in the event that it is impossible to evaluate portfolios, dispose of assets or meet redemption requests.
The aim of this measure is to protect all investors in the relevant fund notably by preventing several investors from exiting a fund on the basis of an incorrect net asset value. This measure may be combined with other measures (suspension of subscription requests or the introduction of subscription fees).
In the past, suspensions of redemption requests were decided in 2001 when the equity markets in the United States of America were closed following the attacks of September 11, 2001, as such closures made it impossible to reliably estimate and dispose of the assets in the portfolio of funds. In 2009, this measure was also implemented for UCITS that invested in vehicles exposed to the Madoff fraud, while awaiting for information on the scope of the fraud and on the possibility to evaluate these investments. On this occasion, the AMF published recommendations for the attention of management companies in order to clarify its expectations on the implementation of this measure (Recommandations de l'AMF à destination des sociétés de gestion gérant des OPCVM de droit français susceptibles d'être impactées par l'affaire Madoff, 17 décembre 2008, 17 December 2008).
These exceptional measures taken at the initiative of management companies do not preclude the intervention of the regulator. Indeed, the AMF can request a management company to terminate the implementation of a gating mechanism, to suspend redemption requests or to limit the use of these measures. The AMF may also request, at its own initiative, the temporary suspension of redemption requests for one or more CIUs when exceptional circumstances so require and when the interests of investors or the public demand it.
When part of the assets of a UCITS or AIF cannot be evaluated, management companies also have the option to ring-fence these assets in so called "side pockets", to continue to manage and establish a net asset value for the portfolio of liquid assets and to meet redemption requests on the basis of these assets.
In this respect, when exceptional circumstances so require it and when the interest of the holders and the public demand it, if several assets cannot be disposed of in the interest of investors, the relevant fund may be split so that the illiquid assets are kept in the existing fund which is put into extinctive management and liquid assets are then transferred to a new fund.
Initially created in France in 2008 during the subprimes crisis, this mechanism was used to ring-fence assets impacted by the Madoff fraud, and was lately modified by the PACTE Law in order to be fully consistent with the UCITS Directive. The initial mechanism consisted in splitting the existing fund through the creation of two new funds: a "replication" fund intended to receive the liquid assets and a "side pocket" fund intended to receive the illiquid assets. Henceforth, the "side pocket" fund is no longer to be a new fund: the illiquid assets are kept in the existing vehicle and the liquid assets are transferred to a new vehicle of the same type as the existing one.
Decree no. 2020-286 of 21 March 2020, which came into force on 22 March, aligned regulatory provisions of the French monetary and financial code with the legal provisions introduced by the PACTE Laws and harmonized rules applicable to investment funds formed either as mutual funds (fonds communs de placement) or as investment companies with variable capital (sociétés d'investissement à capital variable). The General Regulations of the AMF should also be amended in the near future to supplement the new legal and regulatory framework. In the meantime, the possibility to implement ring fencing mechanisms is not delayed. In this regard, in its Q&A, the AMF requests management companies to liaise with their official contact (chargé de portefeuille) at the AMF prior to implementing a ring fencing mechanism.
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This legal update is not intended to be and should not be construed as providing legal advice. The addressee is solely liable for any use of the information contained herein and the Law Firm shall not be held responsible for any damages, direct, indirect or otherwise, arising from the use of the information by the addressee.
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