On 28 April 2022, the Financial Conduct Authority (FCA) published Consultation Paper 22/08: Protecting investors in authorised funds following the Russian invasion of Ukraine (CP22/08).

The FCA has published CP22/08 in light of the significant impact that Russia’s invasion of Ukraine is having on financial markets. Many investments have been affected both by the events themselves, and by the wide range of financial sanctions on Russia, Belarus, certain individuals and businesses that the UK and other nations have imposed in response.

In CP22/08 the FCA sets out proposed rules to address the potential harm caused by the exposure that UK authorised retail funds have to ‘affected investments’ being:

  • equities and fixed-income securities issued by governments, public authorities and corporates in Russia, Belarus and Ukraine and securities listed, offered or placed in those countries;
  • assets listed and traded on other stock exchanges and backed by such securities, for example depositary receipts;
  • securities issued by companies whose operations are particularly severely affected by the current situation, or which are owned or controlled by individuals who are the subject of UK or international sanctions relating to Russia; and
  • units in other collective investment schemes that have suspended dealings because of exposure to such assets.

The FCA draft rules and guidance will allow an authorised fund manager (AFM) to structure the fund differently, using separate new classes of units to hold the affected investments. The FCA refers to these unit classes as “side pockets”. Side pockets are commonly used in non-retail funds, such as hedge funds or institutional funds, either as a routine way of dealing with certain illiquid assets or in response to unforeseen circumstances. However, they are not normally available to retail funds, which are meant to hold liquid assets so that they can offer redemption on demand.

The FCA proposes that managers of UK authorised retail funds with exposure to affected investments use their discretion to determine whether it is in unitholders’ best interests to create a new class of unit relating only to the affected investments, distinct from other classes of unit relating to all the unaffected liquid assets. After the new unit class is created, the existing investors would be given units which are linked to the value attributable to the affected investments, proportionate to the exposure they had immediately before the creation of the side pocket. The unit class linked to the affected investments would then close to subscriptions, and redemptions may be suspended. The AFM would manage the side pocket class in order to close it down as and when this can be done in the best interests of its unitholders. Existing investors would also continue to have units in the fund which are linked to the value attributable to the liquid assets. Ultimately, existing investors’ overall exposure to assets (both the affected investments and all liquid assets) and their ownership rights would not change as the result of creating a side pocket class.

The FCA believes that this arrangement offers benefits to both AFMs and unitholders in affected funds. For example, the FCA states that:

  • The fund itself would continue to operate with minimum disruption. The fund would remain a single entity for accounting purposes, so there should be no need to adjust the book cost of affected investments.
  • There would be no change to the fund’s identity, the custody registration of the underlying assets in the fund would be unaffected with little or no impact on the depositary and its sub-custodians.
  • Funds registered for sale outside the UK would not have to update their local registration, and the AFM would not need to publish new pre-sale disclosure documents.
  • The fund’s investment performance record could also continue uninterrupted, though the AFM might need to explain in some cases that past performance is based on a materially different asset allocation profile.

The FCA’s proposals would not be consistent with the Money Market Funds Regulation, so they do not apply to money market funds.

The proposed rules are a limited emergency measure to deal with the impact of the Russian invasion of Ukraine. The FCA is not considering allowing the wider use of side pockets in authorised funds – they would only be available for UK UCITS and non-UCITS retail schemes (NURS) (UK authorised retail funds) that hold affected investments which are subject to sanctions, or for which there are no accurate, reliable and regular prices. The proposed rules and guidance in CP22/08 should not be interpreted as meaning that the FCA will allow side pockets in retail funds for any other current or future situations.

The deadline for comments on CP22/08 is 16 May 2022.

The FCA will consider the feedback to CP22/08 and publish a Policy Statement and final Handbook rules and guidance as soon as possible.

The FCA is not proposing to set any time limit on when AFMs may elect to create a side pocket under the new rules on the basis that it is too early to know how the situation in Ukraine might develop. The FCA intends to keep matters under review and consult further when it judges it is appropriate to withdraw this emergency measure.