The COVID-19 pandemic is spreading rapidly around the world, leaving great uncertainty in all areas of our day-to-day life. It has created a multitude of challenges also for financial markets. As in every crisis where markets start moving unpredictably, the investment management industry is highly impacted: not only must investment managers and fund management companies continue to manage and administer the funds, they must also address investors’ inquiries during these unprecedented and uncertain times.
High volatility make for unsettled investors
As investors try to navigate the COVID-19 data fog, trading frequency of various products has increased rapidly. In this historically unique and quickly evolving situation, the risk of large numbers of redemptions is imminent for collective investment schemes. Although the industry has not yet seen substantial redemptions over a longer period, ongoing uncertainty is likely to result in an increased risk of a run on funds. Particularly if a fund is holding illiquid or complex investment products that are difficult to turn into cash for redemption in a timely manner, numerous redemptions may result in a forced liquidation of the fund. Another issue is excessive bid-ask spreads in certain asset-classes and markets that make pricing and the calculation of the NAV a challenging conundrum for fund management companies.
The Swiss Financial Market Supervisory Authority FINMA and the Swiss Funds & Asset Management Association SFAMA are closely monitoring the situation, but currently no special measures should be expected. Financial institutions, however, are unsettled and want to protect themselves against possible liquidity problems.
When the going gets tough…
In order to navigate these stumbling blocks as successfully as possible, financial institutions and in particular fund managers are well advised to understand their scope of action. In a situation where a run on the fund potentially is in the offing, postponing redemptions and repayments (so called "deferred repayments", Article 110 CISO) are two effective support mechanisms that fund management companies may want to consider.
"Gating" may become attractive
As an exceptions from the right to redeem at any time, the regulations of a collective investment scheme whose value is difficult to ascertain, or which has limited marketability, may provide for notice to be served only on specific dates, subject to a minimum of four times per year. Furthermore, if justified, FINMA may restrict the right to redeem units at any time for specific investments, i.e. investments which are not listed and not traded on another regulated market open to the public, mortgages, or private equity investments. The right to redeem at any time may be suspended for a maximum of five years.
While the (complete) postponing of the redemptions "by design" (Article 109(1) and (2) of the Collective Investment Schemes Ordinance, CISO) is a well-known option, the possibility of cutting redemption requests prorate upon reaching a certain percentage or threshold – known as "gating" – only became law on 1 January 2020 (despite the fact that FINMA already accepted gating clauses beforehand). Gate provisions built into the fund offering may restrict redemptions and help to prevent a forced liquidation in an adverse market situation. However, they may not only help in a crisis scenario but may also give fund managers the leeway to ensure that the capital is intact to carry out a critical phase of their strategy.
A gate provision is a clause in a fund's prospectus or offering document that entitles the fund manager to restrict or halt redemptions above a certain threshold. Unprocessed redemption requests are treated as having been received for the next valuation date. Gate provisions are invoked at the discretion of the fund managers. Investors, however, need to be informed when the gate provision is invoked. Such notification should state the need for the provision and outline how much, if any, investors will be able to receive when requesting a redemption. According to FINMA practice, only affected investors (i.e. those above the relevant threshold) must be informed. This is an immense advantage of gating as the measure is only "made known" to institutional investors with large volumes, with whom the fund management company ideally already maintains frequent contact.
While gating gives fund managers the ability to prevent redemptions above a certain threshold, thereby providing much-needed flexibility in this time of crisis, it is not currently available for all funds. As an exception to the fundamental right of investors in open funds to redeem their investment at any time, gating is linked to certain requirements: it (1) is only intended for extraordinary circumstances (undoubtedly the case, at present), (2) must be in the interest of the remaining investors and (3) must be included in the fund regulations. The latter requirement will be an issue for all those funds that do no already have such a provision in place, which is the majority.
The possibility to incorporate a gating clause into the fund regulations is currently restricted due to the COVID-19-induced extension of judicial vacations and the standstill of limitation periods until 19 April 2020, as changes to the fund regulations are subject to a 30-day objection period (Article 27 (3) of the Collective Investment Schemes Act, CISA). As at present, neither an emergency ordinance by the Swiss Federal Council nor a lenient approach by FINMA are to be expected, this requirement currently presents a barrier to those institutions that do not have a gating provision in place in their fund regulations, which is the vast majority of fund management companies in Switzerland.
Beyond the formal hurdles, the practical implications of such an approach must be kept in mind. When a fund enacts a gate provision, it is generally seen as a negative event and the decision to invoke a gate provision is often heavily disputed as investors who find their money locked in question the fund managers’ judgment. It is therefore important for investment professionals to weigh the disadvantages and advantages of gating carefully.
Instead of gradually redeeming fund units, fund managers may need to resort to a deferment of repayment in view of a distressed situation where there might be no other choice.
The measure of deferred repayment is generally used to satisfy investors who redeem their units in the face of insufficient liquidity (cf. Article 110(1)(d) of the Collective Investment Schemes Ordinance, CISO: "large-scale redemptions which may significantly endanger the interests of the other investors"). On the one hand, this mechanism may avert "fire sales" which devalue the units held by the remaining investors. On the other hand, it does not restrict the valuation of the fund or prevent new subscriptions. Having said that, new subscriptions tend to remain a hypothetical scenario as prospective investors must be informed of the payment deferral before subscribing to units.
A second, less common case concerns valuation challenges, i.e. "where a market which serves as the basis for the valuation of a significant proportion of the fund’s assets is closed or if trading on such a market is restricted or suspended" (Article 110(1)(a) CISO). As a rule of thumb, this is the case when assets that cannot be valued make up more than 10% of the fund assets. Where a valuation of the fund after redemption and therefore publishing of an NAV is not possible, repayment can be temporarily put on hold. Received redemption requests will then only be processed once the first NAV is published after the lifting of the deferment. While the uncertainty on the markets due to the COVID-19 pandemic initially raised liquidity concerns, valuation problems could follow further downstream if the crisis were to worsen and market fluctuations increase further.
It should be noted that the scenario involving "political, economic, military or other emergencies" (Article 110(1)(b) CISO) is not per se applicable to the COVID-19 pandemic, despite being an international health crisis. Knock-on effects from the pandemic may, however, lead to a political or economic emergency, providing a further justification for a payment deferral.
Beyond falling under one of the above cases, this mechanism generally also requires a basis in the fund regulations. It is therefore subject to the same challenges as outlined in the section on gating as a special form of postponing redemptions. In exceptional cases FINMA may, however, grant a payment deferral for funds whose regulations do not contain such a provision. This exception can only be invoked if a deferral is in the interest of all investors, i.e. if a payment deferment is necessary to satisfy redemption requests and in order to avoid "fire sales", which would reduce the investment value for the remaining investors.
While payment deferments are technically speaking a milder measure than gating (as the redemption of fund units remains possible for all investors), a deferral of repayment nonetheless impairs the "open-end" principle of open collective investment schemes. But it provides fund managers with additional room to manoeuver difficult circumstances.
However, the potential adverse signalling effects of such a measure is more significant than in the gating scenario. In practice, a payment deferment is often seen as a death sentence for a particular fund. The current widespread nature of potential liquidity problems may assuage investors’ doubts and be deemed acceptable nonetheless if adequately communicated.
Should a fund manager decide to implement such a payment deferral (by means of a formal resolution), both the auditor and FINMA must be informed without delay, while investors are to be notified in an appropriate manner.