FSA’s Investment Entities Listing Review

FSA's Investment Entities Listing Review and the London Stock Exchange Specialist Fund Market

SIMON FIRTH, UK HEAD OF INVESTMENT FUNDS & OWEN WATKINS, CONSULTANT INVESTMENT FUNDS GROUP, KAYE SCHOLER LLP
Originally published in the September 2007 issue

In June 2007 the Financial Services Authority (FSA) issued CP0712, 'Investment Entities Listing Review: further consultation, feedback on CP0621, policy statement on CP064 and CP0621 and final Handbook text'. The consultation period ends on 28 September. Not to be outdone, in July the London Stock Exchange announced its proposals for a Specialist Fund Market, to be launched on 1st November. This article considers investment fund listings in light of these developments.

FSA'S INVESTMENT ENTITIES LISTING REVIEW

As the title indicates, CP0712 is not the FSA's first set of proposals in this area. Indeed, it contains the third set of proposals since March 2006 when CP064 was issued. The fact that in some areas the FSA has rejected what was proposed in CP0621 and gone back to its original proposals in CP064 would appear to indicate that it has found it difficult to make up its mind as to the right approach to be adopted for listing of investment entities in London.

There and back again: one regime to rule them all

The main change to FSA's policy is that it has decided, as a result of comment from respondents to a previous consultation, to withdraw its proposal to allow listing of investment funds under chapter 14 of the Listing Rules (secondary listings of overseas companies). That proposal had been prompted by the success of Euronext Amsterdam in attracting floats of substantial overseas investment funds in the course of 2006, such as KKR Private Equity Investors, MW Tops and AP Alternative Assets. These issuers were required to comply only with the minimum obligations that the relevant underlying European directive – the Consolidated Admissions and Reporting Directive ('CARD') – imposed, which had obvious advantages for themwhen compared to the more inflexible and onerous requirements on offer in other jurisdictions (such as the UK). The FSA concluded that to prohibit 'directive minimum' listing of these funds in the UK, and effectively to force such funds, if they wished a London listing, to comply with the 'directive super-equivalent' requirements of chapter 15 of the Listing Rules would not be effective as a means of investor protection. The funds concerned would simply list elsewhere in the EU, and the securities concerned would be readily accessible to investors in the UK. The result would be that UK regulated markets would be at a disadvantage to their competitors. All these points would seem to be well made. Yet a clear majority of respondents expressed strong opposition to what the FSA had proposed, principally among the investment trust community. The particular grounds of opposition were:
 

  • CARD was not intended for investment funds, and would not provide the appropriate level of investor protection – so for the FSA to permit a directive-minimum listing would be inconsistent with its consumer protection objective.
  • Investors would not understand the difference between shares listed in the UK under chapter 14 of the Listing Rules and chapter 15 of the Listing Rules.
  • Since listing under the 'directive minimum' requirements of chapter 14 of the Listing Rules would not be available to UK domiciled investment companies, they would be able to list only by following the 'directive super-equivalent' provisions in chapter 15 – this would constitute discrimination by domicile and be contrary to European law.

On the basis of this opposition, and despite a substantial minority arguing that 'two-tier' listing of investment funds could be made to work provided that its scope was extended to UK issuers (hedge fund voices among them), the FSA is now proposing that all listed closed-end investment funds, whether domiciled in the UK or not, should be required to be listed under chapter 15 (as amended by the proposals in CP064 and 0621, and as further modified by the proposals contained in CP0712). Consequently, chapter 14 of the Listing Rules will be modified to prohibit directive-minimum listings of investment entities. Assuming that there is no further re-think of the policy as a result of consultation responses, this regime will take effect in the first quarter of 2008.However, the FSA is also proposing that any investment entity that lists in the UK under the directive-minimum provisions of chapter 14 of the Listing Rules before the new FSA regime is introduced will continue to be able to do so, although a mechanism will exist under which it may elect to move to the chapter 15 regime. Although this is from one perspective a pragmatic approach, it rather undermines the argument that, going forward, a single listing regime is required to protect investors and avoid confusion. It would perhaps have been more consistent to have given chapter 14 listed entities a period of grace after which they would have the choice of complying with the new chapter 15 requirements, or ceasing to be listed. The removal of the directive minimum approach under chapter 14 does not augur well for the level playing field among stock exchanges, now tilted heavily against the UK (but see below re the SFM). Hedge and private equity fund promoters will find some of the proposed chapter 15 rules unpalatable, for example having to give voting rights to investors when these are not required by Euronext.

The interim regime

From September 2007, there will be in place what the FSA calls an 'interim regime', which is the regime as it currently stands as amended by various modernising and simplification changes. The FSA believes that there is a clear benefit in making these changes without further delay, given the benefits to stakeholders and the widespread support they command. These changes include:
 

  • Controlling positions: the prohibition on taking controlling positions in investee companies has been removed, in principle if not in practice opening the door for the first time to private equity funds;
  • Investment policies: the provisions governing the content of investment policies have been simplified, and non-material changes to investment policy will not require prior shareholder consent (and guidance is provided on what a material change might be);
  • Further deregulation for property focused funds subject to chapter 15 rules: such funds will no longer need to comply with the significant transaction provisions in chapter 10 of the Listing Rules; and
  • Further deregulation for listed overseas collective investment schemes: overseas recognised schemes will no longer be subject to the full requirements of chapter 15 of the Listing Rules, as this would in effect make them subject to a second degree of regulation on top of the requirements applying to them as FSA regulated investment companies with variable capital (ICVCs) or EEA authorised schemes; instead, the relevant provisions will be moved to a new chapter 16 (Open-ended investment companies).

The new proposals

As noted above, the FSA is proposing further changes to chapter 15 of the Listing Rules which are intended to come into force in the first quarter of 2008. These include:
 

  • Deletion of the detailed requirements relating to the experience of the investment manager, replacing these with guidance reminding the board of directors of the applicant for listing of their obligation to consider whether the directors and investment manager collectively have 'sufficient and appropriate expertise' available to them to manage the portfolio. The FSA seems to think that this marks a change from the current 'sufficient and appropriate experience' requirement, though others may think that in practice this is a distinction without a difference.
  • The requirement for board independence is to be retained, though made more principles-based (in keeping with the general thrust of FSA's current rulemaking). In addition, a restriction on more than one representative of the investment manager being on the board of the listed entity has been removed; it will be sufficient that a majority of the board is independent of the manager.
  • Feeder funds will now be allowed to list, provided that the master fund does in fact deliver the required diversification of risk. This shows a welcome, if belated, recognition by the FSA of the underlying investor protection issue, and of the fact that the present position discourages certain types of investment fund from listing in the UK.
  • Removal of the current rules on periodic disclosure of portfolio information, replacing these with quarterly (rather than monthly) disclosures of cross-holdings, disclosures of inside information, notifications of acquisitions/disposals of major holdings, disclosure of portfolio information in interim management statements and other periodic reports, and a new requirement for a quarterly disclosure of details, including the value, of any investment representing 10% or more of the investment portfolio. (On the last point, the fact that the FSA has specifically asked for views on a disclosure threshold of 20% suggests that it is by no means certain that the figure of 10% is appropriate.)
  • Whilst the FSA is not persuaded that the time is right to remove the designation of the investment manager as a 'related party' for the purposes of chapter 11 of the Listing Rules (although it has asked for views on that point), it is proposing to mitigate the effect of the related party rules by exempting arrangements between an investment manager and a listed investment entity designed to facilitate the provision of finance to an investee company, provided that the investment is made at the same time and on the same terms, or in accordance with a pre-existing agreement. The FSA has also provided clarification of circumstances in which the related party rules in chapter 11 would not apply to transactions with clients of the manager or to transactions with the manager itself (see paragraphs 3.39 and 4.38 of CP 0712).

THE LONDON STOCK EXCHANGE SPECIALIST FUND MARKET

Nature abhors a vacuum and therefore in order to preserve its competitive edge, and not least given the vacillation of the FSA described above, the London Stock Exchange (LSE) recently announced that it will launch a dedicated new market for the issuers of specialised investment funds known as the Specialist Fund Market (SFM) as from 1 November 2007. The SFM will impose (and benefit from) the directive minimum standards shunned by the FSA. The SFM will be available only to issuers of "Specialised Investment Funds" (SIFs) targeted at institutional, professional and highly knowledgeable investors. Both UK and non-UK domiciled investment entities are eligible to seek admission to the SFM. The SFM will be a regulated market as defined in the Markets in Financial Instruments Directive (MiFID), and as a result MiFID organisational and procedural provisions will apply to it. It will also be a regulated market for the purposes of the UCITS Directive, which means that UCITS funds will be able to invest in SFM securities, subject to the usual UCITS spread restrictions.A SIF is defined by the LSE to include, among other things, single strategy funds, feeder funds, specialist sector funds, limited partnership structures, specialist geographic funds and funds with specialist corporate governance structures and therefore clearly encompasses hedge funds. Issuers that wish to market such funds to a wider audience, including retail investors, will continue to have access to the Main Market which offers the potential for inclusion in index tracker funds, and to the Alternative Investment Market (AIM), which has been very successful in attracting investment entities, primarily property funds or other conventional investment funds. In order to be eligible for listing on the SFM an applicant will be required to follow the initial and ongoing obligations as laid down in the LSE's Admission and Disclosure Standards and the FSA Conduct of Business Rules, which broadly will require that any applicant to the SFM, among other things, needs to do the following:
 

  • to have its prospectus approved by the applicant's EEA Competent Authority, which will be the FSA (through the UKLA) for applicants whose home member state is in the UK. Applicants with a prospectus drawn up in accordance with the EU Prospective Directive (200371EC) and approved in an EEA member state other than the UK are eligible for entry into the SFM on a passported basis. Where a prospectus has been approved by an EEA competent authority other than the UKLA, the issuer will need to request that its home competent authority submits the relevant documentation to the UKLA.
  • to apply to the LSE for admission to trading on the SFM, which application must:
    1. include a demonstration that the securities to be listed will be transferable and freely negotiable in accordance with MiFID; and
    2.  
    3. highlight relevant risk factors in any prospectus
  • otify corporate actions (such as dividend payments, rights issues and early redemptions) in accordance with the relevant LSE standards.

Acceptance of sophisticated legal structures

The SFM will accept a variety of sophisticated legal structures including limited partnership interests and non-voting share structures allowing the flexibility to create structures that can comply with home country tax or securities laws whilst also allowing access to permanent capital.

Trading system and efficient secondary market

To be admitted to trading, SFM securities must be eligible for electronic settlement through CREST. (Other Central Securities Depositaries will also be considered, upon request.) The LSE must also be informed at the time of application of any settlement restrictions that will apply to the securities that are to be considered for admission. Liquidity in SFM securities will be facilitated by the LSE world class trading platform, TradElect. SFM securities will be traded on dedicated segments of either the SETS or SETSqx services depending on their anticipated trading pattern and size.

Transfers from other markets

It is possible for investment entities that are currently admitted to AIM, or listed on the Main Market or other regulated markets, to transfer to the SFM. Such entities will generally be required to produce a prospectus in accordance with the rules of their competent authority (unless an applicable exemption applies); in the case of those entities for whom the FSA is not the competent authority, that prospectus must be approved by the relevant home state competent authority and passported into the UK before a request is made to the LSE for admission to trading. In the case of transfers from the Main Market or other regulated markets, investment entities will also generally need to comply with any applicable delisting requirements (for example, in the case of delisting from the Main Market, the requirements of chapter 5 [suspending, cancelling and restoring listing] of the Listing Rules). It will be interesting to see whether any such transfers actually occur. Given that a transfer would not be without cost to the issuer, and that funds currently admitted to AIM or to the Main Market benefit from the ability to be marketed more widely than will be possible for a SFM fund, one wonders whether this mechanism is of theoretical value only.

The saga continues

The FSA has indicated that CP 0712 is far from being the last chapter in this particular story. In view of the ongoing debate about the structure and quality of the UK's listed markets, the rights of participants in them, and their relation to other markets both in the UK and overseas, the FSA will be holding further discussions with stakeholders, with a view to publishing either a discussion or consultation paper later in 2007. That paper also looks likely to contain the FSA's updated thinking on listing categories, a proposition which appears to have received sufficient support to be adopted in general terms, but where the details (such as the descriptions of the categories) require further consideration. Against such a fluid background, one thing seems certain: investment entities and their advisers can expect more changes before the regime is finally settled. As for the SFM, targeted at private equity and hedge fund promoters, it remains to be seen whether it will take the challenge to Euronext when it opens for business in November.