The CSSF provides guidance on the liquidity management tools in the context of the Ukraine crisis

In recent weeks, investment fund managers have been faced with the question of how to deal with Russian and Belarussian assets in their managed funds. The Commission de Surveillance du Secteur Financier (CSSF) has now published guidance on how to treat this situation.

On 31 March 2022, the CSSF published an FAQ on the application of liquidity management tools (LMTs) by investment funds. With this guidance, the CSSF is responding to questions received from market participants regarding temporary as well as more structural measures for dealing with assets rendered illiquid due to the Ukraine crisis and to the restrictive measures taken by the EU and other countries in this context.

While the FAQ mainly relates to UCITS, it might also have some application for AIFs. At present, the FAQ contains three questions. The first two questions focus on the LMTs that the CSSF considers suitable for addressing the issue of illiquid assets, depending on the percentage represented by these assets in the relevant fund’s portfolio. The third question specifically dives into the creation of side pockets.

The CSSF emphasises that the approach taken, including the choice of LMTs and the valuation to be applied to affected assets, is the responsibility of the governing body of the respective investment fund. The CSSF also clarifies that it is not setting a precedent for the systematic use of side pockets in investment funds, as the FAQ only applies to illiquid assets resulting from the Ukraine crisis.

General clarifications about LMTs

The CSSF states its expectations regarding the use of LMTs for addressing the issue of illiquid assets by funds with different exposures to such assets.

For investment funds whose exposure to illiquid assets is limited, the CSSF expects managers to apply fair valuation adjustments and, if relevant, to close the relevant investment funds to subscriptions by new investors. The CSSF also clarifies that side pocketing may be considered as a subsequent measure.

For investment funds with a higher exposure to illiquid assets, the CSSF expects managers to immediately suspend the relevant investment funds to protect the interests of investors. Where necessary, investment funds may subsequently apply structural measures such as side pocketing: for instance, to try to reopen the fund with only the liquid assets remaining, or even to liquidate the fund. If the governing body resolves to suspend new subscriptions, the CSSF must be informed of this suspension via the usual notification process.

Three side pocket options

The CSSF provides for three segregation or “side pocket” options. However, it also clarifies that other options may be considered, leaving it up to the fund’s governing bodies to find the most suitable solution while always keeping the investors’ interests in mind.

Option 1 | New share class: creation of a side pocket by allocating the illiquid assets to a new share class with the aim of realising them in the best interests of the investors. The CSSF clarifies that the ESMA opinion on share classes of UCITS does not oppose this option.

Option 2 | Splitting a sub-fund into two sub-funds: creation of a side pocket by splitting the sub-fund in two, with the initial sub-fund retaining the illiquid assets and the liquid assets being transferred to the new sub-fund. The initial sub-fund would be closed to subscriptions and redemptions. The CSSF also provides the option of creating a sub-fund in a new umbrella fund.

Option 3 | Splitting a sub-fund into two sub-funds with immediate liquidation of the illiquid sub-fund: creation of a side pocket by splitting the sub-fund in two, with the initial sub-fund retaining the liquid assets and the illiquid assets being transferred to a new sub-fund that is put into immediate liquidation.

Regulatory process for the implementation of side pockets

Before determining the most suitable option, the fund’s governing body must perform a thorough analysis from a tax, legal, and accounting standpoint (that additionally covers other aspects further detailed in the FAQ, such as a cost assessment for the selected model). The use of a side pocket is also subject to CSSF authorisation, with the FAQ listing the information that such authorisation requests are expected to contain.

The CSSF requires that impacted investors be informed about the implemented option, in accordance with the prospectus provisions on investor notifications. Where the prospectus does not provide for specific provisions with respect to a specific scenario, the governing body of the fund must decide on the appropriate means of communication.

Regarding option 2 and option 3, the CSSF does not specify whether the authorisation process for creating a new sub-fund will be simplified for sub-funds created to implement a side pocket.

Our observations

With this long-awaited FAQ, the CSSF has addressed the key questions regarding the possibility to use segregation mechanisms. We expect that the positions taken by the CSSF in this FAQ will be positively received by the market overall, as it leaves the door open to side pockets in UCITS with flexible structuring options.

However, the implementation of side pockets may raise complex questions from a legal, accounting, regulatory (such as the applicable sanctions) and tax standpoint that should be duly assessed before submitting an authorisation request.

For further information, please reach out to your usual contact within the Fund Formation Group.

To access the CSSF FAQ, click here_

MICHÈLE EISENHUTH - Partner - Investment Management
JOSIANE SCHROEDER - Counsel - Investment Management
JASMINE CORNIL  - Senior Associate - Investment Management