_The COVID-19 pandemic is unprecedented both in terms of its immediate and prolonged economic effects, and the organisational disruption it has caused to financial market participants, which now threatens their ability to respond effectively. Firms are faced with a series of rapidly changing challenges that they must prioritise with limited resources.
The aim of this short note is to help portfolio managers of Luxembourg funds in addressing certain regulatory responsibilities that have arisen as a result of the market turbulence caused by COVID-19.
The specific challenges and responsibilities will be unique to each manager and ultimately depend on its fund structure, target market, trading strategy and portfolio exposures during the crisis; as such, and given the rapid rate of change, this is by no means an exhaustive list, but will hopefully provide some guidance.
ESMA Recommendations and Short Position Disclosure
On 11 March, The European Securities and Markets Authority (“ESMA”) released four recommendations to financial market participants in the wake of the COVID-19 market turbulence.
While these recommendations focus on the need for issuers to be transparent about the impacts of COVID-19, they also recommend that all financial market participants should be ready to deploy business continuity measures to ensure operational continuity in line with regulatory obligations (emphasis added). Managers should consider the regulatory obligations relating to each of the jurisdictions in which it has a footprint, and be mindful of any changes to those obligations. The CSSF has, for example, issued a communiqué reminding supervised entities to “remain vigilant with respect to risks relating to fraud and IT security, as ill-intentioned persons try to take advantage of a context in which financial players are primarily focussed on protecting their collaborators”.
The ESMA recommendations also include a reminder that asset managers should continue to apply ESMA’s requirements on risk management and react accordingly.
ESMA followed this up on 16 March by issuing a decision temporarily lowering the reporting threshold for net short positions in shares traded on a European Union regulated market, and requiring the holders of such net short positions to notify the relevant national competent authority (“NCA”) if a position reaches or exceeds 0.1% of the issued share capital (applying after the entry into force of the decision). Where managers are not the reporting person for the purposes of the European Union Short Selling Regulation, they should have been informed of the threshold change. Similarly, trade counterparties should inform managers of any temporary bans on short-selling in certain markets, but managers should nonetheless keep themselves appraised of the rapidly changing situation.
ESMA, in coordination with NCAs, is continuing to monitor developments in financial markets and is using its powers with a view to ensuring the orderly functioning of markets, financial stability and investor protection, so managers should be aware of the possibility of further measures being introduced.
Effective Liquidity Management
The Commission de Surveillance du Secteur Financier (“CSSF”) implemented the latest IOSCO recommendations for liquidity risk management in collective investment schemes into Luxembourg regulation at the end of 2019 (Circular 19/733). The rules are applicable to various classes of investment fund managers managing open-ended funds, including UCITS and AIFs.
A new element of the updated IOSCO recommendations was around contingency planning, and the CSSF requires that contingency plans should be implemented and periodically tested to ensure that any applicable liquidity management tools can be used where necessary and, if activated, can be used in a prompt and orderly manner. Any shortcomings in liquidity management tools emerging as a result of the COVID-19 pandemic should be addressed immediately, and models should be kept under ongoing review as the market situation develops.
Monitoring of regulatory, investor and counterparty limits should be fully integrated into every manager’s business as part of the three lines of defence approach. While these policies and procedures may be well-tested, the extremities and pace of the current market situation risks overwhelming the identification, escalation and remediation of issues, and therefore the consequential reporting to investors, NCAs or trade counterparties.
Regardless of the immediate challenges of the markets and resource limitations, managers must ensure that relevant parties are notified of any breach comprehensively, quickly and accurately.
Investor Documentation, Including UCITS KIIDs or PRIIPs KIDs
Managers will need to consider any action necessary regarding the accuracy of investor documentation, beyond simply updating performance disclosures. Clearly, on a longer-term basis, risk factors will need to be updated to account for the lessons learned (or not) from the COVID-19 market shock.
Given the rapid rate of change in the market environment, it will be more challenging to ensure that immediate communications are fair, clear and not misleading, so caution must be exercised while also ensuring that investors receive the necessary level of transparency.
Other regulatory obligations around investor documentation include the need to account for the change in market conditions (and continued change) and the impact that such changes may have on Synthetic Risk and Reward Indicator (UCITS KIIDs) or Summary Risk Indicator (PRIIPs KIDs) calculations. Where there is a material change of the market conditions such that the data on which the KID/KIID is based are no longer representative for the market conditions or would cause it to be no longer accurate, the document should be reviewed.
Possible MiFID II Drawdown Trigger
Where a manager is operating under a delegation arrangement with a Luxembourg AIFM or UCITS management company, that manager may also have to consider any additional regulatory obligations that it has under MIFiD II. In addition to trading and transparency rules that should be considered in the ordinary course of business, there is a requirement for a portfolio manager to report to its client (the AIFM or UCITS management company, as applicable) where the overall value of the portfolio at the beginning of each reporting period depreciates by 10%.
Contractual delegation arrangements generally account for the reporting of all regulatory obligations. However, managers should check that they meet this obligation, as it is a home state obligation for the manager and not an obligation of the AIFM or UCITS management company (and, as such, may not be captured in contractual arrangements).
As mentioned above, these points are general and non-exhaustive. Managers should consider any other factors that may be specific to their asset class and monitor the regulatory position as it changes in response to the markets.
If you are in any doubt as to your regulatory obligations at this time, then you should take specific legal advice. Our Investment Funds Practice Group will be happy to assist with any queries relating to regulatory obligations in the wake of the market shock caused by the COVID-19 pandemic.