Economic history shows that there will always be events that impact upon the financial services industry. These events, whether wars, natural disasters, pandemics or economic shocks, may have an adverse impact on financial returns over the short to medium term. The financial services industry is used to experiencing external events, their economic impacts and the inevitable recovery.
What perhaps makes COVID-19 unique in the last half century is the speed with which it has disrupted the financial markets worldwide and cash flows while hampering the capacity of the funds management industry to operate in their normal environment. What also appears unique has been the consistent approach of the governments, regulators and financial markets in most countries to seek to apply new approaches and learnings from the events of the past, such as the Global Financial Crisis.
As we see a potential for the relaxing of the social distancing that has impacted business operations and a re-opening of the economy, it is worthwhile surveying the current status and thinking about approaches going forwards. Financial issues and need for funds to meet them will undoubtedly continue while Australia and the world recover from the impact of COVID-19.
Regulatory issues
ASIC approach: ASIC has issued general guidance to a range of AFSL holders, including responsible entities and superannuation trustees. In particular, it has written to a number of the larger responsible entities in Australia reminding them of their obligations particularly in the context of managing scheme liquidity.
ASIC has been focused on providing relief to permit financial advisers to provide urgent advice as required to meet the impacts of COVID-19, but has not provided any general or generic relief to the financial services industry that applies during the impact of COVID-19. It has indicated, rather, that it will entertain specific requests for relief in response to difficulties faced by funds managers.
As the holder of an Australian Financial Services Licence, (AFSL), the fund manager will need to consider the following regulatory requirements:
Business continuity plan: Licensees will need to check and continually monitor their business continuity plan during the crisis. Where they have found that their plan has not been fit for purpose, they should revise their plan for future issues. One potential area to stress test is manual processes: many businesses are finding that they have significant numbers of manual processes (for example, communications and reconciliations) which would be adversely affected by the loss of an individual.
Financial resources: AFSL holders are obliged to maintain financial resources that may require a proportion of their assets to be held in liquid investments. As well as continuing to monitor and report on their financial resources, holders should consider where the stresses on those resources and consider adjusting their allocations of resources accordingly. Responsible entities should continue to carefully review their own liquidity on a regular basis to ensure they are satisfying their cash needs and NTA requirements.
Financial reporting: ASIC has extended the deadlines for lodgments of financial reports, director’s reports and audit reports for unlisted entities, including AFSL holders, by one month.
The deadline for half-year financial reports, directors’ reports and audit/review reports for unlisted schemes has been extended to 75 days plus one month.
The deadline for profit and loss and balance sheets for unlisted AFSL holders that are bodies corporate and are also disclosing entities or registered schemes is extended from 3 months to 4 months.
For unlisted AFSL holders that are bodies corporate but not disclosing entities, the deadline is extended from 4 months to 5 months.
Finally, for AFSL holders that are not bodies corporate, it is extended from 2 months to 3 months.
Responsible Managers and Key Persons: Licensees should put in place arrangements to cover their Responsible Managers or Key Persons should they become unwell.
Scheme Liquidity: ASIC expects responsible entities to actively manage scheme liquidity. Should a scheme become non-liquid, ASIC has powers to grant hardship relief and rolling withdrawal relief on a case-by-case basis. Responsible entities should notify ASIC if any registered scheme becomes non-liquid or if redemptions are suspended.
New regulatory measures may be introduced to respond to COVID-19. We expect the regulators will be actively considering whether any COVID-19-specific measures are required for funds. It is likely that ASIC, like other regulators, will focus their attention on managing the response to COVID-19, and other serious or time-critical issues.
Investor relations, reporting and unit pricing
Fund managers should consider what obligations they may have to inform their investors about the impacts of COVID-19 whether in relation to the fund assets (and the business of any underlying investments) or the fund manager’s business. Fund managers should review their fund documents and disclosure documents as these will likely contain guidance as to the matters fund managers should consult with, or seek consent from, investors. While this pandemic is unlikely to be specifically covered, the impact of the pandemic on funds (such as impact on the investment period or the ability to transact on assets) is likely to be a matter about which investors must be consulted. We suggest regular and clear communication from managers is critically important during these uncertain times as a way of providing reassurance and reducing potential fallout from disgruntled investors
Fund managers will also need to review the impact of COVID-19 on their capacity to prepare for and compile their financial reporting and review their fund documents. ASIC has indicated that it is monitoring the impact of the pandemic on financial reporting obligations, but has yet to announce any changes.
Unit pricing may be difficult during the current instability, particularly where pricing is based on the value of illiquid assets or the fund manager considers processing transactions would not be consistent with their duty to act in the best interests of investors as a whole. Fund managers may, given the circumstances and their powers under fund documents, be permitted to suspend unit pricing however they should consider the potential impact suspensions will have on their fund.
Fund managers will need to consider whether they can or are required to re-value assets and whether they can determine an accurate valuation. Fund managers are often required to provide current valuations to institutional investors as part of their regular reporting and should have regard to how their valuation policies or international guidance apply in the current circumstances.
The value of underlying assets may also impact investment decisions, asset allocations as well as factoring into value calculations that determine the management fees payable to the fund manager and other fund management related service providers, such as custodians and professional trustees.
Member meetings
Registered managed investment schemes are required to hold annual general meetings of members as are some wholesale funds. Fund managers should review the extent to which they are entitled to delay those meetings (including under ASIC’s no action position) or to hold them using virtual or remote technology.
Fund managers, or members, may need to convene meetings of the fund members or investors review committees, in order to discuss fund issues or pass needed resolutions, such as amendments to the fund documents.
Fund managers should review their fund constitutions (and the Corporations Act for registered schemes) to ensure they comply with any requirements when arranging virtual meetings.
Liquidity
Fund managers should actively monitor levels of redemptions and applications, as well as transfer requests and consider the impact upon the liquidity of investors. In doing so, they must act in the best interests of members as a whole. Responsible entities of registered managed investment schemes and trustees of wholesale funds have an obligation to treat members fairly. In the case of a registered scheme, the responsible entity has an obligation to treat members of the same class equally.
Where fund managers have significant investments by superannuation funds, they may receive redemption requests to fund the permitted withdrawals from superannuation fund members.
ASIC guidance indicates that it expects responsible entities to actively monitor redemption requests and potentially adjust redemption terms to reflect available liquid funds. This might include moving from treating the fund as a non-liquid scheme rather than a liquid scheme and adjusting the buy/sell spreads. ASIC has asked responsible entities to inform it if they consider their fund has become a non-liquid scheme or if they are moving to suspend redemptions.
Fund managers will also need to review their fund constitutions for relevant provisions to permit them to vary the redemption terms or suspend withdrawals.
Fund operation
Experience tells us that few fund managers will have built the risk of a global pandemic or other force majeure event into their fund documentation. There is no general practice of including force majeure clauses into fund documents, nor is force majeure a concept well recognized within the funds management industry. Fund managers with financial alignment with their investors through their fee structures and co-investments will need to carefully consider the reputational risk of claiming force majeure while their investors are subject to the same financial impacts
The current crisis and its longer term impacts may affect a range of aspects of fund operation and performance including:
The capacity of funds to make calls and investors to meet them, and the purpose for which calls may be made. For example, funds may be required to meet the operational requirements of portfolio investments where debt facilities are fully drawn or unavailable or to pay management fees and other fund related costs;
The ability of funds to make investments using available funds within their investment periods;
The investment returns and the calculation of fees, such as carry and performance fees (including sponsor catch ups) that are calculated based on achieving a particular investment return;
Cash flow from underlying investments, and whether there will be sufficient funds to meet fund management related fees and other out of pocket expenses;
The rights of the fund to return and recall cash from members as it is needed by the fund in order to mitigate the “cash drag” on the investment performance of the fund’s underlying investments.
Extension of fund term or wind up periods in order to permit an orderly disposal of investments once the economic impact of the COVID-19 crisis has abated. A significant issue will be determining how long an extension will be needed to overcome the economic downturn that is anticipated to continue after the immediate lock down has ended.
The ability for third party service providers to funds to perform their services to the levels required by the contracts governing their appointment due to COVID-19 impacting their performance ability.
We anticipate that fund managers will be in dialogue with their members, or their investors review committees, to arrive at practical solutions. Fund managers should also plan ahead to build in contingency measures and review third party contracts to assess what level of protection they have if services are interrupted (particularly for registered schemes where responsible entities are statutorily liable for the actions of agents).
Fund investments
Where the fund is invested in entities that require the fund manager to appoint directors to the boards of those invested entities, the nominee directors will need to monitor the ongoing solvency of the entities and make decisions bearing in mind their duties, particularly not to permit insolvent trading. The Commonwealth Government has passed a range of measures to assist small and medium sized entities. A description of the various measures is set out on the PwC COVID-19 website here (insert link).
Fund managers should also review their asset allocations and debt facilities to consider whether their asset allocations and diversifications fit within investment parameters, debt to equity ratios and funding covenants. It may be worthwhile seeking amendments to the investment parameters to permit funds to take advantage of opportunities through the recovery from COVID-19.
Preserving cash
Generally speaking, funds that are structured as trusts in Australia must distribute all of their taxable income in a financial year in order to be tax transparent. If a fund is facing liquidity challenges, the fund manager may wish to preserve cash in the fund. To the extent that the fund has investments in Australian companies, those companies may be able to withhold cash to preserve their liquidity without affecting the tax status of the fund.
Fund managers should review their fund constitutions (and the constitutions of any underling trusts within the fund) depending on their tax status (for example whether the fund is an AMIT) to see if they are entitled to make provisions, hold back cash or require deemed reinvestment of distributions. Depending on what fund managers determine, investors may be required to pay tax in respect of cash distributions when they do not receive any actual funds.
Default
Fund members may be unwilling or unable to meet their commitments to fund calls from funds or may otherwise be defaulting. This is not a circumstance unique to the current crisis; similar issues arose during the Global Financial Crisis. Where a member defaults, the fund manager will need to consider whether to take enforcement steps, and if so what steps, having regard to interests of fund members as a whole and the capacity of other members of the fund to step into the position of the defaulting member. Fund managers should check their fund constitutions to see what (if any) discretions they are given to take or waive commitments or enforcement steps.
Disclosure
A product disclosure statement (PDS) must be up to date at all times. COVID-19 and the impact of this pandemic may mean that information in an existing PDS has inadvertently become out of date and needs to be updated. We suggest fund managers carefully review and consider their disclosures in PDSs (and similar documents) and update, wherever necessary, the existing disclosure contained in them.
In addition, the ability for registered schemes to raise capital by relying on the shorter PDS regime may no longer be an available avenue if they have ceased to be a simple managed investment scheme due to the impact of COVID-19 on liquidity and markets. A simple MIS includes a scheme that invests at least 80% of its assets in investments where the responsible entity reasonably expects to be able to realise the investment, at market value of the assets, within 10 days. Given market disruption in present times, registered schemes that previously met this definition may now need to issue longer form PDSs.
If you would like to discuss the matters raised, please contact the authors. PwC has a team of specialists who are closely monitoring and working with clients to respond to the developments arising from COVID-19. For more information, please refer to our dedicated COVID-19 site.