One of the key areas likely to be affected by Brexit is the financial services industry. Although the full effects will not be known for months, if not years, the referendum result has already produced immediate concerns of FX derivative misselling claims and potential disputes arising from the suspension of trading in UK property funds.
Property Fund Suspensions
Over the past week or so several of the biggest UK property funds have closed the gates on investors attempting to withdraw their money following a sharp rise in redemption requests since the Brexit vote. This has led to a number of issues between funds and their investors. Some investors are unhappy because they are being prevented from moving their money out of the fund when they want to reduce exposure to UK Real Estate. Conversely, other investors are unhappy because, in their view, gates were not closed quickly enough to avoid the need to sell assets to pay out to those redeeming, resulting in a loss of value of their stake – avoiding such losses being the purpose of the gates sold as an “enhancement” to protect investors in times of market turmoil.
This gives rise to a number of legal questions about the contractual mechanisms relating to the suspension mechanisms, for example:
- What can investors do to challenge the way in which the use of the gate mechanism has affected them?
- Who decides when to close the gates and on what basis?
- What duties are owed by the fund manager when deciding whether and when to close the gates and to whom?
- How long should the gates remain closed and who decides when to reopen them and on what basis?
- Have the assets been valued fairly and accurately when pricing redemptions?
- What happens when the suspension is lifted? Can the fund revalue the assets to reflect a fire sale price and give investors the option to redeem at that level?
This is not a new phenomenon. Similar moves occurred in the wake of the global financial crisis - the Wall St Journal refers to "echoes of Lehman" and it is usual for provisions allowing funds to take action to protect the value of the fund and avoid a messy and expensive fire sale to form part of the contractual documentation investors sign up to when making an investment into the fund.
The rights and duties of fund managers are largely dependent on the terms of this documentation. The FCA has issued guidance for fund managers stating that it expects them to have a clear understanding of how and when such tools might be used and reminding them that they must consider how to ensure the ongoing fair treatment of all investors in their funds in the context of current market conditions.
The funds which have been suspended this week are all “open ended” retail funds, meaning that they do not have a defined size and investors (in normal times) have the right to ask for their money back at any time. Since (again, in normal times) investors do not want their money back all at the same time, the funds only have to keep around 20% of their assets in cash to satisfy redemption requests. However, when an unexpected market event such as Brexit occurs, the level of those requests can quickly exceed the amount of cash available and that presents fund managers with a dilemma. The only way they can satisfy outgoing investors is to sell the property invested in the fund - but that takes time and if too much is sold at one time, it can force prices down, leaving those investors who remain with lower values to their investment. Hence the need to suspend redemption requests to allow the necessary sale of assets to be carried out in a controlled way.
The prospectuses for the funds which have been suspended this week tend to be in similar form and say in essence that the fund manager, with the consent of the fund trustees, may suspend redemptions “due to exceptional circumstances” and “in the interests of all investors”. The relevant Standard Life fund prospectus says that the suspension is “only allowed to continue as long as justified in the interests of investors”. Typically, suspensions need to be formally reviewed every 28 days.
While it seems clear that the current suspensions have been justified, they do need to be kept under review. The ongoing questions will be how long will the “exceptional circumstances” last and therefore how long will the suspensions be justified?
Misrepresentation - Rubenstein v HSBC Bank Plc  EWCA 1184
One potential area for disputes would be where investors have been negligently advised as to the risks when investing. One unfortunate investor who suffered following the 2008 financial crisis was Mr Rubenstein, who sold his £1.25m home and based on advice by HSBC that an AIG Bond in its Enhanced Variable Rate Fund was "the same as cash deposited in one of our accounts" invested the proceeds in that, whilst he and his wife looked for a new property.
However, when Mr Rubenstein sought the return of the funds he discovered that the fund had suspended withdrawals (as it was entitled to do) and by the time he was allowed to withdraw this investment some time later, he had suffered a significant capital loss. Mr Rubenstein was understandably aggrieved as this situation was very far from that of a "cash deposit".
The Court of Appeal found that HSBC had been negligent in its description of the fund to Mr Rubenstein and was ordered to compensate him for his loss. Interestingly the Judge at first instance had found that HSBC should not be liable for Mr Rubenstein's loss as the extent of it was unforeseeable, resulting as it did from unprecedented market turmoil. The Court of Appeal disagreed and considered the important point was that Mr Rubenstein had made it clear that he wanted no risk to capital.
It is to be expected that financial advisors and those promoting investment funds have learned the lesson of Rubenstein and will have placed more emphasis on the risks posed by "gates" and have been alert for investors who had time-sensitive requirements for access to their capital. However, issues will always arise in unusual or unprecedented circumstances about the interpretation of contractual provisions setting out triggers for the ability to impose a "gate", how long it lasts, how any parameters by which the gate is set or removed are to be assessed and the exact timing of the cut off in comparison with the notifications provided i.e. where does the guillotine fall within the flood of redemption requests, who will be the last man out?
Dangers of contagion
Of more concern is the possibility that the contagion of redemption requests may spread in the market. Since 2008 such gates have become much more popular and, in many cases, more complicated. They are often viewed as a "credit enhancement" for investors as they protect the value of the fund overall in times of market stress. Which is fine as long as investors don't need urgent access to the funds invested, or have an investment strategy that involves redeeming according to a set timescale.
However, if market conditions continue to slow as a result of Brexit uncertainty, businesses may find that cashflow becomes a problem and that could lead to investors requiring withdrawals, not just to reallocate funds between asset classes but because they are in urgent need of cash.
If hedge fund investors start withdrawing their funds to the extent that the funds suspend trading, more disputes may arise because hedge fund suspension terms are likely to be a lot more complicated and open to interpretation.
Where a contractual discretion can be applied by the fund manager or administrator in deciding when to close the gate and on what terms, then the courts have considered on many occasions the meaning of the various subtly different forms of wording that regulate the operation of such discretions. Parties have argued on numerous occasions about whether the decision maker has acted in good faith, or in a commercially reasonable manner, as the case may be based on the interpretation of the particular wording in question. Cases from the 2008 financial crisis will help to inform parties of the way the court views the obligations of decision makers in this situation, but the contractual wordings are constantly evolving and it will be interesting to see whether sufficient certainty has been achieved to avoid disputes in the wake of this recent spate of "gate" closures.
There may even be clauses referring specifically to the impact of Brexit - it will be interesting to see whether the unprecedented next steps take a form anticipated under such clauses, or whether the pristine path now to be trodden in the wake of the referendum will throw up some unforeseeable obstacles that lead to many more questions than answers.
FX derivative misselling
One of the immediate results of Brexit has been a huge increase in volatility in the financial markets including the foreign exchange and equities markets. The ongoing uncertainty will mean this volatility is sure to continue for the foreseeable future.
In relation to FX, Brexit will affect not just sterling but also the euro, dollar and other major currencies. In our experience, one effect of high FX volatility will be a rise in the number of businesses suffering major losses triggered by larger than expected FX movements. These losses are often caused by companies having been missold complex FX derivatives by banks or brokers.
We have a great deal of experience of acting for clients who need to hedge their FX requirements but who have been persuaded to enter into extremely complex FX derivative contracts without being made aware of the potential serious losses which may arise. We are able to assist clients who find themselves in this situation and to advise on making FX derivative misselling claims against banks and brokers. Click here for further information on FX misselling claims.
Investors and businesses holding other derivatives contracts referencing equities, interest rates, commodities and credit markets will also be affected, including in relation to margin/collateral calls and valuation of positions to be closed out where the parties rights and obligations are not always clear where there is market turmoil.
The International Swaps and Derivatives Association (ISDA) has published guidelines on the impact of Brexit for derivatives contracts and we will be monitoring developments in this area, and in other aspects of the financial services industry, closely and providing updates and guidance on our website.
If you require assistance in relation to any of the above or have any other questions or concerns regarding banking or finance matters arising from the vote to leave the EU, please contact Robin Henry or Janine Alexander.