Known for its picture-postcard harbour towns and miles of quiet beaches, sleepy Guernsey had a rude awakening 13 days ago when the world’s media turned a spotlight on the Channel island, its penetrating beam homing in on a dubious piece of regulatory arbitrage by embattled fund manager Neil Woodford.
Several months before the crisis — which broke on June 3 when Mr Woodford froze his flagship fund to investor withdrawals — the former star stockpicker had quietly shifted stakes in three unquoted companies to the Guernsey stock exchange. Mr Woodford’s aim was to allow his flagship Equity Income fund to stay within a regulatory limit of 10 per cent for unquoted holdings.
The three stocks, biotech company Benevolent AI, cold fusion company Industrial Heat and technology investor Ombu, made up 11 per cent of the Equity Income fund’s portfolio. This meant that the fund’s unquoted exposure was close to 20 per cent, far above the cap — a fact that compounded the liquidity crunch which forced Mr Woodford to gate his fund.
Mr Woodford acted within the rules but Andrew Bailey, head of UK regulator the Financial Conduct Authority (FCA), was disapproving on BBC Radio 4’s Today programme, saying on Tuesday: “I don’t think it is right. Investors should be able to determine where their assets are held.”
Questions are being asked over why regulators did not intervene, particularly as Woodford Investment Management has so many retail clients.
Equity Income is covered by the EU’s Ucits directive, designed to ensure funds are highly liquid and so protect investors from unnecessary risk. “Ucits puts in place safeguards and controls to protect investors. Clearly, those have been found lacking,” says Ed O’Bree, head of funds and markets at Bovill, the regulatory consultancy.
The FCA has come under intense criticism after the run on Mr Woodford’s business.
UK Green MEP Molly Scott Cato, who is on the European Parliament’s economic and monetary affairs committee, says: “Woodford’s creative interpretation of the rules may have kept within the letter of the law but went very much against its spirit, which is to limit risks for small investors.”
She describes the fund suspension as “a blow to the confidence of investors in the ability of the FCA to properly regulate funds”, adding that the regulator “needs to be proactive in investigating funds rather than depending on fund managers to do the decent thing”.
The FCA has voiced its disapproval of the Guernsey move but there are questions over why it did not act sooner, notably in the wake of the suspension of Mr Woodford’s stakes in the three companies by the Guernsey stock exchange in April.
The International Stock Exchange, which operates the Guernsey bourse, said it contacted the FCA at the time but received no initial response.
Former City minister Paul Myners has berated the FCA. “Woodford was obliged to begin to do clever dealings to try to stay within the word of the law,” he said. “The FCA said they didn’t know certain things were happening — they were in the newspapers. The FCA should have been awake.”
Some say the FCA’s response was constrained by gaps in the rule book. The Ucits rules are European regulations that the FCA does not have the power to amend.
Writing in the Financial Times, Mr Bailey suggested that the framework needed to be updated. “The Woodford fund points to a potential problem with the limits on illiquid assets: the purpose of these limits is to ensure that the fund remains liquid. Simply listing an unquoted company overseas does not in itself make the stock liquid,” he said.
Liberal Democrat MEP Neena Gill, who has a particular interest in finance, is calling for prescriptive rules to prevent a repeat of the Woodford fund run. She believes the Ucits directive is vague on what constitutes an illiquid asset. “There is a particular problem with the fund’s exposure to illiquid and unquoted shares, and this despite rules and caps foreseen by the EU and UK legislation.”
Ms Gill plans to question the European Commission on how the unquoted cap is calculated and intends to open a debate about improvements.
She adds: “It is clear that a review and clarification of the Ucits rules could be helpful to avoid this type of situation and to allow [regulators] to intervene faster.”
Another issue that Ms Gill plans to raise is how companies that say they intend to list within 12 months can be classified as liquid stocks, which does not guarantee immediate liquidity.
The commission may come under pressure to look at the issue in a review of Ucits rules, likely to take place next year.
In its defence, Brussels says that the failing in the Woodford episode “seems to be a supervisory issue concerning the application of EU rules”.
It says: “We do not see [an] immediate reason for changing rules which are, in our view, clear but need to be applied in order to ensure the intended protection of investors.” It adds that it remains open to potential rule changes should the need be shown.
Monica Gogna, a partner at law firm Dechert, says that while the FCA cannot change the Ucits directive, it could act alone to “provide additional guidance on what their expectations are on meeting the requirement”.
Some think the Woodford meltdown should prompt the UK to ban Ucits funds from investing in illiquid assets. The FCA is sensitive to illiquid holdings in funds in times of crisis: trading in several UK property funds was frozen in the weeks after the 2016 Brexit referendum.
Stuart Alexander, chief executive of Gemini Investment Management, says: “The letter of the law has been misinterpreted in terms of what is an eligible asset. The regulator should turn around and say you can only invest in liquid assets and provide a definition of a stock that can trade.”
That said, restricting investments in illiquid assets would be counter to the FCA’s parallel objective of channelling more money into long-term capital projects, such as infrastructure.
Mr O’Bree adds: “Neil Woodford is a poster boy for patient capital. This story may have a negative effect on the [FCA’s] patient capital review, which would be a worry.”