22 October 2019
Wojciech Kobylinski - Piotr Zbyszynski
Is the sky really the limit? Investment limits in Polish closed-end investment funds
In this article, we take a look at what happens when certain investment limits in a closed-end investment funds are exceeded and in particular what is the position of the Polish Financial Supervision Authority (Polish: Komisja Nadzoru Finansowego, the “PFSA”) on this topic.
Why do we have investment limits?
The investment limits for closed-end investment funds have been introduced in order to secure the funds contributed by investors (the fund’s participant) to a closed-end investment fund1 (“investment fund”). Firstly, certain investment limits refer to the class of assets that may be part of the investment portfolio of an investment fund2 and/or what kind of conditions must be met in relation to a particular class of assets allowing an investment fund to be invested in them3. Such restrictions set rather a strict distinction between classes of assets that do not generally pose a great risk on the funds invested by such investors and those being more risky.
Secondly, the investment limits also oblige an investment funds management company (Polish: towarzystwo funduszy inwestycyjnych) (“management company”) to diversify the investments towards different assets4. Such diversification guarantees, to some extent, that in case the diversification and the management of an investment fund are carried out properly, the possible losses due to one or two investments that turned out to be less successful than initially expected will not result in the loss of the whole investment made by the fund’s participants.
Moreover, the Investment Funds Act establishes restriction on entering into transaction with certain entities that have close links with an investment fund, including in particular investments in securities issued by management company and/or entering into transaction in relation to securities with its management company (or its shareholders), depositary (Polish: depozytariusz) and/or subsidiaries and dominant entities of its management company or depositary5;6 . The above restrictions have been introduced due to a potential conflict of interests when, inter alia, a management company or a depositary would act in different roles which may have potentially negative consequences for the fund’s participants.
Finally, the investment limits are established in the statute of investment funds which also need to be followed by a management company while structuring its investment portfolio.
What happens when the investment limits have been exceeded?
The breach of investment limits does not impact the validity of the legal acts breaching these limits7. This does not mean, however, that no actions are required to be undertaken in case of such breach.
In case the relevant investment limit is breached, the closed-end investment fund is obliged to immediately undertake actions allowing to meet the investment limits8.
In the view of the PFSA, it is not allowed to exceed certain investment limits even in case it would be in the interest of a fund’s participants (for instance, it would be a very profitable investment) or that fund’s participant would be aware or even agree to exceed the relevant investment limit9. In other words, even if the relevant transaction may be very profitable for the fund’s participants, it cannot contradict with the obligation to meet investment limits. Then, such a transaction, in the view of the PFSA, may not be executed even if it is preceded by the approval of the investment fund’s investors’ meeting. Generally, such an approach is reasonable as the Investment Funds Act does not provide for such an exemption. However, one can argue that in case the investment limits are exceeded for a short period of time (for instance, an investment fund is in the process of selling other assets, yet cannot wait with the acquisition until the end of the selling process), then it should not always result in imposing sanctions by the PFSA and should not be understood as an intention to breach the investment limit(s) per se (especially when the investors’ meeting approves the transaction). Instead, it should be understood as a way of controlling over activities undertaken by a management company by the investors’ meeting and allowing the investors’ meeting to make a final decision as the transaction (in short term) may result in exceeding the investment limits which are generally set out to secure the fund’s participants interests. Consequently, the assessment of exceeding the investment limits should be analysed on a case-by-case basis and should not always be treated as wrongdoing which must result in PFSA imposing sanctions.
What does it mean immediately? And what needs to be considered while certain remedies are undertaken?
The Polish legislation does not set out a strict rules on the period during which the relevant breach of an investment limit must be remedied. The reason for that is rather simple. The required time for the remedy may vary significantly and for this reason, “immediate” standard is established, which means that a management company must take immediate actions considering circumstances at the given case. Considering recent PFSA’s position, the greater attention should be taken during the remediation period, in particular in relation to making other transactions that may be perceived as being in the interest of investors but at the same time would, in short term, result in putting an investment fund in a worse position in terms of fulfilling investment limits.
What are the transitional rules for an investment fund?
Generally, an investment fund has 12 months from its registration in the funds’ register to adjust its investment portfolio to the required limits set out in the Investment Funds Act and the fund’s statute10;11 . In the case of closed-end investment fund of non-public assets (Polish: fundusz inwestycyjny zamknięty aktywów niepublicznych)12 the transitional period is 36 months13.
There was rather a market consensus that during the transitional period the investment fund may generally structure the investment portfolio with certain flexibility with the aim to meet all the investment limits at the end of the transitional period. However, since the PFSA’s recent statement was released, it is not so obvious anymore. In the view of the PFSA, an investment fund has generally no flexibility in respect of the allocation of fund’s assets considering investment limits. The PFSA reminds that all activities undertaken by a management company acting on behalf of an investment fund should take into account the obligation to adjust the structure of an investment portfolio to the requirements of the Investment Funds Act, as well as the fund’s statute investment limits, and these activities should not result in the breach of investment limits during the transitional period14. Therefore, it seems that for the PFSA the interest of the investment fund’s participants is mainly secured by the mere fact that the management company activities are focused on following the investment limits also during the transitional period rather than in building the investment portfolio more flexibly during the transitional period. Such a position is rather surprising as it was widely understood that the transitional period is granted in order to allow the management company to structure the investment portfolio considering business opportunities without the need to strictly follow investment limits during that time15. Otherwise, the benefits related to the transitional period are rather theoretical. As a result, it is difficult to agree with the PFSA in this respect in case the management company generally intends to meet the investment limits in the long term (and has a plan to do so) and at the same time focuses on certain investments at the given time (for instance, the focus is first on one asset / class of assets and then the focus is directed to other(s), which eventually results in a well-diversified investment portfolio at the end of the transitional period).
What are the potential consequences of breaching the investment limits?
The PFSA may request the management company not to breach investment limits16.
In most extreme cases the PFSA may, inter alia, recall the licence for the management company and/or the management company may face up a fine up to PLN 5,000,000 (the sanctions may be imposed jointly)17.
Moreover, the PFSA publishes the decision on the imposed sanctions (it is also possible that the PFSA publishes the decision in the national newspapers at the expense of the management company in case it is very important considering investors protection)18, as well as shame and blame the management company by informing the market, inter alia, on the sanction imposed and type and character of the breach (also by providing details on the matter) and details on the management company19.
Additionally, in the case of non-compliance with investment limits, the depositary of an investment fund may also be found liable for the relevant breach as a depositary of an investment fund is obliged to monitor the activities of an investment fund against the relevant regulations (in particular the Investment Funds Act), the investment fund’s statute and considering the investment fund’s participant interest20.
What can we learn from the recent activities of the PFSA?
The management companies should once again check how the investment portfolios are structured in the investment funds managed by them and take greater care of meeting the investment limits also during the transitional period. The internal regulations of the management company regarding control over the investment limits should be verified and updated (if required).
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