Investment funds update

15 DECEMBER 2020

| 7 min read

There have been several changes to investment funds over the past year. The National Security and Investment Bill, a Capital Gains Tax rate review, a new regulatory gateway and changes to LIBOR will all affect investors and investees over the coming months.

Dona Ardeman reviews each area and gives you some practical guidance on what you should be looking out for.

Investment funds update 2020

National Security and Investment Bill
What is being proposed and why?

On 11 November 2020, the National Security and Investment Bill (“Bill”) was introduced to Parliament. The Bill sets in motion the UK Government’s intention to enhance its powers of intervention with respect to foreign investment transactions which pose a risk to national security. The Bill follows a similar theme of decisions made in other jurisdictions both within the EU and globally to enable governments to tighten their levels of control over foreign investment. The catalyst for the Bill, in the form of the COVID-19 pandemic and the resulting economic environment, was manifested in the financial distress felt by businesses and increased concerns over their vulnerability to rapid and opportunistic takeovers.

Mandatory notification: The Bill proposes that transactions which are in progress or in contemplation in relation to entities operating within 17 specified sectors, and which will involve certain ‘trigger events’, will be subject to mandatory notification, and subsequent clearance from the Secretary of State.

Voluntary notifications: A voluntary notification system will be in place, where various facts about a transaction are unknown, to encourage notifications from parties who consider that their transaction or other event may raise national security concerns.

What sectors might be concerned?

The relevant sectors in which these entities operate, will be set out in secondary legislation to allow the Government to review the definitions of the relevant sectors and to reflect changes in the national security risks faced by the UK.

The consultation proposing the definitions (which closes on 6 January 2021) currently covers 17 sectors: Advanced Materials; Advanced Robotics; Artificial Intelligence; Civil Nuclear; Communications; Computing Hardware; Critical Suppliers to Government; Critical Suppliers to the Emergency Services; Cryptographic Authentication; Data Infrastructure; Defence; Energy; Engineering Biology; Military and Dual Use; Quantum Technologies; Satellite and Space Technologies; Transport.

When does it apply and what powers will the Government have?

Trigger events: The trigger events relate to a person’s acquisition of:
- certain thresholds (more than 25%, 50%, and 75%) of shareholding or voting rights in an entity, or
- rights that will allow it to pass or block a resolution governing the affairs of the entity; or
- material influence over the policy of the entity; or
- a right or interest giving the acquirer greater control over the use of a qualifying asset (e.g. land, tangible moveable property, or ideas, information or techniques which have industrial, commercial or other economic value).
Whilst not a “trigger event”, the acquisition of 15% or more of the shareholding or votes in an entity will qualify as a notifiable acquisition and require mandatory notification.

Retrospective effect: The Bill, once enacted, will have retrospective effect in relation to trigger events that take place after the 11 November 2020 (the date the Bill was laid before Parliament), and such trigger events will be subject to the Government’s “call-in” power.

Mandatory notification process: The obligation to notify is on the acquirer in respect of notifiable acquisitions. Once the Secretary of State accepts a notification, it will have 30 days to give clearance to the transaction to proceed, or alternatively, to exercise its call-in power to begin a full national security assessment.

Call-in power and available remedies to protect national security: Following the day a formal call-in notice is given, the Secretary of State then has a further 30 days to carry out the assessment which is extendable by a further 45 days.
- Following the assessment, the Secretary of State may approve the transaction, which may be subject to conditions to prevent or mitigate national security risks, or it may impose an order to block (or if already completed, unwind) a transaction. Any order applied by the Secretary of State is subject to the qualification that it reasonably considers it necessary and proportionate to do so.
- The Secretary of State has the power to call in a trigger event which has taken place up to six months after it becomes aware of the trigger event, provided it does so within five years of the trigger event occurring (whether or not voluntary notification had been given). If the acquisition was subject to mandatory notification, the five-year time limit does not apply.
- The call-in power also extends to transactions that raise national security concerns, but where there is no direct link to the UK, but where, for instance, the entity established outside the UK is carrying on activities within the UK, or supplying goods or services to persons in the UK.
Unapproved transactions and sanctions: Any notifiable acquisition which is completed without the Secretary of State’s clearance will be void. Penalties for completing a transaction without clearance include civil and criminal sanctions and range from fines up to the higher of 5% of total global turnover or £10 million, and imprisonment of up to five years.

Further considerations

CMA: The CMA and national security regimes are intended to run in parallel to avoid any delays to the CMA’s competition assessment.

Scale of impact: Since 2003 there have been only 12 national security interventions under the Enterprise Act 2002. Under the new regime, a new Investment Security Unit will be established within BEIS to provide a point contact, given the Government has estimated that between 1,000-1,830 transactions will be notified every year.

If you are concerned about whether a prospective transaction might be affected by the new legislation, please contact us as early as possible for advice about the potential impact it may have on your transaction.
Capital Gains Tax rate review
Following its review, the Office of Tax Simplification (OTS) has suggested a number of changes to the capital gains tax (CGT) regime, including increasing CGT rates to better align them with much higher income tax rates and reducing CGT reliefs (following the redesign of entrepreneurs’ relief).

If implemented this would impact the tax position of fund managers’ carried interest under the BVCA memorandum of understanding, since carried interest’s tax advantages (like much individual tax planning) are achieved partly through capital’s preferential tax treatment compared to income.

It seems unlikely that the Government will align income and CGT rates completely, and carried interest is in any case already generally taxed more than certain other capital items (though much less than employment income is).

Nonetheless, some form of rate increase is likely given that:
- the OTS’ review was undertaken at the request of the Chancellor;
- the UK needs to cover its budget deficit from COVID-19; and
- many expect a global upward trend in tax rates given the US election and the need to fund COVID-19 costs.
- Some fund managers are already considering other options for restructuring carried interest arrangements to maximise tax efficiency where
New regulatory ‘gateway’
On 26 October 2020, the consultation closed on the UK Government’s proposal to establish a regulatory ‘gateway’ through which an authorised financial firm must pass before it is able to approve the financial promotions of unauthorised firms. The regulatory ‘gateway’ would require any firm wishing to approve the financial promotions of unauthorised firms to first obtain the consent of the Financial Conduct Authority (FCA).

The proposal sets out to address a perceived gap in the FCA’s ability to effectively oversee financial promotions and to ensure that they meet the FCA’s minimum standards and are fair, clear and not misleading. Currently, any authorised firm is able to approve any financial promotion of an unauthorised firm. There is no specific process through which a firm must be assessed as suitable and competent before it is able to approve the financial promotions of unauthorised firms. The consultation stems also from the FCA’s observation of increased online marketing channels which risk misleading financial promotions quickly reaching a mass audience.

The regulatory ‘gateway’ would act as an additional safeguard to enable the more effective oversight and supervision of the FCA. In practice, each authorised firm would need to apply to the FCA to gain permission to approve financial promotions of unauthorised firms, and the FCA would assess the fitness and competence of the firm when considering the application. An alternative option has also been proposed, to make the approval of financial promotions of unauthorised firms a regulated activity under FSMA. However, HM Treasury has indicated that this would appear to be disproportionate and that the regulatory ‘gateway’ is preferred.

Consequences:
- The consultation has so far not set out in detail how the FCA would assess an applicant firm as suitable and competent before it is able to approve the financial promotions of unauthorised firms, nor how different types of investments are to be categorised for purposes of granting specific consents.
- Once the relevant application process and investments categories are better understood, authorised firms which currently regularly approve, or which are contemplating approving, the financial promotions of unauthorised firms will firstly need to be aware that they will need to consider how they might demonstrate that they are suitable and competent, which is to say that they have the relevant expertise and understanding of the relevant risks to approve specific financial promotions in relation to specific types of investments.
LIBOR
What is LIBOR?

The London Interbank Offered Rate (“LIBOR”) is used in many loans, derivatives, bonds and other financial transactions as a reference to calculate a floating rate of interest.

LIBOR is based on the rate at which banks lend to each other. Each day large banks (known as panel banks) would submit their funding rates to the administrator of LIBOR, who would then average those rates and publish the figures. LIBOR is published across a range of currencies (GBP, USD, EUR, JPY and CHF) and maturities (overnight, one week, one month, two months, three months, six months and one year).

Why is LIBOR being replaced?

The transactions that are used to calculate LIBOR (in the unsecured inter-bank lending market), have dropped significantly in volume since the 2008 financial crash, which led to fewer banks reporting rates and fewer transactions to base the rates on. The rate of LIBOR increasingly was not representative of the global market and was based on expert judgement of certain banks.

On 27 July 2017, Andrew Bailey, Chief Executive of the UK Financial Conduct Authority, announced that market participants should not rely on LIBOR being available after 2021. Instead, the market has been encouraged to more to alternative floating rates.

LIBOR cessation: what do you need to know?

LIBOR is set to cease being published after 31 December 2021 and LIBOR rates are, in most circumstances, being replaced by so-called “Risk Free Rates” (RFR). RFRs will be available in all 5 LIBOR currencies.

There are numerous differences between LIBOR and the RFRs, which means that it’s not simply a case of deleting reference to “LIBOR” in contracts and replacing it with a reference to “[Selected RFR]”. For example, the biggest difference between sterling LIBOR and SONIA (being the sterling RFR) is that LIBOR looks forwards, so you can establish today what your rate of interest will be over the next 3, 6 or 12 months. SONIA is an overnight rate, it looks at transactions that happened the day before in the market and averages out the rates to produce a figure the following working day. This means that you cannot know the interest that will be paid for the next 3 months, until those 3 months have expired.

Since Andrew Bailey’s announcement, a huge amount of work has gone into producing market conventions for replacing LIBOR and how RFRs or alternatives can be calculated for market use. Replacing LIBOR is a phenomenal task in the financial sector and requires new market conventions, new documentation and ultimately new legislation. However, this task is well underway with market conventions being established and agreed as we progress to the end of 2020.

Timeline (in brief)

The Financial Stability Board has set out a Global Transition Roadmap for LIBOR (published in October 2020), which set out a timetable of actions for the transition away from LIBOR:
- From the end of Q3 2020, all new sterling LIBOR-referencing loans (and other financial products) should contain provisions that set out the mechanism for LIBOR to be replaced with a RFR and banks should be offering non-LIBOR products.
- By the end of Q1 2021, new LIBOR-linked linear derivatives and cash products maturing after 2021 to cease.
- By end of Q2 2021, all new LIBOR-linked products that mature after 2021 to cease.
In an update on 20 November 2020, the FSB noted that, with only one year left, all financial and non-financial market participants across the globe must now ensure they follow the necessary steps to avoid disruption to the performance of their contracts.

What do you need to do?

Identify all LIBOR exposures: both financial and non-financial contracts will need to be checked to ascertain if they contain any LIBOR exposure (that extends beyond 2021) and the mechanism for amending these contracts.

Understand the alternatives: there are various options for transitioning from LIBOR and it’s important to understand what’s currently available.
- Risk Free Rate – in most instances, LIBOR will be replaced with a RFR such as SONIA (the sterling RFR), €STR (the euro RFR) or SOFR (the USD RFR). Each rate differs as it’s based on a different underlying loan market but they are all the same in that they look back over a pool of investments that have taken place, unlike LIBOR which looks forward.
- Bank rate – the drafting and calculation exercise required to use a RFR is complex and may not be appropriate in all circumstances. By reference to a central bank rate, this cuts out that lengthy process. For example, commercial contracts that reference LIBOR for the purpose of default interest on late payments can be updated to refer to a central bank rate.
- Fixed rate – this is likely to be appropriate in the same circumstances as bank rate and, in particular, for use in intra-group lending.
Engage with counterparties: where your LIBOR expires are with financial institutions, they are likely to have their own transition plan for LIBOR exposures and should be able to offer post-LIBOR products to consider, however less formal lending may require more consideration.

Consider accounting/tax implications: tax advisors and accountants may need to be consulted as necessary.

Prepare for the rate switch: ensure that the necessary documentation is drawn up and in place, systems may require updating and establish when the switch will take place.

If you would like to talk in more detail to one of our team on corporate law, capital markets, private equity or Venture Capital investments, please contact us.

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