It is almost five years since the Woodford fund was closed, with a warning notice issued two weeks ago against Neil Woodford and the investment manager he founded, over liquidity related failings.
Timed with that announcement came the final notice attached to the authorised corporate director, Link Fund Solutions, which is meant to keep a check on the running of the fund, setting out in full detail where the company went wrong.
It makes for compelling reading.
On June 3 2019, following a request from Kent County Council to redeem its holding in full, Woodford’s flagship Equity Income Fund (WEIF) was suspended, leaving many investors trapped in a fund whose value had deteriorated by almost 70 per cent in the space of two years.
Kent Council was at the time the largest single investor in the fund, managed by Woodford Investment Management, with £237mn (6.5 per cent of NAV) at the end of May 2019.
But as far back as November 20 2017 Link had concerns, saying that Woodford (ie WIM) was “in need of better management of its liquidity”.
Had Link adopted "reasonable and appropriate monitoring metrics, which it failed to do", its trigger threshold for WEIF’s most illiquid assets would have been breached in April and May 5 2018, at least a year before the suspension, and then continuously from July 2018, according to the damning 83-page final notice document issued against Link by the FCA.
The losses were unfairly and disproportionately borne by those investors who did not redeem early.FCAThis is not the first time the Link business has got into trouble with the regulator.
Under the former name of Capita Financial Managers (CFM) it received a public censure in November 2012 for breaching regulatory rules between June 2006 and March 2009 in connection with failures in its oversight, as ACD, of the CF Arch cru Investment Funds and the CF Arch cru Diversified Funds, according to the final notice.
In November 2017, CFM again received a public censure for breaking rules and failing in its oversight, as operator – managing the investments – of the Connaught Income Fund between between April 7 2008 and September 25 2009. Connaught was suspended in March 2012 and subsequently wound up.
Settlement scheme approved
A High Court judge has now approved a £230mn settlement scheme for the affected WEIF investors, who held investments in the WEIF at the point of suspension.
This figure is short of the £298mn that, according to the FCA, reflected the losses suffered by investors.
Under the terms of the scheme, Link has agreed to pay all its available assets to WEIF, together with a contribution of £60mn by parent company Link Administration Holdings.
The FCA also said that an additional imposition of a financial penalty would have reduced the amount of restitution to investors – £50mn, or £30mn in the event of a settlement – available to be paid by Link.
Instead of imposing the financial penalty, the FCA published the statement of Link’s misconduct and failings in full.
Since being suspended, the value of many of the assets held within the WEIF has reduced significantly, meaning that investors have received, or will receive, significantly less than the value of their investments at the point of suspension.
The FCA says Link’s failings materially contributed to the risk that suspension would be required, and placed those investors who did not redeem prior to the point of suspension at a disadvantage.
The ‘first mover advantage’ for those redeeming earlier was exacerbated by the failure of Link to adequately monitor how redemptions were being met by WIM and to help prevent further deterioration of liquidity.
The FCA said: “[The] losses were unfairly and disproportionately borne by those investors who did not redeem early and were left with a fund with an illiquid rump of unquoted assets.”
Regulatory responsibilities
According to the final notice, as WEIF’s ACD from the fund’s inception in May 2014, Link had regulatory responsibilities for the management of the fund. Link monitored and oversaw WEIF and was required to ensure that it acted in the interests of all investors.
Managing liquidity risk is a key function of an ACD. While an ACD may delegate the investment management of a fund to an investment manager, in this case WIM, the ACD remains responsible for ensuring that liquidity risk is managed appropriately.
Broadly, an ACD maintains regulatory documentation, including the prospectus and the key investor information document.
It also maintains operational relationships with key stakeholders, including shareholders and the FCA, values and ensures accurate pricing of the fund’s assets, and monitors relevant activities of the investment manager.
According to the final notice, WIM had two roles: it was the sponsor of WEIF and WEIF’s investment manager.
As sponsor, WIM defined the principal features of WEIF and engaged Link as ACD. WIM provided Link with all necessary documentation to establish the fund, and maintained those documents throughout the life of the fund.
WIM also retained responsibility for discretionary investment management and advisory services to achieve WEIF’s investment objectives.
From July 31 2018 until the fund’s suspension, Link failed to comply with its regulatory obligations as ACD in respect of liquidity in four key areas, the FCA said:
- WEIF’s liquidity profile was unreasonable and inappropriate in light of the redemption policy in the fund prospectus, which allowed investors to redeem their investment within four days. However, Link failed to take adequate steps to deal with the problem.
- The metrics used to measure liquidity contemporaneously (including stress testing) were unreasonable and inappropriate.
- Link failed to properly supervise WIM.
- WEIF held securities that were originally unquoted but later admitted to eligible markets.
Between October 2014 and October 2015, WEIF invested in a collection of companies that were unquoted, which meant that the relevant securities they issued were not listed and traded on an exchange..
On August 2017, WIM suspended any further investments in unquoted securities, as WEIF was approaching the 10 per cent limit of unquoted securities in the portfolio, as set out in the FCA's Ucits rules.
By the end of November 2017, the percentage of unquoted securities held by the WEIF was 9.82 per cent.
The FCA said, unknown to Link, WIM notified each of the four companies – Sabina Estates, Ombu Group, Industrial Heat, and Benevolent AI – about the challenges of making further investments as well as WEIF nearing the 10 per cent limit.
WIM was unable to provide further funding to them unless the securities held by the WEIF were listed, which meant they would no longer be affected by the 10 per cent limit.
Subsequently, each of these four companies listed shares in their companies on The International Stock Exchange (TISE) in Guernsey.
Even with the businesses becoming listed, prior to the suspension of the WEIF on June 3 2019, there were no arm’s length market dealings in any of the TISE securities, and only one trade recorded for any of the securities.
Additionally, the securities were valued by Link using fair value pricing at all stages, even after their listing.
This meant that the fund held assets that remained illiquid even after listing, increasing the risks of liquidity issues arising, the FCA concluded.
But Link did not change its treatment of the securities in the TISE companies from a liquidity perspective, being aware that the relevant listings were likely to be, at most, thinly traded.
The liquidity thresholds were set in such a way that action would only be required when it was already too late.FCAAdditionally, it failed to give sufficient consideration to the potential implication of the WEIF holding what it knew would be illiquid assets, in addition to those within the 10 per cent limit.
The FCA said: “It was entirely foreseeable by Link that the use of the ‘intention to list’ process increased liquidity risks. It created an ability to invest in more assets within the WEIF which were of the same characteristic in liquidity terms as unquoted assets.
“WIM capitalised on this opportunity not only to continue to hold the assets once they had been removed from the 10 per cent unquoted restrictions but, significantly, in some cases to increase the holdings in the TISE assets above the amount originally held.”
The regulator added: “Link was aware that WEIF held a high percentage of unquoted securities.
"Link failed to give sufficient consideration to the potential implication of the WEIF holding what it knew would be illiquid assets, in addition to those within the 10 per cent limit.
“Link failed to sufficiently recognise the risks of increased levels of illiquid assets being held and the increased risk of liquidity issues arising. Link should have been fully aware of the risks and acted to prevent the repeated use of this process which enabled a higher level of illiquid funds to be held.”
Where did it begin?
WEIF did not start out this way.
The fund made its first investment in unquoted securities in June 2014 – the month after it was launched.
Altogether it made 68 investments in a number of unquoted securities during its lifetime. The value of unquoted securities that is permitted in a fund is 10 per cent of its net asset value.
By the end of June 2014, the total NAV of WEIF reached nearly £1.7bn.
From June 2014 to May 2017, WEIF continued to attract investors and the fund grew to a peak of almost £10.2bn by May 2017.
Between June 2 2014 and May 31 2017, WEIF generally outperformed the FTSE All-Share Index.
In April 2017, WIM began to implement a refocus of WEIF’s investments from global companies to UK-focused companies, which were frequently smaller, less well-capitalised companies.
And from June 2017 onwards, the WEIF generally underperformed against the market benchmark.
Owing to poor investment performance and persistent investor withdrawals, WEIF’s NAV more than halved from £10.08bn at the end of June 2017 to just over £3.5bn by the end of May 2019.
The WEIF was an outlier among comparator funds. From mid-2018 until its suspension, it was less liquid than the least liquid such comparable fund in a number of areas.
During the period that the fund deteriorated, despite several meetings between Link and WIM concerning the fund’s liquidity, Link did not ensure necessary changes were made, nor did it ensure the liquidity monitoring framework was appropriate, the FCA said.
Link presided over changes to the liquidity monitoring framework that were adopted without “proper justification”.
Liquidity frameworks
On one occasion, following a discussion between Link and WIM, Link approved a change in the liquidity monitoring framework, at WIM’s instigation.
The FCA said: “That change was approved despite the fact that metrics which had hitherto been part of the monitoring programme and which were identifying, and were likely to continue (and did in fact continue) to identify, breaches of liquidity thresholds, were abandoned.
“Additionally, the new monitoring framework was less prudent (in the sense that it did not identify the liquidity profile as breaching thresholds, whereas the previous framework did), but the relevant thresholds were not adjusted downwards to take this into account.
“The liquidity thresholds were inappropriate in light of the redemption policy and metrics adopted. They were set in such a way that action would only be required when it was already too late."
According to the regulator, even on Link’s own contemporary calculations, it was or ought to have been clear that the liquidity of WEIF was deteriorating.
From September 2018 onwards, Link did repeatedly tell WIM that there was a need to improve the overall liquidity profile of WEIF.
However, it failed to ensure that the necessary actions were taken.
I didn’t expect the eventual outcome, but if I acted surely an ACD with far more responsibility should have.Ben Yearsley, Fairview InvestingFCA said: "Had Link properly calculated the liquidity in the WEIF, the true scale of the liquidity problem would have been known.
“Link was aware that WEIF’s liquidity was deteriorating throughout the relevant period, but did not effectively communicate these problems to WIM; and, insofar as Link did communicate them, it did not ensure that they were acted upon.”
A section 166 skilled persons report, issued on October 19 2018, found that Link used inappropriate participation rates for its liquidity monitoring, including of WEIF, but Link took no action to remediate the position.
The FCA also criticised Link for using an incorrect data source for its liquidity calculations.
Responding to the final notice, a spokesperson for Link Fund Solutions Limited (LFSL) says: “As we have previously stated, LFSL entered into a conditional settlement agreement with the FCA and Link Group expressly on the basis that there is no admission of liability.
"If the scheme had not been approved, LFSL would have challenged the FCA's findings and defended itself against any claims made against it by scheme investors.
"We are pleased the scheme has become effective and the initial payment has now been made to scheme investors. We have always believed the scheme was the best option to provide investors with a substantial level of redress.”
Ben Yearsley, director at Fairview Investing, says if Link had concerns, it should have acted on them more forcefully.
Yearsley adds: "I’m not saying I foresaw what was to happen, but I sold the fund in [around] November 2017 as the fund was no longer the income fund I wanted and I was concerned about the level of unquoted holdings.
"I didn’t expect the eventual outcome, but if I acted surely an ACD with far more responsibility should have."
In the FCA warning notice against Woodford, the regulator accused him of having a “defective and unreasonably narrow” understanding of his responsibilities for managing his fund and failing to ensure the fund had an appropriate liquidity profile.
In response, Woodford’s lawyers say the fund's liquidity framework was Link's responsibility and vow to challenged the findings.
The statement from WilmerHale and BCLP, legal counsel to Woodford Investment Management and Neil Woodford, says: "As the delegated investment manager, WIM was required to manage the fund in accordance with both the liquidity framework and all the other portfolio constraints set by Link.
"Central to the failings alleged against WIM and Mr Woodford is the FCA’s claim that the framework used to measure and monitor the fund’s liquidity risk and the corresponding parameters of the fund’s liquidity were not appropriate.
"Importantly, that framework and its parameters were set by Link, one of the most experienced ACDs in the industry.
"At the time, Link managed fund assets for over 100 investment managers. As acknowledged by Andrew Bailey shortly after the fund’s suspension, responsibility for liquidity rested with Link.
"Additionally, staff at WIM had it confirmed by Link that the FCA and the depositary knew the details of the liquidity framework that was being applied to the fund, including its parameters, throughout the period."
Ima Jackson-Obot is deputy features editor at FT Adviser
