UK/EU Investment Management Update (December 2023)

1. UK — ESG
2. UK — IFPR
3. UK — Change in Control
4. UK — Market Abuse
5. UK — Cryptoassets
6. UK — Short Selling Regulation
7. UK — Financial Promotion
8. UK — Tax Updates
9. EU — AIFMD II
10. EU — ESG

1. UK — ESG

FCA publishes policy statement on UK Sustainability Disclosure Requirements (SDR) and investment labels

On 28 November 2023, the FCA published its policy statement on the UK SDR and investment labels (PS23/16). We have published our analysis of PS23/16 in our Sidley Update Final Rules on UK Sustainability Disclosure Requirements and Investment Labels — Key Takeaways for Asset Managers.

FCA review of ESG and sustainable investment funds

On 16 November 2023, the FCA published findings from its review of AFMs’ compliance with its expectations regarding the design, delivery, and disclosure of ESG and sustainable investment funds, as set out in the FCA’s July 2021 Guiding Principles letter.

The review focused on both active and passive authorised retail funds that market themselves as having ESG or sustainable characteristics. The FCA findings, while not directly applicable to alternative investment fund managers (AIFMs) or wholesale funds, are informative in the general approach that fund managers should be taking with respect to ESG and sustainable investment funds. In total, the FCA tested 12 AFMs of varying sizes. The AFMs under review provided an overview of their ESG and sustainability approaches. The FCA also reviewed fund disclosures available to consumers and visited the AFMs to discuss their ESG approaches.

The FCA provided detailed guidance on good practice for firms across the three ESG/sustainability Guiding Principles of Design, Delivery, and Disclosure as well as Governance.

• Design. The FCA found varied approaches among AFMs in setting specific ESG objectives, with some funds lacking explicit ESG or sustainability objectives or not aligning with stated objectives in investment policies. Further, the FCA emphasises the need for AFMs to clearly define their stewardship approaches, demonstrating how these contribute to fund objectives and comply with regulatory requirements, including ensuring fair, clear, and non-misleading communications.
  
• Delivery. The FCA found inconsistencies between some fund holdings and their stated ESG objectives, urging AFMs to explain such discrepancies to investors. The FCA expects AFMs to embed robust investment research and due diligence processes, understand external data methodologies, and maintain systems to ensure ESG data accuracy.
  
• Disclosure. The FCA found that key ESG and sustainability information was often not explained or put into context in disclosures. The FCA notes that disclosures should contain all relevant information, including (where feasible) data on Scope 3 emissions, to enable investors to make fully informed product choices. Further, AFMs should reconcile fund and firm-level disclosures, explaining how an individual fund contributes to firm-wide sustainability objectives.
  
• Governance. The FCA calls for AFMs to enhance oversight and control structures surrounding ESG and sustainable investment funds; in particular, AFMs should monitor adherence to the fund investment objective and policy, with exceptions reported to the relevant committee and overseen by the Board.

The FCA expects AFMs to assess how they are meeting applicable rules and guidance concerning their ESG and sustainable investment funds, an exercise the FCA considers useful in preparation for the implementation of the UK SDR.

UK Transition Plan Taskforce (TPT) consultation on Sector Deep Dives — Asset Managers

On 13 November 2023, the UK TPT launched a consultation on its sector-specific guidance for preparers and users of climate transition plans.

The consultation consists of seven Sector Deep Dives. Each Deep Dive contains detailed draft guidance for one of seven key economic sectors: banks, asset owners, asset managers, electric utilities and power generators, food and beverage, metals and mining, and oil and gas.

The TPT’s guidance aims to help these sectors develop detailed climate transition plans, including strategies for climate mitigation and management, and governance frameworks. The guidance for asset managers focuses on developing strategies for stakeholder engagement, investment, product development, and managing climate-related risks, including both physical and transition risks. It emphasises the importance of disclosing the sources and extent of data used, the financial effects of transition plans, and how these plans address climate-related considerations in investment activities and affect (among others) stakeholders, society, and the natural environment.

The TPT’s efforts align with the UK’s broader regulatory approach to climate disclosures, focusing on climate-related factors within the wider context of sustainability and ESG metrics.

The consultation remains open for comments until 29 December 2023.

2. UK — IFPR

FCA publishes final report on implementation of the Internal Capital Adequacy and Risk Assessment (ICARA) process

On 27 November 2023, the FCA published its final report from its multi-firm review of firms’ implementation of the ICARA process (and reporting requirements) under the IFPR. The report should be read alongside the FCA’s initial observations, which was published in February 2023 and, which was covered in our Sidley Update of April 2023.

The final report highlights several areas requiring significant improvement including, among others, the following:

• Liquidity Assessment. The FCA found that several firms did not adequately consider stressed conditions in their liquidity assessments, risking cash shortages during stress periods and potential firm failure. Further, most firms lacked structured internal intervention points, thus potentially delaying actions to mitigate harm, particularly in a firm failure scenario.
• Operational Risk Capital Assessment. The FCA identified significant shortcomings in the application of operational risk capital approaches. These failings included inadequate consideration of risks from an individual firm’s perspective, inappropriate use of group models without customisation, and poor governance and oversight around complex modeling approaches.
• Wind-Down Plan. The review found that many firms’ wind-down plans did not sufficiently consider group relationships, leading to an incomplete assessment of resources needed for an orderly wind-down. This included a lack of consideration for the impact of group-wide wind-down plans on shared systems, costs, and resources.

The FCA expects firms to consider its findings and act now to strengthen their processes.

3. UK — Change in Control

PRA and FCA publish joint consultation on FSMA controller regime

On 23 November 2023, the Prudential Regulation Authority (PRA) and FCA published a joint consultation paper on prudential assessment of acquisitions and increases in control. The paper contains a draft (i) PRA supervisory statement (for firms regulated by the PRA) and (ii) FCA guidance (for FCA solo-regulated firms).

The draft FCA guidance will replace (and largely replicate) the existing guidelines on the prudential assessment of acquisitions and increases of qualifying holdings in the financial sector published by the Joint Committee of the European Supervisory Authorities, which the FCA generally consults when assessing (applications for) changes in control of firms it regulates.

Of particular note for investment managers, the draft FCA guidance provides detail on circumstances in which the FCA may request additional information from, and its approach to assessing the reputation/financial soundness of, proposed controllers in light of the IFPR and Financial Services and Markets Act 2023 (FSMA 2023), as follows:

• Firms subject to IFPR. Additional financial information may be required from a proposed controller where an investment firm group will be created, or added to, as a result of the transaction. Such information is likely to include longer-ranging group forecasts or management accounts as well as evidence of being able to meet the higher capital and liquidity requirements that may be applicable to the group.
  
• Assessment of reputation of proposed controller. The FCA’s assessment of the reputation of the proposed controller covers two elements: (i) integrity and (ii) professional competence. The FCA notes (when assessing a proposed controller’s reputation) it will consider the impact of allegations (their nature and re-occurrence) and may seek to mitigate risks by imposing conditions on its approval of a transaction (in order to advance its objectives under FSMA 2023). The FCA notes that in some circumstances, the potential imposition of conditions on an approval of a transaction (and the requirement for the FCA to publish such conditions) may result in a proposed controller’s withdrawing from, or at least delaying, the proposed transaction.

The consultation remains open for comments until Friday 23 February 2024. The finalised FCA guidance is expected to apply from summer 2024. We will publish a detailed Update on the implications of the new guidance for investment managers when the FCA publishes its policy statement in 2024.

4. UK — Market Abuse

FCA censures NMC Health Plc (in Administration) for market abuse

On 17 November 2023, the FCA found that NMC Health plc (NMC), a collapsed United Arab Emirates–based hospital operator that had its shares admitted to trading on the London Stock Exchange, committed market abuse by (among other things) understating its debts by as much as USD 4 billion.

The FCA observed that NMC — which entered the FTSE 100 in 2017 before being placed into administration in April 2020 — misled the market between March 2019 and February 2020 by publishing false or misleading information in its financial disclosures.

In particular, the FCA found that NMC had been operating dual sets of accounting records, including internal spreadsheets where borrowing recorded as “Non-Showing” was not included in the figures reported to the market. The FCA’s investigation followed a 2019 report by Muddy Waters Capital LLC that made detailed allegations about the accuracy of NMC’s financial reporting to the market.

The FCA found NMC’s conduct to be serious, stating that such market abuse undermines investor confidence in the integrity of the financial markets and would ordinarily attract a substantial financial penalty. However, as no funds are expected to be available once creditor claims have been met, the FCA imposed a public censure instead.

5. UK — Cryptoassets

FCA finalised guidance on cryptoasset financial promotions

On 2 November 2023, the FCA published its finalised non-handbook guidance on cryptoasset financial promotions (FG23/3).

FG23/3 provides information on, and sets out the FCA’s expectations of, the communication and approval of financial promotions for qualifying cryptoassets (broadly, any cryptographically secured digital representation of value or contractual rights that are transferable and fungible, excluding cryptoassets that meet the definition of electronic money or an existing controlled investment).

The guidance does not create new obligations for firms but instead provides a basis on which in-scope firms could evidence their compliance with existing regulatory obligations, including the requirement to ensure that financial promotions (for qualifying cryptoassets) are fair, clear, and not misleading.

The guidance also addresses how firms communicating or approving financial promotions for qualifying cryptoassets should apply the Consumer Duty to their marketing, as well as specific concerns raised by respondents regarding stablecoins and cryptoassets claiming to be backed by a commodity or an asset. With respect to stability claims or links to a fiat currency, the FCA expects firms to assess financial promotions on a case-by-case basis, conducting due diligence and verifying the validity of claims made. For further information on, and developments regarding, the future financial services regulatory regime for cryptoassets, see our Sidley Update UK Confirms Regulatory Regime for Cryptoassets.

6. UK — Short Selling Regulation

HM Treasury publishes draft Short Selling Regulations 2024

On 22 November 2023, HM Treasury published a draft statutory instrument, the Short Selling Regulations 2024 (the Draft UK SSR) and an accompanying policy note.

The Draft UK SSR forms part of HM Treasury’s wider programme to build a smarter regulatory framework for financial services in the UK and follows the publication of HM Treasury’s response to its Call for Evidence, which we covered in our Sidley Update of August 2023.

Key reforms proposed by the Draft UK SSR include the following:

• Designated Activities. The Draft UK SSR specifies short selling of shares and related instruments as designated activities under FSMA, empowering the FCA to regulate these activities by shifting most firm-facing requirements to rules in the FCA Handbook.
• Increased Notification Threshold. The Draft UK SSR increases the initial notification threshold for net short positions from 0.1% to 0.2% of issued share capital. This change is being implemented through a separate statutory instrument (The Short Selling (Notification Threshold) Regulations 2023), with the new reporting threshold expected to apply from 5 February 2024.
• Publication of Aggregate Net Short Positions. The FCA is required to publish aggregate net short positions based on the notifications it receives, a shift from the current regime of publishing individual net short positions above 0.5% of issued share capital. This is a change the investment management industry, in particular, has advocated for.
• Shares Subject to UK SSR. The FCA must publish and regularly update a list of shares to which the UK SSR requirements apply and that are not exempt, responding to feedback for a “positive” list of in-scope shares from market participants.
• No Restrictions on Sovereign Debt and CDS. The Draft UK SSR removes restrictions on uncovered short selling of sovereign debt and credit default swaps (CDS), aligning with the government’s response to the consultation on these aspects.
• Emergency Powers for FCA. The FCA is granted emergency intervention powers to require additional short selling-related information and restrict short selling in exceptional circumstances, such as a significant threat to financial stability or market confidence. The use of such powers would extend to sovereign debt and CDS.

HM Treasury invites comments on the Draft UK SSR by 10 January 2024 and intends to lay the final version of the document before Parliament in 2024. The FCA is expected to publish a consultation paper on the UK SSR in 2024, covering various topics, including the items noted above (for example, the arrangements and criteria for lists of reportable shares, including the criteria that shares in scope of the regime must be principally traded on a UK regulated market or multilateral trading facility).

7. UK — Financial Promotion

HM Treasury publishes draft Financial Services and Markets Act 2000 (Financial Promotion) (Amendment) (No. 2) Order 2023

On 7 November 2023, HM Treasury published a draft statutory instrument (the Financial Services and Markets Act 2000 (Financial Promotion) (Amendment) (No. 2) Order 2023 (the draft FPO 2023)) and an explanatory memorandum amending the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (FPO).

Key amendments in the draft FPO 2023 include the following:

• Financial Thresholds for High Net Worth Individuals. The income and net assets thresholds required to satisfy the high net worth individual exemption in Article 48 FPO are increased to £170,000 and £430,000 respectively, from the current thresholds of £100,000 and £250,000.
• Criteria for Self-Certified Sophisticated Investor Exemption. The criterion of having made more than one investment in an unlisted company in the previous two years in Article 50A FPO is removed. The company turnover required for the “company director” criterion is increased to £1.6 million.
• Updating Statements for Exemptions. The format of high net worth individual and self-certified sophisticated investor statements required by Articles 48 and 50A FPO respectively has been simplified. The statements will also require greater investor engagement as the individual or prospective investor will be required to select which specific criterion they meet to be classified as “high net worth” or “sophisticated” and state how they meet the relevant criterion.

The draft FPO 2023 also updates the certified high net worth individuals (Article 21) and self-certified sophisticated investors (Article 23A) exemptions in the Promotion of Collective Investment Schemes (Exemptions) Order 2001 to align with the FPO amendments.

The FPO 2023 is expected to take effect from 31 January 2024. Where a firm has made a financial promotion to an individual before 31 January 2024, and the promotion was compliant with the existing exemptions, the firm can continue to engage with the individual for up to 12 months from the date of the promotion without requesting an updated investor statement. However, new financial promotions made from 31 January 2024, even if made to individuals already promoted to under the current exemptions, will need to be made in accordance with the updated exemptions.

Investment managers who rely on the above exemptions should review their compliance processes and investor communication strategies to ensure continued reliance on the relevant exemptions.

8. UK — Tax Updates

Tax Case: Upper Tribunal decision in HMRC v BlueCrest Capital Management (UK) LLP: Salaried Member Rules

The UK’s salaried member rules were introduced in 2014 to ensure that an individual member of a UK limited liability partnership (LLP) whose working and remuneration arrangements are more akin to those of an employee than a partner in a traditional partnership is in fact taxed as an employee. An individual member of an LLP will be treated as an employee for UK tax purposes (including pay-as-you-earn and employer national insurance contributions for the LLP) if each of the following three conditions is met:

1. It is reasonable to expect that at least 80% of the amounts payable by the LLP to the member year-on-year will constitute “disguised salary” — that is, remuneration that is not variable by reference to or (in practice) affected by the LLP’s overall profits and losses (Condition A).
2. The member does not have “significant influence” over the affairs of the LLP (Condition B).
3. The member’s capital contribution is less than 25% of the amount of their “disguised salary” (Condition C).

In practice, many asset managers operating through UK LLPs seek to rely on either or both of Condition A and Condition B to ensure that their senior staff are not taxed as employees in the UK, and the Bluecrest case itself is concerned with the application of both Condition A and Condition B. This latest decision from the Upper Tribunal broadly confirms last year’s First Tier decision and should give taxpayers further comfort around certain arguments in favour of Bluecrest that have now been endorsed by both Tribunals.

With respect to Condition A, it remains clear that the mere “possibility” that the amount payable by the LLP to a member might need to be reduced in the event the LLP has insufficient profits was not, of itself, enough to avoid Condition A applying. It was also re-emphasised that Condition A needs to be assessed by reference to the profits of the LLP as a whole and not (for example) by reference to the performance only of certain areas of the LLP’s business or of specific investment portfolios. Although the tribunal did not provide a bright-line test for what constitutes a sufficient link between the amount payable to the member by the LLP and the overall profits of the LLP, it remains clear that the amount payable to the member needs to be determined by way of a “top down” allocation that starts with the overall profits of the LLP (which should, in practice, themselves be sufficiently variable).

With respect to Condition B, the Upper Tribunal declined to create or apply any rigid test as to what constitutes “significant influence.” The decision confirms that “significant influence” does not need to extend to influence over the entirety of the affairs of the LLP for each individual member but could relate to members exercising significant influence over one or more material areas of the LLP’s business. The Upper Tribunal also confirmed the view that “significant influence” in this context need not relate only to formal managerial or governance influence (through, for example, membership of committees) but could also extend to influence arising from financial clout within the business. In the Bluecrest case, such influence was taken to be exercised by managers with portfolios over $100 million and desk heads — the tribunal affirmed the taxpayer’s argument that this resulted in those members’ exercising practical influence over the running of the LLP’s business. While the confirmation of this argument in the Upper Tribunal is helpful, most asset managers will nonetheless continue to formalize governance arrangements around “significant influence” for those members intending to rely on Condition B.

This case came to the Upper Tribunal with both HM Revenue and Customs (HMRC) and the taxpayer appealing certain aspects of the original First Tier decision. The latest decision has not moved greatly on any of those points, so it remains to be seen whether either side will be willing to appeal. The arguments that have now been rehearsed for both sides in two binding decisions will be helpful to asset managers who wish to ensure that their UK LLP remains on the right side of the salaried member rules.

Tax Case: Supreme Court decision in Vermillion Holdings Ltd v HMRC: the employment-related securities deeming rule

A security or securities option acquired by a person will be treated as being “employment-related” (and as an employment-related security, or ERS) if the right or opportunity to acquire it was made available to that person:

1. by reason of his employment (the causation rule); or
2. by his employer or a person connected with his employer (the deeming rule).

The status of a security or securities option as an ERS has far-reaching implications for the UK tax treatment on its award and on future vesting or disposal events. ERS treatment is also relevant to whether carried interest needs to be assessed under the “income based carried interest” regime.

The Supreme Court has clearly held that the deeming rule should be applied in priority to and independently of the causation rule, which need be considered only if the deeming rule does not apply on the facts. In Vermillion, the deeming rule was held to apply to the securities option on the basis that it had been granted by the option holder’s employer. The lower courts had determined that the securities option was (notwithstanding it had been granted by the employer) not factually awarded by reason of the option holder’s employment. The Supreme Court held that such questions of causation were simply not relevant to the application of the deeming rule and that the deeming rule should generally function as the primary and only test of ERS status if the factual conditions provided for by the deeming rule were satisfied.

The Supreme Court agreed with the lower courts that the deeming rule should not be applied so far as to produce an unjust, absurd, or anomalous result, but it held that no such result was produced in this case. The Supreme Court did not provide any insight as to what would constitute an unjust, absurd, or anomalous result, but taxpayers should expect the bar for this to be set high following this case. In particular, it seems clear that the mere fact that there is no causal link between the acquisition of securities and the employment will no longer provide a valid argument against ERS treatment. Taxpayers will first need to demonstrate that the result of applying the deeming rule first is unjust, absurd, or anomalous.

This case is a stark reminder that the deeming rule is of extremely broad application. In a funds context, for example, the deeming rule as now affirmed by the Supreme Court could (in principle) result in carried interest or other securities falling within the scope of the ERS rules even where the only connection with “employment” is that the holder is a director of a general partnership company connected with the issuing company. Special care will also need to be taken over the timing of awards of carried interest or other securities around an employee’s promotion to a partnership role; any overlap with an ongoing employment could result in ERS treatment under the deeming rule, even where (factually) it may be understood by the parties that the award of securities is in fact a consequence of promotion (and hence the cessation of employment).

9. EU — AIFMD II

Final compromise text on proposed Directive amending AIFMD and UCITS Directive

On 10 November 2023, the Council of the EU published the final text of AIFMD II, following the political agreement on 19 July 2023 and a technical trialogue on 9 October 2023.

AIFMD II does not represent a complete overhaul of the AIFMD framework; rather, it proposes targeted amendments to improve the functioning of the AIFMD. Among other changes, it will introduce new requirements and restrictions for alternative investment funds that originate loans and introduce additional investor disclosure requirements.

The European Parliament will consider the text in early February 2024, after which (subject to any delays and/or changes) AIFMD II will enter into force 20 days following its publication in the Official Journal of the EU. EU member states will then have 24 months to implement AIFMD II, with member state implementing laws expected to take effect in 2026. For more information on the revised AIFMD, please see our Sidley Update EU AIFMD II — Implications of the Commission Proposal. We will publish a detailed Update on AIFMD II when the final text is published in the Official Journal of the EU.

10. EU — ESG

EU Taxonomy Regulation — European Commission publishes delegated regulations

On 21 November 2023, the European Commission published the following delegated regulations supplementing the EU Taxonomy Regulation in the Official Journal of the EU:

• Commission Delegated Regulation (EU) 2023/2486, which establishes the technical screening criteria for economic activities making a substantial contribution to non-climate environmental objectives, namely sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems. This commission delegated regulation amends the Taxonomy Disclosures Delegated Act ((EU) 2021/2178) and applies from 1 January 2024.
• Commission Delegated Regulation (EU) 2023/2485, which establishes additional technical screening criteria for determining the conditions under which certain economic activities qualify as contributing substantially to climate change mitigation or climate change adaptation and for determining whether those activities cause no significant harm to any of the other environmental objectives. This commission delegated regulation amends the Climate Delegated Act ((EU) 2021/2139) and applies from 1 January 2024 (although certain specified provisions apply from 1 January 2025).

EU Council adopts a regulation on access to corporate information

On 27 November 2023, the Council of the EU adopted a regulation creating the ESAP, a platform that will make obtaining financial and non-financial information about EU companies easier for investors without enforcing any additional information reporting requirements on European companies.

The ESAP will provide free access to financial and sustainability-related information made public by European companies, which should ease the decision-making process for a variety of investors.

The ESAP platform is intended to be made available from summer 2027 and will gradually be phased in to allow for a robust implementation.