UK/EU Investment Management Update (June 2023)

1. UK — FCA Updates

2. UK — ESG

3. UK / EU — Post-Brexit

4. EU — AIFMD "Pre-marketing"

5. EU — Retail Investment Strategy

6. EU — Undue Costs Under AIFMD and UCITS Directive

7. EU — ESG

8. EU — European Single Access Point

9. EU — Cryptoassets

1. UK — FCA Updates

FCA to increase sanctions monitoring after screening gaps identified at firms

On 16 May 2023, Sarah Pritchard, FCA Executive Director of Markets and International, delivered a speech in relation to nonfinancial risk and control. Most notably, the speech outlined the FCA’s current approach to assessing firms’ sanctions screening in light of the war in Ukraine.

FCA-regulated firms should note that the FCA has implemented a new synthetic data tool that enables the regulator to directly test a firm’s sanctions screening systems and identify firm-specific weaknesses. In particular, the tool will assess a firm’s system’s ability to screen names that are on the UK’s Office of Financial Sanctions Implementation (OFSI) consolidated sanctions list.

The tool was rolled out to various firms over the last year. So far, the FCA has observed several gaps in firms’ sanctions testing and tools. For example, it found a lack of clear and effective governance and oversight of firms’ sanctions systems and an over-reliance on third parties to provide sanctions screening systems. In addition, some systems were not able to generate alerts against known names, whereas other systems generated a high percentage of false positives.

The FCA identified that good examples of screening systems were capable of adapting to changing sanctions risks and take into account each firm’s customer base and level of risk, for example by having the ability to measure the effectiveness of firms’ systems’ parameters and engaging in sample testing.

Investment firms are encouraged to review their sanctions screening systems and procedures to ensure that they can adapt to the changing landscape and are appropriate for their firms’ customer base and risk.

FCA warns of consequences for neglecting Consumer Duty

On 10 May 2023, Sheldon Mills, FCA Executive Director of Consumers and Competition, further warned financial market participants that the FCA will respond strongly and promptly to firms that fail to comply with the forthcoming Consumer Duty. In certain instances, this could involve investigations, interventions, and possible disciplinary actions, particularly where evidence of harm or potential harm to consumers is identified.

As a reminder, the Consumer Duty rules are due to come into force on 31 July 2023. The Consumer Duty encompasses a comprehensive body of guidelines designed to ensure that consumers obtain suitable products at a fair value, as well as appropriate support in understanding said products. In a preliminary evaluation, the FCA identified significant compliance efforts made by companies, however, it also highlighted the need for further improvement.

For a more detailed discussion of the Consumer Duty and how it may apply to asset managers, please see our Updates of February 2023, January 2023, and May 2022.

2. UK — ESG

UK government published call for evidence to review non-financial reporting rules

The UK government has published a Call For Evidence to review its non-financial (i.e., sustainability) reporting requirements for UK-based companies and limited liability partnerships(LLPs). Currently, such information is mainly provided in the annual report as well as other disclosure statements, such as a company’s strategic report and directors’ report. Some of the key points that the UK government is seeking feedback to consider include:

• how to refresh the UK’s non-financial reporting framework so that it delivers decision-useful information to the market;
• the thresholds and definitions used to determine whether companies and LLPs must comply with certain requirements; and
• how it should harmonise new international and domestic standards, particularly those proposed by the International Sustainability Standards Board (ISSB).

The UK government’s intention is to align its non-financial reporting requirements with the UK’s broader sustainability goals. The feedback will inform the development of comprehensive proposals that are intended to be released for public consultation in the following year and may lead to legislative changes.

Financial Reporting Council consults on additional responsibilities under the UK Corporate Governance Code

On 25 May 2023, the UK Financial Reporting Council (FRC) launched a public consultation on its proposed targeted updates to the UK Corporate Governance Code (the Code).

The Code is applicable to companies with a premium listing on the London Stock Exchange, regardless of where they are incorporated. Accordingly, changes to the Code are relevant to investment managers insofar as they may have invested their clients’ assets in companies subject to the Code.

The proposals have been made in response to the UK government’s white paper Restoring Trust in Audit and Corporate Governance, published in March 2021.

The FRC’s proposed revisions aim to enhance the Code’s effectiveness in promoting good corporate governance amongst UK firms. The changes include:

• setting out a revised framework of prudent and effective controls to provide a stronger basis for reporting on - and evidencing their effectiveness;
• improving the functioning of “comply-or-explain” reporting;
• making necessary revisions to reflect the responsibilities of the board and audit committee for sustainability and environmental, social, and governance (ESG) reporting and associated assurance; and
• strengthening reporting on malus and clawback arrangements.

Notably, the proposed changes would place a responsibility on companies that are subject to the Code to incorporate ESG and sustainability reporting into their corporate governance structures.

The changes would require the board to report on the company’s climate ambitions and transition planning and require audit committees to consider sustainability reporting and ESG metrics in their reviews.

Accordingly, such proposals may help with improving the quantity and quality of sustainability reporting and ESG-related metrics for investment managers who may hold shares in UK companies that are subject to the Code.

The public consultation is open for responses until 13 September 2023. The FRC intends the Code to apply to financial years starting on or after 1 January 2025.

3. UK / EU — Post-Brexit

UK-EU MoU for Financial Services Cooperation

On 19 May 2023, the UK’s HM Treasury and the Commission published a draft MoU to establish a framework for financial services regulatory cooperation between the UK and EU authorities post-Brexit.

The goal of the framework is to enable more supervisory cooperation on financial services across the UK and the EU. The MoU intends to encourage bilateral exchanges of views on regulatory, market, and financial stability developments dialogue relating to equivalence decisions; and coordination in international bodies.

In particular, a joint forum will be set up to facilitate discussions on financial services issues on a semi-annual basis. Notably, the forum seeks to enable UK and EU authorities to identify potential cross-border implementation issues (such as potential regulatory arbitrage by firms) as well as consider working towards compatibility of UK and EU standards.

However, this MoU will not necessarily result in an “equivalence” assessment by the Commission of the UK Markets in Financial Instruments Directive (MiFID) framework (or other UK financial services legislation), which is what UK firms have been hoping for, so that they can provide investment services to professional clients in the EU.

The draft MoU has been adopted by HM Treasury and the Commission, although it still needs final political endorsement from EU member states. The MoU’s arrangements will take effect immediately after a finalised version of the MoU is published.

Non-UK clearinghouse “run-off” regime extended

HM Treasury has introduced amendments to the Financial Services and Markets Bill that would allow non-UK clearinghouses to continue operating under the post-Brexit “run-off” regime beyond 1 July 2023.

The “run-off regime” allows non-UK central counterparties (CCPs) or clearinghouses to wind down relevant contracts and business with UK firms acting as counterparties if the non-UK CCPs are exiting the UK’s Temporary Recognition Regime without equivalence recognition.

HM Treasury’s amendments would ensure that the Bank of England can grant CCPs in the run-off regime further time to apply for recognition whilst ensuring that the relevant CCPs can continue to offer clearing services to UK firms.

4. EU — AIFMD “Pre-marketing"

On 26 May 2023, the European Securities and Markets Authority (ESMA) published an updated Q&A on the Alternative Investment Fund Managers Directive (AIFMD), on the issue of “pre-marketing.” The EU Cross-Border Distribution of Funds (CBDF) Directive amended the AIFMD in 2021 to include a new concept of “pre-marketing.”

A new Q&A addresses the question “Are non-EU AIFMs allowed to carry out pre-marketing activities pursuant to Article 30a of the AIFMD?”

ESMA’s response is no, Article 30a of the AIFMD does not cover pre-marketing activities by non-EU AIFMs. However, ESMA notes that the national laws of each EU member state may allow non-EU AIFMs to carry out pre-marketing activities at national level.

That is, individual member states can extend the concept of pre-marketing to non-EU AIFMs that market their funds into such member states under the AIFMD National Private Placement Regime (NPPR).

For more information on the CBDF Directive and the concept of pre-marketing, please see our Update EU AIFMD — New Rules on the Cross-Border Distribution of Funds From August 2021 — Implications for Non-EU Managers (June 2021).

5. EU — Retail Investment Strategy

EU Commission publishes draft Retail Investment Strategy legislative package

On 24 May 2023, the Commission published its draft Retail Investment Strategy package. The package contains a wide-ranging set of measures designed to “to place consumers’ interests at the centre of retail investing” and empower retail investors to make investment decisions aligned with their needs and preferences (with appropriate levels of protection).

Forming part of the Commission’s 2020 Capital Markets Union Plan, the package is aimed at encouraging retail investment in the EU across a range of investment products by streamlining and modernising rules set out in various sector-specific legislation. It aims to ensure that retail investors receive the same treatment and protection regardless of which investment products, marketing, and distribution channels they choose (i.e., which piece of legislation governs the product).

The package includes an Amending Directive which revises the existing rules under the EU MiFID, the UCITS Directive, and the AIFMD (as well as the Insurance Distribution Directive and Solvency II Directive) and an Amending Regulation, which revises the Packaged Retail and Insurance-based Investment Products (PRIIPs) Regulation.

While the proposed changes are directly applicable only to EU MiFID firms and are designed to harmonise rules and requirements across investment products for the benefit of retail investor, the corresponding amendments to the AIFMD and PRIIPs Regulation will have an effect on non-EU firms (including investment managers) that market financial products (including investment funds) into the EU or otherwise provide investment services to EU professional investors/clients.

At a high level, some of the key changes affecting non-EU firms with professional investors/clients include the following:

Professional client definition

The Amending Directive proposes to reduce the thresholds at which a client can “opt up” from retail client to professional client status, and a new test is introduced. This may make it easier under AIFMD for firms to reach more investors (as AIFMD would allow an AIFM under an NPPR to reach professional clients).

The amendments include:

• for individuals:
  • a reduction of the wealth criterion from €500,000 to €250,000 (and the addition of a three-year average basis to calculate such amount); and
  • the insertion of a possible fourth criterion relating to relevant education or training that demonstrates understanding of transactions/services and the ability to adequately evaluate the risks.

• for legal entities: can qualify as professional on request by fulfilling two of the following balance sheet, net turnover and own funds criteria (and subject to the investment firm’s assessing that the firm can make investment decisions in line with its objectives, needs, and financial capacity):  
  • balance sheet total: €10,000,000
  • net turnover: €20,000,000
  • own funds: €1,000,000

The above also means that the obligation to prepare a PRIIPs Key Information Document (KID) would apply at a higher threshold than under the current regime.

New measures to improve “value for money”

The changes “strengthen existing product governance rules”, particularly around pricing and “undue costs.” In particular, the amendments suggested in Article 12 AIFMD (and Article 14 of the UCITS Directive) in relation to undue costs are not restricted to retail investors.

Amongst other requirements, they require:

• managers to maintain, operate, and review an effective pricing process that allows for the identification and quantification of all costs borne by funds or their unitholders, to ensure that costs are not undue;  
• managers to review at least annually whether undue costs have been charged;
• managers to reimburse investors where undue costs have been charged; and
• managers to report to relevant regulators where undue costs have been charged.

The amendments allow for the Commission to adopt, by means of delegated acts, measures specifying the criteria to be used by the relevant competent authorities to assess whether AIFMs comply with these obligations.

We note that Article 12 AIFMD is not applicable to a non-EU AIFM marketing funds in the EU under Article 42 AIFMD (via an NPPR). However, given that the NPPR is a matter for individual EU states, it is possible that the above revisions could be extended to non-EU AIFMs in certain member states.

Measures to ensure that marketing communication of investment opportunities is clear, fair and not misleading

The Commission seeks to strengthen supervision of marketing, particularly digital marketing via social media and influencers. The new marketing provisions are applicable to EU MiFID firms’ marketing communications with all clients.

Updates to PRIIPs KIDs

Disclosures in PRIIPs KIDs have been revised to include, amongst other things, sustainability-related information and easier digital readability. However, there are no substantive changes that make it easier for firms to target retail investors.

The consultation period on the package is open until 20 July 2023, following which the Commission will summarise responses and present them to the European Parliament and Council.  

6. EU — Undue Costs under AIFMD and UCITS Directive

ESMA advises legislative amendments to provide more protection from “undue costs”

On 17 May 2023, ESMA published an opinion for the Commission with suggested legislative amendments to the AIFMD and UCITS Directive relating to the definition of “undue costs” for investors.

The Opinion was prompted by findings from ESMA’s 2021 Common Supervisory Action on costs and fees (report published in May 2022), which showed divergent market practices concerning what industry participants reported as “due” versus “undue” costs in funds. ESMA was particularly concerned by the lack of consistent investor protection across products, as well as the risk of regulatory arbitrage depending on where a fund or fund manager is domiciled.

In its proposal, ESMA suggests that the EU’s rules should be updated with the following proposals:

• clarifying the definition of “undue costs” and harmonising rules under a common framework;
• ensuring that the assessment regarding whether a cost is “due” or “undue” should take into consideration the amount of the cost (not just the eligibility of the cost); and
• enshrining in legislation that fund managers who intentionally or negligently infringe costs rules should be penalised with a fine proportionate to investor harm.

IESMA’s proposal has been made in the context of the Commission’s policy proposals for its Retail Investment Package (discussed above). As such, the opinion focuses primarily on seeking to implement a consistent and high level of protection for retail investors, and any subsequent legislative changes may affect only investment products that target retail investors.

However, as ESMA’s recommendation is to establish clearer, harmonised legal requirements within the AIFMD and UCITS Directive, it is possible that the proposed legislative amendments may also affect investment products offered to institutional investors.

For a discussion on the Common Supervisory Action, please see our Update from May 2022.

7. EU — ESG

ESAs publish consolidated Q&As for the SFDR

On 17 May 2023, the ESAs published a document that consolidates all of the Commission’s Q&As in relation to the SFDR (such Q&As were previously separated depending on their date of publication from different points in time). 

For our prior discussion of these Q&As, please see our Investment Management Updates from May 2023, December 2022 and separate Sidley Update covering Q&As released by the Commission in May 2022.

EU “sustainable finance package” to be published in June 2023

On 16 May 2023, Mairead McGuinness, the European Commissioner for Financial Stability, Financial Services, and the Capital Markets Union, announced that the Commission will publish a “significant sustainable finance package” in June 2023.

The package is expected to include:

• a proposal for legislation on ESG ratings;
• new secondary legislation to complete the EU Taxonomy (Regulation (EU) 2020/852);
• general guidance to make the EU Taxonomy framework more usable and promote transition finance.

At present, the EU Taxonomy has been supplemented only with the Commission Delegated Regulation (EU) 2022/1288, which provides the technical screening criteria (TSCs) for economic activities in respect of two environmental objectives (climate change adaptation and climate change mitigation).

The proposed secondary legislation is expected to include the TSCs for economic activities in respect of the final four remaining (non-climate) environmental objectives under the EU Taxonomy Regulation (sustainable water and marine use, the circular economy, pollution prevention, and protection of biodiversity).

The legislation will follow the Commission’s consultation on a draft delegated act in April 2023.

Updates on the publication of standards for the Corporate Sustainability Reporting Directive (CSRD)

Further to the above, McGuinness also announced that the Commission plans to publish the first set of European Sustainability Reporting Standards (ESRS) in relation to the CSRD “shortly after” the sustainable finance package in June.

As for the second set of the ESRS, the Commission has indicated that it will slow down the timeline for its adoption. The Commission explained that it is “mindful of the complexity of some of the rules in this area.” Accordingly, it seeks to provide affected market participants with more time to adapt to the annual disclosures required by the first set of ESRS before introducing the second set of ESRS.

For further details on the CSRD, please see our Sidley Update EU Corporate Sustainability Reporting Directive — What Do UK- and U.S.- Headquartered Companies Need to Know?.

ESAs submit common understanding of greenwashing and warn on risks

On 1 June 2023, the three ESAs, including ESMA, published their progress reports on greenwashing in the financial sector.

Common understanding of greenwashing

Alongside the progress reports, the ESAs put forward a common understanding of greenwashing. Whilst it is not a legislative definition, it provides helpful guidance on how the EU intends to approach greenwashing on a consistent basis in the application of its regulatory framework:

a practice where sustainability-related statements, declarations, actions, or communications do not clearly and fairly reflect the underlying sustainability profile of an entity, a financial product, or financial services. This practice may be misleading to consumers, investors, or other market participants.

The ESAs highlight that misleading sustainability-related claims can occur in a wide range of instances. They can occur intentionally or unintentionally, in relation to entities and/or products that are inside or outside the EU regulatory framework, and can arise from the omission of information (as well as from actual claims or actions).

Managers should therefore be mindful that from the EU’s perspective, the potential scope of greenwashing extends beyond deliberate ESG-focused disclosures made to or in the EU.

ESMA progress report on greenwashing

ESMA’s progress report aims to provide market participants and regulators with a shared reference point on greenwashing and highlights the reputational and financial risks of missteps in this area.

Risk areas

In its assessment of which areas of the sustainable investment value chain are most exposed to greenwashing risks, ESMA commented that misleading claims may relate to all key aspects of the sustainability profile of a product or an entity.

The report identified a high risk of greenwashing in relation to pledges about future ESG performance (e.g., an entity’s ESG targets, net zero commitments and transition plan, and taxonomy-alignment plans), engagement with stakeholders, and ESG performance metrics.

The report states that investment firms highlighted a need for clear definitions and methodologies/metrics to define and implement targeted measures and that uncertainties with the current regulatory framework contribute to greenwashing risks. Market participants were also concerned with the effect of the drive to achieve higher ESG scores and overestimations in indicators.

Preliminary remediation actions

ESMA stressed that to mitigate greenwashing risks, all market participants must act responsibly in making substantiated claims and communicating on sustainability in a balanced manner. Of particular note, it reminded firms that sustainability-related information should be provided to clients or potential clients in a fair, clear, and not misleading manner (in both its content and presentation).

The report also suggested various remediation actions to make the EU’s regulatory framework more robust against greenwashing risks and to provide more regulatory certainty on key sustainable finance concepts:

• Clarifying definitions. ESMA highlighted certain terms under the SFDR and EU Taxonomy that would benefit from additional clarification and alignment across the legislative framework: “sustainable investment” and “contribution.”  
  
• Assessing the market’s application of the “Do No Significant Harm” (DNSH) test. ESMA flagged that the thresholds for the SFDR’s DNSH test provides flexible discretion to asset managers. As a result, tolerance levels may be selected in bad faith and lead to greenwashing and inconsistencies in the application of DNSH assessments across financial products.

ESMA has flagged this issue as a topic subject to ongoing review. Accordingly, changes may be considered to tighten asset managers’ interpretation of how principal adverse impact (PAI) indicators are taken into account for the DNSH test.

• Strengthening consideration of social factors. ESMA has noted a lack of an EU-level golden standard for measuring positive and negative social factors (in comparison to the framework that the EU Taxonomy provides for climate and environmental factors). ESMA suggests that a potential social taxonomy could help address this gap.
  
• Building recognition of transition finance. The report notes that a recognition of transition finance can help ease the mismatch between the high demand for ESG products and the limited supply of taxonomy-aligned investment opportunities. However, the industry will need a credible definition of “transition finance” as well as robust legal frameworks and regulatory guidance to support this market.  
  
• Encourage substantiation of engagement efforts. ESMA has suggested that entity- or product-level disclosures could benefit with substantiation of engagement efforts, which may draw from existing disclosure requirements under the Shareholder Rights Directive II and other information, such as number of meetings held with investee companies and intermediate targets for pursuing engagement.

The report also provided some examples of market practices to avoid greenwashing that may be of relevance to managers, for example, using “prudent communication” that is, applying cautious approach and proportionality to marketing communications and labelling ESG-focused products; implementing strong governance and IT systems to ensure access to reliable and comprehensive sustainability data; and creating specific committees to review sustainable products and environmental commitments.

These are progress reports, not final guidance. As such, the recommendations remain subject to change until the final reports (which may include proposals for regulatory amendments) are published. The final reports are expected in May 2024.

8. EU — European Single Access Point

EU centralised portal for investors to access financial and sustainability-related corporate data

The EU is in the process of establishing the European Single Access Point (ESAP). The ESAP will be a cost-free centralised digital platform that aims to assist investors with searching and comparing financial and sustainability-related information in relation to EU investment products and companies, including small and midsize enterprises.

Under the current agreement (which remains subject to change), the ESAP platform is anticipated to be accessible from H2 2027, with a gradual rollout. It will sequentially encompass European regulations and directives based on their priority over a four-year period:

• At launch (Phase 1): The ESAP is intended to cover information in relation to the Short Selling Regulation, the Prospectus Regulation, and the Transparency Directive.
  
• Six months following launch (Phase 2): The ESAP is intended to cover a broad range of information from regulations such as SFDR, the Cyber Resilience Act, and the Benchmarks regulation.
  
• Final phase: In due course, the ESAP is intended to cover pertinent data from roughly 20 additional legislative pieces, including the Capital Requirements Regulation, MiFIR, and the Green Bonds Regulation.

The agreement remains subject to confirmation from the Council and the Parliament before formal adoption.

9. EU — Cryptoassets

European Systemic Risk Board (ESRB) recommends standardised reporting disclosures for investment firms with exposure to cryptoassets

The ESRB has published a report examining the systemic risks associated with cryptoassets and decentralised finance and provided the following key findings and recommendations:

• Increased supervision is needed. The report flagged that cryptoassets markets have experienced considerable volatility over the last year. Although the impact on the financial system has been limited so far, the ESRB warns that the cryptoasset markets’ exponential growth and growing interconnectedness with traditional financial systems warrants increased supervision and monitoring.  
• Regular harmonised reporting standards for banks and investment funds. The ESRB notes that markets in cryptoassets (MiCA) does not establish regular reporting requirements for financial institutions that hold or are exposed to cryptoassets beyond cryptoasset service providers. The report recommends the creation of harmonised reporting standards and templates that would apply to banks and investment funds.  
• A unified EU approach to cryptoassets is needed. The report suggests that to enhance financial stability, it would be advantageous to have a unified view of the EU fund sector's involvement with cryptoassets. The report recommends assessing member states' regulatory measures concerning funds' direct and indirect cryptoasset holdings.  
• Further examination on cryptoasset exposures across different types of funds. The report suggests examining potential susceptibilities resulting from cryptoasset engagement across various fund types (such as the heightened liquidity mismatch and run risk in open-ended funds in comparison to close-ended funds).

This examination could facilitate a determination of whether unifying certain rules could help minimise potential vulnerabilities and deter regulatory arbitrage within the EU and which specific regulations should be aligned.

The report stresses that it may become necessary to implement limits on exposure to cryptoassets (both direct and indirect) for certain fund types, such as open-ended funds.