Funds Legal Update | 27 November 2020

With less than six weeks to go until the end of the Brexit transition period, both HM Treasury and the Financial Conduct Authority (FCA) have been busy getting their ducks in a row to ensure as smooth a transition as possible for the UK's asset management sector. With proposals for a more sustainable future after Brexit, the UK plans to build upon a number of the environmental, social, and corporate governance initiatives developed at EU level and lead the way globally on tackling climate change. While emphasising the importance of sustainable finance, the European Securities and Markets Authority (ESMA) has also been stirring the pot on delegation in a recent speech at the Alternative Investment Management Association (AIMA) Global Policy & Regulatory Forum.

From establishing an overseas fund regime to ensuring that cross-border services between the UK and Gibraltar can continue to run without disruption, the new Financial Services Bill provides some much-needed certainty for the industry. All eyes will also be on the European Commission's next move as the UK legislates to improve the packaged retail investment and insurance-based products (PRIIPs) regime.

When the new EU rules on cross-border marketing go live in August 2021, fund managers will also need to navigate proposed new guidelines on the marketing communications they use. For funds that have significant exposures to corporate debt and real estate assets, ESMA has re-emphasised the need for these funds to be prepared to withstand any potential future adverse shocks.

Overall, the investment funds industry is gearing up for a lot of change next year. How will the new rules on marketing in the EU affect you? How will that be impacted by Brexit? What about "AIFMD II"? Find the answers in our new technical guide on marketing and pre-marketing alternative funds in Europe.

ESMA warns against the inappropriate use of delegation arrangements and confirms sustainability milestones

Verena Ross, the ESMA executive director, in a speech at the AIMA Global Policy & Regulatory Forum (19 November 2020), has warned of the challenges that lie ahead for regulators, the asset management industry and wider investors’ community. Ms Ross focussed on the two hot topics for the industry: delegation, in light of the looming end of the Brexit transitional period, and sustainable finance.

The issue of delegation is somewhat of a "hot potato" in the context of Brexit and the structural solutions UK fund managers are looking to implement– or indeed have already implemented – to ensure continued access to the EU after the end of the transition period. Will the Commission's review of the Alternative Investment Funds Directive (AIFMD) result in a clamping down on delegation and a tightening of the so-called substance requirements? ESMA was keen to make it clear that it is not the enemy of delegation and is not seeking a complete re-write of AIFMD. Nevertheless, there are conditions attached to delegation: entities that are authorised and supervised in the EU should remain in charge of the main business functions and decisions, and there should be rigorous due diligence and delegation monitoring processes.

AIFMD already states that delegated investment management functions shall "not exceed by a substantial margin" the functions retained by the authorised fund manager. It will be up to the Commission to inform the industry, when it releases its proposed amendments to AIFMD next year, how "substantial margin" should be interpreted.

On sustainable finance, EMSA confirmed the following three milestones:

• January 2021: The European Supervisory Authorities (ESAs) aim to launch a consultation paper on additional taxonomy-related product disclosures pursuant to the Taxonomy Regulation. This consultation paper will seek feedback on proposed transparency rules for how taxonomy-related products must disclose their taxonomy alignment.
• End of January 2021: The final report by the ESAs on the Sustainable Finance Disclosure Regulation (SFDR) templates is due.
• 10 March 2021: The level one obligations stemming from the SFDR must be applied from this date. The application date of the technical standards under the disclosure regulation will be delayed; however, ESMA hopes to be able to communicate "shortly" on the exact date of the application of the technical standards and on what the supervisory expectations will be in the "interim" period.

The UK government has not indicated any intention to implement the SFDR (or similar regime) in the UK after the end of the transition period. Nevertheless, in a Brexit webinar hosted by the FCA on 18 November 2020, the FCA reminded those UK firms that will continue to market their funds into the EU after the end of the transition period that they will still need to consider their obligations under SFDR. If the UK does ultimately decide to introduce new rules for the UK, there would be a full consultation process and firms would be given adequate time to prepare.

Securing a sustainable and competitive UK asset management sector after Brexit

The chancellor, in a statement delivered on 9 November 2020, set out proposals to bolster the dynamism, openness and competitiveness of the UK's financial services sector. Measures around sustainability and the UK's approach to regulation outside of the EU will be of particular interest to the UK asset management industry.

• Mandatory disclosures: The government proposes to make disclosures that are in line with the Task Force on Climate-related Financial Disclosures (TCFD) fully mandatory across the economy by 2025, going beyond the existing "comply or explain" approach. The upcoming rules and regulations will capture a significant portion of the economy, including: UK-authorised asset managers (including Markets in Financial Instruments Directive investment firms who provide portfolio management services; alternative investment fund managers (AIFMs), including small authorised AIFMs that have managing permissions; management companies of undertakings for the collective investment in transferable securities (UCITS) funds; and UCITS funds without an external management company. Further detail is contained in the UK TCFD's interim report with a roadmap, which indicates that for the largest UK authorised asset managers, the FCA is targeting implementation in 2022, with the focus of the disclosures on information that will be decision useful to clients and end investors, as opposed to shareholders.
• Green taxonomy: The UK plans to implement a green taxonomy – a common framework for determining which activities can be defined as environmentally sustainable –in order to improve understanding of the impact of firms’ activities and investments on the environment and support the UK's transition to a sustainable economy. The UK taxonomy will adopt the scientific metrics in the EU Taxonomy Regulation as its basis and a UK Green Technical Advisory Group will be established to review these metrics to ensure they are right for the UK market. The UK also intends to join the International Platform on Sustainable Finance to support and benefit from the development of common international standards on taxonomies. Many of the substantive provisions of the EU's Taxonomy Regulation do not apply until 2022 and 2023. Since this is after the end of the transition period, those rules will not automatically become part of UK domestic law. This latest statement from the Chancellor confirms, however, that the UK will at least use the EU legislation as a starting point for developing a taxonomy framework fit for the UK.
• Reforming the UK funds regime and encouraging long-term investment: To enhance the UK's attractiveness for asset management, the government will soon publish a consultation on reforming the UK's funds regime. In addition, to encourage investment in long-term illiquid assets, such as infrastructure and venture capital, the chancellor also announced his ambition to have the UK's first long-term asset fund launch within a year.

All I want for Christmas is...a new and improved PRIIPs regime?

Your Christmas wish may be answered this year in the form of the new Financial Services Bill, which is currently making its way through Parliament and is expected to become law before the end of the year. With proposals for 17 separate measures, it has been heralded by HM Treasury as "the first step in shaping a regulatory framework for the UK’s financial services sector outside of the EU" and welcomed by the FCA.

Since coming into force seven years ago, the PRIIPs Regulation ((EU) No. 1286/2014) has received more than its fair share of criticism. While the UK government supports the objectives of the Regulation, serious concerns about its unintended consequences have been raised extensively by governments, regulators and industry across Europe. In particular, the PRIIPs Regulation has been criticised for requiring the disclosure of potentially misleading information to retail investors and for the lack of clarity surrounding its scope.

In the long term, the UK government intends to undertake a more wholesale review of the disclosure regime for UK retail investors, but in the meantime, the Bill makes targeted amendments to the PRIIPs Regulation to avoid consumer harm and provide the appropriate certainty to industry, by:

• addressing significant uncertainty among industry as to the precise scope of PRIIPs, without changing the definition of a PRIIP;
• removing the obligation for PRIIPs manufacturers to produce performance scenarios, the methodology for which has been criticised for producing misleading predictions; and
• providing UCITS retail schemes with an extended transitional period to comply with the Regulation, up to a maximum of five years.

HM Treasury publishes responses to proposals for overseas funds and Gibraltar authorisation regimes

On 9 November 2020, HM Treasury published a summary of responses to its March 2020 consultation paper inviting views on the overseas funds regime (OFR), reflecting 20 responses primarily from the asset management industry. HM Treasury also held multiple roundtables with industry and conducted meetings with individual stakeholders. The OFR is designed to introduce new equivalence regimes for retail investment funds and money market funds, which will simplify the process for investment funds that are domiciled overseas to market to UK consumers, and forms part of the new Financial Services Bill, which is expected to become law by the end of the year.

HM Treasury simultaneously published a summary of responses to its March 2020 consultation paper inviting views on the main features of the Gibraltar Authorisation Regime (GAR), a new framework enabling UK market access for specified Gibraltar-based financial services firms if they intend to carry on GAR approved activities in the UK. The government has already introduced temporary arrangements to protect this market access, which will be in place until the permanent arrangements of the GAR are implemented. Accordingly, and as confirmed by the FCA at a Brexit webinar on 18 November 2020, the regulator does not expect there to be any disruption to cross border services between UK and Gibraltar after the end of the transition period.

Will UK AIFMs be able to use the NPPR after Brexit?

From 1 January 2021, the UK's ties with the EU will have been cut and the UK will (unless it is agreed otherwise) be treated as a "third country" for the purposes of the AIFMD. This will leave a UK manager in the same position as a US or Hong Kong manager in that any UK-based AIFM will be required to market its funds in Europe by virtue of the National Private Placement Regime (NPPR). Similarly, European Economic Area (EEA) fund managers that want to market EEA and UK alternative investment funds (AIFs) in the UK after the end of the transition period will first need to apply to enter the UK's temporary permissions regime, and thereafter notify the FCA under the UK's NPPR.

Access to the NPPR under Article 42 of the AIFMD by a UK AIFM requires a cooperation agreement to be in place between both: the competent authority of the relevant EU 27 member state and the FCA; and the competent authority of the EU 27 Member State and the competent authority of the non-EEA AIF’s jurisdiction of establishment.

The FCA has confirmed that the multi-lateral memorandum of understanding (MoU) agreed with the ESMA and other EU regulators in 2019 covering cooperation and exchange of information will remain appropriate and effective at the end of the transition period. Both ESMA and the FCA have been vocal about the fact that this MoU will allow the delegation of portfolio management to continue after the end of the transition period, but does the scope of this MoU cover private placement under AIFMD?

On 11 November 2020, ESMA published a guidelines compliance table identifying which EU regulators have informed ESMA that they comply or intend to comply with ESMA’s guidelines on the model MoU concerning consultation, cooperation and the exchange of information related to the supervision of AIFMD entities. The guidelines, among other things, require national competent authorities to sign an MoU to satisfy the condition set out in Article 42(1)(b) of the AIFMD for a cooperation arrangement to be in place for marketing purposes.

At a Brexit webinar hosted by the FCA on 18 November, the FCA confirmed that the text of the agreed MoU will be published before the end of the year, and the expectation is that it should be sufficient in scope to permit marketing by UK AIFMs under Article 42 after the end of the transition period.

New guidelines on funds' marketing communications

On 9 November 2020, ESMA issued a consultation paper concerning guidelines on marketing communications under Regulation 2019/1156 on facilitating cross-border distribution of collective investment undertakings (CBDR). The CBDR, which come into force on 2 August 2021, will amend the AIFMD by introducing new rules relating to the marketing of AIFs in the EEA.

The proposed guidelines specify that marketing communications should:

• be identifiable as marketing material;
• describe the risks and rewards of purchasing units or shares of an AIF or units of a UCITS in an equally prominent manner; and
• contain information which is fair, clear and not misleading,

The guidelines also take into account the online aspects of marketing communications.

Only fund managers are subject to the guidelines. Distributors, such as investment firms, while not within scope, may still need to apply other (substantially equivalent) rules governing the information issued to investors or potential investors, such as Article 44 of the Commission Delegated Regulation (EU) 2017/5655, which contains conditions for ensuring fair, clear and not misleading information to clients.

As proposed, the guidelines would apply to all communications for UCITS and AIFs, including European venture capital, social entrepreneurship and long-term investment funds as well as money market funds that have a marketing purpose. In this context, ESMA states that it may be useful to refer to how "marketing" is defined by Article 4(1)(x) of the AIFMD. The notion of "marketing communications" under the guidelines is proposed to encompass all communications, regardless of the medium used, which contain a direct or indirect offering or placement of units or shares of a fund to or with investors domiciled or with a registered office in the EU.

Helpfully, the draft guidelines include a (non-exhaustive) list of examples of communications that may be considered as marketing communications (which introduces reference to messages broadcast on social media platforms), and those that should not be.

The deadline for comments on the draft Guidelines is 8 February 2021. ESMA will then consider the feedback received with a view to issuing final guidelines by 2 August 2021.

Find out about these changes and more in our new technical guide on marketing and pre-marketing alternative funds in Europe.

Avoid the shock: corporate debt and real estate funds must be prepared

On 12 November 2020, ESMA issued a report setting out the recommendations of the European Systemic Risk Board (ESRB) on liquidity risk in investment funds. ESMA has identified five priority areas to enhance the preparedness of funds that have significant exposures to corporate debt and real estate assets to potential future adverse shocks, while also emphasising the importance of continued oversight by local regulators. Some of these priority areas will be progressed with local regulators, while others will be picked up as part of the ongoing review of AIFMD.

Important findings in the report include:

• When facing redemption pressures and/or episodes of valuation uncertainty during the market stress linked to the Covid-19 pandemic, only a limited number of the analysed funds suspended subscriptions and redemptions. The vast majority was able to meet redemption requests and maintain their portfolio structure.
• There are some important areas of weakness that need to be addressed. Some funds presented potential liquidity mismatches due to their liquidity set up (for example, a combination of high redemption frequency, no or short notice periods and no liquidity management tools (LMTs) in the case of funds investing in asset classes that are either illiquid by nature or whose liquidity may recede during a period of market stress). Only a few funds have adjusted their liquidity set-up according to the pursued investment strategy and in light of the liquidity issues encountered (for example, introduction of LMTs, adaptation of the redemption frequency, and use of notice periods).
• Funds were broadly able to maintain their portfolio structure when meeting redemptions.
• Fund managers authorised under UCITS and AIFMD should enhance their preparedness to potential future adverse shocks that could lead to a deterioration in financial market liquidity and valuation uncertainty (through valuation procedures, alignment of the liquidity profile and redemption policy, use of special arrangements, and stress tests).