Funds Legal Update | 30 June 2020

UK financial regulator bans marketing of "mini bond" loans to retail investors

The Financial Conduct Authority (FCA) has stated that it will make permanent its temporary ban from November 2019 on the marketing of speculative "mini bonds" to retail investors. These mini bonds (which are not themselves regulated by the FCA) have been used to package up relatively high-risk loans to small businesses for high interest rates, making them popular with retail savers.

The temporary FCA ban on marketing unlisted mini bonds, as well as some high-risk listed bonds, has come in the wake of the collapse of London Capital & Finance in January 2019, leaving investors in mini bonds facing losses totalling £230 million. These bonds, described by Sheldon Mills of the FCA as "complex, high-risk products which are often designed to be hard to understand", may now only be marketed to sophisticated or high-net-worth investors.

The Pensions Regulator approves defined benefit 'superfunds'

The Pensions Regulator (TPR) has published regulatory guidance for those setting up and running a defined benefit (DB) "superfund", including directors, senior managers and trustees. The guidance sets out the standards the regulator will expect to be met in the interim period before longer-term legislation is put in place. A superfund is a model that allows for several DB schemes to be collected together, severing each employer's liability to retirees.

The so-called "pensions superfunds", unlike insurers, are not subject to the Solvency II regime, which has strict capital requirements and, therefore, can provide cheaper options for scheme sponsors looking to rid themselves of their DB scheme obligations. Approving the superfund structures is therefore a somewhat controversial move from the regulator, and the insurance industry has been quick to criticise the guidance. Although TPR describes the interim regime as "tough", Yvonne Braun, director of policy at the Association of British Insurers, is quoted in the Financial Times as saying: "the interim regime is light-touch, short on detail, has only limited powers for the regulator and risks pension savers being sold down the river." However, the large organisations who have been looking to set up these types of structures have welcomed the decision.

Commission's draft regulations on sustainability obligations: summary for AIFs

On 8 June 2020, the European Commission published a series of draft delegated regulations dealing with firms' environmental, sustainability and governance (ESG) obligations.

This comes as part of the EU’s action plan on sustainable finance (see below), with objectives including shifting capital flows away from activities with negative ESG consequences and towards activities that have long-term societal benefits. The draft regulations also seek to clarify the duties of financial institutions to provide their clients with clear advice on the ESG risks and opportunities attached to their investments.

The draft regulation for alternative investment funds (AIFs) does numerous things, including the following:

• The consideration of sustainability risks in due diligence requirements – where AIF managers (AIFMs) consider principal adverse impacts of investment decisions on sustainability factors, due diligence requirements must also take due account of them.
• Requires AIFMs to retain the necessary resources and expertise for the effective integration of sustainability risks.
• Specifies that the identification of conflicts of interest must also include those conflicts of interest that may arise as a result of the integration of sustainability risks.
• Clarifies that AIF risk management policies must also consider exposures of the AIF to sustainability risks.
• Integrates the general requirements around the obligation of AIFMs to consider sustainability risks.
• Ensures that senior management of AIFMs are responsible for the integration of sustainability risks.

The definition of "sustainability risks" used in these draft regulations is aligned with the definition in Article 2 of Regulation (EU) 2019/2088 (on sustainability‐related disclosures in the financial services sector).

Firms who wish to provide feedback to the Commission on the proposed regulations must do so by 6 July 2020.

EU adopts framework to facilitate sustainable investment

The European Parliament has adopted (18 June 2020) the Taxonomy Regulation, which sets out an EU-wide classification system, or "taxonomy", to establish the criteria for determining whether an economic activity qualifies as environmentally sustainable. The regulation provides a set of environmental objectives, including climate change mitigation, sustainable use of water and pollution prevention and control. Where economic activity contributes to at least one of those objectives, without significantly harming any of the others, that activity can be labelled as environmentally sustainable.

This allows investors to compare green investment options and avoids the "greenwashing" of investments by making it compulsory to provide a detailed description of how the investment meets the environmental objectives. Interestingly, the text does not preclude or blacklist any specific technologies or sectors from green activities, apart from solid fossil fuels such as coal.

The Taxonomy Regulation will enter into force imminently (on the twentieth day following its publication in the Official Journal of the European Union). The European Commission will then develop technical criteria for each objective: for climate change mitigation and adaptation, this will be available by the end of 2020. The regulation will come into effect in respect of those objectives from 1 January 2022. The deadline for the development of technical criteria for the other objectives is the end of 2021, and the regulation will come into effect in respect of those objectives from 1 January 2023. The Taxonomy Regulation will therefore not form part of retained EU law following the end of the Brexit transition period – but this standard setting will likely influence the reporting by any clients seeking investment from EU-based investors.

Read more about the background to this regulation here.

ESMA's regulatory expectations around 'undue costs' for UCITS and AIFs

On 4 June 2020, the European Securities and Markets Authority (ESMA) published a supervisory briefing on the supervision by national regulators, known as National Competent Authorities (NCAs) of the cost-related provisions applicable to UCITS (Undertakings for the Collective Investment in Transferable Securities) and Alternative Investment Funds (AIFs). The briefing seeks to ensure NCAs are acting consistently and with equal levels of investor protection throughout the EU.

The briefing is also aimed at providing market participants with indications of NCAs’ expectations and compliant practices regarding the cost-related provisions of the UCITS directive and the AIFMD, including the investment managers’ obligations to prevent "undue costs" being charged to investors. It includes, for example, indicators that should allow NCAs to identify costs that should be considered as "undue" to investors with examples of such costs and elements to be taken into account by NCAs when supervising on this area. One of the briefing’s recommendations is that NCAs require management companies to prepare a pricing process in respect of each of their funds under management. While the FCA are yet to publish any further material with reference to this (non-binding) briefing, we would expect it to take on board this recommendation. Management companies should therefore review their existing pricing processes to ensure they comply with ESMA'a expectations.

The briefing should be read in conjunction with ESMA's Guidelines on performance fees.