Funds Legal Update | May 2021

As the European Commission pushes full steam ahead with its action plan on sustainable finance, the UK government will be monitoring the EU's direction of travel as it finalises its own proposals for an ambitious post-Brexit sustainability strategy. But will it heed the warnings from across the industry against taking a divergent approach?

The Financial Conduct Authority's (FCA) recently broadened remit to encompass the UK target of net zero carbon emissions and appointment of a "director of environmental, social and governance (ESG)" (a new role) is a further reflection of the growth of sustainable finance in the UK from a niche to mainstream market segment.

In a recent speech, the FCA looked at how its rules and evolving expectations of regulated firms are driving changes to organisations' culture and compliance. But can the law really change an organisation's culture or compliance record, or is human nature the real challenge? The regulator has also issued the second phase of proposed rules to introduce the UK Investment Firm Prudential Regime, and separately proposed changes to the UK MiFID rules on research and best execution.

For our more detailed insights on recent developments affecting the UK investment funds industry, you can also access our latest edition of Funds Focus.

Warnings over divergence in sustainable finance standards

Ever since the UK left the EU there have been question marks over whether (and to what extent) the UK will diverge from EU rules and standards. Towards the end of last year, the UK government committed to "at the very least", matching the ambition of the EU's sustainable finance action plan. This includes (among other things) plans to implement the UK's own "Green Taxonomy" and mandatory disclosure rules in line with the recommendations of the Taskforce on Climate Related Financial Disclosures. There have also been indications that the UK will introduce a regime similar to that set out in the EU's Sustainable Finance Disclosure Regulation (SFDR).

While these various commitments will provide some level of comfort to UK asset managers who have operations in Europe or market their funds into Europe and therefore want to avoid becoming subject to two sets of different rules,  as is often the case  the extent of that comfort will depend on the rules that come out of these commitments and which are yet to be drafted..

The Financial Markets Law Committee (FMLC) has therefore written a letter to HM Treasury expressing concern over the risks of uncertainty which may arise between sustainable finance standards adopted in the EU and the UK, in particular in relation to the SFDR, the EU Taxonomy Regulation and the EU Non-Financial Reporting Directive. One particular challenge that the FMLC highlights is the fact that asset managers are currently being required to comply with the high level requirements of SFDR in circumstances where the accompanying Regulatory Technical Standards (which underpin the SFDR and set out the detailed requirements and templates) are not yet finalised.  The FMLC comments that the RTS are very detailed and onerous in some cases, and may be further amended or simplified before they come into effect. Accordingly (and to the probable relief of the UK investment funds industry) the FMLC has urged HM Treasury to "provide clarity on the approach it intends to take towards the SFDR and other pieces of legislation".

So while we cannot yet answer the question of whether UK fund managers operating on a cross-border basis will end up grappling with two divergent regimes, we at least have some insight into where we may end up. The FMLC has suggested two alternative approaches: one which takes into account EU standards (but potentially enhancing detailed disclosure requirements at Level 2, where appropriate), or an outcomes-based approach which is consistent with the direction of travel in the EU.  Ultimately, the industry needs a regime in the UK that avoids regulatory conflict and minimises as far as possible the increasing compliance burden in this area.

Sustainable finance: the evolving EU landscape

On 21 April 2021, the European Commission published a press release and webpage stating it has adopted the texts of six Commission Delegated Regulations and Directives as part of its work on sustainable finance (see our previous Insight on these delegated Acts).

The legislation incorporates sustainability issues and considerations into frameworks for the UCITS Directive (2009/65/EC), the Alternative Investment Fund Managers Directive (2011/61/EU) (AIFMD), the MiFID II Directive (2014/65/EU), the Solvency II Directive (2009/138/EC), and the Insurance Distribution Directive ((EU) 2016/97).

The Commission Delegated Regulation  supplementing the AIFMD sets out certain operating conditions, including:

• Organisational requirements: a requirement for managers to take into account sustainability risks when complying with the organisational requirements in the UCITS Organisation Directive and AIFMR.
• Due diligence: a requirement for managers to take account of principal adverse impacts of investment decisions on sustainability factors as part of their investment due diligence.
• Resources and expertise: a requirement for managers to retain the necessary resources and expertise for the effective integration of sustainability risks.
• Conflicts of interest: a requirement 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 in their processes, systems and internal controls.
• Risk management policies: a requirement that risk management policies must also consider the exposures of AIFs or UCITS to material risks, including market, liquidity, sustainability, counterparty risks and operational risks.
• Senior management: a requirement that senior management be responsible for the integration of sustainability risks.
• UCITS management: in respect of UCITS, an overarching requirement for investment companies to integrate sustainability risks into the management of UCITS.

The delegated legislation is designed to reinforce obligations contained in the SFDR and Taxonomy Regulation, and will apply 12 months after publication in the EU's Official Journal.

In addition, the European Commission has also published a communication on EU taxonomy, corporate sustainability reporting, sustainability preferences and fiduciary duties, and directing finance towards the European Green Deal. The communication comprises a package of measures, including:

• Political agreement on the text of a Commission Delegated Regulation supplementing the Taxonomy Regulation relating to climate change mitigation and adaptation (known as the Taxonomy Climate Delegated Act). The legislation contains a set of technical screening criteria that define which activities contribute to environmental objectives contained in the Taxonomy Regulation (climate change adaptation and climate change mitigation) and will apply from 1 January 2022.

• A proposal for a Corporate Sustainability Reporting Directive (CSRD), which will amend reporting requirements contained in the Non-Financial Reporting Directive. The directive aims to extend EU sustainability reporting requirements to all large companies and listed companies.

If the UK government takes note of the FMLC's warning about the risks of divergent UK-EU regimes (see above), it will be keeping a close eye on these developments. As such, we may see similar rules implemented in the UK in the future.

Compliance, culture and the FCA's evolving expectations

In our recent Insight, we looked at how the FCA has sought to entrench "culture" at the centre of its regulatory supervision, and what this means for UK fund managers.

But can the law really change an organisation's culture or compliance record, or is human nature the real challenge? In a recent speech, Mark Steward, FCA Executive Director of Enforcement and Market Oversight, considered this question in the context of how behavioural change within regulated firms is being driven by laws and regulatory expectations, including in relation to:

• Raising senior manager standards: The Senior Managers and Certification Regime, which now applies to all firms regulated by the FCA, has given rise to some "profound changes" in the way firms allocate responsibilities, align those responsibilities to relevant controls and ensure oversight as to how these controls operate down the line. The fact that the regime imposes personal liability (and uses the senior manager’s self-interest in avoiding liability) to avoid the bear pit of enforcement creates, according to Mr Steward, a virtuous circle: what protects senior management from liability also reduces (though cannot guarantee) the risk of non-compliance more generally within firms.
• Five conduct questions: The FCA has developed five conduct questions or "5CQ", to help firms implement more effective change programmes as well as helping the regulator to interrogate progress. These revolve around the identification of conduct risk, together with the allocation of responsibility, employee support, oversight and assessment. As flagged in our recent Insight, the FCA is also considering adding a sixth question which will interrogate firms on diversity and inclusion.
• FCA enforcement cases: Mr Steward used examples of two insider dealing cases to demonstrate that failures are not necessarily failures of compliance, but the consequence of choices made by individuals. Also, systems and controls are prey to individual assessments of risk that might be wrong.
• Embedding behavioural change: Finally, Mr Steward emphasised that the Senior Managers Regime and the FCA’s 5CQ questions require firms to think about behaviour at the point it might fail. This approach is intended to encourage greater awareness and promote better calculations of judgement: about consequences, foresight of potential harm or damage and the increasing risk of detection or being caught (which, in the case of bad actors, is the one risk that is often miscalculated, as the above enforcement cases demonstrate).

A new UK prudential regime for MiFID investment firms

On 19 April 2021, the FCA issued the second phase of proposed rules to introduce the UK Investment Firm Prudential Regime (IFPR) by publishing Consultation Paper 21/7: A new UK prudential regime for MiFID investment firms (CP21/7). This paper should be read in conjunction with the FCA’s first consultation paper on the IFPR which it published last December (CP20/24).

The FCA's main focus in CP21/7 is the own funds requirement, basic liquid asset requirement, risk management and governance, remuneration rules and guidance, and regulatory reporting. CP 21/7 also provides clarity on the extent which the IFPR rules will apply to Collective Portfolio Management Investment (CPMI) firms, indicating that, with the exception of the fixed overheads requirement and other limited areas, the IFPR rules will not apply to the whole of a CPMI firm’s business; only that part which is a MiFID business.

The deadline for comments on CP21/7 and the proposed templates and forms is 28 May 2021, and the regulator plans to publish a further consultation paper in Q3 2021. Two policy statements are expected, one in late spring and the second in the course of the summer. The final rules on the IFPR will be published once the Financial Services Bill has passed through Parliament and all the consultations are complete.

Changes to UK MiFID rules on research and best execution

On 28 April 2021, the FCA published a consultation paper proposing changes to the conduct and organisational requirements in UK MiFID for two areas: research and best execution.  These rules apply to investment firms and market operators in the UK, banks and Collective Investment Scheme operators providing investment services, firms providing investment advice and reception and transmission of orders who did not opt into MiFID ("Article 3" firms), and firms providing research that the FCA does not authorise.

The consultation will also be of interest to individuals who use the services of these firms, as well as firms not authorised to provide investment services but that use the services of firms providing investment services, including pension funds and corporates.

In summary:

• Research: The FCA proposes to change the existing inducements rules relating to research. These changes broadens the list of what are considered minor non-monetary benefits to include research on SMEs with a market cap below £200m and fixed income, currencies and commodities research, so that it is not subject to the inducement rules. The FCA has also made rule changes on how inducement rules apply to openly available research and research provided by independent research providers.
• Best execution reports: The FCA proposes to remove two sets of reporting obligations on firms: (a) the obligation on execution venues to publish a report on a variety of execution quality metrics to enable market participants to compare execution quality at different venues (known as RTS 27 reports) and (b) the obligation on investment firms who execute orders to produce an annual report setting out the top 5 venues used for executing client orders and a summary of the execution outcomes achieved (known as RTS 28 reports).

The deadline for responses to the consultation is 23 June 2021, following which we can expect any rules or guidance to be published in the second half of this year.

Osborne Clarke responds to call for input on UK funds regime review

On 26 January 2021 HM Treasury published a wide-ranging call for input on its review of the UK funds regime, covering direct and indirect tax as well as funds regulation. The asset management industry contributes 1% of the UK’s GDP and the government’s overarching objective for the review is to identify options which will make the UK a more attractive location to set up, manage and administer funds.

In Osborne Clarke's response to this call for input we looked at both the UK's approach to funds taxation and the opportunities for wider reform. We highlighted that the top priorities for government implementation should be: to ensure any review is holistic and joined up so that any reform works from a tax and regulatory perspective; to address certain issues present in relation to English limited partnerships as fund vehicles; and to introduce an unauthorised fund regime suitable for professional and institutional investors investing in real estate.

To read more about our response to that call for input, see our Insight.