International Funds Legal Update | 8 November 2023

FCA maps out future of the UK regime for asset management

The chair of the Financial Conduct Authority (FCA), Ashley Alder, delivered a speech to the Investment Association on 11 October 2023 updating on the regulator's priorities for the future of the UK regime for asset management, following feedback on its discussion paper in February.

The UK financial regulator will not consolidate the rules for different types of asset managers nor develop a basic category of authorised funds aimed at helping retail investors navigate the market. These suggestions could have had significant implementation implications for asset managers.

Rather, the following three areas will be the main priorities for reform:

• Making the regime for alternative investment fund managers (AIFMs) more proportionate.
• Updating the regime for retail funds to distinguish clearly between requirements applying to managers of authorised retail funds and alternative investment funds.
• Supporting technological innovation; for example, in relation to fund tokenisation.

UK reforms

The key points to note on potential reforms to the framework of the UK's onshored version of the Alternative Investment Fund Managers Directive (AIFMD) are:

• The FCA would like a consistent set of rules across all managers of alternative funds. Rather than having two different categories of managers and applying different rules to each, this would help ensure the regime operates proportionately depending on the nature and scale of each firm’s business.
• The directive prevents full-scope AIFMs from carrying out other activities within the same legal entity. Given the complexities this can result in, the FCA is considering modifications in this area.
• The AIFMD currently requires managers to report to the FCA when a fund is newly established, when there are any material changes to a fund, when there is an acquisition or disposal of major holdings, and in relation to the control of non-listed companies. The FCA will consider easing these requirements, as the cost of compliance may be disproportionate compared to the benefits of the FCA receiving it.

Assessment of value requirements published by UK regulator

On 10 August 2023, the FCA published a website setting out its findings following a review of processes used by selected authorised fund managers (AFMs) when carrying out assessments of value (AoV) for authorised funds. The website contains good and bad practices for six of the seven minimum prescribed areas for considerations as well as a handful of cross-cutting points AFMs need to address.

The FCA has stated that were it to find AFMs that are outliers in terms of AoV, it would follow up and take necessary action to ensure AoVs are conducted in line with the rules and their expectations.

The FCA found that many firms now have a better understanding of the rules so have improved their AoV processes leading to greater savings for consumers. Those that had not improved were not able to support their assumptions and assessments with sufficient evidence.

Examples of the FCA findings are:

• Good practice included moving investors to clean share classes with no trail commission or reducing the fund's fees.
• Most firms' independent non-executive directors did not provide sufficient challenge to the suitability of collection and analysis of information. The FCA thinks there is a balance between being involved in the AoV process to understand the methodology but not being so involved as to compromise independence.
• There were significant differences between good and poor practice in how AFMs assess their funds' performance. Those with good practices set fund objectives and performance thresholds reflecting their investment strategies. Poor practice included emphasising growth targets without applying techniques to reduce market risk.
• While there was a better understanding of the need to justify fees, most remedial action did not involve reducing fund fees. Where they were reduced, it was mostly due to adverse comparable market-rates findings rather than by applying the assessment considerations.
• Some firms now have better processes for allocating costs but others do not have a detailed costing model. The FCA encourages firms to consider whether their current costing models adequately support AoV.

'Dear CEO' letter sets out liquidity management requirements

On 6 July 2023, the FCA wrote a "Dear CEO" letter to authorised fund managers setting out its key findings following a multi-firm review of liquidity management. The UK regulator expects firms, including managers of alternative investment funds, to review the findings, consider them for their businesses, and make any improvements necessary in line with good practice.

In the FCA's view, most firms fell short in some aspects of their liquidity management framework.

The findings have been summarised on a new webpage with a total of 30 examples of good practices across the areas of governance, liquidity stress-testing, redemption processes, liquidity management tools and valuations. These can be used to benchmark a firm's liquidity management framework against the regulator's expectations.

Governance

With few exceptions firms did not provide sufficient weight to managing liquidity in their general framework and governance structures. In many cases, liquidity risks were only flagged on an ad hoc basis, leading to issues being discussed in isolation and little evidence of focus on the composition and evolution of less liquid "buckets" within fund.

Liquidity stress-testing

Firms' approaches vary in sophistication. When stress-testing the regulator prefers a "vertical portfolio slicing" approach rather than a "depletion of liquid assets first" approach. Although few funds ever fail tests, the regulator has asked that firms that do consider whether thresholds and triggers set are challenging enough to reflect volatile and stressed market conditions. Repeated triggering of stress tests should result in follow-up actions. Investor concentration should also be factored into liquidity management. Many firms had not followed all of the relevant EU guidelines. These still apply.

Redemption process

Most firms had redemption processes in place but the processes did not do enough to ensure investors were treated fairly, particularly in stressed scenarios, with little oversight from fund managers. The regulator implies that many firms have inadequate processes relating to the application of redemption thresholds triggering enhanced governance processes.

Liquidity management tools: swing pricing

Firms take a mixed approach to applying swing pricing as a liquidity management tool, and often apply the same triggers across fund ranges irrespective of their different asset classes. The FCA have found weaknesses relating to defining the appropriate size of swing pricing thresholds, static or dynamic application of thresholds, overreliance on third party administrators for calculations and an absence of back testing with respect to executed prices.

Valuation

Valuation processes were reasonably robust across mainstream open-ended funds. However, most of the funds the regulator evaluated had very limited exposures to fundamentally illiquid positions.

Political agreement reached on status of the AIFMD II reforms

The future regulation of the EU's funds industry is looking somewhat clearer as the EU's institutions have reached a political agreement on amendments to the framework for Alternative Investment Fund Managers Directive (AIFMD) and the EU's retail funds regime (regulated by the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive). The European Parliament published a detailed briefing in September on the progress of the AIFMD and UCITS amendment legislation.

Agreement was reached on 20 July 2023 on requirements that will:

• Enhance the integration of asset management markets in the EU and modernise the framework for key regulatory
• Enhance the availability of liquidity management tools, with new requirements for managers to provide for the activation of these instruments.
• Establish an EU framework for funds originating loans (that is, funds that provide credit to companies) supplemented with requirements aimed at alleviating risks to financial stability and to ensure an appropriate level of investor protection.
• Enhance the rules for delegation by investment managers to third parties.

Agreement has also been reached on requirements relating to data sharing and co-operation between authorities, new measures to identify undue costs that could be charged to funds, and rules to prevent potentially misleading fund names.

The agreement is subject to the approval of the Council and Parliament before going through a formal adoption procedure.

Commission consults on Sustainable Finance Disclosures Regulation

The European Commission is currently consulting on the regulation on sustainability-related disclosures in the financial services sector, technically through two consultations: a targeted consultation as well as a public consultation issued on the 14 September 2023.

The Commission has proposed a "comprehensive assessment" of the Sustainable Finance Disclosures Regulation (SFDR) because – in its own words – "the regulation is not entirely working as intended".

In short, the consultations explore concerns about how the SFDR has been implemented in practice and how potential shortcomings need to be addressed. The consultations are broad and so are the range of potential outcomes.

The Commission is focused on how effective the transparency provided by SFDR disclosures has been and whether this has fed through to "actual change": whether this has provided more awareness of the negative impact of investments or changed the way firms make investment decisions and product designs.

The main questions raised relate to legal certainty, the useability of the legislation, and its ability to tackle greenwashing.

The SFDR was designed as a disclosure regime not a product labelling regime; however, it quickly became clear that market participants viewed this as a product-labelling regime and the Commission is concerned about the implications of this. Therefore, it is seeking views on the merits of developing a more precise EU-level product categorisation system based on defined criteria. Four labels are being considered, three of which broadly align with the UK FCA's fund labels.

One possibility is that the SFDR might end up aligning more closely with the UK's Sustainability Disclosure Requirements. In March, the FCA announced a delay to a policy paper setting out these sustainability disclosure rules – and it is now been delayed further with publication anticipated by the end of the year.

The EU consultations close for comments on 15 December 2023, and the Commission intends to publish a report on updating the SFDR in second quarter of 2024.   

US Securities and Exchange Commission finalises private fund rules

On 23 August 2023, the US Securities and Exchange Commission (SEC) finalised a package of rules and amendments to address conflicts of interest and adviser practices that may impose significant risks and harms to investors and private funds. These are expected to have a significant impact on the US private funds industry. (Please note that this is a very high-level overview of these rules.)

The rules can be divided into the "private funds rules" and the "compliance rule". The private funds rules have compliance dates 12-18 months after publication in the Federal Register and the compliance rule 60 days after the same.

While non-US advisers will generally be exempt from these rules with respect to non-US funds, in certain instances, however, they might be in-scope. For example where non-US advisers:

• manage a fund structure that includes a Delaware feeder or parallel vehicle,
• are a "relying adviser" of an affiliated US adviser; or
• are engaged in a joint venture with a US adviser.

Overview of rules

The private fund rules that generally apply to all US private fund managers (whether SEC registered or not) are:

• The restricted activities rule. This restricts private fund managers from engaging in certain activities that are contrary to the public interest and the protection of investors; for example, charging expenses to a fund due to an investigation of the private fund manager by regulators. The activities may be allowed subject to disclosure and in some instances investor consent is also required.
• The preferential treatment rule. Preferential treatment of certain investors in a private fund or a "similar pool of assets" is prohibited, addressing the widespread use of side-letters. Preferential redemption and information access are, as a main rule, specifically prohibited where the manager would reasonably expect that this would have a material, negative effect on other private fund investors. Other forms of preferential treatment are allowed, subject to disclosure to current and prospective investors in a prescribed manner and on an ongoing basis.

 SEC-registered private fund managers must also comply with the following private fund rules:

• The quarterly statement rule. Information to investors must be provided quarterly within certain timeframes, relating to fees, expenses, and performance. The rules also requires consolidated reporting for substantially similar pools of assets in certain cases.
• The mandatory audit rule. An annual financial statement audit of private funds must be obtained complying with certain requirements. This is, however, in line with current practice.
• The adviser-led secondaries rule. Private fund managers must obtain a fairness or valuation opinion, which must be provided to investors before they elect to participate in an adviser-led secondary transaction. A summary of any material business connections between the private fund manager or its related persons and the independent opinion provider must be provided to investors.

The SEC has adopted an amendment to the current compliance rule requiring SEC-registered investment advisors to document their annual review of compliance policies and procedures in writing, which is also in line with current practice.