International Funds Legal Update | December 2023

The second half of November has mainly brought updates on environment, social and governance (ESG) developments, both in terms of supervisory steps and new rules in the UK and European Union. Other important developments relate to fund disclosures.

The FCA requires action on greenwashing

The Financial Conduct Authority (FCA) has published its findings from a multi-firm review on how authorised fund managers (AFMs) are complying with regulatory requirements regarding the design, delivery and disclosure of ESG and sustainable investment funds.

This was a follow-up to the regulator's "Dear AFM chair" letter from July 2021, which includes the guiding principles that AFMs must follow in this area.

While the FCA felt that AFMs generally demonstrated good intent to embed the guiding principles and that there was evidence of good practice, it found that the principles had not been fully embedded. Key information about ESG and sustainable investment funds was difficult to identify, and some disclosures did not contain important information that would have enabled investors to make fully informed choices about investment products.

The regulator has tasked AFMs with assessing how they are complying with ESG and sustainability requirements, especially in relation to disclosure material, and will continue to supervise this area.

In short, it stated that, in relation to their ESG and sustainable investment funds, AFMs should:

• Identify and address any shortcomings in the design, delivery and disclosure of their funds, and ensure they are not conducting their operations in a way that causes harm to consumers.
• Review the FCA's detailed findings that explain how to comply with each of the principles relating to design, delivery and disclosure.
• Consider the potential impact of the new rules on sustainable disclosure requirements and investment labels on their firm and investment products and take necessary actions to comply when the new rules come into force.

The FCA's new sustainable disclosure requirements have arrived

The FCA has published its much-anticipated sustainability disclosure requirements (SDR) and investment labels regime. The rules aim to bring trust and transparency to the UK market for sustainable investment products and represent a major ESG shift for the UK financial services sector.

The SDR regime brings in a general anti-greenwashing rule for all FCA-authorised firms. This will come into force on 31 May 2024 and the FCA is currently consulting on guidance about how this rule will operate. Other rules, aimed at UK asset managers and distributors, include an investment labelling regime, which firms will be able to use from 31 July 2024, as well as new naming and marketing rules and disclosure obligations. These will be phased in from 2 December 2024 and onwards.

Parliament considers investment companies' cost disclosures

The House of Commons Treasury sub-committee on financial services regulations has published a letter from its chair, Harriet Baldwin, to Jeremy Hunt, the chancellor of the exchequer, regarding investment companies (investment trusts) and cost disclosures.

Ms Baldwin has requested HM Treasury assess points relating to cost transparency requirement disclosed by investment companies. The publication of this letter follows a debate in the House of Lords on 13 November 2023, in which Baroness Altmann raised questions about the impact of disclosure obligations under the Alternative Investment Fund Managers Directive (AIFMD) UK Regulations on UK-listed investment companies. The debate referred to a private members' bill the Alternative Investment Fund Designation Bill 2023-24, which had its first reading in the House of Lords.

Parliament has published the text of the bill and explanatory notes. The Parliament webpage on the bill currently states that the date for second reading has not yet been scheduled.

The bill was introduced by Baroness Altmann, intending to amend the UK Alternative Investment Fund Managers Regulations 2013 to remove listed investment companies from their designation as alternative investment funds (AIFs).

Listed investment companies fall within the definition of an AIF, meaning that these companies fall within cost disclosure requirements reflecting the UK's implementation of the Packaged Retail and Insurance-based Investment Products Regulation (PRIIPs) and Markets in Financial Instruments Directive (MiFID II).

Baroness Altmann argues that the lack of recognition in the UK AIF regime of the listed-company structure and the role of share price as the investment value has given rise to reporting requirements that do not distinguish between costs already accounted for within share price and costs that are yet to be deducted from value. The effect is that listed investment companies appear more expensive relative to investment funds.

The bill contains amendments to the AIFMD UK Regulations that will remove closed-ended investment companies whose shares are admitted to trading on any market or venue operated by a UK recognised investment exchange from the definition of AIF. The bill also contains consequential amendments to the cost disclosure requirements in related retained EU law.

HM Treasury sets out the legal framework for UK retail disclosures

HM Treasury has published a policy note on the UK retail disclosure framework, together with a near-final draft version of the Consumer Composite Investments (Designated Activities) Regulations 2024. This includes rule-making, supervisory and enforcement powers for the FCA.

The policy note sets out the background to the new UK retail disclosure framework for consumer composite investments (CCIs), with a summary of the government's policy intent. It also outlines how the regulations will achieve this and the stakeholders likely to be impacted. The regulations replace the UK PRIIPs Regulation and set out provisions to facilitate the creation of the new framework.

The new UK retail disclosure framework for CCIs will be delivered using the designated activities regime under part 5A Financial Services and Markets Act (FSMA), which was introduced by FSMA 2023.

The FCA welcomes a new blueprint for fund tokenisation

The Investment Association has published an interim report on UK fund tokenisation written by the technology working group under HM Treasury's asset management taskforce.

The FCA has published a letter to the chair of the working group, welcoming the interim report. The FCA has not identified any obvious or significant barriers to the baseline approach in its rules applicable to authorised funds nor does the approach change the structure of a fund or the responsibilities of its participants.

The report sets out the first phase of the group's work on harnessing the potential of innovative technologies for the UK asset management industry. It focuses on the application of distributed ledger technology through investment fund tokenisation. The group expects this will improve efficiency, transparency and competitiveness in the UK's investment sector.

The working group has co-operated closely with HM Treasury and the FCA to develop this blueprint for implementing the tokenisation of UK investment funds. It recommends a staged approach, starting with a baseline model that could be used within the existing legal and regulatory framework, which would then progress to more advanced stages over time. The baseline model establishes the infrastructure for fund tokenisation in the UK funds market. Later stages may require legislative or regulatory rule changes, and may also depend on other wider technological developments.

Publication of this report represents phase one of the group's work. The group plans to complete phase two, exploration of further stages of fund tokenisation, in February 2024. Phase three, relating to using new opportunities arising from artificial intelligence and other technologies, is scheduled for the first half of 2024.

HMT may extend the pension funds exemption under UK EMIR

HM Treasury has issued a call for evidence regarding the exemption for pension funds from the UK   European Market Infrastructure Regulation, or the UK EMIR, clearing obligations. The temporary exemption, which has been extended multiple times, is currently set to expire on 18 June 2025. HM Treasury is reviewing the exemption to explore a longer-term policy that would eliminating the need for further extensions. The call for evidence mainly aims to understand how pension funds currently utilise the exemption and assess the potential impact if it were to expire in June 2025. The call for evidence is open until 5 January 2024.

EU's sustainable finance framework sources expand

ESMA has published three explanatory notes covering key aspects of the EU sustainable finance framework:

• Concepts of sustainable investments and environmentally sustainable activities in the EU sustainable finance framework. This note explains how the concept of sustainability is inscribed in the EU sustainable finance framework, as reflected in the definition of "sustainable investments" in the Sustainable Finance Disclosures Regulation and the definition of "environmentally sustainable economic activities" under the Taxonomy Regulation.
• "Do no significant harm" definitions and criteria across the EU sustainable finance framework. This note explains the "do no significant harm" principle, which is embedded in several pieces of EU sustainable finance legislation.
• Concept of estimates across the EU sustainable finance framework. This note explains how key EU sustainable finance legislation deals with the use of "estimates" and "equivalent information", and the conditions under which these are allowed as sources of data to prepare mandatory ESG metrics for the compliance of regulated entities with their obligations.

The explanatory notes aim to set out factual information regarding the concepts they cover and help stakeholders better to navigate and understand the EU sustainable finance legislative framework. The notes are purely descriptive and are not intended to replace relevant legal texts or provide guidance on the application of relevant provisions.

In addition to ESMA's explanatory notes, two delegated regulations relating to the Taxonomy Regulation were published in the Official Journal of the European Union:

• The Amending Taxonomy Climate Delegated Act. This amends the technical screening criteria (TSC) for economic activities that make a substantial contribution to the climate environmental objectives and includes additional activities under the Taxonomy Climate Delegated Act. The act largely applies from 1 January 2024, although some provisions apply from 1 January 2025.
• The Taxonomy Environmental Delegated Act. This sets TSC for economic activities making a substantial contribution to non-climate environmental objectives, namely: sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems. The act also amends the Taxonomy Disclosures Delegated Act. The Taxonomy Environmental Delegated Act applies from 1 January 2024.