UK Funds Legal Update | March 2023

Welcome to a new edition of our UK Funds Legal Update.

In this edition, we take a look at the latest regulatory developments for the UK investment funds and asset management industry, including: the Financial Conduct Authority's (FCA) ideas to improve and modernise the UK's asset management rules, authorisation of the UK's first Long Term Asset Fund (LTAF), an independent review into the UK market for investment research, and HM Treasury's questions to the FCA on its sustainability disclosure proposals.

FCA starts the discussion on updating and improving the UK asset management rules

The FCA has invited views on how to further improve asset management regulation with a more modern and tailored regime to make sure the regime takes account of developments in technology and supports innovation: Updating and improving the UK regime for asset management (DP23/2).

The discussion paper addresses the following possible areas of change:

• Simplifying the regulatory framework for asset managers: The FCA is considering areas where the rules for asset managers could be simplified or restructured. Since the UK's regulatory regime in this area derives from several different EU directives and regulations, the regime isn’t always as clear or coherent as it might be. In some cases, the rules have minor differences of wording or emphasis; in others, the differences are more substantive. In the discussion paper, the FCA focusses on the rules for fund managers of different types and portfolio managers; the regime for retail funds; and the regime for fund managers of professional funds. The FCA has indicated that it has no plans to significantly amend the rules that apply to full-scope alternative investment fund managers (AIFMs). Instead, the regulator is looking at expanding the regime that applies to small UK AIFMs.
• Accommodating technological changes: This includes accommodating the use of technology within the rules that could enable investors to transact directly with funds; allow funds to issue their units to investors as digital tokens, such as by means of distributed ledger technology, and enable existing assets to be held in a fund’s underlying portfolio and traded on a secondary market in tokenised form with fully digitised clearing and settlement.
• Specific changes in relation to retail funds and their depositories: This includes creating a single set of rules for undertakings for the collective investment in transferable securities (UCITS) and non-UCITS retail schemes (NURS), improving the current rules on liquidity requirements for authorised funds managers (AFMs) and clarifying expectations related to depositaries of AFMs.

The FCA will need to weigh up the benefits carefully of a consolidated regulatory framework versus the additional compliance costs and disruption that would likely result from a rewriting of the current rules for UK asset managers.

FCA authorises first Long Term Asset Fund

On 9 March 2023, the FCA announced that it had authorised the first LTAF. The LTAF is a new category of open-ended authorised fund designed to invest efficiently in long-term assets. The FCA enabled the innovation by creating a new regulatory regime which came into force in 2021. The new rules embed longer redemption periods, high levels of disclosure, and strong liquidity management and governance features, thereby providing sufficient investor protection and enabling defined contribution pension scheme investment into the LTAF. 

Consultation responses to the FCA's proposals to broaden out the distribution of the LTAF in a controlled way to a broader subset of retail investors are currently being analysed by the FCA, and the regulator is expected to publish policy proposals in the first half of this year.

Independent review looks at how to boost the UK market for investment research

On 9 March 2023, HM Treasury published a policy paper: Terms of reference – Investment Research Review. The independent review, which was first announced as part of the government’s Edinburgh Reforms, will look at financial services investment research and its contribution to UK capital markets competitiveness. 

Investment research can provide investors with information that can allow them to understand better a company’s business model, performance, and risks and, therefore, to assess its value as an investment. It is used by potential investors who are looking to trade in both public and private markets to inform investment decisions. Low levels of investment research can therefore make it harder to value companies, make it more difficult for companies to attract investors, and make UK markets less attractive to businesses that want to raise capital. Several commentators have suggested that the UK has lower levels of investment research capability in comparison to other jurisdictions, in particular the US, and that this problem is particularly acute for certain sectors, such as for tech and life sciences companies

Among other things, the review will consider how investment research provision in the UK compares or is perceived to compare with other international financial services centres, in both public and private markets. It will also review the current level of demand investors have for research, factors driving this demand, and evidence of whether the amount, quality and type of investment research is sufficient to meet such demands.

An initial report is expected by mid-June 2023. This will include options for improving the UK market for investment research. It may, for example, recommend additional regulatory measures and actions that industry should take. In addition, the Investment Research Review will consider the impact of the Markets in Financial Instruments Directive II unbundling rules on the levels and quality of investment research and evaluate the likely impact of any proposed changes on investment and fees.

Treasury sub-committee questions the FCA following its SDR and investment labels consultation

On 9 March 2023, the House of Commons’ Treasury Sub-Committee on Financial Services Regulations published a letter addressed to the FCA, following the UK financial regulator's consultation on sustainability disclosure requirements and investment labels (CP22/20).

In the letter, the sub-committee highlights the following issues:

1. Cost-benefit analysis: The FCA's cost-benefit analysis (CBA) of the measures included within its consultation focuses on the administrative burdens of firms complying with the new regulatory framework (such as costs arising from familiarisation with the rules, training, IT changes, change and governance and ongoing costs). According to the sub-committee, the FCA has failed to take into account the substantial costs to the consumer. Such costs would include, for example, their time spent reconsidering which products they wish to invest in, which they wish to divest from and related transaction costs; buy-and-sell spreads that consumers will be exposed to when their investments are reallocated to different funds; and the potential for the proposed new disclosures to change the fundamental prices of the funds themselves. 
2. Enforcement against misleading customers: The sub-committee is concerned that despite stating in the consultation that consumers are being misled, the FCA appears unwilling to take enforcement action because no specific rules were in place when the misleading took place. The FCA has stated previously that fines would not be issued retrospectively based on the new disclosure rules and that the regulator has existing powers that enable it to impose financial penalties where appropriate. The sub-committee has asked the FCA to set out what enforcement work it will be doing to make sure that where fund managers have been promoting misleading financial products, the FCA will pursue redress for consumers (including the legal basis for not doing so, where that is the case).
3. International divergence or convergence: In its consultation, the FCA stated that its aim was to make the UK disclosure regime compatible with other initiatives internationally as far as possible, while remaining appropriate for the UK market. The sub-committee has asked the FCA for its assessment of the risks to consumers and to the funds industry, were the FCA requirements to be too onerous for US or EU based funds to meet, and whether as a result the UK consumer may end up with less choice. The sub-committee also asks the FCA to confirm whether there is a risk that UK-based funds have to spend time and money to become compliant with three separate jurisdictional environmental, social, and governance (ESG) criteria, resulting in additional management costs that will be passed onto UK consumers.

The sub-committee has requested a response from the FCA by 23 March 2023.

BVCA publishes 'Creating sustainable growth: private capital at work' report

The British Private Equity and Venture Capital Association (BVCA) has published a report entitled "Creating Sustainable Growth: Private Capital at Work", which highlights how the private capital industry is improving its ESG performance and transparency. The report outlines the current regulatory landscape and the BVCA's work in bringing together investment firms, regulators and standard-setting bodies.

Private capital-backed firms are increasingly focusing on transparency and disclosure of greenhouse gas emissions, board diversity, and corporate governance due to increasing pressure from stakeholders. In response the BVCA started a new initiative to gather data from private equity and venture capital firms on key ESG metrics, covering a range of areas such as carbon footprints, female representation across industries, and the adoption of policies to combat bribery and cyber-attacks.

The report outlines a survey on ESG metrics conducted in late 2022 by the BVCA along with Invest Europe and other trade associations. In total, the BVCA were able to gather data on 694 funds and around 1300 companies. The survey found that nearly 25% of medium-sized firms and over 5% of small firms that responded collect data on greenhouse gas emissions from their supply chain, which goes beyond existing legal requirements. It found that 85 companies surveyed had net-zero targets and 72% of firms that had a date for net zero were aiming for 2030 or earlier. 

With regards to diversity, the survey found that on average only 17% of board members at portfolio companies backed by private capital firms were women, which is far off the 40% target set by the FCA for listed companies. In terms of good governance, the survey found that the majority or businesses have policies in areas such as anti-bribery and cyber security. However, larger companies particularly those in the financial and insurance sectors were more likely to have established anti-corruption and cybersecurity policies.

Latest Financial Services Regulatory Initiatives Grid maps next 24 months

On 28 February 2023, the Financial Services Regulatory Initiatives Forum published the latest edition of the Regulatory Initiatives Grid (last updated in May 2022). The purpose of the grid is to set out details of regulatory initiatives relevant to the financial services sector that are planned for the next 24 months.

For each of the initiatives, the forum provides details of the lead authority, milestones, the indicative impact and the likely timetable for key developments. Where appropriate, the grid specifies where the timings of the initiative have changed since the previous edition and where a new initiative has been added.

New initiatives and key milestones for the investment funds and asset management sector include:

• Review of the Senior Managers and Certification Regime (SM&CR): The government and regulators will commence a review of the SM&CR in the first quarter of 2023. The government will launch a call for evidence and the FCA and Prudential Regulation Authority will issue a joint discussion paper. These reviews will garner views on the regime’s effectiveness, scope and proportionality, and seek views on potential improvements and reforms.
• Sustainability disclosure requirements (SDR) and investment labels: The FCA has issued a consultation on proposals for SDR and investment labels for asset managers, which has now closed. The FCA plans to publish a policy statement with finalised rules in the second quarter of 2023 (provisionally June 2023). Further parts of the overall SDR regime will be consulted on by relevant government departments and regulators in due course.
• Regulatory framework for approval of financial promotions: The policy proposals to establish a regulatory "gateway" which an authorised firm must pass through before it is able to approve the financial promotions of unauthorised firms are included in the Financial Services and Markets Bill currently going through Parliament. The FCA published a consultation on 6 December 2022 on how it intends to operationalise the new gateway and publish final rules once the bill has been finalised. When this is, and when the gateway itself opens, depends on when the bill receives Royal Assent. The timeline for the opening and closing of the application period will be in secondary legislation that is not yet finalised

The forum intends to publish the next edition of the Regulatory Initiatives Grid towards the end of 2023. It also intends to publish a statement once the Financial Services and Markets Bill 2022-23 receives Royal Assent with details of any important and imminent changes to the grid.

Alternative Investment Management Association publishes DDQs on digital assets

On 27 February 2022, Alternative Investment Management Association (AIMA), together with digital asset investors and industry experts, published a new set of due diligence questionnaires (DDQs) for digital asset investment managers and funds.

These DDQs have been primarily designed for investors to evaluate the unique investment and operational risks that come with allocating to digital asset investment funds. AIMA's questionnaires will also assist investment managers in the space to meet investor demands for transparency more efficiently by creating a comprehensive standard template for information sharing. There are versions for open-ended funds as well as closed-end fund vehicles so that these templates can be used by hedge fund, venture capital and hybrid funds.

The questionnaires address strategy, trading, risk management, leverage, liquidity risk, and fund service providers including custody, costs and expenses, performance and valuation.