Funds: Five by Five - Summer 2021

Welcome to the Summer 2021 edition of Five by Five.

Five by Five is a summary of the key developments that we have been discussing with our fund clients and contacts over the last few months.

This edition covers:

• the FCA's Consultation Paper (CP) on enhancing climate-related disclosures by asset managers;
• the delay to the full implementation of the EU's SFDR regime;
• the FCA's Discussion Paper (DP) on strengthening the UK's financial promotion rules for high-risk investments and firms approving financial promotions and HM Treasury's publication of the response to its consultation on the regulatory framework for approval of financial promotions;
• the FCA's review of host Authorised Fund Management firms and its potential implications for host AIFMs;
• the EU's cross border distribution of funds (CBDF) directive and regulation, which come into effect on 2 August 2021;
• The Chancellor’s 2021 Mansion House speech and the accompanying HM Treasury paper, "A new chapter for financial services".

FCA Consultation Paper CP21/17 - Enhancing climate-related disclosures by asset managers, life insurers, and FCA-regulated pension providers

This CP was published in June 2021 and comments are required by 10 September 2021.

The key elements of the proposals are:

• Entity-level disclosures: UK-authorised firms would be required to publish, annually, an entity-level report on how they take climate-related risks and opportunities into account in managing or administering investments on behalf of clients and consumers. These disclosures must be made in a prominent place on the main website for the firm’s business and would cover the entity-level approach to all assets managed by the UK firm.
• Product or portfolio-level disclosures: Firms would be required to produce, annually, a baseline set of consistent, comparable disclosures in respect of their products and portfolios, including a core set of metrics. Depending on the type of firm and/or product or portfolio, these disclosures would either:
  • be published in a product report in a prominent place on the main website for the firm’s business, while also being included, or cross-referenced and hyperlinked, in an appropriate client communication, or
  • be made upon request to certain eligible institutional clients.

The proposals will not apply to firms with less than £5 billion AUM in assets on a three-year rolling average, on an annual assessment.

The FCA proposes to bring into scope the different types of fund management activities, as well as portfolio management defined more broadly. This includes, for instance, investment advice provided by a UK entity to institutional clients within a group where substantive investment decisions are based on that advice. The proposed approach aims to bring into scope asset management activities conducted by private equity and other private market firms. The draft wording in the proposed rules is "private equity or other private market activities consisting of either advising on investments or managing investments on an ongoing basis in connection with an arrangement the predominant purpose of which is investment in unlisted securities".

The regime may or may not be extended to smaller firms in 2024/2025 as "further refinement to measures may be considered, including in response to evolving best practice". In any event, smaller firms may wish to voluntarily comply with the regime or may find that investors expect such compliance in any event.

Larger firms (AUM of more than £50bn) will have to make their first disclosures by 30 June 2023 and remaining firms with more than £5bn AUM will have to make their first disclosures by 30 June 2024. 

The FCA is generally trying to be consistent with the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (the "TCFD") and recommended disclosures. The proposed core metrics for the product or portfolio-level disclosures are a subset of the metrics listed in the recommendations of the TCFD. Where prescribed calculation methodologies differ between the TCFD’s recommendations and the final report on draft Regulatory Technical Standards (RTS) for the EU's SFDR, the FCA is proposing that they be reported according to the formulae under both regimes. The FCA is proposing that firms must supplement the core, mandatory, metrics with certain additional metrics on a "best efforts" basis. These are less established, mostly forward-looking, metrics for which methodologies are still evolving.

The FCA is introducing a new "Environmental, Social and Governance (ESG) Sourcebook" in the FCA Handbook to set out the proposed rules and guidance.

SFDR implementation delay

The European Commission has informed the European Council and the European Parliament that it plans to defer the implementation deadline of the RTS of the sustainable finance disclosure regulation (Regulation EU 2019/2088) (the "SFDR") to 1 July 2022, instead of 1 January 2022.
The delay is welcome, particularly as the implementation deadline will be closer to the many ESG-related changes to EU legislation that are expected to come into effect in October 2022 and January 2023, but it does raise more questions as to why some of the SFDR was rushed into force in March 2021.
Given the fact that the implementation timeline of the EU's ESG rules is still a bit of a mess, we should hope for further delays and transitional periods.

The FCA's DP on changes it can make to strengthen the UK's financial promotion rules for high-risk investments, and for authorised firms which approve financial promotions

The FCA has published Discussion Paper 21/1 on 29 April, Strengthening our financial promotion rules for high-risk investments and firms approving financial promotions.

By "high-risk investments" the FCA means those products subject to marketing restrictions, e.g., non-readily realisable securities (e.g. mini-bonds), P2P agreements, non-mainstream pooled investments and speculative illiquid securities.
In broad terms, DP21/1 focuses on three areas:

• the classification of high-risk investments (asking whether (i) there are classes of product that should be within scope of marketing restrictions which currently are not and (ii) whether the current classifications need to be changed);
• the segmentation of the high-risk investment market (i.e., what could be done to strengthen the investor categorisation process where access to a financial promotion is restricted to certain types of investor); and
• the responsibilities of firms which approve financial promotions (seeking views on what the responsibilities of s 21 approvers should be).

The consultation closed on 1 July 2021.

The Response to HM Treasury's Consultation regarding the Regulatory Framework for Approval of Financial Promotions

In July 2020, HM Treasury proposed a new gateway through which authorised firms would need to pass to be able to approve the financial promotions of unauthorised firms. On 22 June 2021, HM Treasury published the response to its consultation on the regulatory framework for approval of financial promotions.

In the response, HM Treasury summarises responses received to its July 2020 consultation paper, and explains the next steps. Most respondents support the introduction of a regulatory gateway, with a slight preference for option 1 (that is, imposing FCA requirements to restrict financial promotion approvals). Those who were not supportive had a number of concerns, including disorderly transition, additional administrative burdens and market disruption caused by an excessive reduction in the number of approver firms.

HM Treasury advises that it has taken on board the concerns, and will incorporate the feedback received into its wider policy making process. Its proposed approach is set out in Section 3 of the response. HM Treasury agrees that a gateway should be introduced for the approval of unauthorised persons' financial promotions by way of option 1. It believes that this approach will achieve the desired objective of strengthening the FCA's supervision of firms approving unauthorised persons' promotions, while maintaining the existing distinction between regulated activities and financial promotions as set out in FSMA.

All new and existing authorised firms will be prohibited from approving unauthorised persons' financial promotions by way of a requirement on their permission: the "Financial Promotion Requirement". Both new and existing authorised firms that wish to approve financial promotions will have to apply to the FCA to have the prohibition removed either entirely (allowing them to approve all types of financial promotions) or partially (allowing them to approve certain types of financial promotions). Firms will do this by submitting a variation of requirement application to the FCA. The FCA will determine, and accept or refuse, an application under powers in Part 4A of FSMA.

HM Treasury has also developed proposals to implement a transitional period (with three distinct phases) allowing an orderly transition between the two regimes. It intends to bring forward the necessary legislation when parliamentary time allows. The FCA will consult on its proposals for implementing the gateway in due course.

The FCA's review of host Authorised Fund Management firms

On 30 June 2021, the FCA published its Review of host Authorised Fund Management firms.

Host Authorised Fund Management firms (AFMs/ACDs) are managers that delegate investment management of UK regulated funds (UK UCITS, NURS, QIS) to third parties outside of their corporate group. In other words, a UK ManCo that provides the service of acting as the AFM/ACD of a UK regulated fund for a UK or non-UK investment manager that does not have permission to be an AFM/ACD.

The FCA wanted to test the viability of the host AFM business models and assess whether conflicts of interests were being effectively managed.

Host/Incubator AIFM models were not the subject of the review but the implications for these models are clear. Indeed, the review states: "While the main focus of the review was AFMs managing UK UCITS funds through a host model, AFMs managing other types of authorised funds and other firms who manage AIFs should also consider the implications for their business."

We feel that the FCA simply started with the sector of the hosting industry that presents the greatest regulatory risks (because retail investors can invest in regulated funds) and expect that the FCA is not far from making a related publication in relation to host/incubator AIFM models.

The FCA regularly gives a little shake of the host/incubator AIFM tree and a few usually fall off (quietly). We are aware of the FCA recently focussing on this again and feel that the FCA may shake the tree harder this time.

"The findings of this review are significant, and we intend to conduct further work to identify whether it is appropriate to make changes to our regulatory framework. Part of that work may involve potential rule changes which would go through the standard consultation processes, separate from this review."

We do not believe, however, that this tree will be cut down.

The FCA grouped its key observations into four main areas:

• Due diligence over delegated third-party investment managers and funds ("overall, firms performed poorly in this area")
• Oversight of delegated third-party investment managers and funds ("a number of firms displayed poor oversight of delegated third-party investment managers".)
• Governance and oversight ("Most firms in our sample had a framework for managing conflicts of interest, but not all appeared effective. … Several host AFMs in the review were unable to show us sufficient evidence that they had identified relevant conflicts of interest despite some appearing obvious.")
• Financial resources ("some host AFMs may not be adequately charging to execute their services effectively", "We are considering whether firms should hold additional capital against the risks they have in their business and will write to firms separately on this, where appropriate"). We have heard anecdotal reports that the FCA is challenging several host AIFMs on this theme.

The review is a good summary of best practice and the FCA's expectations, perhaps best summarised in this extract:

"We sometimes observed AFMs referring to a third-party investment manager to whom they have delegated functions as their 'client'. This is an incorrect description of the relationship anticipated by the regulatory framework."

The EU's cross border distribution of funds (CBDF) directive and regulation

The operative provisions of Directive 2013/36/EU and Regulation 2019/1156 will come into effect on 2 August 2021.

The CBDF directive introduces the following definition of pre-marketing (i.e. promotional activities that do not trigger the notification/registration requirements relating to "marketing" under the AIFMD):

""pre-marketing" means provision of information or communication, direct or indirect, on investment strategies or investment ideas by an EU AIFM or on its behalf, to potential professional investors domiciled or with a registered office in the Union in order to test their interest in an AIF or a compartment which is not yet established, or which is established, but not yet notified for marketing in accordance with Article 31 or 32, in that Member State where the potential investors are domiciled or have their registered office, and which in each case does not amount to an offer or placement to the potential investor to invest in the units or shares of that AIF or compartment;"

The provision of information will not be treated as "pre-marketing" where the information presented to potential professional investors: (a) is sufficient to allow investors to commit to acquiring units or shares of a particular AIF; (b) amounts to subscription forms or similar documents whether in a draft or a final form; or (c) amounts to constitutional documents, a prospectus or offering documents of a not-yet-established AIF in a final form.

The provision of a draft prospectus or offering documents can still be "pre-marketing", provided they do not contain information sufficient to allow investors to take an investment decision and clearly state that: (a) they do not constitute an offer or an invitation to subscribe to units or shares of an AIF; and (b) the information presented therein should not be relied upon because it is incomplete and may be subject to change.

On a strict reading, the new definition of "pre-marketing" should only apply to an EU AIFM that is marketing an EU AIF, although we note that, as the definition is in a directive, EU member states can "gold-plate" this requirement and extend it to non-EU AIFMs and non-EU AIFs.

AIFMs should confirm the position in those EEA member states in which they pre-market. From 2 August, the position might have improved or got worse.

There are various other provisions in the CBDF directive relating to the performance of, and the consequences of, pre-marketing and we would note, in particular, the potentially problematic provision that states: "Any subscription by professional investors, within 18 months of the EU AIFM having begun pre-marketing, to units or shares of an AIF referred to in the information provided in the context of pre-marketing, or of an AIF established as a result of the pre-marketing, shall be considered to be the result of marketing and shall be subject to the applicable notification procedures referred to in Articles 31 and 32".

The CBDF directive also lays down base requirements relating to the de-notification of marketing using the AIFMD's marketing passport and requires an EU AIFM that markets an EU AIF to retail investors to have facilities in the relevant member states that are equivalent to those required for a UCITS.

The CBDF regulation primarily relates to marketing communications by EU AIFMs.

The Chancellor’s 2021 Mansion House speech and the accompanying HM Treasury paper "A new chapter for financial services"

Rishi Sunak, the Chancellor of the Exchequer, delivered the Chancellor's 2021 Mansion House speech on 1 July 2021 and there are some very interesting statements about the UK's post-Brexit regulation of financial services.

"…our ambition had been to reach a comprehensive set of mutual decisions on financial services equivalence [with the EU]. That has not happened. Now, we are moving forward, continuing to cooperate on questions of global finance, but each as a sovereign jurisdiction with our own priorities. We now have the freedom to do things differently and better, and we intend to use it fully."

On the same day, HM Treasury published "A new chapter for financial services", to which the Chancellor refers in his speech. We would recommend reading both the speech and the HM Treasury document in full but, in any event, it is clear that the UK government intends to strike its own regulatory path away from the EU rulebook, whilst assuring us that "the EU will never have cause to deny the UK access because of poor regulatory standards".

The four themes of the vision are for the UK to be: (1) An open and global financial hub; (2) A sector at the forefront of technology and innovation; (3) A world-leader in green finance; and (4) A competitive marketplace promoting effective use of capital.

Some points that we noted in the HM Treasury document were:

• The government's intention to deliver changes to the financial services regulatory framework to reflect the UK’s position outside the EU through the Future Regulatory Framework Review.
• The government agreed an ambitious new financial services partnership between the UK and Singapore on 30 June 2021, which will ensure greater information sharing, closer cooperation in international fora, and increased certainty over firms' access to Singapore's markets.
• The government intends to deliver an outcome-based Mutual Recognition Agreement with Switzerland in order to establish "a ground-breaking system of deference and market access, opening up new opportunities for trade".
• The government intends to deepen the UK's financial services relationships with the largest emerging markets, including China, India and Brazil.
• The government intends to combat greenwashing with common and transparent definitions of sustainable activities and investments and has established the Green Technical Advisory Group to provide advice on the implementation of the UK Green Taxonomy.

Please contact us if you would like to discuss any of the points we have raised in this edition.