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Five by Five is a short summary of the key developments that we have been discussing with our fund clients over the last few months.
This edition covers; ESG and the EU's Sustainable Finance Disclosures Regulation; HM Treasury's review of the UK funds regime; and the improvements to the Irish Investment Limited Partnership.
ESG
Across Europe, governments are introducing ambitious targets to encourage society to adopt environmental, social and governance (ESG) measures, principally to transition to a low carbon economy.
Despite the economic downturn caused by the Covid-19 pandemic and the varied response to climate change across developed economies, ESG is not just a fad that will continue to require organisations to change their approach to business.
ESG is becoming more pertinent for businesses as governments ramp up their green agenda. One sector that will see greater scrutiny over the coming months is financial services, where both the UK and Europe are proposing changes to existing legislation and new legislation to address ESG in financial markets and products.
In December, Fieldfisher launched its 'ESG in Finance' paper which looks at the background to ESG in financial services, where legislation and regulation is heading and touches on what clients need to be thinking of in the coming months. This report focuses on how financial organisations can adopt ESG practices and contribute to helping the world achieve a low carbon economic future.
Recently, we released "Sustainable Finance: the loan market’s hot topic – what does it mean for real estate finance?" and "Turning the world from brown to green - the ESG revolution"
SFDR
On 10 March 2021, the EU's regulation on sustainability‐related disclosures in the financial services sector (the "SFDR") started to bite.
Before that, as of 11pm on 31 December 2020, the European Union (Withdrawal) Act 2018 on-shored EU law (to the extent not EU-derived in directives and extant in English law) and so many of the sources of law are now different from those we are accustomed to advising on even if, for the most part, there is no substantive difference.
11pm on 31 December 2020 marks the time from which UK law can start to diverge from EU law. Only those EU laws that were fully in effect by this time have been on-shored. EU laws that were not fully in effect by this time were not on-shored and technically the UK can decide whether or not to implement equivalent laws under UK law.
A good example of EU law that is caught up in this scenario is the SFDR and the UK may or may not implement equivalent UK laws. UK "financial market participants" will be treated as non-EU ("third country") entities.
The extent to which the SFDR applies to non-EU entities is still not 100% clear.
In an official document called "Frequently Asked Questions about the work of the European Commission and the Technical Expert Group on Sustainable Finance on EU Taxonomy & EU Green Bond Standard" the EU Commission states: "The disclosure obligations for financial market participants in the Taxonomy Regulation apply to anyone offering financial products in the EU, regardless of where the manufacturer of such products is based."
The Taxonomy Regulation is very closely linked to the SFDR but there is no equivalent guidance for the SFDR.
Potentially, the SFDR could apply in full to:
(i) non-EU AIFMs that market funds in the EU;
(ii) non-EU managers that manage the portfolio of an EU client; or
(iii) non-EU advisers that provide investment advice an EU client.
Solely based on the wording of the SFDR, however, there is less scope to argue that non-EU AIFMs that market funds in the EU are not caught by the SFDR. It may turn out, however, that such non-EU AIFMs will only have to amend the AIFMD wrapper to the relevant funds' offering documents (the AIFMD Article 23 disclosure document) or the relevant funds' offering documents.
In any event, non-EU persons will need to check the local laws of each EU jurisdiction that is relevant in order to confirm the precise application of the SFDR to them as some EU jurisdictions may expressly apply SFDR requirements to non-EU entities. Also, EU investors may simply expect the non-EU managers with which they invest to comply with the SFDR.
The main requirements of the SFDR that started to apply from 10 March, are manager-level disclosures (which are required to be on the manager's website) and product-level disclosures (which, in the case of an AIF, are required to be in the AIF's offering documents or the AIFMD wrapper). Information relating to ESG-focussed funds will need to be on the website and in the fund's disclosure documents.
The manager-level disclosures for the website include:
- information about their policies on the integration of "sustainability risks" (defined) in the investment decision-making process;
- a statement on due diligence policies with respect to "principal adverse impacts" (not defined) of investment decisions on "sustainability factors" (defined) or, where such impacts are not considered, clear reasons for why they do not do so (NB further legislation is really required to clarify this obligation); and
- information on how their remuneration policies are consistent with the integration of sustainability risks.
The fund-level disclosures for the fund disclosure documents include:
- information on the transparency of the integration of sustainability risks (discussed further below)
- extra information for certain funds that promote environmental or social characteristics ("Article 8 Funds");
- even more information for any fund that has "sustainable investment" (defined) as its objective ("Article 9 Funds").
Sustainability risks
"Sustainability risk" means an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment.
Article 3(1) of the SFDR provides:
"Financial market participants shall publish on their websites information about their policies on the integration of sustainability risks in their investment decision‐making process."
Article 6 of the SFDR provides:
"Financial market participants shall include descriptions of the following in pre‐contractual disclosures:
(a) the manner in which sustainability risks are integrated into their investment decisions; and
(b) the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available.
Where financial market participants deem sustainability risks not to be relevant, the descriptions… shall include a clear and concise explanation of the reasons therefor."
Recital (15) of the SFDR adds the following guidance: "Where the sustainability risk assessment leads to the conclusion that there are no sustainability risks deemed to be relevant to the financial product, the reasons therefor should be explained. Where the assessment leads to the conclusion that those risks are relevant, the extent to which those sustainability risks might impact the performance of the financial product should be disclosed either in qualitative or quantitative terms."
In this edition, we will focus on Articles 3 and 6 for three reasons: they are the obligations that do not need further legislation to clarify them; they are of most pressing relevance to non-EU managers; and they are a good entry point to the colossal topic of ESG.
The definition of "sustainability risk" will only include an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment but it is still a challenge to consider all relevant "environmental, social or governance events or conditions".
There is no definition of this phrase. One can get some guidance by reverse engineering the definitions of "sustainable investment" and "sustainability factors". There is a bit of guidance in the EU's Taxonomy Regulation (but this only really deals with the "E" of "ESG"). You can also get some excellent guidance from the UN Principles for Responsible Investment, the FSB Taskforce on Climate-Related Financial Disclosure (TCFD) and the World Economic Forum's Global Risk Reports etc.
It is, however, extremely difficult to note all the risks. We put together a long list of risks that could be considered, ranging from climate change to cyber security. The size of the topic of ESG is quite scary (and the risks covered by the topic are scarier!). Does a manager have to use a third-party's ESG compliance solution or can it create its own policy? Can the risks ever be boiled down or organised in a way that can be put into practice?
Is that the real point here? Legislators around the world do not want ESG obligations to be a tick-box exercise: they want to make investors and managers think about their specific circumstances and realise the importance of ESG risks, their exposure to ESG risks and their contribution to ESG risks.
The EU legislation marks the first legislative effort to codify and embed ESG considerations and concepts in the context of fund managements. It will only get more detailed from now but will hopefully not result in over-standardisation and a tick-box exercise.
Recent Developments
On 4 February 2021, the Joint Committee of the three European Supervisory Authorities (the ESAs: EBA, EIOPA and ESMA) delivered to the European Commission (EC) their Final Report, including the draft Regulatory Technical Standards (RTS) which provide extra details on the content, methodologies and presentation of disclosures pursuant to Article 2a(3), Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of the SFDR.
On 25 February 2021, the ESAs published a joint supervisory statement on the effective and consistent application and national supervision of the SFDR. The statement aims to achieve an effective and consistent application and national supervision of the SFDR.
In the statement, the three ESAs recommend the draft RTS be used as a reference when applying the provisions of the SFDR in the interim period between the application of SFDR (as of 10 March 2021) and the application of the RTS at a later date. The ESAs have proposed in the draft RTS that the application date of the RTS should be 1 January 2022.
Helpfully, the ESAs have also set out in an Annex to the joint statement more specific guidance on the application of timelines of some specific provisions of the SFDR. The Annex also includes a summary table of the relevant application dates of the SFDR, the Taxonomy Regulation and the related RTS and is recommended as an excellent point of reference.
We will return to ESG and the SFDR in future alerters.
Review of the UK funds regime: A call for input
HM Treasury released the call for input in January 2021. Responses are due by 20 April 2021.
It is enormously encouraging that the call for input was released so soon after the end of the Brexit Implementation Period. This makes us optimistic that the government is motivated to make changes to enhance the UK’s attractiveness as a location for funds and their managers.
We were particularly interested in the parts relating to UK limited partnerships and Qualified Investor Schemes; the proposed Long-Term Asset Fund; and proposals for UK authorised funds aimed only at professional investors. The latter has been a pipe dream of the UK alternative fund industry for years. There are a number of tricky issues (including tax) to work through but we really do feel optimistic that it looks like it is going to happen this time. Over the next few years, we may see UK-domiciled managers of UK-domiciled hedge funds…or the Unauthorised Professional Fund of the United Kingdom may end up being an 'UPFUK'.
The Irish Investment Limited Partnership
After a number of years of discussion, Ireland has recently made several improvements to its Investment Limited Partnership vehicle (ILP).
The improvements include the introduction of several safe harbours for LPs, allowing them to participate in advisory committees, vote on changes to the LPA and engage in other related activities without losing their limited liability status. The improvements generally seek to permit the ILP to have the standard features of a typical closed-ended limited partnership fund (such as a Private Equity or Real Estate fund) and, amongst other things, allows an ILP to be established as an umbrella fund, with segregated liability between sub-funds.
The ILP is Ireland's answer to Luxembourg's RAIF limited partnership offering, although there are differences. For example, the ILP is itself authorised whereas the RAIF is not, although the RAIF needs to have an EEA authorised AIFM whereas the ILP does not.
In any event, the Luxembourg offering has been the dominant closed-ended EEA fund vehicle used to access EEA investors via the AIFMD's marketing passport for about five years. Against this backdrop, it will be interesting to see how ILP performs.
We understand that Ireland is also looking into updating the rules relating to unregulated limited partnership structures.
Derivatives
In case you missed, it our Derivatives team released "Derivatives Alert: Alternatives to Cash Price under the ISDA Definitions: will the ISDA 2021 Definitions finally solve the issues?"
Please contact us if you would like to discuss any of the points we have raised in this edition.