Welcome to the latest edition of our Asset Management and Investment Funds Legal and Regulatory Update.
This issue includes updates on the Central Bank's financial conduct priorities for 2020, a round-up of some recent ESG legislative developments, the Central Bank's recent clarifications on its index confirmation requirements for UCITS, and IOSCO's proposed framework for measuring leverage in investment funds.
If you would like to discuss any of the topics covered, please feel free to contact a member of our team.
Central Bank Outlines its Financial Conduct Priorities for 2020
Speaking at an ACOI event on 15 January 2020, Derville Rowland the Central Bank's Director General, Financial Conduct, provided an overview of some key cross-sectoral priorities for financial conduct supervision, enforcement and policy throughout 2020. Key matters of relevance for funds include:
Funds Specific Actions
- The Central Bank will be focussing on the completion of its CP86 reviews and liquidity management. The Central Bank is working closely with ESMA to complete a common supervisory action on liquidity management in UCITS.
- The Central Bank will also be commencing a review of UCITS' use of securities lending.
Please see our November e-zine for a more detailed update on the Central Bank's supervisory priorities for the funds sector.
- Transaction monitoring and risk assessments will be among the AML supervisory priorities for the Central Bank in 2020. The Central Bank will be examining the design and operation of firms' business risk assessments and firms are encouraged to have regard to the Central Bank's AML Guidelines in the design and operation of these frameworks.
- The Central Bank will also be focusing on Schedule 2 firms, who are reminded that failure to register with the Central Bank for anti-money laundering purposes is a criminal offence. For more information on the registration requirements for Schedule 2 firms, please see our previous client briefing.
- Senior Executive Accountability Regime ("SEAR"): The Central Bank will continue to work with the Department of Finance to develop legislation to introduce this regime, which will place obligations on firms and senior individuals within firms to set out clearly where responsibility and decision-making lies. For more information on the SEAR proposals, please see our Financial Regulation Group's article.
- Climate Change/Sustainable Finance: Now that the regulation on disclosures relating to sustainable investments and sustainability risks (Disclosure Regulation) has entered into force, it is likely that ESMA will consult on these disclosure requirements in Q1 2020.
Central Bank Clarifies UCITS Index Confirmation Requirements
The Central Bank has clarified that where a UCITS proposes to use an index for which there is no requirement to submit an index certification, a confirmation that the proposed index meets the regulatory requirements must be provided:
- at the authorisation stage, where the index is required to be referenced specifically within the fund's prospectus; and
- post-authorisation, a confirmation is only required where an index that required confirmation as part of the initial authorisation process is changed.
The Central Bank has reiterated that where an index requires certification, the UCITS, at all times, may only gain exposure to that index after the relevant certification has been submitted to the Central Bank. The responsible person must determine whether a certification or confirmation is relevant to the particular index.
On 23 July 2019, the Central Bank issued updated guidance amending its UCITS index certification process and clarifying when an index certification is not required to be submitted. Where a certification is not required, a confirmation that the proposed index meets the regulatory requirements must be provided as outlined above.
An index certification is not required where:
- the index is used for tracking or replication, investment or efficient portfolio management purposes and on a look-through basis the UCITS could invest directly in the constituents of the index/indices as permitted under the UCITS Regulations (for example, the "5/10/40" rule);
- market movements or other events may cause the weightings of a financial index to change so that it no longer complies with the "5/10/40" rule. Where this happens and on the basis that the UCITS confirms as part of its authorisation/post authorisation process that the index meets the regulatory requirements (i.e. it is comprised of eligible assets and complies with the "5/10/40" rule), the financial index will be deemed to meet index criteria set out in the Guidance; or
- an index is used solely as a performance benchmark.
For more information, please see our previous client briefing.
December 2019 saw a number of ESG-related developments, which are summarised below.
Taxonomy Regulation Politically Agreed
In December 2019, political agreement was reached between the European Parliament ("Parliament") and European Council ("Council") on an EU-wide classification system, or "taxonomy", which will create a unified classification system on what can be considered an environmentally sustainable activity ("Taxonomy Regulation").
A core objective of the Taxonomy Regulation is to reduce "greenwashing", which is the practice of marketing financial products as green or sustainable, when in reality they do not meet basic environmental standards.
The future framework will based on six EU environmental objectives:
- climate change mitigation;
- climate change adaptation;
- 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.
In order to qualify as environmentally sustainable, economic activities will have to fulfil the following requirements:
- contribute substantively to at least one of the six environmental objectives listed above;
- not significantly harm any of the environmental objectives;
- be carried out in compliance with minimum social safeguards; and
- comply with specific 'technical screening criteria'.
The taxonomy will also include two sub-categories of "enabling" and "transitional" activities. There will be an obligation to disclose for each financial product the proportion invested in those enabling and transitional activities.
The European Commission will be tasked with establishing the actual classification by defining technical screening criteria, in the form of delegated acts, for each relevant environmental objective and sector respectively.
The taxonomy for climate change mitigation and climate change adaptation should be established by the end of 2020, in order to ensure their full application by end of 2021. For the four other objectives, the taxonomy should be established by the end of 2021 for an application by the end of 2022.
The next step is for the Taxonomy Regulation to be formally adopted by the Council and the Parliament.
Disclosure Regulation Enters Force
On 29 December 2019, the regulation on disclosures relating to sustainable investments and sustainability risks ("Disclosure Regulation") entered into force. The Disclosure Regulation applies to financial market participants ("FMPs"), which includes AIFMs, UCITS management companies and self-management investment companies, and introduces disclosure and transparency requirements in the form of website, pre-contractual, and periodic accounts disclosures. FMPs will also have to disclose how their remuneration policies take the integration of sustainability risks and sustainable investments into account. The Disclosure Regulation will apply from 10 March 2021, with the requirement for the annual accounts disclosure applying from 1 January 2022.
ESMA Proposes Strengthened Rules Addressing Undue Short-termism in Securities Markets
Under the Action Plan 'Financing Sustainable Growth', the European Commission ("Commission") invited the three European Supervisory Authorities ("ESAs") to each develop a report presenting evidence and possible advice on potential undue short-termism. In its call for advice, the Commission asked the three ESAs to investigate potential sources of undue short-termism on corporations from the financial sector and provide advice on areas which regulators should address. On 18 December 2019, ESMA published the findings, which include recommendations to the Commission for action in key areas, such as the disclosure of ESG factors and institutional investor engagement.
In preparing its findings ESMA considered:
- investment strategy and investment horizon;
- contribution of disclosure of ESG factors to long-term investment strategies;
- role of fair value in better investment decision-making;
- institutional investor engagement;
- remuneration of fund managers and corporate executives; and
- use of Credit Default Swaps ("CDS") by investment funds.
Regarding fund manager remuneration, ESMA did not recommend immediate legislative action. Rather, it advised that the Commission should monitor the effect of the Disclosure Regulation, which requires UCITS ManCos and AIFMS to disclose information in their remuneration policies on how those policies are consistent with the integration of sustainability risks before assessing a potential need for further regulatory amendments to address potential undue short-termism.
The review of the use of CDS by UCITS funds was prompted by empirical evidence suggesting that the potentially elevated use of CDS by a portion of UCITS funds may lead to excessive risk taking and focus on short-term results. In this regard, ESMA stated that while concerns about potential tail risk in UCITS funds holding sell only or net sell CDS positions may be warranted, it did not find sufficient grounds to recommend specific policy measures on CDS use by investment funds in the context of its short-termism advice.
Handbook on Climate Benchmarks and Benchmarks' ESG Disclosures
On 20 December 2019, the EU technical expert group on sustainable finance ("TEG") published a handbook on climate benchmarks and benchmarks' environmental, social and governance (ESG) disclosures. The handbook aims to answer frequently asked questions that have been asked of the TEG and covers among other things: terminology and related classifications; anti-greenwashing measures; and ESG disclosures.
On 20 December 2019, the FCA published details of the implications for financial services regulation if the UK leaves the EU with a withdrawal agreement on 31 January 2020 and consequently the UK enters into a transition period until at least 31 December 2020.
The FCA notes that during the transition period EU law will continue to apply in the UK. This means that passporting will continue and new EU legislation that takes effect before the end of the transition period will also apply to the UK.
The FCA expects firms to consider how the end of the transition period will affect them and their customers, and what action they may need to take to be ready for 1 January 2021.
No-deal Brexit: ESMA Extends Recognition Decisions for 3 UK CCPs
In February 2019, to limit the risk of disruption in central clearing in the event of a hard-Brexit, ESMA adopted decisions to recognise three UK established central counterparties ("CCPs") as third country CCPs under Article 25 of EMIR. LCH Limited, ICE Clear Europe Limited and LME Clear Limited have been recognised to provide their services in the EU in the event of a no-deal Brexit. On 23 December 2019, ESMA announced that it had extended the recognition decisions for these three CCPs.
This follows the European Commission's extension of its temporary equivalence decision ("Decision") granted in respect of the UK's regulatory framework for central counterparties under EMIR, which was due to expire on 30 March 2020. This Decision permits ESMA to temporarily recognise UK CCPs to allow these CCPs to continue to provide clearing services in the EU for a limited period after a no-deal Brexit. In a no-deal Brexit scenario, the Decision will expire on 31 January 2021. The Decision does not apply if a withdrawal agreement is agreed.
ESMA also issued a statement noting that the date for Brexit in all of ESMA's previously published measures and actions, including public statements, issued regarding the possibility of a no-deal Brexit scenario, should now be read as 31 January 2020.
IOSCO Launches Framework for Monitoring Leverage in Investment Funds
In January 2017, the Financial Stability Board issued a report, "Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities", which included policy recommendations to address risks to global financial stability associated with certain potential structural vulnerabilities that may result from asset management activities. Recommendation 10 of that report, required IOSCO to:
"identify and or develop consistent measures of leverage in funds to facilitate more meaningful monitoring of leverage for financial stability purposes, and help enable direct comparisons across funds and at a global level. [IOSCO should also] consider identifying and/or developing more risk-based measure(s) to complement the initial measures with a view to enhance authorities' understanding and monitoring of risks that leverage in funds may create. In both cases, IOSCO should consider appropriate netting and hedging assumptions and where relevant build on existing measures."
Accordingly, in November 2018, IOSCO consulted on a two-step framework to help assess leverage used by investment funds. The consultation closed on 1 February 2019 and on 13 December 2019 IOSCO published its final report setting out recommendations for this "two-step" framework for assessing leverage in investment funds that may pose stability risks.
- Step 1 indicates how regulators could exclude from consideration funds that are unlikely to produce financial stability risks, while identifying a subset of funds for further analysis that may pose such risks; and
- Step 2 consists of a risk-based analysis of the subset of funds identified in step 1. A set of tools for each step is offered, which can be adjusted to the needs of a jurisdiction and the characteristics of funds.
IOSCO recommends that regulators use the framework as a basis for their assessment of leverage-related risks in funds.
IOSCO intends to publish an annual report reflecting leverage trends within the asset management industry at the global level, with the first report scheduled to be published in 2021.
ESMA's Strategic Priorities for 2020-2022
ESMA has published its strategic plan for the next three years, which will see an increased focus on supervisory convergence and investor protection. ESMA will also carry out a number of activities reflecting its new responsibilities and powers granted following last year's review of the European Supervisory Authorities.
ESMA's strategic priorities include:
- Supervisory Convergence: ESMA will work with national regulators to significantly enhance its risk-based approach to supervisory convergence by focusing on supervisory outcomes and using convergence tools such as common supervisory actions and more effective peer reviews. Regarding peer reviews, ESMA intends to increase the number of reviews and these will be more outcome-focused with emphasis being placed on the effectiveness of supervisory and enforcement actions taken;
- EU Supervisory Handbook: In conjunction with national regulators, ESMA intends to develop a principles-based Supervisory Handbook. ESMA states that it will phase-in the development of the handbook by prioritising areas where there is an urgent need for enhanced coordination;
- Equivalence: ESMA will undertake new tasks for third-country equivalence assessments including monitoring regulatory and supervisory developments in equivalent third countries, and assisting the European Commission in preparing equivalence decisions; and
- Promoting Sustainable Finance.
This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.