Member Update

ESG Disclosure: Get Preparing

Although a number of asset managers purport that their investment products embrace ESG (environment, social, governance) principles,  EU regulators are now insisting that they be able to prove it. This intervention comes following widespread regulatory and investor concern that some fund managers have been mis-labelling their funds as being ESG-compliant when they are not, a practice otherwise known as greenwashing. In order to put an end to this behaviour, the EU is pushing ahead with its Sustainable Finance Disclosure Regulation (SFDR), which comes into effect from March 2021, and will impose heightened ESG transparency requirements on asset managers.

SFDR in a nutshell

SFDR applies at both an entity and fund level, although larger managers (i.e. those with more than 500 employees) are subject to tougher disclosure requirements. At a firm-level, managers must now provide information on their websites articulating clearly their policies on how they integrate sustainability risks into their investment decision-making process and remuneration practices. At a product-level, there needs to be a pre-contractual disclosure outlining how sustainability risks are factored into investment decisions, along with the potential impact sustainability risks could have on returns. Even if sustainability risks are deemed irrelevant to a product, investment firms must give a comprehensive explanation as to why this is the case. Where firms are promoting ESG products, SFDR will require them to fill in a template in which they mustoutline their sustainability features.

SFDR’s impact will be widely felt

The rules will impact any asset manager currently regulated under the MiFID (Markets in Financial Instruments Directive), AIFMD (Alternative Investment Fund Managers Directive) and UCITS regimes. According to a legal note prepared by Sidley Austin, it also appears that the SFDR (and the Taxonomy Regulation) will simultaneously apply to non-EU AIFMs which are marketing AIFs into the EU through national private placement regimes (NPPRs). “The product-level requirements may also indirectly affect non-EU asset managers that act as delegates of non-EU financial market participants (such as EU AIFMs or UCITS management companies). As such, EU firms are likely to require the information from the non-EU delegate to comply with their own regulatory obligations. That is, a non-EU manager might not have a direct regulatory obligation to prepare the disclosures but might be contractually required by the delegating EU manager to do so,” continued the Sidley Austin briefing.

So what does it mean for UK asset managers post-Brexit? With the UK transition period ending on December 31, EU rules introduced after that date will no longer apply. This will include the SFDR. However, the SFDR is extraterritorial meaning it will affect UK AIFMs distributing AIFs via NPPR. It is also clear that the UK is unlikely to deviate substantially from EU rules, especially if it wants to ensure fund managers can continue to access EU investors in the months and years after Brexit. As a result, most legal experts advise that UK managers prepare for the SFDR or something very similar.

NCI members should be planning for the incoming requirements ahead of their implementation. NCI is conducting a survey of its membership on SFDR, and will be producing a white paper on this topic.

Member Update

Beware the threat to delegation

Having had more than four years to prepare for Brexit, the majority of UK investment firms appear to be in a reasonably robust position to withstand any challenges that may arise. In July 2020, the European Securities and Markets Authority (ESMA) and national EU regulators reiterated that the memoranda of understandings (MOUs) it agreed with the UK Financial Conduct Authority (FCA) on cooperation and information exchange in the event of a no-deal Brexit were still valid. According to ESMA, the MOUs will help facilitate continuity for financial institutions if no UK-EU deal is obtained.

Although fund managers are confident that existing distribution channels will not be disrupted when Brexit takes effect on January 1, there are some more longer-term concerns about the ease in which investment firms will be able to sell into the EU. This trepidation stems in part from a letter penned by ESMA in August 2020. While the bulk of the letter’s contents were not especially controversial or substantive in nature (i.e. calling for greater harmonisation between UCITS and the AIFMD [Alternative Investment Fund Managers Directive]), its comments on delegation elicited criticism.

Delegation is the process whereby an EU entity – known as a ManCo (management company) – outsources investment and risk management activities to a third country manager – enabling them to seamlessly passport or distribute their funds into the EU. For non-EU managers, this allows them to maximise their distribution footprint. It is also one of the reasons why UCITS and AIFMD structures are so universally popular, especially among SME (small to medium sized) asset managers who otherwise would be unable to afford the costs of building up a physical presence inside the EU.

While the ESMA letter did not say it would ban delegation outright, it did acknowledge there were flaws in the model. ESMA accepted that delegation arrangements did generate efficiencies for investment firms but added it “may also increase operational and supervisory risks and raise questions as to whether those AIFs and UCITS can still be effectively managed by the licensed AIFM or UCITS management companies.” ESMA continued there needed to be legal clarification on the maximum extent of delegation that is permitted so as to ensure supervisory convergence and that authorised AIFMs and UCITS management companies maintain sufficient substance within the EU.

Any attempt to impose additional barriers around delegation is likely to frustrate third country asset managers – including those located in the UK post-Brexit, as it could force them to increase their operations and headcount inside the EU at significant cost. In the past, there have been attempts by some member states to restrict delegation but these efforts came to nothing, owing to effective lobbying by industry groups and representatives from onshore fund domiciles such as Ireland and Luxembourg. However, fund managers are under no illusion that future bids to roll back on delegation by European policymakers could potentially gather more momentum over the next 18 to 24 months. As a result, this is an issue, which UK fund managers should be paying close attention to.

Member Update

Well-intentioned but light on substance: The ESMA review of AIFMD

In August 2020, the European Securities and Markets Authority (ESMA) published a letter to the European Commission (EC) outlining its recommendations on future potential amendments to the Alternative Investment Fund Managers Directive (AIFMD). The letter’s contents have yielded a mixed response from the asset management industry. The NCI takes a look at some of ESMA’s proposals.

Greater harmonisation

The lack of harmonisation between UCITS and AIFMD has been a source of frustration at asset managers for a long time. Accordingly, ESMA has asked the EC to align AIFMD and UCITS where possible. ESMA also said there needed to be greater consistency between AIFMD/UCITS and MiFID (Markets in Financial Instruments Directive) to ensure that entities providing similar services are subject to comparable regulatory standards. Again, this is a welcome development for the funds’ industry. Having made improvements to AIFMD’s Annex IV reporting, ESMA also said it was vital that UCITS reporting should now become more harmonised and less duplicative. The lack of reporting standardisation in member states has been a significant barrier for asset managers undertaking cross-border distribution. The implementation of a more homogenised regulatory and reporting regime for UCITS would help provide a much-needed boost to cross-border distribution and sales.

ESMA added there needs to be greater EU-wide consistency on liquidity risk management, an issue which has become more crucial following the Covid-19 crisis. “In ESMA’s view, the EC should take the opportunity to  review the availability of all liquidity management tools outlined in the European Systemic Risk Board’s (ESRB) recommendation A. In addition, the availability of tools should also be included in the UCITS directive.” Among the ESRB’s suggestions were that additional provisions be inserted into AIFMD and UCITS clarifying the roles of regulators when using their powers to suspend redemptions in situations where there are cross-border financial stability implications. For instance, there is still uncertainty as to which regulator is responsible for supervising redemptions and subscriptions– when the fund and its management company are located in different member states.

Delegation in the spotlight

Delegation arrangements at asset managers have been subject to intense scrutiny ever since Brexit. While ESMA accepts delegation promotes efficiency, it warns the practice can increase operational and supervisory risk, especially if more strategic activities take place outside of the EU. In response, ESMA said “further legal clarifications on the maximum extent of delegation would be helpful to ensure supervisory convergence and ensure authorised AIFMs and UCITS management companies maintain sufficient substance in the EU.” Although previous attempts by some member states to limit delegation were rebuffed, it continues to be an ongoing risk for non-EU investment managers.

A damp squib

While advocating for further harmonisation of UCITS and AIFMD is not a bad thing, the ESMA letter is deliberately vague. The section on reverse solicitation simply calls for greater clarity owing to the fact different member states are adopting their own interpretations. This is a sensible recommendation but ESMA provides little detail on how this should be achieved. Similarly, ESMA takes a fairly ambiguous position on the establishment of a pan-EU depositary passport – a topic which has been under discussion since the early 1990s – by  kicking the issue into the long grass. Even though ESMA’s message is generally positive, the letter is extraordinarily light on substance.  

Member Update

Not the time for deviation on ESG standards

Although interest in ESG (environment, social, governance) investing has been gathering momentum for several years now, Covid-19 has accelerated this trend exponentially. Data released by Morgan Stanley shows issuance of social and sustainable bonds topped $32 billion in April 2020, a monthly total surpassing that of green bonds for the first time ever. The market share grab by social bond issuers has been extraordinary, but it is reflective of a wider shift into ESG by investment managers.

The rise of ESG has been organic, fuelled by institutional clients becoming more aware about societal and environmental issues, and who in turn are demanding asset managers plough more resources into ESG investing. It has also been regulatory-led. The EU’s Sustainable Finance Action Plan is widely seen as being a trailblazer on ESG. Assuming deadlines are met, the European Commission has said it wants financial institutions – including fund managers – to be compliant with the new rules by 2021. 

The Brexit effect

Although the UK has said repeatedly that it does not intend to deviate from EU regulations following the Brexit transition, the government has yet to publish comprehensive legislation on sustainable finance, something which could result in ESG requirements coming into force later in the UK than in the EU. A senior official from the Department for Work and Pensions (DWP) also said the extent of the UK’s application of EU directives and regulations – such as the adoption of sustainable finance disclosure rules – would be conditional on the ease of market access following the Brexit transition.

A handful of industry associations are beginning to sound the alarm. The UK Sustainable Investment and Finance Association (UKSIF), a body that represents financial institutions with assets totalling more than £7 trillion, implored the Treasury to outline its regulatory approach on sustainable investing. This comes amid fears the UK is at risk of undermining its reputation as an ESG leader in financial services. Moreover, asset managers with cross border operations have warned they could face added costs if the UK develops ESG regulation that does not correspond with the EU’s rules. 

Standards correspond with success

The Treasury’s plans are not yet known , but it has said that more information about its ESG disclosure regime will be released in due course. The issue of the UK arbitraging with the EU is worrying, particularly on ESG standards. Right now, ESG standards are a mess, mainly because so many bodies and associations (albeit good-intentioned) have developed their own, customised standards. In addition, different regulators are pursuing their own ESG regimes, further complicating the process.  All of these conflicting rules are going to prove incredibly confusing for global investors. 

A failure to develop harmonised, sensible and easy to understand standards will undermine regulatory efforts to stamp out green-washing and ESG mis-selling, an issue which is likely to become more prevalent moving forward. It is vital that regulators and industry bodies communicate with each to create common standards to preserve the integrity of the rapidly-growing ESG market.