Q1 2023 – European Regulatory Update for Funds

Authors: Gregg Beechey and Zac Mellor-Clark

The first quarter of 2023 has already seen a number of regulatory developments that will be relevant for managers active in and marketing into Europe. Highlighted changes include developments on:

• ESG
• the revised Alternative Investment Fund Managers Directive (“AIFMD2”)
• the future of UK financial services regulation (the “Edinburgh Reforms”)
• the Key Information Document (“KID”) required under the Packaged Retail and Insurance-based Investment Products (“PRIIPs”) Regulation.

ESG

The evolution of regulation around environmental, social and governance concerns continues.

All funds managed in or marketed into the EU are subject to the EU Sustainable Finance Disclosure Regulation (“SFDR”), and have for several years been required to prepare (amongst other things) pre-contractual disclosures addressing the extent to which the relevant fund makes sustainable investments.

With effect from 1 January 2023, the SFDR Level 2 Regulation came into force, imposing additional requirements as to the form and content of these pre-contractual, disclosures as well as additional requirements around periodic reporting and the content of the “principal adverse impacts” assessment that certain managers will be required to carry out.

Although this should come as no surprise to managers active in Europe, the new rules are considerably more prescriptive than the rules contained in the Level 1 Regulation and additional thought is likely to be required to ensure compliance.

In addition, in the UK the Financial Conduct Authority (“FCA”) has just closed its consultation on sustainability disclosure requirements (“SDR”) and investment labels as part of the UK’s drive to encourage sustainability and combat greenwashing. The SDR is only a consultation, and it has been subject to extensive industry comment, so it would be premature to summarize the rules that have been proposed at this time, but managers should be aware that from next year, they are likely to face a parallel regime in the UK that is similar, but far from identical, to that in force in the EU.

AIFMD2

Following months of intense negotiation, the European Parliament has reached political agreement on proposed amendments to the EU Alternative Investment Fund Managers Directive (“AIFMD”).

Readers will recall that, in November 2021, the European Commission published its long-awaited legislative proposal to amend the AIFMD. The Commission’s proposals were widely reported by commentators within the industry at the time but, by way of refresher, key proposed amendments included:

• a new loan origination regime for alternative investment funds (“AIFs”);
• more stringent rules around delegation by alternative investment fund managers (“AIFMs”);
• an extension to pre-investment and periodic disclosure requirements;
• new substance requirements for AIFMs;
• flexibility to appoint a depositary in a Member State other than the fund’s home Member State;
• new liquidity management obligations;
• an extension to the “top-up permissions” (i.e., the services an AIFM may perform in addition to fund management);
• an extension to “Annex IV reporting” requirements (i.e., reports submitted by an AIFM to its national competent authority); and
• technical changes to criteria for marketing under National Private Placement Regimes.

These headline changes generally reflected targeted enhancements to the AIFMD rather than wholesale reform, and many of the changes originally proposed have made it through to Parliament’s final text.

Whilst there is disappointment in some quarters about opportunities for reform that seem to have been lost (e.g., the proposed broadening of the “professional investor” definition, which would have facilitated managers’ pushes into retail markets), concerns around some of the original proposals that have survived (e.g., the requirement for a loan originating AIF to retain 5% of the notional value of any loan that they originate and subsequently sell on the secondary market), concern around some proposals that have emerged since the Commission’s original text (e.g., a requirement that where an AIFM manages a fund that is marketed to retail investors, the AIFM must appoint at least one non-executive director to its governing body), and various points to watch (including the mandated publication of certain reports and regulatory technical standards), on the whole, most fund managers are generally relieved with where the Parliament has landed. Particularly those that will recall some of ESMA’s proposals to the European Commission in August 2020 (outlined here in a previous Fried Frank client memorandum).

The process is not however over yet. The next step will be for the European Council, the European Parliament and the European Commission to enter into “trilogue” negotiations. Such negotiations are however expected to commence in short order and progress quickly, with the final AIFMD2 Directive expected to be published later this year and to come into force in 2025.

The Edinburgh Reforms

The "Edinburgh Reforms" refer to a wide-ranging set of regulatory and tax reforms designed to drive growth and competitiveness in the UK financial services sector, as announced by the UK Chancellor of the Exchequer on 9 December 2022.

These reforms are divided into four categories: a competitive marketplace promoting the effective use of capital; sustainable finance; technology and innovation; and consumers and business.

The reforms build on measures being introduced by the Financial Services and Markets Bill due to be introduced in early 2023 which will, amongst other things, repeal EU law relating to financial services.

In December 2022, the UK government also published a policy statement on “Building a smarter financial services framework for the UK,” which stated that the aim of the reforms was to:

“ensure that the UK maintains a coherent, agile, and internationally-respected approach to financial services regulation that supports a thriving financial services sector which contributes to UK’s international competitiveness and economic growth, while providing robust safeguards for consumers, market integrity and financial stability.”

This policy statement identifies 43 “core” files of retained EU financial services law that the government intends to repeal or reform. It intends to carry out the repeal of this legislation by dividing it into a series of prioritized tranches.

Notable changes affecting the financial services sector announced as part of the Edinburgh Reforms include:

UK PRIIPs

The existing PRIIPs regime, criticized by the government as “unnecessarily prescriptive… unhelpful or, worse, misleading…,” will be scrapped and replaced with an alternative disclosure framework for UK retail investors.

A Treasury consultation is currently underway, closing 3 March 2023, with the new regime to be developed and implemented by the FCA. Among other things, the consultation asks about initiatives the government could take to improve retail investor access to investment products from other jurisdictions.

These changes will fall into “Tranche 2,” and significant progress is expected by the end of 2023.

Senior Managers and Certification Regime

There will be a Call for Evidence in Q1 2023 to review the Senior Managers and Certification Regime to look at the legislative framework of the regime, and the FCA and PRA will review the regulatory framework.

There is currently no indication from the government as to what reform will look like in this area, and the review is expected to be an information gathering exercise to garner views on the regime's effectiveness, scope and proportionality, and to seek views on potential improvements and reforms.

ESG and Sustainable Finance

An updated Green Finance Strategy will be published in early 2023. There is little from the government about what this could entail, but it will likely cover further support for the government’s 2050 net zero commitments and potentially further development of the UK taxonomy. Additionally, ESG ratings providers are to be brought into the regulatory perimeter, and a consultation is expected in Q1 2023.

FCA and PRA Remit

There are new remit letters for the PRA and the FCA to introduce new secondary objectives to provide for a greater focus on growth and international competitiveness (particularly in the financial services sector), while maintaining their existing primary objectives. These secondary objectives will include having regard to the government’s “commitment to ensuring that the UK is attractive to internationally active financial services firms and activity.”

Further reforms announced as part of the Chancellor’s speech include:

• Tax reforms aimed at the funds sector (including new REIT tax rules from April 2023).
• Reform of the UK prospectus regime to widen participation in the ownership of public companies, simplify the capital raising process for companies on UK markets and make the UK a more attractive destination for initial public offerings.
• The UK LTIF is being scrapped as no ELTIFs or UK LTIFs were ever launched in the UK, and the government believes that the new UK Long-Term Asset Fund (LTAF) provides a better fund structure for the UK market.
• Wholesale markets reforms, including reform of MiFID II investor reporting obligations in connection with wholesale capital markets.
• Reform of the Consumer Credit Act 1974, currently subject to a government consultation.
• Reform of the ring-fencing regime for banks in 2023.

PRIIPs KIDs

Effective 1 January 2023, Commission Delegated Regulation (EU) 2021/2268 amended the regulatory technical standards (“RTS”) supplementing the PRIIPS Regulation with respect to the presentation, content, review and revision of key information documents (“KIDs”). In addition to requiring KIDs to include additional narrative information on the features and objectives of the relevant “packaged retail investment product” (“PRIP”), the updated RTS sets out new methodologies for the calculation of performance scenarios, changes to the presentation of costs information and new requirements for PRIPs with multiple share classes and/or investment compartments. KIDs in respect of PRIPs which are open for subscription on or after 1 January 2023 are required to comply with these updated requirements.

Changes to the onshored UK version of the RTS, as set out in FCA Policy Statement 22/2, came into effect at the same time, resulting in two distinct forms of KIDs required to be provided to retail investors in the UK and the European Economic Area. The updated form of the UK RTS replaces in its entirety the requirement to calculate and present performance scenarios in percentage terms with a requirement to include a narrative description of the main factors and conditions that will affect the investment performance of the relevant PRIP. As with the updates to the EU PRIIPS regime, KIDs in respect of PRIPs which are open for subscription on or after 1 January 2023 are required to comply with these updated requirements.

Please contact one of the team if you have any questions in respect of the above.