Private funds regulatory update

As previously reported, the European Commission (the Commission) is seeking responses to its long-awaited consultation on the review of Directive 2011/61/EU (the AIFMD). The consultation takes the form of a questionnaire and seeks the views of stakeholders on several areas where the Commission considers that the AIFMD framework could be improved. The consultation is open for responses until 29 January 2021.

Key areas of interest for private fund managers

• Investor protection: interestingly, the EU raises questions on how the AIFMD framework can be amended to improve AIFM access to retail investors, which appears to be in line with the points raised in the Commission’s MiFID/MiFIR review, as reported on in our May briefing. In addition, the Commission notes that the introduction of a depositary passport would be desirable, but invites other solutions which could address the issue of the short supply and concentration of depositary services, which will be potentially welcome news to private fund managers.
• International issues: the Commission seeks views on how the EU AIF market could interact with international partners and focuses on the appropriateness of the AIFMD third country passport and delegation rules. Importantly for private fund managers:
  • the European Commission invites views on national private placement rules in the EU and whether they create an uneven playing field between EU and non-EU AIFMs. No further substantive information is given on this but given the variety of national private placement rules across the EU, one can imagine this being an area of regulatory focus in the future; and
  • the efficacy of the AIFMD delegation rules are questioned, including whether they are sufficient to prevent the creation of letter-box entities and to ensure effective risk management. Notably, many of the questions (for example, whether or not the current delegation rules should be “complemented” with other criteria) suggest that the European Commission is looking to make the AIFMD delegation rules more restrictive. Inevitably, this could have a significant impact on the structures of both UK and EU private funds.
• Investing in private companies: targeted seemingly specifically at private equity funds this section questions whether the rules in Section 2 of Chapter V of the AIFMD are (amongst other things) adequate and proportionate. The Commission notably questions not only whether the asset stripping rules are necessary, effective and proportionate but equally whether they can be improved, again suggesting that this could be an area of regulatory focus in the future.
• Sustainability/ESG: the Disclosure Regulation requires AIFMs to integrate an assessment of all relevant sustainability risks which might have a material negative impact on the financial return of an investment or advice in their processes. However, AIFMs are not currently required to integrate the quantification of sustainability risks under AIFMD itself. The consultation therefore seeks views on whether AIFMs should be required to quantify sustainability risks and seeks views on whether AIFMs should be required to look beyond what is required in EU law in respect of sustainability-related impacts when considering investment decisions. This seems to imply that the European Commission may look to impose even stricter ESG requirements in the EU AIF market in the not too distant future.

Only a few months remain until the EU Disclosure Regulation (Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector (SFDR)) comes into force, bringing into effect a swathe of sustainability-related transparency and disclosure requirements. The SFDR will only apply to private fund managers that operate or market their funds in the EU and will not be onshored in the UK.  Firms and funds which are in scope of SFDR will need to comply with the requirements by 10 March 2021. We have summarised below what private fund managers should be doing at this stage given the current regulatory agenda and pressure on firms to demonstrate their ESG approach. 

• Establish firm-level response to SFDR: the extent of a firm’s compliance with the SFDR requirements will depend on several factors, such as the firm’s upcoming fundraising and marketing activities, its current and prospective demographic of LPs, and, where applicable, its group strategy to sustainable investing. Firms should be well on their way to establishing whether and how they will comply with SFDR at firm and fund level.
• Review and update internal policies and processes: investment processes, risk policies and remuneration policies may need amending to align with the firm’s ESG aspirations. Firms should be identifying any relevant gaps in their current approach and planning the steps necessary to integrate their ESG ambitions across their business and operating models. 
• Determine data sources: firms reporting on the principal adverse impacts of their investment decisions on “sustainability factors” or disclosing prescribed information on “Article 8” or “Article 9” funds should be determining the process for gathering and monitoring necessary data to ensure this information is suitably disclosed.
• Prepare website disclosures: in-scope firms should be preparing suitable disclosures on how they integrate “sustainability risk” (including how its remuneration policy is consistent with its approach) and consideration of principal adverse impacts on “sustainability factors”. Firms managing or marketing “Article 8” or “Article 9” funds should be gathering the prescribed information to make website disclosures on these products whilst considering any marketing issues in doing so.
• Review and update fund documents: in-scope firms should be considering how best to incorporate the mandatory pre-contractual disclosures in offering documents, particularly for new funds being raised, considering timings and any notification requirements.

Comment

The broad scope and extraterritorial application of SFDR mean that many private fund managers will be pulled in scope of the SFDR requirements either as a direct legal obligation or owing to commercial pressures from their investor base. Firms should continue to monitor the EU and local regulatory requirements which may affect marketing and fundraising activities and be adaptable in integrating ESG in investment processes as ESG rises up LPs’ agendas. 

The FCA

The FCA set up a dedicated webpage providing firms with information about its response to Covid-19. The below will be of particular interest to private fund managers.

• FCA’s expectations for funds: the FCA has set out its guidance and temporary measures in light of Covid-19. This includes guidance for firms holding client money and/or custody assets in accordance with CASS and temporary flexibility on portfolio management firms making 10% depreciation notifications.
• Workplace arrangements: for financial services firms, the FCA expects the chief executive officer senior management function (SMF1) or, where a firm does not have an SMF1, the most relevant member of the senior management team to be accountable for ensuring adequate procedures are in place for complying with the government guidance.
• LIBOR: while the FCA has considered the impact of Covid-19 on LIBOR transition and acknowledged that the present situation poses challenges to firms’ transition plans, there is no change in the timetable for the phasing out of LIBOR. We consider the implications of LIBOR transition in greater detail below.
• SMCR: in response to Covid-19, the FCA has confirmed that the deadline for certification for solo-regulated firms in relation to SMCR has been postponed from 9 December 2020 to 31 March 2021.
• Approved Person Regime: the FCA has set out its expectations for benchmarks administrators and firms using Appointed Representatives during the pandemic. It has also issued a direction modifying the consent period for temporary arrangements for controlled functions from 12 weeks to 36 weeks.
• Culture: the culture of firms remains a key priority for the FCA during the pandemic, and it considers that firms require purposeful leadership which will introduce strategic and cultural change to respond to the challenges posed by Covid-19.
• Financial resilience: the FCA is asking a number of firms to complete a survey to help it obtain a more accurate view of firms’ financial resilience as a result of the Covid-19 pandemic.
• Regulatory change: while the FCA continues to face significant challenges from the pandemic, it recognises that it must not lose sight of long-running ESG issues that are reshaping financial services, including gaps between generations in terms of wealth and opportunity, increasing pressure on the financially vulnerable, the growth of big data and climate change.
• Market abuse: in a speech on market abuse, the FCA has reiterated the importance of firms adapting their processes so that they are aligned with the risks caused by Covid-19 and to ensure that suspicious transaction and order reports continue to be submitted where relevant.
• Handling of complaints: the FCA considers that firms have had enough time to implement new working practices and so delays in responding to complaints should only occur because of exceptional circumstances related to Covid-19.
• Continuing Professional Development (CPD): the FCA expects firms to ensure that effective and consistent CPD measures are in place, but is allowing firms to defer individuals’ CPD to the next CPD year.
• UK Corporate Insolvency and Governance Bill: the FCA has issued a statement on the provisions in the Bill for the financial services sector which it considers necessary to protect consumers and financial stability. It notes that some measures, such as a company moratorium and a suspension of termination clauses will not be available for some financial services firms and contracts.
• Professional Indemnity Insurance (PII): the FCA reiterates that firms need to have PII policies in place in accordance with its rules to support their ability to meet liabilities as they fall due and protect consumers, notwithstanding that the pandemic may affect a firm’s ability to renew its PII in a timely manner.
• Wet ink signatures: as we discuss in further detail in our briefing, the FCA has clarified that it does not require wet-ink signatures in agreements, and that it will accept electronic signatures from firms for all interactions with it. However, it stresses that firms should consider the legal position on the validity of electronic signatures.
• Listed companies and recapitalisation issuances: the FCA has introduced a series of measures to assist companies with raising new share capital, while also protecting investors. These include measures on smaller share issues, shorter form prospectuses, working capital statements and general meeting requirements.

ESMA

In response to Covid-19, ESMA have adapted their existing work programme and have also taken new regulatory action. We have been tracking the latest developments and summarise below key areas of interest.

• CSDR settlement discipline: on 28 August 2020, ESMA published its final report on draft regulatory technical standards postponing the date of entry into force of the CSDR settlement disciple regime by a year until 1 February 2022.
• Short selling: on 16 September 2020, the ESMA issued a decision renewing its original decision on 16 March 2020 temporarily to amend the threshold for notifying net short positions to Competent Authorities under the Short Selling Regulation (SSR) from 0.2% of issued share capital to 0.1%. This decision will apply from 18 September 2020 for a period of three months.
• Stress testing: in August 2020, ESMA reviewed the scenarios envisaged in its 2019 guidelines on stress test scenarios under the Money Market Funds Regulation in light of Covid-19. ESMA confirmed that the guidelines will be updated in 2020 to include a modification of the risk parameters to reflect extreme market movements related to Covid-19. ESMA is due to publish the 2020 update of the guidelines shortly and the updated guidelines will apply from two months after the publication of the translations. Separately, ESMA’s guidelines on liquidity stress tests of investments funds (applicable to AIFs and UCITS) became applicable on 30 September 2020. These guidelines require fund managers to stress test the assets and liabilities of the funds they manage, which includes redemption requests by investors.
• ESMA 2021 annual work programme: on 2 October 2020, ESMA published its work programme for 2021, setting out its priorities and areas of focus for the next 12 months in support of its mission to enhance investor protection and promote stable and orderly financial markets. ESMA's key priorities in 2021 are:
  • supervisory convergence and building an EU common risk-based and outcome-focused supervisory culture;
  • integrating the new focus on financial innovation and ESG into its risk analysis, providing data for risk-based supervision and supporting policy;
  • contributing to the legislative reviews of MiFID and AIFMD and assessing whether changes to the rulebook are needed to develop the Capital Markets Union, enhance the attractiveness of EU capital markets, and/or to promote sustainable finance or proportionality; and
  • direct supervision of third country central counterparties as critical financial market infrastructures and preparing for the new supervisory mandates regarding benchmarks and data service providers.

As we approach the end of the Brexit transition period, private fund managers are keen to understand the contours of the UK’s regulatory regime following 31 December 2020. This is not least because, in the past few months, there have been a number of developments which will help to shape this regulatory architecture.

Whilst these changes clearly have an impact across the entire financial services industry in the UK, there are a number of developments which will have a particular impact on private funds and their managers.

Speech by the Chancellor of the Exchequer

On 9 November 2020, Rishi Sunak, the Chancellor of the Exchequer gave a speech in the House of Commons on the future of the UK financial services industry. We have already reported on this in more depth but, for private fund managers, the key takeaways are highlighted below.

• Equivalence: the Chancellor announced that HM Treasury had made a series of equivalence decisions, which will be welcome to financial markets participants in that they provide more certainty in financial markets post-31 December 2020. Notably for private funds:
  
  • one of these equivalence decisions (The European Market Infrastructure Regulation (Article 2A) Equivalence Directions 2020) enables UK private funds to continue to treat derivatives traded on EEA regulated markets as exchange-traded rather than OTC; and
  • another equivalence decision (The Central Counterparties (Equivalence) Regulations 2020) provides a framework, provided that certain regulatory hurdles (such as appropriate cooperation arrangements) are met, for the use by UK private funds of EEA central counterparties following the end of the transition period.

Both of these equivalence decisions will be welcome to UK private funds which have EEA derivatives exposures, whether for investment or hedging purposes.

• Climate change: the Chancellor announced that the UK would mandate climate disclosures by financial institutions by 2025 and that it would be implementing a ”green taxonomy”. It is yet to be seen how this will have an impact directly on private funds and their disclosures but this could lead to a significant increase in the disclosure obligations of portfolio companies. Nonetheless, as ESG considerations become more and more significant for private fund investments, it should help to ensure greater visibility for private funds at the start of the lifecycle of investment.

The “Future Regulatory Framework” 

HM Treasury published, on 19 October, Phase II of its consultation on the Future Regulatory Framework (FRF) which seeks to set out a high-level blueprint for financial services regulation in the UK. This consultation will be followed by a second consultation in 2021 with a more finalised set of proposals.

Perhaps the most important change proposed is that in terms of the powers of the FCA and the PRA. The consultation notes that, historically, EU financial services regulation has been implemented in law (rather than, for instance, by regulator’s rules). Whilst this EU law has been carried across into the statute book by virtue of the European Union (Withdrawal) Act 2018, the consultation notes that this could lead to an inflexible, fragmented and inefficient regime, unable to benefit fully from the expertise of the FCA and the PRA.

In response to this, the consultation proposes, broadly speaking, the delegation of responsibility for financial services regulation to the FCA and PRA, with the “vast bulk” of retained EU law being transferred to the FCA Handbook and the PRA Rulebook. As HM Treasury notes, this dovetails with the approach taken in the Financial Services Bill 2019/21 (please see below) where broad powers are given to the UK financial services regulators. This approach can also be seen in a recent speech by Sam Woods, CEO of the PRA, on which we commented.

Clearly, it remains to be seen what the effect of these high-level proposals will have on the regulation of private funds in the UK. However, if the consultation paper is to be believed, this should lead to a more proportionate approach towards private funds by the FCA, avoiding perhaps some of the inflexibility of the past. Private fund managers should therefore keep an eye on how the FRF develops in the coming months.

The new Financial Services Bill

On 21 October 2020, the Financial Services Bill 2019/21 (the Bill), which deals with the UK’s post-Brexit financial architecture, was introduced to Parliament and is currently at committee stage in the House of Commons. Some key points for private funds are as follows.

• Prudential regulation: the FCA will be given the power to introduce the Investment Firms Prudential Regime in the UK, which is broadly based on the EU’s Investment Firms Regulation and the Investment Firms Directive. As we previously explained in our article on so-called “exempt CAD” firms, this new regime has the potential to raise (potentially significantly) the capital requirements of UK private fund managers structured as adviser/arranger firms as well as subjecting them to additional requirements in respect of remuneration. The Bill does not confirm that such requirements will come into force but does give the FCA the power to implement such rules and private fund managers would be wise to plan on the basis that such stringent rules will come into force.
• Benchmarks: the FCA’s powers in respect of the wind-down of critical benchmarks, such as LIBOR, would be strengthened under the Bill. In particular, the FCA is given the power to “designate” a benchmark, such as LIBOR, which will allow the FCA to require the administrator to change the benchmark’s methodology or rules (amongst other things). This could allow the FCA to change the methodology of LIBOR such that it is no longer reliant on panel bank submissions.
  
  Once “designated”, all use of that benchmark will be prohibited to prevent the use of that benchmark from growing. Crucially, however, the FCA will have the power to exempt ”legacy use” from this prohibition but can specify the type and length of such an exemption. Again, how this works in practice is yet to be seen but private funds with LIBOR exposures ought to keep an eye out for any FCA announcement on the “designation” of LIBOR in order to manage their LIBOR transition projects and relevant timelines.

• OTC derivatives: the Bill expressly requires that the firms offering clearing services (whether directly or indirectly) provide such services in a fair, reasonable, non-discriminatory and transparent (FRANDT) manner, with the FCA given the power to make rules setting out the conditions under which commercial terms are considered to be FRANDT. Whilst this obligation implements EMIR Refit rules which come into force in the EU after 31 December 2020 (and are therefore anticipated by the wider market), it should nonetheless assist private funds in gaining greater access to the OTC derivatives markets.

The U.S. Securities and Exchange Commission (SEC) is reconstituted at the start of each new administration. Under a Biden administration, the SEC will likely comprise of a Democratic chair with a Democratic majority. The direction the SEC takes depends heavily on the individuals appointed and the party in power, but it is anticipated that it will launch an active rulemaking agenda with a renewed focus on enforcement and ESG matters.

We have identified three headline focuses which might be of particular relevance to any private fund manager raising capital from US investors or making US investments.

Financial stability

The key focus following Covid-19 will be financial stability. Financial services are expected to be seen as a tool to assist with this. Any proposed regulatory changes will have this as a key objective and will likely hinder any drastic financial sector changes in the initial years of a Biden administration.

Enforcement and inspections 

The Trump administration had a low number of enforcement and inspection cases. This was a stark contrast from Mary Jo White under Obama’s administration who pursued the “broken window” strategy on enforcement – pursuing even minor cases to send a message of non-tolerance. We expect a return of a similar approach under a Biden administration.

The Covid-19 pandemic will also likely prompt SEC investigative and enforcement actions within the life sciences and pharmaceutical industries as more money is invested in these areas. Private fund managers operating in this area will likely notice this (e.g. requiring more disclosures and public reporting). 

ESG matters

As part of Biden’s focus on reducing climate change, we expect the SEC to focus on ESG matters and bring about legislative changes on ESG disclosures. This is supported by recommendations made by the SEC’s Investor Advisory Committee in May 2020.

We do not anticipate any disclosure legislation going as far as the new European Sustainable Finance Disclosure Regulation. For example, it may not extend to fund managers marketing into the US (as the SFDR does for fund managers marketing into the EU). As a result potential conflicts between the two regimes may emerge.

Commentary

A change of SEC leadership will result in a change in regulatory focus, in particular, on enforcement and ESG matters. However, the current economic environment and need to ensure financial services assist in the economic recovery post-Covid-19, will mean any drastic changes are likely to be put on hold until later in the Biden administration.