Here we are in the third calendar year of the Covid-19 pandemic; a period in which the funds industry has faced a wide range of challenges, from adapting to travel and work restrictions, to extremes of market volatility. At the same time, we have seen the first stages of integration of sustainable finance litigation by the EU in order to support the European green deal, which is a significant body of legislation adding to an already significant regulatory burden to EU financial professionals.
In this newsletter, we are looking at some of the latest developments and those in the pipeline for investment funds in 2022 across trading, distribution, ESG and fund structuring.
During the rapid market drawdown at the outset of the Covid-19 pandemic, the European Securities and Markets Authority (“ESMA”) took steps to lower the notification threshold for short positions under the EU Short Selling Regulation (Regulation (EU) No. 236/2012, “SSR”) from 0.2% to 0.1% on a temporary basis, although this was subject to a series of renewals (Episode 11 - COVID-19 Webcast - Where Are We Now? Legal & Regulatory Update | Wildgen) and ultimately applied until 19 March 2021, at which point the disclosure threshold reverted to 0.2%.
The lower disclosure threshold will now be put on a permanent footing from 31 January 2022, as Commission Delegated Regulation (EU) 2022/27 was published in the Official Journal on 11 January 2022 to reduce the SSR threshold for reporting of significant net short position in shares to EU National Competent Authorities from 0.2% to 0.1% of the issued share capital of the company concerned.
As a reminder, the net short position notification requirements under the SSR apply to investment managers regardless of where they are located and apply with respect to shares of any issuer admitted to trading on an EU trading venue (unless those shares are excluded).
Firms should therefore ensure that their operational and compliance frameworks are updated to reflect this permanent lowering of the reporting threshold.
MiFID Quick Fix
In February 2021, the European Commission published its MiFID II "Quick Fix" Directive (Directive (EU) 2021/338), which acknowledged the disruption caused by the Covid-19 pandemic and also considered market concerns with an attempt to streamline certain regulatory requirements. Its amendments are due to apply from 28 February 2022.
The word count of MiFID II and its derivative legislation exceeds that of War and Peace, so it will come as no surprise that there is little that is quick about the Quick Fix. Rather than attempt to examine the whole regime in detail, we will just look at a couple of headline issues relevant to EU investment firms.
Best Execution Reporting
There are two sets of Regulatory Technical Standards (RTS) applicable to best execution reporting under MiFID II: RTS 27 (applicable to execution venues) and RTS 28 (applicable to investment firms). There are numerous shortcomings in these reports that have been identified; ultimately, what relevance or value is this data to an end investor? As a short-term measure, the European Commission introduced a waiver from the requirement for execution venues to produce best execution reports, which is expected to end in February 2023. And on 23 December 2021, an ESMA consultation closed on the application of RTS 27 and RTS 28 (Microsoft Word - CP - Review of Best Execution RTSs 27-28 (europa.eu) ). The consultation included suggested amendments to RTS 27 and RTS 28, so the output of the consultation process is something to be aware of in 2022.
One of the unforeseen consequences of the research unbundling changes under MiFID II was the decrease in broker research coverage of smaller issuers. The Quick Fix aims to reverse this by allowing firms to bundle costs for research and execution with respect to small and mid-cap issuers, whose market capitalisation does not exceed EUR 1 billion. In order to benefit from this relief, managers must inform their clients that they have entered into an agreement with the research provider to identify the portion of any payments attributable to research.
In order to save trees and energy, the default method for firms to communicate with their clients will be switched from paper-based to electronic communication. However, retail clients can elect to continue receiving paper-based communications.
Where firms are providing investment advice or portfolio management involving the switching of financial instruments, they need to provide information to clients whether the benefits of switching outweigh the costs. However, they will not be required to carry out this analysis for professional clients (unless those clients elect to opt-in). This will significantly streamline what would otherwise be a cumbersome process for firms operating segregated accounts on a discretionary basis for professional clients.
Since the Cross Border Distribution Directive came into force last August (August 2021 Changes to the Distribution of Funds in the EU | Wildgen), we have seen inevitable divergence between Member States on pre-marketing rules for funds that are subject to national private placement regimes (NPPR). The CSSF has a straightforward notification system for funds being distributed under NPPR ( Pre-marketing by AIFMs – CSSF), but the key challenge for firms looking to distribute on an NPPR basis is that they now have to approach pre-marketing on a jurisdiction-by-jurisdiction basis as well as then having to complete the NPPR registrations that follow.
A consequence of this has been the continued questioning around reverse solicitation, something which itself has been in the regulatory spotlight for some time. As a reminder, under the Cross Border Distribution Directive, all applicable fund distribution activity prior to passporting is deemed to fall under pre-marketing, which effectively closes off reverse solicitation as a route to market.
As part of the continued regulatory focus, on 17 December 2021, ESMA wrote to the European Commission (esma34-45-1485_letter_chair_commission_on_reverse_sollicitation.pdf (europa.eu)) to explain the limitations of the information held by National Competent Authorities relating to reverse solicitation. Furthermore, on 13 January 2022, ESMA issued a public statement (esma35-43-2509_statement_on_reverse_solicitation.pdf (europa.eu)) to remind firms of the MiFID II requirements on the provision of investments services to retail or professional clients by firms not established or situated in the European Union. In particular focus is cross border activity from firms in the UK post-Brexit, seeking to solicit clients in the EU but then simply including contractual clauses to make this activity appear to be at the own exclusive initiative of the client.
Despite the changes introduces by the Cross Border Distribution Directive, reverse solicitation is still permitted in certain circumstances, although its scope is being narrowed and it remains very much in the regulatory spotlight.
At the end of 2021, many firms were anxiously awaiting the go live date from which UCITS would have to provide key information documents (KIDs) under the PRIIPs Regulation. On 23 November 2021, the European Parliament voted to extend the UCITS exemption from providing PRIIPS KIDs, and pushed the implementation date from 1 July 2022 to 1 January 2023. It should also be noted that a UCITS KIID will no longer be required as long as a PRIIP KID is produced, removing a previous provision that required them to be produced in tandem for a period of time.
The EU’s regulatory framework relating to sustainable finance is a hugely complex system of rules, which is undergoing something of a difficult birth, largely because of the breadth and nature of its scope, but also the extent to which it applies not only to financial market participants inside and outside the EU, but also commercial enterprises. 2022 will see further developments and the continuation of debates around application, such as the current question of whether nuclear energy should be considered in the “EU taxonomy” for sustainable activities.
The Sustainable Finance Disclosure Regulation (“SFDR”) is the centerpiece of the EU’s sustainable finance framework. Its implementation is a hugely complex undertaking, and we have already seen a delay to the application of the regulatory technical standards (“RTS”) to 1 July 2022, which itself was a delayed application date. On 25 November 2021, the European Commission confirmed that, due to the length and technical detail of the 13 RTS under consideration, it is further postponing the date of application of the RTS to 1 January 2023. While this delay is welcomed, financial market participants are reminded that, where they have to provide disclosures under SFDR, they are expected to comply with the requirements on a best-efforts basis until then.
In order to allow firms to comply with SFDR, they need to be fed relevant ESG data from their underlying holdings. Key to this will be the EU’s Corporate Sustainability Reporting Directive (“CSRD”), which will apply from 1 January 2023 and which replaces the Non-Financial Reporting Directive. The CSRD extends the scope of the EU’s sustainability disclosure regime to large private companies and listed small to medium-sized enterprises (SMEs).
> FUND STRUCTURES
Proposal for a Directive amending the AIFM and UCITS Directives
On 25 November 2021 the European Commission issued a proposal for a Directive amending Directives 2011/61/EU (“AIFMD”) and 2009/65/EC (UCITS Directive) (the “Proposal”). The Proposal was published further to a public consultation on the functioning of the AIFMD. Despite overall positive feedback in the consultation, the following main areas were identified as requiring further improvements to take into account new developments since the entry into force of the AIFMD for the purpose of preservation of financial stability and investor protection:
introduction of harmonised rules for AIFMs managing funds active in direct lending space (LOFs). Such funds can provide alternative source of financing and absorb shocks when liquidity is constrained by continuing to provide loan financing when traditional lenders pull back from the market. The Proposal aims to make financing more accessible to companies.
improvement of the supply of depositary services in smaller markets (It should be noted that this is not intended to create a depositary passport): the current AIFMD provisions require that the depositary is appointed in the same Member State as the AIF which appeared difficult for smaller and concentrated markets due to fewer available service providers. The Proposal would enable such markets to access depositary services on a cross boarder level until further harmonisation becomes feasible.
inclusion of Central Securities Depositaries (“CSDs”) in the custody chain where they are providing competing custody services to ensure that depositaries can fulfill their duties and safeguard the protection of investors. It was noted that depositaries are sometimes prevented from performing their duties, such as oversight duties, where the fund’s assets are kept by CSDs which are not considered as delegates of the depositary. However, the Proposal does not create additional due diligence requirements on depositaries as the authorised CSDs are already subject to stringent sectorial requirements and supervision.
further clarification of the requirements for fund managers delegating certain functions to third parties by ensuring that they adhere to high standards applicable across the Union in order to enhance investor protection. The proposal foresees reporting to ESMA on delegation arrangements in cases where risk or portfolio management is delegated outside the European Union.
improvement of the level of data gathered through regulatory reporting by creating a common data space for the reporting by AIFMs and UCITS to enable an efficient reporting and minimise reporting costs and burden; and
harmonisation of the availability of liquidity management tools (LMTs). Fund managers of open-ended funds would be able to suspend the repurchase/redemption of the units or shares temporarily but would also be required to choose at least one other liquidity management tool of their choice.
This Directive, once adopted, would be subject to evaluation five years after the date of its transposition.
The European Commission published a proposal to review the ELTIF Regulation (EUR-Lex - 52021PC0722 - EN - EUR-Lex (europa.eu) ) on 25 November 2021. This was in light of the fact that, due to their technical eligibility requirements, ELTIFs have been something of a failure of a product concept, which only 57 being in existence across the EU as at October 2021, according to the European Commission’s own data.
The proposed review of the ELTIF Regulation would extended the types of assets in which ELTIFs can invest, such as equity or quasi-equity instruments issued by qualifying portfolio undertakings or by subsidiaries thereof, debt instruments, issuance of loans by ELTIFs, participations in underlying funds, real assets, securitisations. Previous limitations on portfolio composition would be increased allowing managers more flexibility. With respect to borrowing provisions, ELTIFs marketed to retail investors would be able to borrow up to 50% of the value of their capital, while those marketed only to professional investors could borrow up to 100%; furthermore, borrowing would also be permitted for the purpose of making investments or providing liquidity and, under certain circumstances, could be made in a currency other than the currency of the assets to be acquired. Additional changes in the proposed Review of the ELTIFs Regulation would concern inter alia redemption policies, minimum investment requirements and conflict of interest provisions affecting ELTIF managers.
The proposed review of the ELTIF Regulation is now being reviewed by the EU Parliament and the Council, and their output is due during the course of the year.