In this Sidley Update, we cover the latest from the UK Financial Conduct Authority (FCA) and HM Treasury, including a consultation on UK equity markets, a statement on market abuse, the UK’s future financial services framework and environmental, social, and governance (ESG)-related developments. On the EU side, we cover the Council of the EU’s text for the revised Alternative Investment Fund Managers Directive (AIFMD II) and significant ESG developments, including the publication of the agreed text of the EU Corporate Sustainability Reporting Directive (CSRD), and the successful passage of the European Commission’s (Commission) complementary delegated act that will see natural gas and nuclear included in the EU’s Taxonomy for environmentally sustainable economic activities.
1. UK — FCA
FCA appoints new Chair
On 8 July 2022, the Treasury announced the appointment of Ashley Alder as the new Chair of the FCA. Alder is currently Chief Executive Officer of the Securities and Futures Commission in Hong Kong, a role he has held since 2011. Alder also chairs the board of the International Organization of Securities Commissions (IOSCO) and sits on the Financial Stability Board’s Plenary and its Steering Committee.
Alder will succeed interim FCA Chair Richard Lloyd (who replaced Charles Randell on 1 June 2022) and is expected to take up his role in January for a five-year term.
FCA Consultation Paper on Equity Markets
On 5 July 2022, the FCA published a Consultation Paper (CP22/12) on proposals to improve trade execution and post-trade transparency in equity markets. CP22/12 also seeks views on future FCA guidance on outages and the structure of UK markets for retail orders. CP22/12 is part of the Wholesale Markets Review, the review of UK wholesale financial markets being conducted by the FCA and the Treasury (discussed in our March 2022 Update). The consultation is open for responses until 16 September 2022.
The FCA’s proposals seek to improve requirements that have been identified as imposing compliance and operational costs on firms but that do not deliver demonstratable benefits to end users or to the functioning of equity markets. The FCA also proposes amendments to improve the quality of post-trade information and the efficiency of consolidating trade reports from multiple sources.
The proposals include the following changes:
- improving the post-trade transparency regime by excluding non-price-forming transactions, improving the use of post-trade flags, and improving the consolidation of trade reports from multiple sources;
- simplifying post-trade transparency reporting of over-the-counter (OTC) transactions by establishing designated reporting firms with responsibility for post-trade transparency (and removing systematic internaliser (SI) status as a determining factor);
- allowing UK trading venues to use reference prices from overseas venues, and allowing UK trading venues to calibrate the order management facility waiver according to the characteristics of their markets;
- improving the quality of execution by removing restrictions preventing trading venues from using the same tick size used by trading venues established overseas where the overseas venues are the primary markets in a financial instrument; and
- enhancing market resilience by consulting on what future guidance should cover in relation to the operation of markets before and during an outage.
2. UK — HM Treasury
Future financial services framework
On 16 June 2022, the UK Treasury Select Committee published a report on the “future of financial services regulation” in the UK post-Brexit.
While the report recognises the opportunity for the UK to tailor (and, where appropriate, simplify) legacy EU financial services regimes for the UK market, the report’s key conclusions and recommendations include a number of items addressed at concerns of potential watering down of the financial services regulatory landscape in the UK as well as the need to protect regulatory independence from the Treasury. The report is not in favour of a secondary international competitiveness objective for the regulators on the basis that this could lead to a weakening of the UK’s strong regulatory standards.
In respect of the prospective new regulatory framework post-Brexit, the report recommends:
- clear timetables for regulatory changes to specific EU financial services regimes be published by the FCA, the Prudential Regulation Authority and the Treasury to allow industry to plan for the changes it may need to make and to allow stakeholders to plan their engagement in the process;
- the Treasury to be sparing in its use of the proposed power to require regulators to review their rules, which could otherwise potentially weaken the independence of the regulators, and for the Treasury to fund any such regulatory reviews in order to avoid crowding out the regulators’ budgets.
The report also notes that the Committee will be conducting further work to determine how challenges, such as those associated with innovations in payments, including consumer protection, preventing crime, and financial stability, arising from cryptoassets should be managed. The report recognises that potential for cryptoassets, stablecoins, and central bank digital currencies to provide opportunities to address weaknesses in international payments systems, serve consumer needs, and (for central bank digital currencies) safeguard monetary sovereignty.
3. UK — Market Abuse
FCA update on market abuse
On 17 June 2022, the FCA published an update on the FCA’s work on market abuse and manipulation.
The FCA notes that it adopts a data-led approach, undertaking daily monitoring to ensure the timeliness and accuracy of the disclosure of inside information by firms and venues. Firms and venues send over 30 million transaction reports and over 100 million order reports a day to the FCA. Such reports are analysed by the FCA’s market data processor, which allows the FCA to oversee the market in close to real time, with dedicated software and algorithms to detect potential problems.
The date collected and analysed by the FCA is complimented by Suspicious Transaction and Order Reports (STORs) sent to the FCA by market participants when they have “reasonable grounds” to suspect market abuse, such as insider dealing or market manipulation. The FCA received over 90 reports a week in 2021, and the number sent increased by almost 15% in 2020. Each STOR is assessed by a specialist team within the FCA that seeks to establish whether any abusive or manipulative behaviour has taken place and, if the FCA suspects it has, what further action should be taken.
Where it is right to do so, the FCA takes criminal action. The FCA has already been in court for a trial in 2022 in which the jury was unable to reach a verdict. The FCA has another trial involving two defendants scheduled to start in October 2022 and a further three cases in which prosecution decisions will be made relating to 10 individuals before the end of the year.
Alternatively, the FCA also makes use of its civil enforcement powers, which have a different standard of proof. More than 10 subjects are awaiting decisions on their cases following investigations for market abuse or manipulation.
4. UK — Sanctions
Breaches of UK trade and financial sanctions are enforced through criminal or civil proceedings. As of 15 June 2022, civil enforcement of the UK’s financial sanctions is on a strict liability basis. This means liability may be determined even where there was no knowledge or reasonable suspicion of the breach.
Please see our Sidley Update Enforcement of UK's Financial Sanctions: Strict Liability and a Stronger Approach for a discussion about the new standard and how firms should consider their approach to sanctions compliance.
5. EU — AIFMD
AIFMD II — European council reaches agreed position on AIFMD II proposal
On 21 June 2022, the Council of the EU published its “general approach’ for a directive amending the existing EU AIFMD, following a review of the AIFMD as part of the EU Capital Markets Union package.
Given that the European Parliament has also published its draft report on the text, the next step in the legislative process will be for the Council and the Parliament to enter into trilogue negotiations with the Commission to agree on a final version of the text for publication in the Official Journal of the EU.
The Council text updates the draft published by the Commission in November 2021, which proposed a number of changes to the AIFMD, including in respect of the national private placement regime, delegation, loan origination, liquidity risk management, data reporting, and depositaries (see our December 2021 Update EU AIFMD II Implications of the Commission Proposal). The Council text includes a more fulsome draft and introduces a number of further changes, including the following:
- Delegation: The Commission proposal had provided for EU Member State national competent authorities (NCAs) to notify the European Securities and Markets Authority (ESMA) on an annual basis when an alternative investment fund manager (AIFM) “delegates more portfolio or risk management to entities in third countries than it retains.” The Council text now proposes that the reporting of delegation arrangements should instead be brought under the Annex IV reporting framework (where AIFMs simply report to NCAs), with the result that ESMA would not be provided with the reporting. The Council also drops the envisaged two-year ESMA peer review for delegation arrangements.
- AIFM activities: The Commission had proposed to extend the scope of permitted activities for AIFMs to include benchmark administration and credit servicing as additional “top-up permissions.” However, the Council proposes to give Member States the ability to prohibit alternative investment funds (AIFs) from servicing credits to consumers within their territory. AIFMs would also be unable to administer benchmarks that are used in their managed AIFs. The Council’s proposal also clarifies that AIFMs will be permitted to carry out any other ancillary service that represents a continuation of the services already undertaken by the AIFM and that does not create unmanageable conflicts of interest.
- Loan origination: Under the Council’s proposal, loan origination is defined as “granting loan [sic] by an AIF as the original lender.” The Council introduces a number of new rules in relation to loan originating funds, including these:
- It prohibits AIFMs from managing “originate-to-distribute” AIFs, that is, AIFs whose investment strategy is to originate or gain exposure to loans through special-purpose vehicles (which originate a loan for or on behalf of the AIF or AIFM in respect of the AIF), with the sole purpose of transferring those loans or exposures to third parties. The Council’s proposal also extends the scope of persons to whom an AIF would not be permitted to grant loans including certain entities within the same group as the AIF. Member States would also have the ability to prohibit certain loans to consumers.
- The Commission’s proposed requirement for an AIF to be closed-ended if it originated loans exceeding 60% of its net asset value is replaced by a general requirement for the AIF to be closed-ended unless its liquidity risk management system is compatible with its investment strategy and redemption policy. ESMA will develop regulatory technical standards (RTS) to set out the precise requirements.
- It proposes a new limitation on leverage, with leverage of a loan originating AIF limited to no more than 150% of the net asset value of the AIF. This is measured on the commitment method, which permits certain netting and hedging positions in relation to derivatives. This limit would include loans originated by the managed AIF and by certain special-purpose vehicles on behalf of the AIF.
- Member States will have discretion to make certain derogations from applying the full regime for loan origination funds to private equity or real estate funds making shareholder loans.
- The Council’s proposal provides for a five-year transition period for AIFMs managing loan-originating AIFs that are constituted before the adoption of AIFMD II as well as deemed compliance for pre-existing loan-originating AIFs that do not raise additional capital.
- Liquidity management: The Council increases standards required for liquidity management compared to the Commission’s proposal, requiring AIFMs of open-ended funds to select at least two (as opposed to at least one) liquidity management tools as well as introducing restrictions on the use of redemptions in kind as a liquidity management tool.
- Disclosure and reporting: The Council’s proposal reduces the frequency of certain new reporting requirements under the investor precontractual disclosures from quarterly to annually.
- Depositaries: The Council’s proposal does not seek to create a depositary passport but sets out a limited framework for the provision of depositary services on a cross-border basis for concentrated markets with few providers.
AIFMD MoUs signed by NCAs
On 23 June 2022, ESMA published the latest version of the table of Memoranda of Understanding (MoUs) entered into by Member State NCAs with third-country (i.e., non-EU) regulators for purposes of the AIFMD.
6. ESG — UK
FCA delays publication of consultation on Sustainability Disclosure Requirements
On 4 July 2022, the FCA confirmed that its plan to consult on the forthcoming Sustainability Disclosure Requirements (SDR) during Q2 2022 has been delayed to Autumn 2022 to allow the FCA to take account of other international policy initiatives and ensure that stakeholders have time to consider these issues.
In its Discussion Paper, the FCA had sought initial views on UK-specific disclosure requirements for asset managers and certain FCA-regulated asset owners that would be elaborated on in proposed rules in Q2 2022.
Climate change — Paris agreement alignment disclosure requirements for UK occupational pension schemes
On 17 June 2022, the UK government’s Department for Work and Pensions (DWP) published a consultation outcome response relating to proposed changes to the Occupational Pension Schemes (Climate Change Governance and Reporting) Regulations 2021 and accompanying statutory and nonstatutory guidance.
From 1 October 2022, occupational pension schemes with greater than £1bn under administration will be required to report on the extent to which their investments are aligned with the Paris Agreement goal of pursuing efforts to limit the global average temperature increase to 1.5˚C above preindustrial levels from 1 October 2022. While trustees will have some flexibility to select the type of portfolio alignment metric most appropriate to their scheme (such as is being developed by the Glasgow Financial Alliance for Net Zero), asset managers whose investors include UK occupational pension schemes can expect to receive further detailed disclosure requests to allow the pension scheme trustees to meet their obligations. Indeed, the flexibility afforded to trustees in selecting their alignment metric could result in asset managers receiving overlapping but distinct data requests from trustees. The DWP’s statutory guidance will be amended to emphasise the need for trustees to describe the methodology and data assumptions used when disclosing their portfolio alignment metric. The DWP acknowledges concerns with methodological challenges when calculating and reporting portfolio alignment metrics but has determined that such concerns are not strong enough that a delay to implementation of portfolio alignment metrics would be appropriate.
The DWP’s consultation had also addressed the connection between a portfolio’s Paris alignment and the pension trustee’s stewardship (i.e., voting and engagement) activities. The outcome response sets out changes to the DWP’s non-statutory guidance explaining best practice in relation to pensions trustees’ Statements of Investment Principles (which includes descriptions of trustees’ climate change and stewardship policies) and statutory guidance explaining DWP’s expectations across the Implementation Statement (which describes how trustees have implemented these policies). Trustees are encouraged to provide additional detail about asset manager voting policies and behaviour and the extent to which the trustees are engaging with asset managers on this topic. In general, the response document highlights that asset managers could take steps to improve their governance around voting and engagement.
7. ESG — EU
European Parliament allows Taxonomy complementary delegated act on nuclear and gas to pass unamended
On 6 July 2022, the plenary session of the European Parliament voted on a resolution to block a complementary delegated act adopted by the European Commission that provided technical standards under which gas and nuclear power generation could qualify as environmentally sustainable economic activities under the EU Taxonomy Regulation on the basis of their potential deployment as transition technologies that can help to displace more polluting forms of energy generation (such as coal). The measure was defeated in the Parliament, and as the Council of the EU (heads of each Member State) did not object to the Commission’s delegated act by 11 July 2022, the complementary delegated act will come into force on 1 January 2023.
For gas and nuclear to be regarded as environmentally sustainable economic activities under the Taxonomy Regulation, the relevant installation must meet criteria that determine when such activities are not regarded as doing “significant harm” to environmental objectives.
The Commission’s standards have been very controversial. Indeed, gas and nuclear are included in the complementary delegated act a year after the initial delegated act for economic activities contributing to climate change mitigation and climate change adaptation objectives was adopted, having been excluded from it. The resolution to block the complementary delegated act was adopted earlier in June at a joint meeting of the Parliament’s Economic and Monetary Affairs and Environment, Public Health, and Food Safety Committees.
The Commission has written to the European Supervisory Authorities (ESAs) in light of the complementary delegated act to request that the ESAs propose amendments to the regulatory technical standards (including disclosure templates) that the Commission has adopted relating to the precontractual and periodic disclosures under the Sustainable Finance Disclosures Regulation (SFDR). The amended standards will be required to provide for disclosures on the proportion of Taxonomy-aligned investments constituted by investments in fossil gas and nuclear energy activities. To allow for sufficient implementation time, the ESAs have been asked to produce the amended RTS by 30 September 2022.
The inclusion of gas and nuclear in the EU Taxonomy could influence the design of the forthcoming UK Green Taxonomy, which is expected to closely align to the EU’s Taxonomy. Earlier in June 2022, the UK Sustainable Investment and Finance Association, the UN Principles for Responsible Investment, and the Institutional Investors Group on Climate Change wrote a joint letter to the UK Prime Minister to argue against the inclusion of natural gas in the UK Green Taxonomy.
Council and Parliament reach agreement on text of CSRD
On 30 June 2022, the final text of the Corporate Sustainability Reporting Directive (CSRD) was published, having been agreed by the European Parliament and the Council in a trilogue meeting on 21 June 2022. The text of CSRD will now be subject to translation into the official languages of the EU before it is published in the Official Journal of the EU. CSRD will come into force 20 days after publication in the Official Journal. As an EU Directive, CSRD must be implemented into national law by EU Member States, with the first in-scope reporting periods to commence 1 January 2024.
The revised text of CSRD amends the scoping provisions for third-country undertakings such that non-EU companies will be in scope where they generate net turnover of €150 million in the EU and have at least one EU subsidiary (that is itself a large undertaking) or an EU branch generating at least €40 million in the EU. The €150 million threshold aligns CSRD with the Commission’s proposals for an EU Corporate Sustainability Due Diligence Directive.
Notwithstanding that non-EU undertakings will not directly be in scope of the CSRD until 2029, to the extent that such non-EU undertakings would be in scope on the basis of an EU subsidiary, such subsidiary would itself be subject to a reporting obligation from 2024 (if it is a public interest entity) or 2025 (if it is a large undertaking).
The final sustainability reporting standards that will be required under CSRD are still subject to development by the European Financial Reporting Advisory Group (EFRAG), but given that the CSRD will include a “double materiality” perspective, the CSRD will go beyond current international global sustainability standards, which currently relate to financial materiality only (e.g., the standards being developed by the International Sustainability Standards Board (ISSB)). Nonetheless, the CSRD text specifically references the ISSB standards and provides that the EU’s standards should contribute to the process of convergence of sustainability reporting standards at global level by supporting the work of the ISSB so as to reduce the risk of inconsistent reporting requirements for multinational companies by integrating the content of the ISSB’s global baseline standards.
ESMA publishes results of call for evidence on ESG ratings
On 27 June 2022, ESMA published a letter to the Commission providing its findings from the call for evidence to gather information on the market structure for ESG rating providers in the EU, which had included a survey for asset managers (see our March Update). ESMA highlights that the feedback received indicates an immature but growing market that, following several years of consolidation, has seen the emergence of a small number of large non-EU-headquartered providers.
The most common shortcomings identified by the users were a lack of coverage of a specific industry or a type of entity, insufficient granularity of data, and a lack of transparency around methodologies used by ESG rating providers.
ESMA notes that the majority of ESG rating users that responded to the call for evidence use more than one provider for ESG ratings. In relative terms, MSCI was the most often mentioned ESG provider, followed (in descending order) by Morningstar/Sustainalytics and ISS, then S&P, Moody’s/VE and Refinitiv, and RepRisk.
ESMA’s analysis generally confirms the concerns about the unregulated nature of the ESG ratings market raised in ESMA’s letter to Commissioner Mairead McGuinness in January 2021 and the need to match the growth in demand for these products with appropriate regulatory requirements to ensure their quality and reliability.
ESMA chair Verena Ross gives speech on greenwashing and ESG initiatives
On 9 June 2022, the chair of ESMA, Verena Ross, gave a speech to the International Capital Market Association Annual General Meeting and Conference, outlining ESG-related work that ESMA is looking to focus on in the year ahead, including on greenwashing and ESG ratings. As is clear from Ross’s speech, ESG remains a key area of focus for ESMA. ESMA is working to increase supervisory convergence in this area to improve the quality of ESG disclosures and combat a continuing concern with greenwashing.
As covered in various of our previous Sidley Updates (see here, here, and here), under the EU SFDR, asset managers that offer ESG-focused funds to investors in the EU are now in scope of detailed investor-facing and public disclosure requirements with respect to their ESG processes.
- On greenwashing, ESMA will continue its supervisory activity and single rulebook work and will take an active role in the implementation of regulatory requirements, such as by working with national authorities as they supervise financial markets. As noted below, ESMA is also establishing the Consultative Working Group (CWG) to enhance exchanges between ESMA and the private sector in relation to ESG.
- Ross also discussed corporate sustainability reporting, which, she acknowledges, “should have ideally and logically come first, prior to product disclosure, but has in reality taken a bit longer to come to fruition”.
Importantly, Ross acknowledges the number of international corporate sustainability reporting standards under development and the need for European and global reporting standards to be interoperable, “both to ensure helpful disclosure to investors internationally and to limit unnecessary burdens on companies who operate both within and outside the EU.” Ms. Ross states her belief that there “is sufficient common ground between all of us on ESG reporting to make all possible efforts to converge in building a common baseline of reporting requirements that can be internationally accepted.”
As noted above, the EU co-legislators recently agreed a final compromise text of the CSRD, with detailed reporting standards to be developed by EFRAG.
- On ESG ratings providers, ESMA will continue to support IOSCO’s work on ESG ratings. As noted above, ESMA recently conducted a call for evidence concerning the ESG rating providers market structure in the EU.
ESMA confirms CWG Members for Coordination Network on Sustainability
Members include asset managers, corporate organisations, ESG consultancies, financial service providers, NGOs, and analytic institutions. The CWG forms part of ESMA’s wider strategy to incorporate industry consultations into its evaluation of the ESG market and the implementation of new supervisory powers.
The CWG will provide an industry perspective on ESMA’s sectorial standing committees and networks on sustainable finance matters, cross-cutting issues, and initiatives, with a mandate to promote the coordination of regulatory, supervisory, and enforcement initiatives across securities regulators in the EU and across ESMA activities, in the field of sustainable finance.
The European Central Bank announces “greening” of corporate debt portfolio
On 4 July 2022, the European Central Bank (ECB) announced a commitment to place greater emphasis on climate change in their corporate bond purchases, collateral framework, disclosure requirements, and risk management.
The ECB announced measures aimed towards more comprehensive incorporation of climate-related financial risk into the Eurosystem balance sheet and to support the green transition of the European economy in accordance with the EU’s Paris agreement commitments and the European Climate Law that establishes a climate neutrality goal for 2050 and a 55% reduction in net GHG emissions by 2030.
Over time, the ECB’s measures could improve the quality of climate-related disclosures by issuers of corporate bonds and potentially have an impact on bond market prices.
- From October 2022, the ECB will gradually decarbonise its corporate bond holdings on a path aligned with the goals of the Paris Agreement by tilting its holdings towards companies with better climate performance. The ECB will start publishing climate-related information on corporate bond holdings regularly as of the first quarter of 2023.
- In addition, from 2024, the Eurosystem will limit the share of assets issued by entities with a high carbon footprint that can be pledged as collateral by individual counterparties when borrowing from the Eurosystem. As of 2022, the Eurosystem will also consider climate change risks when reviewing haircuts applied to corporate bonds used as collateral.
- From 2026, for companies in scope of the CSRD, the Eurosystem will accept only collateral that complies with the requirements of the CSRD. For non-CSRD companies, the Eurosystem will engage closely with the relevant authorities to support better and harmonise disclosures of climate-related data to ensure a proper assessment of climate-related financial risks for such assets.
- From 2024, the Eurosystem will apply common minimum standards for the consideration of climate-related risks in national central banks’ in-house credit assessment systems. The ECB will also urge rating agencies to be more transparent about how they incorporate climate risks into their ratings and to be more demanding in their disclosure requirements regarding climate risk.
8. ESG — International
Basel Committee — principles for effective management and supervision of climate-related financial risks
On 15 June 2022, the Basel Committee on Banking Supervision (BCBS) published its final principles for the effective management and supervision of climate-related financial risks.
BCBS outlines 18 high-level principles that it suggests be implemented as soon as possible by banks (Principles 1-12) and banking supervisors (Principles 13-18).
While the BCBS focuses on banking supervision, the principles on climate-related financial risks could become relevant for other financial services providers, including asset managers. In particular, BCBS addresses corporate governance of climate related risks, internal controls, and risk management process.