Horizon Scan For Private Investment Funds: Key Recent And Expected Funds, Regulatory And Tax Developments To Look Out For - Fund Management/ REITs

Welcome to the second edition of our Horizon Scan, where we focus on some of the principal recent and expected developments and changes that we expect to be of interest to those in the non-listed funds sector. We have grouped the topics under the following headings: UK and EU funds; sustainable finance (UK, EU, and US); regulatory issues (UK and EU); tax topics (UK and EU); and US specific developments (for non-US fund managers marketing in the US and other than ESG). At the end, we set out additional topics and anticipated developments to look out for this year. They are also likely to impact the private funds industry, but in the interests of trying to be as succinct and focused as possible, we have not covered them in detail. There are a few items that remain of interest for which there have been no updates to report on since our January 2023 horizon scan (and which we have designated "no update" in the table for reference).

We pick out three broad themes that influence the legislative developments set out below:

sustainable finance and proposals to tackle greenwashing
steps toward the "retailisation" of investments that would otherwise be available only to professional investors
on the UK side in particular, initiatives aimed at promoting the competitiveness of the private funds market. Further EU level output on the review of the Alternative Investment Fund Managers Directive (AIFMD) is expected imminently and will be important to track, for the impact on EU strategies as well as looking to how UK policy makers may choose to diverge from AIFMD II in the future

We will continue to refresh and update this Horizon Scan as we move through the year. In the meantime, please speak to your usual Goodwin contact, or one of the co-authors of this briefing, for any further detail, or if you want to discuss how any of these initiatives may affect your fund structures and investments.

UK AND EU FUNDS DEVELOPMENTS

Reform of UK Limited Partnership (UKLP) Law

Issue

Draft legislative limited partnership reforms make up part of the Economic Crime and Transparency Bill (ECT Bill). If enacted, the changes will represent a significant reform to UKLP law, in parallel with reforms to the powers of Companies House and law enforcement for economic crime.

See our October 2022 client alert for background.

Recent and Expected Developments

Once the ECT Bill is enacted, we expect a short (six month) transitional period for existing UKLPs to comply. This will include gathering the required information to be submitted to the registrar for each partner (including specifics on each individual limited partner), ensuring a UKLP has access to a Scottish or English registered office where its principal place of business is not also in the UK, and arranging appointments of individual registered officers of GPs.

The ECT Bill completed its committee stage in the House of Lords on 11 May 2023 and will now move to report stage for further scrutiny. It is expected to receive Royal Assent in mid-2023. Pending the legislation being finalised, secondary legislation being drafted, and the Authorised Corporate Service Provider (ACSP) regime becoming effective, GPs of existing UKLPs will want to make sure that they have the necessary information and make the necessary adaptations to their models within the six month transitional period.

Comment

Helpfully, various initial concerns have now been addressed through proposed legislative amendments - namely, on the protection of a limited partner's liability following dissolution and during the UKLP's winding up period and regarding any change to the current regulatory treatment of whether a UKLP is a UK alternative investment fund (AIF) or a non-UK AIF (due to the new concept of a UK registered office - see below). However, we would note the broad provision that remains in the ECT Bill giving the Secretary of State the power to make regulations that apply company law with modifications to fit the circumstances of limited partnerships (mirroring an existing power for LLPs). This is a far-reaching provision for potential future amendments to align partnership with company law (although it seems that there is no current initiative to extend the Persons of Significant Control regime to English limited partnerships).

UKLPs will be required to have a registered office in the UK. This is a new concept as previously the LP Act contained references only to a UKLP's "principal place of business." As the UK AIFM Regulations specify that a UK AIF is an AIF with a registered office in the UK, the concern was that many UKLPs with a principal place of business outside the UK (and therefore non-UK AIFs for regulatory purposes) would suddenly be treated as UK AIFs. Amendments to the UK AIFM Regulations tabled as part of the ECT Bill process should deal with this issue.

The Long Term Asset Fund (LTAF) and Theme of Retailisation/Democratisation

Issue

Available since November 2021, the LTAF is a new open-ended authorised fund structure that can invest in a full range of illiquid asset classes. With news of the first LTAF Financial Conduct Authority (FCA) authorisations in March 2023 and several other firms reportedly having formally applied to launch one (and many more exploring a launch), LTAFs are now a reality.

The development of the LTAF is significant to the retailisation agenda, as an investment platform to access retail wealth outside the listed market. A manager seeking to target the retail market would need to accept increased compliance, detailed authorisation requirements and regulatory risk.

The Productive Finance Working Group's November 2022 publication "Investing in Less Liquid Assets - Key Considerations" includes a Legal Guide to the LTAF. It has also published a model instrument of incorporation for the LTAF.

On 24 November 2022, the FCA published guidance on valuation and unit pricing for LTAFs, broadly a high-level summary of the rules and expected policies and procedures.

Recent and Expected Developments

To help ensure the success of the LTAF, in August 2022 the FCA consulted on its broader retail distribution. A final policy statement and FCA Handbook rules are awaited. This would potentially extend the LTAF's investor base to restricted retail investors (up to 10% of their investable assets and subject to certain conditions being met) in addition to professional investors, certified sophisticated retail and high-net worth investors, and defined contribution (DC) pension schemes as either professional investors or using a unit-linked insurance wrapper. The proposals are aligned with the changes to the financial promotion rules for "high risk investments."

From April 2023, the government has introduced an option for pension scheme trustees to be able to exempt the performance-based element of investment arrangement fees from an 0.75% cap on annual charges that can be levied on auto-enrolled pension savers. This will again broaden investment opportunities for DC pension schemes to make it easier for them to invest in funds featuring carried interest or performance fees.

The authorised fund manager (AFM) of the LTAF need not appoint an external valuer if the depositary has determined that the AFM has the resources and procedures for carrying out asset valuation. Also for an LTAF that invests in other collective investment schemes or AIFs subject to external independent valuations, the AFM can rely on those.

LTAFs must publish monthly valuations, regardless of their dealing policy.

Comment

Broadening pension schemes and retail access may help increase the appeal of the LTAF as either an alternative to the Qualified Investor Scheme (QIS) or for those looking to the authorised funds market for the first time. The FCA authorisation timescale for LTAFs remains six months, which compares negatively with other regulated forms (the FCA aims to process applications to complete a QIS within one month and a Non-UCITS Retail Schemes (NURS) within two months).

There is growing interest in the evolution of different investment routes for retail wealth (including DC pension schemes) in less liquid assets. Alongside closed-ended options (listed investment companies, evergreen funds with fixed liquidity windows to align with the investment cycle of less liquid assets and European Long-Term Investment Funds (ELTIFs) in Europe - see below), and non-fund options such as bespoke investment management arrangements, the LTAF open-ended authorised vehicle provides an important route to consider.

The EU legislation on the ELTIF is to be repealed in the UK (as part of the Edinburgh Reforms package of provisions to address retained EU law), given the lack of take-up in the UK and the recently-introduced option of the UK-specific LTAF.

UK Stewardship Code (the Code)

Issue

The Code aims to encourage the quality of engagement between institutional investors and companies to help improve long-term returns to shareholders and the efficient exercise of governance responsibilities.

It applies to asset owners, asset managers, and service providers. Asset owners include institutional investors, pension funds, insurance companies, local government pension pools, sovereign wealth funds, investment trusts, and other collective investment vehicles. Reports are to be made across an organisation's business, i.e., as a single global organisation (if not possible it can be done as a UK entity).

Recent and Expected Developments

A consultation on a review of the Code (most recently revised in 2020) is expected in Q4 2023. This Green Finance Strategy 2023 update stated that this would include:

ways to evaluate and communicate the efficacy of stewardship activity and outcomes
the need for a common language for stewardship, e.g., defining engagement
the role of systemic stewardship in supporting the achievement of positive sustainability outcomes
evolving expectations for stewardship in asset classes other than listed equity

The Financial Reporting Council expects improved disclosures of how rights and responsibilities are exercised on asset classes such as private equity, real estate and infrastructure.

Comment

Except for certain FCA-regulated investment firms (who have to disclose the nature of their commitment to the Code or where they do not, their alternative investment strategy), the Code and reporting on its application are voluntary. However, there is an expectation that asset managers and asset owners are seen to be taking active steps, including embracing environmental, social, and governance (ESG) considerations, in their stewardship role, regardless of whether or not they are a signatory to the Code.

As highlighted in the UK Green Finance Strategy (see below), evidence of active stewardship is seen as crucial to the successful management of risks, opportunities, and impacts presented by climate and environmental change.

Reform of UK Funds Regime: The New Reserved Investor Fund Regime

Issue

On 27 April 2023 HM Treasury and HMRC published a consultation on the potential scope and design of a new type of investment fund: the Reserved Investor Fund (Contractual Scheme) (the RIF). The consultation closes on 9 June 2023. The aim is to add value to the existing range of UK fund structures.

The consultation followed HM Treasury's January 2021 call for input on a review of the UK funds regime, covering tax and relevant areas of regulation.

Recent and Expected Developments

The proposal under development is that of a UK unregulated contractual structure (in co-ownership form) that is an AIF that is closed-ended or hybrid and unlisted, but with tradable units. The RIF would be treated as a Non-Mass Market Investment that could be promoted to certified high-net-worth individuals and certified and self-certified sophisticated investors as well as professional investors.

It is hoped that the RIF would be able to convert to a Long Term Asset Fund (see below) that is an Authorised Contractual Scheme (ACS) with no tax friction.

See below (under UK Tax) for other developments on the tax side which that formed part of the original UK funds review, in particular on the VAT treatment of fund management services and further amendments to the REIT rules. We also cover other tax developments of interest in this section.

Comment

The RIF is designed predominantly for investment in real estate and the tax rules being consulted on include expanding SDLT seeding reliefs that apply to PAIFs and CoACS to seeding of schemes that elect into the RIF regime, with conditions applying. The proposal provides that units in a RIF may be issued only to those set out below (on the same basis for an ACS). GDO or non-close tests also apply.

professional investors (but note that under the NMMI rules the RIF could also be promoted to other investor categories, namely certified high-net-worth individuals, certified and self-certified sophisticated investors)
large investors (i.e., those who make a payment or contribute property with a value of not less than £1 million)
a existing RIF investors

The government is keen to ensure that there is no risk of loss of tax from non-UK resident investors on disposals of UK property and is exploring various options to achieve this.

Updating and Improving the UK Regime for Asset Management

Issue

This FCA discussion paper (DP23/2) sets out thoughts on how the FCA might modernise, update, and improve the UK regime for asset management. Feedback is sought by 20 May 2023, following which the FCA will, as part of its Future Regulatory Framework Review, prioritise focus areas.

Recent and Expected Developments

Some of the themes covered include:

creating a common framework of rules for asset managers regardless of the type of firm (AIFM, MiFID portfolio manager, AFM of authorised funds, etc.)
changing/removing the boundary of the UK authorised funds regime (e.g. rebranding NURS as "UCITS-plus," allowing wider distribution to retail investors or creating a more basic fund category for certain investments in, for example, large/more liquid investments)
amending the threshold at which AIFMs must apply full-scope rules; providing a core set of high-level rules for small authorised AIFMs (on valuation, liquidity management and investor disclosure)
setting minimum contractual requirements between host AIFMs and portfolio managers
reviewing rules and guidance on liquidity stress testing
exploring digital tokenisation in UK authorised funds

The discussion paper also asks for input on potential reform of the UK regulatory regime for asset managers and funds in scope of the paper but not discussed in detail.

Comment

A goal of achieving a more streamlined and consistent approach (rather than a wholesale revision to the rules for asset management firms) is welcome, in particular to achieve:

clearly distinguished rules between AIFs that admit retail investors and those that admit only professional investors;
increasing the threshold at which the full-scope regime applies to an AIFM;
continuing to engage on liquidity management issues to ensure best practice while not necessitating further regulation.

Related areas not specifically addressed in the discussion paper but on which clarity would be useful include: (i) the UK's future alignment with the EU AIFMD and EU UCITS Directive; (ii) a framework that aligns with the EU rules (with a view to benefitting from any future third country passport in AIFMD, for example); and (iii) any separate UK regimes that would be more appropriate for those firms operating in the UK only.

Bill of Law on Modernisation (and Retalisation) of Luxembourg Fund Laws

Issue

On 24 March 2023, the Luxembourg government published the bill of law 8183 (the Bill), which is expected to amend the following key laws regulating investment funds and their managers in Luxembourg:

the Luxembourg law of 17 December 2010 on undertakings for collective investment, as amended (the UCI Law)
the Luxembourg law of 15 June 2004 on investment companies in risk capital, as amended (the SICAR Law)
the Luxembourg law of 13 February 2007 on specialised investment funds, as amended (the SIF Law)
the Luxembourg law of 23 July 2016 on reserved alternative investment funds, as amended (the RAIF Law)
The Luxembourg Law of 12 July 2013 on alternative investment fund managers, as amended (the AIFM Law).

Recent and Expected Developments

Among myriad proposed amendments, the following are of particular interest in the context of the aim to increase the attractiveness and competitiveness of the Luxembourg financial centre for retail investors:

Amendment of the definition of "well-informed investors" under the RAIF Law, the SICAR Law and the SIF Law. The minimum investment threshold of ?125,000 will be lowered to ?100,000. The definition of "well-informed investor" will also be harmonised throughout the SIF Law and the SICAR Law to reflect the definition set out in the RAIF Law.
Extension of the deadline to meet the minimum amount of assets under management. At present, (a) the minimum of ?1,250,000 must be reached (i) within six months as of its authorisation for a Part II UCI, (ii) within 12 months of its authorisation for a SIF, (iii) within 12 months of its establishment for a RAIF and (b) the minimum of ?1,000,000 must be reached within 12 months of its authorisation for a SICAR. The Bill proposes to extend the deadline to 12 months for a Part II UCI and to 24 months for SIFs, RAIFs and SICARs.
New legal forms available to structure Part II UCIs. At present, Part II UCIs can be structured only as SAs. The Bill proposes that a Part II UCI may also be established as an SCA, an SCSp, an SCS or a S.à r.l., in line with what is allowed for RAIFs and SIFs.
More flexible rules for the issuance price of closed ended Part II UCI units. At present, units of all Part II UCIs must be issued at NAV (as is the case for UCITs). The Bill proposes an amendment to the UCI Law pursuant to which the constitutive documents of closed-ended Part II UCIs could freely determine the issuance price.

Marketing of RAIFs, SICARs, and SIFs in Luxembourg. The Bill proposes amendments to the RAIF Law and the AIFM Law to allow RAIFs, SICARs, and SIFs to be marketed to non-professional investors in Luxembourg, provided they qualify as well-informed investors (noting that this is already possible for Part II UCIs in relation to retail investors).

Comment

The introductory section of the Bill clearly sets out its objectives, i.e. "to enhance and modernise the Luxembourg investment funds' toolbox and to increase the attractiveness and competitiveness of the Luxembourg financial centre."

The proposed changes, to be read in conjunction with the new ELTIF regime, are a response from the Luxembourg legislator to the increasing trend from alternative fund managers seeking to raise capital from retail investors across the world.

The Bill is very much welcomed by the Luxembourg fund industry and is considered to be an important milestone toward alternative offerings to retail investors by Luxembourg investment funds.

SUSTAINABLE FINANCE (UK)

FCA Proposals on Sustainability Disclosure Requirements (SDR) and Investment Labels

Issue

The proposals set out in the FCA's October 2022 consultation CP22/20 aim to increase transparency on the sustainability profile of products and firms and to reduce the risk of harm from greenwashing. In addition, to protect consumers, providing better comparables among products and ultimately increasing capital flows into sustainable activities. As part of this package, the FCA proposes three sustainable labels that in-scope firms can use where they meet the relevant criteria.

Although not in scope to start, non-UK managers and overseas funds being marketed in the UK are expected to be brought into the new regime in due course.

See our October 2022 client alerts on SDR and on TCFD rules for background.

Recent and Expected Developments

The consultation closed on 25 January 2023 and the FCA received about 240 written responses. A policy statement was originally expected by end June 2023 (with a subsequent consultation due to follow on bringing overseas funds within scope). However, this has been delayed to Q4 2023.

Apart from the anti-greenwashing rule (which will apply to all FCA-authorised firms immediately), the rules were originally expected to apply on a phased basis from September 2023. Given the delay to the Policy Statement, the effective dates will now be adjusted accordingly.

The FCA says it will use the extra time to consider more carefully its approach to various issues. In particular it recognises the challenges that many firms have raised (as set out below).

Modifications can be expected in areas like the naming and marketing rules and in the criteria for the application of investment labels (including multi-asset and blended strategies)
The FCA are not going to require independent verification of product categorisation in order to qualify for a label
There will be a place in the regime for products that do not qualify for a specific sustainability label but nevertheless have some sustainability-related characteristics
In relation to international coherence, the FCA will continue to consider how to further support compatibility, while stressing the need for robust UK standards

Comment

The FCA commented (see its 29 March 2023 press release) that there is broad support for the regime and outcomes it is seeking to achieve and it is grateful for the rich and constructive feedback on some of the detail.

The following key questions are still relevant, pending the outcome of the consultation: (i) the extent to which a firm and its products are in scope; (ii) how (and if) the labels may apply to their existing products; (iii) whether or not a firm wants to use a label for its future products, and if so, any changes it may have to make (for instance to strategic, governance, or resources matters) to achieve this; (iv) information to be disclosed and what information needs to be gathered to be able to comply, for instance to identify any challenges with data availability and how these can be best managed; and (v) how (and when) to have conversations with investors on what these rules mean for investment portfolios.

The government wants to ensure that the financial system plays a major role in the delivery of the UK's net zero target, and is acting to secure the UK as "the best place in the world for responsible and sustainable investment."

UK Green Finance Strategy

Issue

An update to the 2019 Green Finance Strategy, "Mobilising Green Investment: 2023 Green Finance Strategy," was published on 30 March 2023, as part of the Green Day announcements, setting out updates on the government's plans to achieve its green finance objectives.

The review of Solvency UK is mentioned in this paper - the government's objective is to support insurance firms in supplying long-term capital to underpin growth, including innovative green assets and renewable energy infrastructure. There are no proposals to tailor the real estate Solvency Capital Requirements (SCR) of 25% (something the real estate sector has been arguing for some time, based on the argument that the volatility of non-listed real estate investments is lower than that represented in the short-term standard model applied in the legislation).

Recent and Expected Developments

The following are the key points of industry to the asset management and investment funds industry:

Consultation on a UK Green Taxonomy in Q4 2023 to provide investors with definitions of which activities should be labelled as green. This is likely to feed into the UK SDR proposals (set out above) in terms of demonstrating that assets meet a credible standard of sustainability. The government plans to mandate reporting after a two year voluntary reporting lead-in.
Consultation on rules for UK largest companies on publication of TCFD-aligned transition plans in Q4 2023, once the Transition Plan Taskforce has finalised its framework. These are intended to complement the FCA's existing transition plan "comply or explain" obligations in place for listed companies and asset managers/owners and to ensure consistency.
A consultation (Q1 2023) on bringing ESG ratings providers within the regulatory perimeter (closes 30 June 2023).
Supporting the work of the International Financial Reporting Standards (IFRS) Foundation's new standard-setting board, the International Sustainability Standards Board (ISSB) and assessing it for adoption in the UK once finalised (expected summer 2023).
The Financial Reporting Council - working with the FCA, government and the Pensions Regulator - will review the regulatory framework for effective stewardship, including the operation of the Stewardship Code (see above).

Comment

These refinements are intended to reinforce and expand the UK's position as a world leader on green finance and investment. We would comment as follows:

Nuclear energy is proposed to be included in the UK taxonomy, which would be consistent with the EU's approach under the Complementary Climate Delegated Act (although this is causing controversy in some member states, and various NGOs have commenced legal proceedings against the European Commission (the Commission)).
The ISSB standards will provide a standardised framework across the UK regulatory framework, including company law and FCA requirements for listed companies.
A key area will be the outcomes of the FCA's SDR and investment label proposals, in particular given the regulatory focus on identifying and addressing greenwashing.

The funds industry will welcome robust and clear standards as these initiatives take effect, and implementation taking place in a cohesive and structured way to avoid any uncertainty and disruption.

SUSTAINABLE FINANCE (EU)

Sustainable Finance Disclosure Regulation (SFDR)

Issue

The EU sustainable finance legislative framework is dynamic and industry understanding and market practice are still evolving. Regulators continue to issue new guidance and statements on the application and interpretation of SFDR and the Taxonomy Regulation.

Although the European authorities did not intend SFDR, a transparency regulation, to create a product labelling/classification regime, the EU has acknowledged that SFDR is being used by market participants as if it were a product labelling regime. As a consequence, minimum standards/legislative amendments for the financial products in scope may well be produced in due course. In the meantime, the current legislative framework continues to apply.

Recent and Expected Developments

The following developments are of note:

On 12 April 2023, the European Supervisory Authorities (ESAs) published a consultation on SFDR Level 2 regulatory technical standards (RTS) amendments relating to principal adverse impact (PAI) indicators and product disclosures. See our client alert ESAs propose adjustments to the EU SFDR rules for more.
On 20 February 2023, the SFDR RTS were amended in respect of information to be provided in pre-contractual documents, on websites and in periodic reports about the exposure of financial products to investments in fossil gas and nuclear energy activities (with updated Annexures II-V).
Further guidance in the form of Q&A continues to be published (the most recent in the Commission's April 2023 Q&A publication).
On 5 April 2023 the Commission published a draft Delegated Act that amends the technical screening criteria (TSC) for climate change and a draft Delegated Act with TSC for the remaining four environmental objectives (which both closed on 3 May 2023). These will apply from 1 January 2024 (assuming the legislative process proceeds without objection).

Comment

A few points of interest from the April 2023 Commission Q&A:

Noting that the SFDR does not prescribe specific criteria or minimum requirements that qualify concepts such as "contribution", "do no significant harm" (DNSH) or "good governance", firms must carry out their own assessment for each investment and disclose their underlying assumptions. A firm would have to demonstrate that any transitioning assets meet the DNSH and governance tests straightaway in order to qualify as a sustainable investment under SFDR.
Funds that passively track Paris-Aligned Benchmarks or Climate Transition Benchmarks would be sufficient for an Article 9 categorisation.
Firms that consider principal adverse impacts PAIs at the product level should disclose information on policies and procedures put in place to mitigate those PAIs (as well as PAI metrics).

ESAs Call For Evidence on Greenwashing (no updates to previous edition)

Issue

This paper requests views across the financial sector on how to understand greenwashing (for sustainability-related claims relating to all aspects of ESG) and its main drivers.

Recent and Expected Developments

This was open for comment until 10 January 2023, a progress report by the ESAs is expected by end May 2023 and a final report by end May 2024.

Comment

Tracking progress on this will provide insights in terms of evidence on potential greenwashing practices within and outside the scope of current EU sustainable finance legislation, and how the European authorities intend to address this, in terms of policy and regulatory risk and enforcement actions. Clarity and sectoral focus in this area will no doubt help to significantly reduce the potential harm or impact of any otherwise misleading or unsupported claims.

SMSG's Responses to ESMA on ESG

Issue

Following the Securities and Markets Stakeholder Group's (SMSG) submission to the ESA's joint call for evidence on greenwashing (outlined above), ESMA submitted four additional questions to SMSG requesting its input. These questions concerned whether there needs to be a more holistic definition of greenwashing, the so-called "greenbleaching" phenomenon, and what ESMA's role should be in this area.

Recent and Expected Developments

SMSG submitted its additional responses to ESMA on the 16 March 2023. These will inform the ESA's final report on greenwashing which is due to be published by the end of May 2024.

Comment

SMSG has suggested that the current definition of greenwashing in European legislation is too narrow in scope and that there should be greater focus on ESG as a whole, rather than just the environmental aspects, which are the focus of many existing regulations.

SMSG has also taken the viewpoint that greenbleaching, where funds downplay their ESG credentials, should not be considered a misrepresentation. However, it has recommended that ESMA should monitor how many funds are undertaking this practice and if greenbleaching is widespread then ESMA should consider whether the existing sustainable finance legislation is achieving its goals. It has suggested that uncertainty in existing ESG legislation, such as what liquidity, hedging, and transition strategies are permitted for Article 9 funds, could be a cause of greenbleaching, with fund managers taking an overly cautious approach to avoid being accused of greenwashing. This could lead to ESMA recommending legislative reform to the Commission.

ESMA Consultation on Guidelines on Fund Names Using ESG or Sustainability-Related Terms

Issue

The purpose is to tackle greenwashing risk in funds by using quantitative thresholds for the use of ESG and sustainability-related terminology in fund names, to ensure that marketing communications are fair, clear, and not misleading and that fund managers are acting honestly.

Recent and Expected Developments

This was open for comment until 20 February 2023, and expected to be finalised by Q2 or Q3 2023. To date, there has been no further output on this.

If a fund has any ESG or impact-related words in its name, a minimum proportion of at least 80% of its investments should be used to meet the E or S characteristics or sustainable investment objectives in accordance with the binding elements of the investment strategy to be disclosed in the Article 8 and 9 pre-contractual SFDR disclosures. If a fund has the word "sustainable" or any derivation of it in its name, 50% of the overall investments should be a minimum proportion of sustainable investments (as defined in Article 2(17) SFDR) (ESMA confirmed that the 50% proposal relates to overall investments not of the 80% figure referred to above).

Comment

This initiative is reflective of current developments elsewhere. For instance, in the UK, the FCA consultation CP22/20 on SDR and product labels (set out above) proposes restrictions to ensure that those marketing products to retail investors where those products do not use a sustainable label cannot promote them as sustainable through names or in marketing materials (although firms may use such terms in their disclosures.

Similar initiatives have been proposed in France, Germany, and the US.

Corporate Sustainability Due Diligence Directive (CSDDD)

Issue

The purpose of the CSDDD, according to the Commission, is to "foster sustainable and responsible corporate behaviour and to anchor human rights and environmental considerations in companies' operations and corporate governance." It seeks to establish a corporate due diligence duty (as well as duties for directors) on companies in relation to actual and potential humans rights adverse impacts and environmental adverse impacts.

Recent and Expected Developments

The proposal by the Commission was published in early 2022 and it is currently in the legislative process, with the EU Council adopting its negotiating position in November 2022. The next step is for the European Parliament to publish its position, after which a trialogue period will begin. A finalised directive was expected in 2024 with implementation in 2026, but there are currently delays due to discussions on directors' duties and whether it will apply to financial institutions. More clarity on these areas many be seen once the Parliament publishes its position.

Comment

While laudable for its aims, the CSDDD is yet another piece of legislation in relation to sustainability and corporate governance. The financial services industry is still getting to grips with SFDR and the interaction between this and CSDDD is currently uncertain. There are also concerns about the legislation grouping funds with their portfolio entities in which they take a majority stake, as there is currently no separation between "trade" groups and those entities linked only by financial investments.

It is worth noting that companies must meet a threshold (both by number of employees and turnover) in order for the CSDDD to apply. It will also apply to non-EU companies if they are active in the EU and their turnover generated in the EU meets the relevant threshold.

Corporate Sustainability Reporting Directive (CSRD)

Issue

The CSRD came into force on 5 January 2023 and amends several EU laws: the Audit Regulation, Audit Directive, Transparency Directive, and Accounting Directive. It is designed to strengthen the rules for companies and the social and environmental information that they have to report on.

Recent and Expected Developments

The Commission estimates that CSRD will apply to approximately 50,000 companies which includes a wider group of large companies and listed small and medium-size enterprises (SMEs).

It will apply to different groups of companies in stages, with the first group (public interest entities with more than 500 employees) having to report in 2025 in relation to the 2024 financial year. Large EU companies/groups (defined as an entity or group that meets two of the following three tests: (a) a balance sheet of €20m; (b) net turnover of €40m; (c) an average of 250 employees in the financial year) will have to report in 2026 in relation to 2025, and listed SMEs that are not micro-undertakings begin in 2027 in relation to 2026.

Lastly, non-EU parent companies with a subsidiary that is either a large EU company or a listed SME, or that has a large EU branch, will be required to report from 2029 in relation to 2028.

Comment

The CSRD amends some of the rules brought in by the Non-Financial Reporting Directive, but the requirements of the NFRD remain in force until the new rules start to apply.

Importantly, CSRD widens the scope of companies that are subject to the rules when compared to NFRD, with a major change being that listed SMEs are now included (unless they are "micro-entities").

SUSTAINABLE FINANCE (US)

SEC Proposed ESG Disclosure Rules (no updates to previous edition)

Issue

On 25 May 2022, the US SEC proposed ESG disclosure rules to address and enhance investor disclosure practices, and related policies and procedures regarding ESG investment considerations and objectives, as well as proposed changes to the existing "Names Rule" applicable to registered funds. The proposed ESG disclosure rules would require registered investment companies and registered investment advisers that employ ESG strategies in their investment processes to make ESG disclosures either in the fund prospectus for a registered investment company or in the brochure (Form ADV Part 2A) for a registered investment adviser. Disclosure requirements would vary based on the extent of ESG factor integration into investment strategies, characterized as "ESG Integration Strategies," "ESG-Focused Strategies", and "Impact Strategies."

See our June 2022 client alert for background and more details.

Recent and Expected Developments

Finalisation of the proposed rules and amendments is expected sometime in 2023. The SEC, however, is already actively engaged in enforcement activity based on inaccurate or misleading ESG-related disclosures.

The proposed ESG disclosure rules would apply to investment advisers to registered investment companies and private funds and other clients and are intended to provide investors with clear and comparable information about how advisers consider ESG factors.

The proposed changes to the Names Rule would, among other things, significantly expand the scope of the terms used in the names of registered funds that would subject the fund to the requirements of the Names Rule, including terms indicating that the fund's investment decisions incorporate one or more ESG factors.

Comment

The proposed rules, meant to address greenwashing, are the US version of the EU's SFDR that has applied since March 2021 and the UK's SDR proposals (both of which are covered above). The focus, however, is solely on disclosures, and the SEC does not promote the adoption of a particular ESG strategy or any ESG strategy at all.

As proposed, the additional disclosure requirements applicable to "ESG-Focused" funds would be very easy to trigger. For example, the use of a single negative screen seemingly would cause a fund to fall within this category.

The US Department of Labor (DOL) Released Final Amendments to Its Regulation on Investment Duties

Issue

This relates to those amendments under Section 404(a) of the Employee Retirement Income Security Act of 1974 (ERISA) regarding the consideration of ESG factors by retirement plan fiduciaries. The amendments took effect on 30 January 2023.

See our January 2023 client alert for background and more details.

Recent and Expected Developments

On 20 March 2023, President Biden vetoed a resolution passed by the US Congress that would have overturned this rule.

Comment

The DOL's final amendments expressly reference ESG factors but take a neutral stance on whether investment fiduciaries should consider them and, to the extent they are considered, the weight to be afforded to them, providing investment fiduciaries leeway to determine whether and to what extent ESG factors are relevant in any given case.

Several US States or Groups of States Have Engaged in "Anti-ESG" or "Pro-ESG" Activity

Issue

This is taking place via new legislation, investment policies, attorney general opinions, letters, reports, statements, and unilateral state treasurer action, such as South Carolina's divestment from BlackRock. Some states have also "blacklisted" certain companies that they have determined to act contrary to the principles and obligations that are the subject of the anti-ESG action.

Recent and Expected Developments

States that have engaged in anti-ESG activity (pending or finalized) include: Alabama, Alaska, Arizona, Arkansas, Florida, Georgia, Idaho, Indiana, Iowa, Kansas, Kentucky, Louisiana, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, New Hampshire, North Dakota, Ohio, Oklahoma, Pennsylvania, South Carolina, South Dakota, Tennessee, Texas, Utah, Virginia, West Virginia, and Wyoming. By contrast, Connecticut, Illinois, Maine, Maryland, Nevada, New Hampshire, New Jersey, New York, Rhode Island, Vermont and Virginia have recently proposed or adopted policies or legislation to advance one or more ESG-related cause.

In response to the anti-ESG activity of certain states, representatives from California, Colorado, Delaware, Illinois, Maine, Massachusetts, Nevada, New Mexico, New York, Oregon, Rhode Island, Vermont, Washington, and Wisconsin released an open letter urging support for ESG-themed investment strategies.

Comment

The anti-ESG efforts, though widely acknowledged to promote a "red state" political agenda, are having a practical, if not a legal, impact. For example, a leading global investment company recently withdrew from the Net Zero Asset Manager initiative and was shortly thereafter excused from a hearing on ESG investment factors convened by the Texas Senate Committee on State Affairs.

Click here to continue reading . . .

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.