UK/EU Investment Management Update (October 2023)

1. UK — FCA Updates

2. UK — FCA Enforcement Actions

3. UK — Diversity and Inclusion

4. UK — Cryptoasset Regulation

5. UK — Financial Crime

6. EU — AIFMD

7. EU — Securitisation Regulation

8. EU — Cryptoasset Regulation

9. EU — ESG

10. EU — Sanctions

11. International — ESG

FCA publishes ‘Dear CEO’ Letter on supervision strategy for Corporate Finance Firms (CFFs)

On 28 September 2023, the Financial Conduct Authority (FCA) published a ‘Dear CEO’ letter addressed to the CEOs of CFFs. The letter outlines the role of CFFs in the UK economy and the potential risks of harm that such firms pose. The letter also explains the FCA’s strategy to address these harms and its expectations of CFFs and to set out the FCA’s supervisory priorities. Whilst the letter is directed primarily at CFFs, asset managers should also be mindful of the content of the letter, much of which also raises issues relevant to asset management business. In particular, as detailed below, the FCA will be looking closely at unused regulatory permissions.

The FCA explains that its supervisory priorities are as follows:

• Client categorisation. The FCA expects firms to comply with the client categorisation requirements in COBS 3 of the FCA Handbook in relation to clients they provide a service to in the course of carrying on a regulated activity. The FCA will be undertaking a targeted review of CFFs’ client categorisation processes and will request evidence of compliance with the relevant rules. The FCA makes clear in the letter that firms should expect the FCA to take robust action, including the application of business restrictions, where it finds abuse of the corporate finance contacts regime or financial promotion exemptions.
• The Consumer Duty. Whilst the Consumer Duty generally applies to firms that provide services to retail clients, the duty has an intentionally wide perimeter, so firms that do not usually face retail clients should nonetheless consider, in the course of carrying on regulated activities, whether their activities may be in scope of the Duty. Further, CFFs should be mindful of the Duty during client categorisation. Encouraging clients to opt up to professional client classification to circumvent the protections afforded to retail clients, or financial promotions restrictions, would breach the Duty. The FCA will be collecting data about firms’ approach to the Duty in due course and will expect firms to be able to explain how the Duty applies to them.
• Dealing with problem firms. The FCA expects CFFs to use their regulatory permissions to advance a legitimate business purpose and to construct and maintain their permission profile in a way that accurately reflects this. However, it notes that it continues to see firms that appear to hold permissions for no clear business purpose or in order to favourably influence public perceptions of their unregulated business. The FCA will contact firms that do not appear to be using their regulatory permissions to understand why they need them and, where necessary, request firms to vary or cancel their permissions. The FCA also emphasises the importance of being transparent and maintaining channels for communication; firms should keep their contact details up to date on the FCA Connect Portal and be responsive to requests from the regulator.
• Market abuse. Firms must ensure that market abuse controls are tailored to their individual business models. The FCA expects CFFs to have robust prevention cultures and systems and controls to discharge their obligations under the UK Market Abuse Regulation. The FCA also expects CFFs to properly identify, record, and manage conflicts of interest. These requirements are set out in Principle 8 and the rules in SYSC 10 of the FCA Handbook. CFFs must consider conflicts arising both from their inherent business model and from new clients and new transactions taken on.

FCA publishes report on the Appointed Representative (AR) regime

On 28 September 2023, the FCA published a report setting out an analysis of data collected from principal firms that oversee ARs and firms applying for authorisation. The report outlines how the FCA is using the data it has gathered to inform its enhanced supervisory approach with respect to the AR regime and what their expectations are for firms.

As discussed in our August 2022 and December 2022 Updates, the FCA introduced new rules in a policy statement (PS22/11) to improve the AR regime that came into force on 8 December 2022, including new requirements on principal firms to provide the FCA with information on their AR relationships and to review the ARs’ activities on a regular basis. The FCA report also provides feedback on firms’ implementation of the new rules.

In addition, the report set out several specific areas of concern:

• Introducer Appointed Representatives (IARs). IARs are appointed representatives appointed by a firm whose scope of appointment is limited to effecting introductions and distributing non-real-time financial promotions. The FCA noted that as IARs have a limited scope and fewer regulatory requirements, it is important for principal firms to ensure that their IARs are sticking to their limited activities as they become increasingly common; IARs who engage in activities beyond the terms of the scope of their appointment may be committing an offence. The FCA’s most recent statistic, in August 2023, indicated that 37% of AR relationships were IARs.
• Overseas ARs. Whilst less than 1% of ARs are headquartered outside the UK (Overseas ARs, or OARs), the FCA nonetheless noted that it had faced challenges involving OARs, include difficulties in understanding and managing legal, accounting, and regulatory requirements for each jurisdiction. As a result, the FCA’s supervisory engagement with some principals to address these difficulties has led to some principals’ choosing to terminate contracts with OARs. Firms should therefore be conscious of the potential challenges in monitoring and effectively overseeing OARs.
• Professional Indemnity Insurance (PII) and Capital Adequacy. Principal firms with ARs must hold compliant PII to cover the activities of their current and former ARs (including IARs) where required to do so by the FCA rules. The collected data showed that that a minority of principals either held only partial cover or were relying on insurance taken out by the ARs themselves. Through its wider supervisory work, the FCA also saw some firms with incorrect policies that did not cover ARs and had significant exclusions that greatly limited cover. As such, the FCA urges firms to ensure they have an appropriate level of PII cover for all ARs and is also consulting on changes to clarify its PII requirements for principal firms in its September 2023 quarterly consultation paper.
• Monitoring of ARs. The FCA requires principal firms to have ‘adequate’ controls over the AR’s activities and resources to monitor and enforce the AR’s compliance. The FCA noted that there have been several examples where this has clearly not been the case. In such cases, the FCA has required firms to address these concerns, including implementing stronger controls and temporarily stopping AR recruitment. As an example statistic, the collected data showed that over 70% of principals that offered regulatory hosting services had at least one full-time employee for every five ARs in their network. Principal firms that do not meet this ratio may wish to consider if they are adequately resourced for AR monitoring.

In terms of next steps, the FCA will continue to analyse data collected under the new rules in force from December 2022 to strengthen scrutiny of authorisations and approvals and supervise high-risk principals more assertively. The FCA will use all the tools at its disposal where it identifies emerging harms, for example attestations for senior figures, requirements on firms, skilled persons reviews, and appropriate enforcement action.

FCA approach to post-Brexit handbook

On 13 September 2023, the FCA announced a joint approach towards developing a UK financial services rulebook post Brexit. This will involve working closely with HM Treasury and the Prudential Regulation Authority (PRA) in order to collectively deliver a government statute book, a PRA rulebook, and a FCA handbook that complement one another.

The FCA’s overall aims for the handbook are to reduce regulatory requirements and instead enhance accessibility. To achieve this, the following principles will be applied:

• bringing together regulatory provisions so that the Handbook becomes a ‘one-stop shop’;
• using existing structures to minimise changes;
• considering outcomes-based regulation, where appropriate; and
• aligning standards which address similar issues across files.

The FCA is committed to making sure its website is updated as further progress is made.

FCA announces new screening checks for approving financial adverts

On 12 September 2023, the FCA published its policy statement (PS23/13), which introduces a gateway for firms that approve financial promotions.

Firms will need to demonstrate the necessary skills and expertise before they can approve financial marketing by unregulated firms. Those signing them off must understand the product and will be required to report regularly on what they sign off as well as any concerning adverts they cancel approval for, helping the FCA to move faster to crack down on rogue adverts.

Firms will need to apply to the FCA between 6 November 2023 and 6 February 2024 to continue approving adverts ahead of the new rules, which come into force on 7 February 2024. Further information on the application process is available on the FCA website.

2. UK — FCA Enforcement Actions

FCA fines ADM Investor Services for serious money-laundering control breaches

On 2 October 2023, the FCA fined ADM Investor Services International Limited (ADMISI) £6,470,700 for inadequate anti-money-laundering (AML) systems and controls.

The FCA had initially raised concerns with ADMISI in relation to its AML systems in 2014 and expected ADMISI to make improvements. However, during a follow-up firm visit in May 2016, the FCA found significant failings remained. In particular:

• The firm’s AML customer risk assessment was basic and did not enable an assessment of a customer’s financial crime risk.
• It did not conduct a firm-wide money laundering risk assessment.
• There was little evidence of adequate on-going monitoring in the form of periodic customer reviews.
• Policies were outdated and referred to old legislation.

Whilst the deficiencies noted during the May 2016 firm visit were eventually remedied by October 2016, the FCA nonetheless determined that by failing to comply with the applicable regulatory and legal AML requirements and failing to remedy the weaknesses the FCA had identified in its 2014 assessment, ADMISI had breached Principle 3 of the FCA’s Principles for Business, which requires a firm to take reasonable steps to ensure that it has organised its affairs responsibly and effectively, with adequate risk management systems.

This enforcement action underscores the importance for all regulated firms to ensure that they have an effective AML compliance program in place, to ensure that such program is adhered to in practice and to periodically review and update the program as appropriate. Further, where the FCA has raised concerns about a firm’s regulatory deficiencies, firms must commit to taking action to remedy such deficiencies within a reasonable timeframe.

FCA takes action against Darren Reynolds and Andrew Deeney for dishonest pensions advice

On 28 September 2023, the FCA decided to fine Darren Reynolds of Active Wealth (UK) Limited (Active Wealth) £2,212,316 and ban him from working in financial services. Andrew Deeney was fined £397,400 and banned from working in financial services.

Reynolds has referred his Decision Notice to the Upper Tribunal where he will present his case. Any findings in his Decision Notice and the details below are therefore provisional and reflect the FCA’s view as to what occurred and how it considers his behaviour should be characterised.

Reynolds had dishonestly established, maintained, and concealed a business model that incentivised recommending products that produced the highest commission for the adviser rather than the best outcome for the customer, and he exploited this to the detriment of Active Wealth’s customers so that he could receive £1.01 million in prohibited commission payments. These payments were funnelled via companies connected to Reynolds and were intentionally designed to disguise their true origins.

Deeney made personal financial gains exceeding £200,000 by providing Active Wealth customers with unsuitable advice so that he could dishonestly receive banned commission payments. Deeney’s misconduct then continued at Fortuna Wealth Management Limited (Fortuna), a firm he established that purchased Active Wealth’s goodwill and client database, where he repeatedly sought to mislead the FCA about his role in advising customers to invest in high-risk investments.

By June 2023, the Financial Services Compensation Scheme (FSCS) had paid compensation of over £19.8 million to 511 of Active Wealth’s former customers. At least 270 customers suffered losses over the FSCS’s compensation cap of £50,000. Were it not for this cap, the compensation amount would be over £42.3 million.

Therese Chambers, Joint Executive Director of Enforcement and Market Oversight, said that “this is one of the worst cases [the FCA] have seen. Mr Reynolds, who allowed evidence to be destroyed and who has consistently sought to evade accountability, and Mr Deeney, lied and lied again. First, to dupe people into leaving safe pension schemes and placing money meant for their retirement in unsuitable, high-risk investments. Then to try and hide their misconduct from us. Their motivation was based on self-enrichment. Such people have no place in our industry.”

This decision follows the enforcement action taken by the FCA against Paul Steel on 4 July 2023 for similar conduct in relation to the provision of unsuitable defined benefit pension transfer advice. Whilst neither case relates directly to investment management, firms should nonetheless take note of the FCA’s enforcement approach in relation to individuals engaging in the provision of intentionally dishonest investment advice.

3. UK — Diversity and Inclusion

FCA and PRA publish consultation papers on D&I in financial services

On 25 September 2023, the FCA and PRA published a joint announcement on consultation papers in relation to proposed measures to boost diversity and inclusion (D&I) in financial services as well as to enhance the safety and soundness of firms to improve understanding of diverse consumer needs. The FCA considers that increased D&I in regulated financial services firms can deliver better internal governance, decision making, and risk management.

The proposals include new rules and guidance to make clear that misconduct such as bullying and sexual harassment poses a risk to healthy firm culture and requires firms to consider certain non-financial misconduct in their fit and proper assessments of individuals. The proposals set flexible, proportionate minimum standards to raise the bar, including requirements to:

• develop a diversity and inclusion strategy setting out how firms will meet their objectives and goals
• collect, report, and disclose data against certain characteristics
• set targets to address under-representation

Certain of the requirements, including setting targets, regulatory reporting, and disclosure, would apply only to firms with greater than 250 employees (but excluding limited-scope Senior Managers and Certification Regime firms).

Speaking in relation to the proposals at the Ethnic Diversity and Inclusion in the Financial Services Summit on 27 September, Alicia Kedzierski, the FCA’s head of environmental, social, and governance (ESG), said that while many firms do already have D&I targets, they were restricted to gender representation at senior management level. Going forward, UK financial services firms will be expected to set “ambitious” targets for D&I.

The consultation is open until 18 December 2023. Feedback will be used to develop final rules planned for publication in 2024. The FCA Consultation Paper and the online response form are available here.

4. UK — Cryptoasset Regulation

FCA clarifies expectations on cryptoasset promotions

On 7 September 2023, the UK FCA announced, following a review of firms’ preparations in relation to incoming cryptoasset promotion rules, that it would consider giving firms more time to implement certain changes before the new rules come into force. The FCA’s announcement was accompanied by a letter to cryptoasset firms setting out the relief measures in more detail.

In June 2023, the FCA had published new rules for cryptoasset financial promotions, which were intended to come into effect from October 8, 2023. This is the same date that the Financial Services and Markets Act 2000 (Financial Promotion) (Amendment) Order 2023 brings the promotion of cryptoassets within scope of the UK regulatory regime.

The FCA’s review of firm preparations for the incoming rules had indicated that many firms had faced significant challenges in preparing for the financial promotions regime, including difficulties in preparing ‘back-end’ financial promotion rules (i.e., personalised risk warnings, 24-hour cooling-off period, client categorisation, and appropriateness assessments), compounded by the fact that firms had prioritized compliance with the UK’s ‘Travel Rule’ which came into effect on 1 September 2023.

Accordingly, the FCA is allowing cryptoasset firms to apply for consent from the FCA to modify the effective date of application for certain new rules. This consent would be available, on application, to:

• firms registered with the FCA under the Money Laundering, Terrorist Financing, and Transfer of Funds (Information on the Payer) Regulations 2017 that intend to communicate cryptoasset financial promotions
• authorized firms that intend to communicate or approve cryptoasset financial promotions

For firms that have been granted consent, the new ‘back-end’ financial promotion rules will apply to them only from January 8, 2024. The rules on risk warnings, risk summaries, the ban on incentives to invest, and the requirement that financial promotions must be fair, clear, and not misleading will still come into effect from October 8, 2023.

The FCA has also published expectations for firms to which the incoming cryptoasset promotion rules will apply, providing detailed feedback on good and bad practices identified in its review of firms’ preparations. In addition to the difficulties in preparing for the ‘back-end’ financial promotion rules, the FCA noted the following:

• Firms in global group structures are having to make significant changes to their business models to comply with the regime. These firms must significantly restructure how they provide services to UK customers to ensure they comply. They must also implement effective systems and controls in their wider group to prevent UK consumers being promoted to by unauthorised/unregistered firms or risk committing a criminal offence.
• Firms have under-appreciated the broad scope and nature of the financial promotions regime. The regime covers ‘traditional’ promotional material and also applies to a wide range of customer communications including websites and apps.
• Firms were not sufficiently considering how certain rules apply to the specifics of the cryptoasset services they provide. In particular, they did not consider how their risk summaries and appropriateness assessments should be tailored to the specific cryptoassets being promoted.

After the new rules are brought into force, there will be four routes cryptoasset firms can take when lawfully communicating cryptoasset promotions:

(i) an authorised person communicates the promotion (ii) an authorised person approves the promotion (iii) a crypto firm registered under the money laundering regulations communicates the promotion (iv) the promotion otherwise complies with the conditions of an exemption in the financial promotion order

The FCA has warned that anyone continuing to promote cryptoassets to UK customers past the October 2023 deadline without complying with the rules may be committing a criminal offence punishable by an unlimited fine and/or up to two years’ imprisonment.

5. UK — Financial Crime

FCA director delivers speech on tackling financial crime

On 6 September 2023, Sarah Pritchard, Executive Director of Markets and International at the FCA, gave a speech at the 1LoD Financial Crime Summit 2023. She emphasised that tackling financial crime is a “super-charged” priority for the FCA and that the FCA expects firms to be the first line of defence for UK consumers and markets against financial crime, noting the following in particular:

• Firms should not outsource responsibility. Instead, firms must know who their clients are and how they are structured. They should identify the types of transactions clients are expected to make and develop calibrated systems to flag suspicious activity.
• By taking early action in response to suspected financial crime and introducing risk-based, proportionate controls, firms can protect the public and avoid heavy fines and reputational damage.
• The FCA itself is also focussed on improving outcomes. In 2022, the authority removed more than 8,500 misleading adverts, a 14-fold increase over the previous year. The FCA has also already opened over 610 financial crime supervision cases in 2023, up 65% on 2022.

Pritchard outlined three specific areas where the FCA is taking action.

• Sanctions. The FCA is using data, tech, and artificial intelligence to increase its proactive testing of firms’ systems and compliance with UK and international sanctions (see update on FCA assessment of firms’ sanctions controls directly below). It carried out 352 sanctions assessments last year — four times as many as the year before. Firms that fall short can expect surprise FCA visits.
• Whistleblowing. The FCA is encouraging whistleblowing in high-risk sectors and pushing for enhanced AML supervision of lawyers and accountants.
• Politically Exposed Persons (PEPs). The FCA is launching a review of the PEP regime, focussing on proportionality. The FCA wants to maintain clean markets without excluding innocent PEPs from financial services. Firms are reminded that domestic PEPs should generally be treated as lower risk than foreign PEPs.

FCA publishes findings on assessment of firms’ sanctions controls

On 6 September 2023, the FCA published findings from its assessment of sanctions systems and controls in UK financial services firms. The FCA reviewed over 90 firms across different sectors.

The FCA identified some (limited) good sanctions practice among firms. The review found that some firms have in place calibrated, risk-based sanctions screening tools and technology as well as internal testing and parameters.

Other firms had prepared effectively for Russia’s invasion of Ukraine, for example, by conducting advance risk assessments of their exposure to Russia. Good preparation led to improved responses when sanctions were later imposed.

The FCA’s findings reveal several areas where UK financial services firms must improve their sanctions systems.

• Management information (MI). Senior management need sufficient MI to fulfil their responsibilities. Sanctions MI is sometimes limited and lacks basic metrics.
• Multinational firms. Global firms sometimes approach UK sanctions measures using systems and processes designed for sanctions regimes in other jurisdictions. Communication between global and regional sanctions teams can be poor.
• Outsourcing. Some firms outsource their sanctions screening tools and do not understand them properly. Other firms lack expertise and have to rely on external resources.
• Contingency planning. While some firms anticipated Russia’s invasion of Ukraine, contingency planning for geopolitical events and consequent sanctions escalations can improve.
• Reporting. Many firms have major backlogs in assessing and reporting screening alerts to Office of Financial Sanctions Implementation and the FCA. Reporting has generally been inconsistent and too slow.
• Customer Due Diligence (CDD) and Know Your Customer (KYC) procedures. Some firms are carrying out deficient CDD and KYC checks. Effective CDD must reveal the full ownership structure of entities to check for sanctioned individuals.

Firms should evaluate and improve their sanctions frameworks, addressing any weaknesses highlighted by the FCA review. Firms must keep up to date with the evolving UK sanctions regime and the latest legislation and regulatory guidelines.

6. EU — AIFMD

FIN-FSA updates AIFMD reporting system

On 30 September 2023, the Finnish Financial Supervisory Authority (FIN-FSA)’s new reporting system for Alternative Investment Fund Managers Directive (AIFMD) reporting, the Reporter portal, went live.

As such, from October 2023 onwards, registered and authorised Finnish alternative investment fund managers, as well as non-EU asset managers who market funds in Finland under the National Private Placement Regime, will be required to use the Reporter portal to satisfy their Annex IV reporting obligations.

The AIFMD reporting obligation takes effect at the beginning of the next quarter following the approval of the notification on the commencement of marketing. If an alternative investment fund (AIF) receives a marketing authorisation from the FIN-FSA at a time when the AIF is not yet filed in the Finnish Trade Register, the FIN-FSA must be re-notified as soon as the fund is filed and also when fund operations are initiated.

AIFMD reports are submitted to the Reporter portal from reference date 30 September 2023 onwards. Reports, including amendment reports for a reference date of 30 June 2023 or older are submitted via email to the legacy reporting system.

Further guidance and instructions on the new Reporter portal are available on the FIN-FSA website.

7. EU — Securitisation Regulation

ESMA publishes study of trends in EU securitisation markets

On 21 September 2023, the European Securities and Markets Authority (ESMA) published a study setting out details and key figures relating to the EU securitisation market. The study is based on the data ESMA receives under the Securitisation Regulation (SECR) and from the ESMA register of simple, transparent, and standardised (STS) securitisations. The SECR requires the reporting of public securitisation data, including on underlying exposures and investor reports, through registered securitisation repositories.

Overall, the study found that the size of the European securitisation market has decreased significantly since the €2 trillion it reached at the end of 2010. At end-2022, there were 390 individual securitised products outstanding in the EU as reported to the registered securitisation repositories, amounting to €540 billion. 54% of these outstanding amounts were linked to residential mortgages, followed by automobile loans (16%), loans to small and medium-size enterprises (SMEs) (15%) and consumer loans (12%). 86% of the outstanding was originated in the five largest markets, namely France (25%), Germany (21%), Italy (17%), Spain (13%), and the Netherlands (10%).

The study also presents data from the ESMA register of STS securitisations. These securitisations fulfil a various set of predetermined requirements to help investors identify high-quality securitisations and thus foster EU securitisation markets. The ESMA STS register contained 586 non-asset-backed commercial paper (ABCP) and ABCP STS notifications in the STS register as of 31 December 2022: 238 public and 348 private. Additionally, there were 54 synthetic STS. The report also sets out the geographical distribution of the STS securitisations across the EU member states.

The scope of the study is limited to public securitisation deals issued after 1 January 2019 and does not cover earlier issuances. The overall market including pre-2019 securitisations is significantly larger, as suggested by industry reports such as the Association of Financial Markets in Europe’s estimate of €700 billion of EU asset-backed securities. The market coverage of the ESMA reporting will increase as the EU approaches the maturity of the pre-2019 deals, although private securitisation will remain out of scope.

8. EU — Cryptoasset Regulation

EBA publishes response to European Commission call for advice on MiCAR

On 29 September 2023, the European Banking Authority (EBA) published its response to the European Commission (EC) call for advice on two EC-delegated acts under the Markets in Crypto-Assets Regulation (MiCAR) relating to the criteria for determining the significance of asset-referenced tokens (ARTs) and electronic money tokens (EMTs) and to the supervisory fees that EBA may charge to issuers of significant ARTs and significant EMTs.

By way of background, MiCAR establishes a regime for the regulation and supervision of crypto-asset issuance and crypto-asset service provision in the EU. MiCAR establishes an EU-level supervision framework for specific types of crypto-assets, namely ARTs and EMTs that are determined by the EBA to be ‘significant’. MiCAR came into force on 29 June 2023, and the provisions relating to ARTs and EMTs will be applicable from 30 June 2024.

In its response, the EBA proposes a set of core and ancillary indicators for each significance criterion within the scope of the call for advice: financial sector interconnectedness and activities on an international scale. These indicators provide the EBA with a quantitative indicator of the ‘significance’ of the relevant token to EU and international financial markets, and the EBA will set significance thresholds in due course.

Regarding the supervisory fees, the EBA proposes criteria for allocating costs between issuers, as defined in MiCAR, and ensures that all costs it will incur in the performance of its supervisory tasks, including the establishment of supervisory colleges and in the context of any delegation of tasks to NCAs, can be charged to issuers of significant ARTs and significant EMTs in accordance with the full cost-recovery approach foreseen in MiCAR.

9. EU — ESG

EC launches SFDR consultations

On 14 September 2023, the EC announced that it had launched a targeted consultation and a public consultation to gather feedback on the Sustainable Finance Disclosure Regulation (SFDR).

For a discussion on the consultations, see our Update, Five Key Takeaways From the European Commission’s Consultation on the Sustainable Finance Disclosures Regulation.

ESMA launches CSA on the integration of sustainability in firms’ suitability assessments

On 3 October 2023, ESMA announced that it will launch a Common Supervisory Action (CSA) with National Competent Authorities (NCAs) on the integration of sustainability in firms’ suitability assessment and product governance processes and procedures in 2024.

The goal of the CSA will be to assess the progress made by intermediaries in the application of the key sustainability requirements, which entered into application in 2022 following the amendments to the Markets in Financial Instruments Directive II Delegated Acts.

The CSA will cover the following aspects:

• how firms collect information on their clients’ “sustainability preferences”
• which arrangements firms have put in place to understand and correctly categorise investment products with sustainability factors for the purpose of the suitability assessment
• how firms ensure the suitability of an investment with respect to sustainability (including the use of a “portfolio approach”)
• how firms specify any sustainability-related objectives a product is compatible with as part of the target market assessment of the investment product

ESMA believes this initiative, and the related sharing of practices across NCAs, will help ensure consistent application of EU rules and enhance the protection of investors in line with ESMA’s objectives.

The CSA follows ESMA’s recent update of two sets of guidelines on suitability and product governance published on 23 September 2022 and 27 March 2023 respectively, both of which enter into application on 3 October 2023. See our April 2023 Update for further information on the product governance guidelines.

ESMA publishes article on use of ESG-related language in the EU fund industry

On 2 October 2023, ESMA published a study exploring the use of language related to ESG factors in EU investment fund names and documentation.

In this study, ESMA shows that the share of EU Undertakings for Collective Investment in Transferable Securities investment funds with ESG words in their name had increased from less than 3% in 2013 to 14% in 2023. The article further highlights that fund managers tend to prefer using generic language (‘ESG,’ ‘sustainable’) rather than more specific words. This can make it more difficult for investors to verify that the fund portfolio is in line with the name.

ESMA notes that tackling greenwashing is one of the key priorities in its Strategy on Sustainable Finance, and in this respect its assessment of how investment funds signal themselves (via their name or their documents) is an important first step in the detection and monitoring of potential greenwashing.

To carry out this study, ESMA used natural language processing (NLP) techniques to examine the use of ESG-related language in more than 100,000 fund documents. As expected, funds with ESG words in their names, as well as funds disclosing under Article 9 of the SFDR, tend to use relatively more ESG words in their documentation. However, the results also point to differences between the document types (regulatory document vs. marketing material), suggesting that fund managers adapt their communication based on the expected types of readers.

ESMA notes that it will continue to scale up the monitoring and supervision of greenwashing. NLP-based tools have the potential to greatly assist effective supervision across the EU; therefore ESMA will continue to monitor ESG-related disclosures for greenwashing risks, given the rapid growth and important role of the market for ESG investing. As such, asset managers marketing funds in the EU should ensure that the use of ESG-related terms in fund documents appropriately reflect the character of the funds on offer and are not greenwashing attempts intended to draw in ESG-conscious investors.

ESAs publish report on voluntary disclosure of principal adverse impacts

On 28 September 2023, the Joint Committee of the three European Supervisory Authorities (ESAs: the EBA, European Insurance and Occupational Pensions Authority, and ESMA) published their second Annual Report on the extent of voluntary disclosure of principal adverse impacts under the Article 18 of the SFDR.

Principal adverse impacts (PAI) are the most significant negative impacts of investments on the environment and people. When a financial market participant considers PAI, it means that it should seek to reduce the negative impact of the companies they invest in.

Similar to the approach adopted for 2022 Report, the ESAs launched a survey of NCAs to assess the current state of entity-level and product-level voluntary PAI disclosures under the SFDR and have developed a preliminary, indicative, and non-exhaustive overview of good practices and areas that need improvement.

Key points set out in the annual report:

• The results show an overall improvement compared to the previous year, although there is still significant variation in the extent of compliance with the requirements and in the quality of the disclosures both across financial market participants and jurisdictions.
• Disclosures appear easier to find on websites compared to the previous year.
• When financial market participants do not consider PAI, they should better explain the reasons for not doing so.
• Even though they are encouraged to do so under the SFDR, financial market participants are generally not disclosing to what extent their investments align with the Paris Agreement.
• Voluntary disclosures of PAI consideration by financial products will be further analysed in future reports.

EC shares update on ESRS

On 7 September 2023, at an exchange of views in the European Parliament Committee on Legal Affairs (the JURI Committee), EU Commissioner Mairead McGuinness shared an update on the thinking of the EC on sustainability reporting.

In her opening remarks, the Commissioner discussed the main changes made by the EC with respect to the draft European Sustainability Reporting Standards (ESRS) submitted by the European Financial Reporting Advisory Group (EFRAG). She emphasised efforts to align with the work of the International Sustainability Standards Board (ISSB) to ensure that companies using the ESRS automatically comply with the ISSB Standards, specifically noting the following three categories of modifications to the draft ESRS:

• first, introducing additional phase-in provisions for some of the most challenging reporting requirements on top of those already proposed by EFRAG
• second, giving companies more flexibility to decide exactly what information is relevant to their specific situation
• third, making a limited number of the reporting requirements voluntary instead of mandatory

Focussing on next steps, the Commissioner confirmed that EFRAG will continue to focus on developing guidance for materiality assessment and value chain reporting and on the development of proportionate standards for SMEs. She reiterated that the draft documents are expected to be published for public consultation shortly. The EC is also working on a proposal for a decision to postpone the deadline for sectoral standards from 2024 to 2026. The aim of this proposal is to reduce overall reporting burdens so that companies can concentrate on applying the first set of the European standards and EFRAG would be able to focus on supporting the companies in this process.

10. EU — Sanctions

EC publishes new sanctions guidance

On 7 September 2023, the EC published due diligence guidance on Russia sanctions for European firms to help them identify, assess, and understand the possible risks of sanctions circumvention — and how to avoid it.

Russian targets are deploying various techniques to evade EU sanctions. Under EU law, EU operators must conduct due diligence to ensure trading partners are not breaching EU sanctions measures. Firms that facilitate sanctions circumvention undermine the sanctions regime and are in breach of EU law.

The guidance is intended as a practical guide to outline the steps to be applied by EU firms when conducting strategic risk assessments. In particular, firms should conduct enhanced due diligence based on risk assessment and management:

• Risk assessment. EU operators should carry out a continuous five-step risk assessment of possible sanctions circumvention. This involves identification of threats and vulnerabilities; risk analysis; design of mitigating measures; implementation of mitigating measures; and regular updating.
• Enhanced due diligence. Following risk assessment, EU companies should calibrate their own proportionate due diligence models. Firms should focus on areas of greatest exposure to sanctions circumvention, such as high-risk sectors and regions and complex supply chains. Due diligence should be performed on business partners, transactions, and goods.

The guidance also provides a list of sanctions circumvention red flags for EU firms. If detected during due diligence, these should trigger deeper sanctions screening. Red flags include indirect transactions, the involvement of high-risk geographical areas, and complex corporate structures or trust arrangements to obscure ownership information.

11. International — ESG

TNFD delivers final recommendations

On 18 September 2023, the Taskforce on Nature-Related Financial Disclosures (TNFD) published its final recommendations (TNFD Recommendations) at the New York Climate Week.

Launched in 2021, the TNFD Recommendations are a voluntary system that build on the Task Force for Climate-Related Financial Disclosures (TCFD) recommendations and are consistent with the ISSB and the Global Reporting Initiative standards. The TNFD Recommendations are also consistent with Target 15 of the Kunming-Montreal Global Biodiversity Framework, which calls for assessment and disclosure of nature-related risks, impacts, and dependencies.

TNFD Key Concepts. The TNFD framework consists of conceptual foundations for nature-related disclosures, a set of general requirements, and a set of recommended disclosures.

General Requirements

The TNFD Recommendations include six general requirements that are additional to the general requirements and other provisions of the ISSB’s International Financial Reporting Standards on sustainability-related financial information. The general requirements apply to all four pillars of the recommended disclosures and describe:

• the application of materiality
• the scope of disclosures
• the location of nature-related issues
• integration with other sustainability-related disclosures
• the time horizons considered
• the engagement of indigenous peoples, local communities, and affected stakeholders in the identification and assessment of the organisation’s nature-related issues

Recommended Disclosures

The 14 recommended disclosures outlined below are science-based and voluntary recommendations for all sectors and are grouped into the same four pillars as the TCFD.

• Governance. Three recommended disclosures related to the organisation’s governance of nature-related dependencies, impacts, risks, and opportunities.
• Strategy. Four recommended disclosures related to the effects of nature-related dependencies, impacts, risks, and opportunities on the organisation’s business model, strategy, and financial planning where such information is material.
• Risk and Impact Management. Four recommended disclosures related to the processes used by the organisation to identify, assess, prioritise, and monitor nature-related dependencies, impacts, risks, and opportunities.
• Metrics and Targets. Three recommended disclosures related to the metrics and targets used to assess and manage material nature-related dependencies, impacts, risks, and opportunities.

The LEAP approach: To assist organisations in identifying, assessing, and, ultimately, disclosing their nature-related dependencies, impacts, risks, and opportunities, the TNFD released additional guidance that uses the LEAP approach. The LEAP approach involves four phases of assessment:

• Locate the interfaces with nature across geographies, sectors, and value chains
• Evaluate dependencies and impacts on nature
• Assess nature-related risks and opportunities to the organisation
• Prepare to respond to nature-related risks and opportunities, including reporting on material nature-related issues to the primary users of financial reports and other stakeholders, aligned with the TNFD’s recommended disclosures

The LEAP approach is designed to be used by all sectors and biomes. An organisation may use the LEAP approach to identify and assess material nature-related issues, but it can ultimately use a different method altogether such as existing nature-related frameworks like the Natural Capital Protocol and the Science Based Targets Network methods for nature.

In addition to the TNFD Recommendations, specific sectors may also use the TNFD’s additional sector guidance, which was developed following the Sustainability Accounting Standards Board’s standards and the EU’s SFDR. It is only suggested by the TNFD, and hence organisations are not required to prepare or make disclosure statements. The final version of the additional sector guidance for financial institutions is expected to be published in 2024.