Q2 2024 – European Regulatory Update for Funds

Authors:Gregg Beechey, Zac Mellor-Clark, Nishkaam Paul, Emirali Mustafa, Ollie Burrows

The second quarter of 2024 saw some key regulatory updates, in particular the continued growth and development of the ESG/sustainability framework applicable to private funds in Europe. Private fund managers active in and/or marketing into Europe will want to be aware of the developments summarised below as we move into the summer period.

Highlighted developments this quarter include:

1. ELTIF Regulation update
2. UK SDR and Investment Labels Regime and the Anti-Greenwashing Rule
3. ESMA Final Report on Greenwashing
4. ESMA Guidelines on Fund Names Using ESG or Sustainability Related Terms
5. ESAs Opinion on Assessment of SFDR
6. CS3D
7. Private Fund Adviser Rules Vacated
8. CSSF Circular 24/856
9. PRA Thematic Review of Private Equity-Related Financing Activities

Update on ELTIF Regulation

Q2 2024 saw slower progress on the development of regulatory technical standards ("RTS") supplementing the European Long-Term Investment Fund ("ELTIF") Regulation than many industry participants had hoped to see. As noted more particularly in our Q1 2024 update, the RTS will address a number of key issues in the context of open-ended ELTIFs, which recent amendments to the ELTIF Regulation (effective January 2024) are intended to promote.

By way of brief recap, in December 2023, the European Securities and Markets Authority ("ESMA") published draft RTS which contained various features which would have been challenging from an industry perspective. Following a significant amount of lobbying, the European Commission (the "Commission") published its proposed amendments to ESMA's draft RTS in early March 2024.

In April 2024, ESMA subsequently published its final opinion containing further proposed amendments to the RTS in response to the Commission's feedback. In doing so, ESMA incorporated many, but not all, of the Commission's proposed changes. Perhaps most importantly for prospective managers of open-ended ELTIFs, ESMA dropped its 40% liquid asset requirement for funds with a redemption notice period of 1-3 months. From an industry perspective, the resulting draft is imperfect but represents a significant improvement on ESMA's December 2023 draft and represents a positive direction of travel.

At the time of writing, ESMA's revised draft RTS are understood to remain under review by the Commission, with an update expected imminently. If accepted, the Commission is expected to send the RTS to the European Parliament and Council of the European Union (the "Council") for scrutiny. The RTS are therefore unlikely to enter into force before Q4 2024.

Until the RTS are finalised, such that the viability of an open-ended ELTIF can be accurately determined, we anticipate that those managers looking to raise semi-liquid retail funds targeted at European semi-professional investors will likely continue to gravitate toward the Luxembourg UCI Part II fund structure, which has proven to be very popular during this period of regulatory uncertainty.

Another potential development in the ELTIF Regulation to watch out for in the coming months is the launch of ESMA's Call for Evidence on the review of the UCITS Directive as regards UCITS eligible assets. For context, ELTIFs are only permitted to invest in "eligible investment assets" (certain types of private markets investments) or specified liquidity investments. The specified liquidity investments are those investments a UCITS is permitted to make under the UCITS Directive. Accordingly, any expansion in the universe of UCITS eligible investments is likely to indirectly expand the range of investments which an ELTIF can make. Stakeholder responses are due 7 August 2024.

UK SDR and Investment Labels Regime and Anti-Greenwashing Rules

On 23 April 2024, the Financial Conduct Authority ("FCA") published its Consultation Paper CP 24/8 on extending the UK's Sustainability Disclosure Requirements ("SDR") and investment labels regime (as summarised in our February 2024 client update) to portfolio management services.

The existing SDR rules, which include an anti-greenwashing rule, an investment labelling regime, naming and marketing rules, as well as detailed, consumer-facing product and entity-level disclosure requirements, currently apply only to UK managers of UK funds, except for the anti-greenwashing rule, which applies to all FCA authorised firms. These rules were summarised in our recent client alert "UK SDR and Investment Label Rules."

The FCA is proposing to extend these rules to FCA authorised firms providing portfolio management services in the UK (the "Extension"). "Portfolio management" for these purposes means a service provided to a client which comprises either: (i) managing investments or (ii) recurring/ongoing advice in relation to unlisted securities.

In order for a UK portfolio manager to be in scope of the Extension, its client must (i) be resident or domiciled in the UK, and (ii) not be a fund nor an alternative investment fund manager ("AIFM") or a management company acting for or on behalf of a fund (i.e., where a portfolio manager acts as the delegated portfolio manager of a fund).

If limbs (i) and (ii) above are satisfied, then portfolio managers providing services to professional clients can opt in to the investment label regime (which is not mandatory) and must produce an entity-level report if assets under management are over GBP 5 billion on a rolling three-year basis. The naming and marketing rules are not applicable when providing services to professional clients. Conversely, if portfolio managers are providing services to retail clients, such entities must comply with the naming and marketing rules and the entity-level report (if AUM is over GBP 5 billion on a rolling three-year basis), and can opt in to the investment label regime (which, again, is not mandatory).

In light of the fact that the Extension's scope does not include UK portfolio managers whose clients are a fund or AIFM or a management company acting for or on behalf of a fund, it is unlikely that the Extension will impact sponsors and managers in the private fund sector.

On 23 April 2024, the FCA also published finalised anti-greenwashing guidance (FG24/3) ("AGW Guidance") in respect of its anti-greenwashing rule, which has applied to all FCA authorised firms since 31 May 2024.

The AGW Guidance builds on the November 2023 guidance consultation on the anti-greenwashing rule and largely adheres to the consultation's draft, with some minor clarifications and amendments.

In summary, the rule requires that any reference to the sustainability characteristics of a product or service is: (a) consistent with the sustainability characteristics of the product or service and (b) fair, clear and not misleading. This rule applies to all FCA authorised firms, across each of the products and services they provide, in respect of communications to persons in the UK/UK clients (including retail and professional clients).

In respect of changes from the November 2023 draft, the FCA has helpfully clarified that the anti-greenwashing rule applies specifically to claims about products and/or services, but not generally to claims about the firm itself (unless such claim could be considered part of the 'representative picture' of a product or service), and that the firm may take into account the nature of the audience of the communication, in particular tailoring communication for professional or retail clients. Unhelpfully, the FCA has not provided any guidance on whether the rule applies to historic documents still being made available. Additionally, the FCA has not provided for any equivalence/substituted compliance with overseas rules (e.g., the Sustainable Finance Disclosure Regulation ("SFDR")) to exempt a firm from the anti-greenwashing rule.

Sponsors and managers that are FCA authorised should, if they have not already done so, review all current and planned marketing materials and client communication templates as against the finalised AGW Guidance to ensure compliance with the anti-greenwashing rule, as well as provide any necessary internal training to relevant teams (e.g., marketing, sales, ESG and compliance teams).

ESMA Final Report on Greenwashing

On 4 June 2024, ESMA published its Final Report on Greenwashing (Final Report). This ESMA report was published on the same day as, and sits alongside, corresponding reports by the European Banking Authority, which is responsible for the banking sector, and the European Insurance and Occupational Pensions Authority, which is responsible for the insurance and occupational pensions sectors. The three separate reports were prepared in response to the Commission's request for input on greenwashing risks in the financial sector in 2022 and, whilst presenting a unified regulatory front prioritising investor protection and market integrity in the face of greenwashing risks, set out each regulator's current supervisory response and future intentions within their specific sectors.

In particular, the three regulators confirmed that they have a common understanding of the concept of Greenwashing as:

a practice where sustainability-related statements, declarations, actions, or communications do not clearly and fairly reflect the underlying sustainability profile of an entity, a financial product, or financial services. This practice may be misleading to consumers, investors, or other market participants.

The concept of greenwashing is understood to have, amongst others, the following characteristics:

• Can be carried out by way of omission of information, as much as by the provision of false information
• May occur intentionally or unintentionally
• Could occur at entity or manager level, financial product level or financial service/regulated activity level
• May occur in the context of legal/regulatory disclosures or voluntary communications
• Could be caused by third parties
• May or may not result in immediate damage to individual investors or an unfair competitive advantage, on the basis that it would undermine trust in sustainable finance markets and policies either way

While the ESMA Report emphasised that ESMA and the regulators of individual Member States have prioritised the supervision of sustainability-related claims, it also acknowledged the limited resources available for this purpose and that supervisory attention has therefore been focused on the most significant risks. Regulators have detected only a small number of occurrences of greenwashing and levels of formal enforcement actions have been low as the regulators give the market time to adjust to a new, complex regulatory framework.

The ESMA Report also sets out a summary of concrete actions that should be considered by market participants. These include the substantiation of sustainability-related claims, the implementation of monitoring and reporting processes, the adaptation of governance structure to mitigate greenwashing risks and the exercise of caution with respect to the use of aspirational language in marketing materials.

Note that the ESMA Report is ostensibly a response to the Commission and, whilst it includes recommendations to the regulators in individual Member States and market participants, is not directly binding on market participants.

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

As discussed in more detail in our client alert "ESMA Guidelines on ESG-related Fund Names," ESMA published its final guidelines on fund names using ESG or sustainability-related terms on 14 May 2024.

Please refer to our client alert for further details.

ESAs Opinion on Assessment of SFDR

On 18 June 2024, the European Supervisory Authorities ("ESAs") (i.e. the European Banking Authority, the European Insurance and Occupational Pensions Authority and ESMA, collectively), on their own initiative, published a joint opinion on the assessment of the SFDR (the "Joint Opinion").

In the Joint Opinion, the ESAs acknowledged that the SFDR framework could be improved. In particular, the ESAs noted that the disclosures to investors in the SFDR may be complex by nature and difficult to understand, and while the SFDR was designed to enhance transparency around sustainability, in practice, 'Article 8' and 'Article 9' status have been used as product labels, consequently posing greenwashing and mis-selling risks.

In the Joint Opinion, the ESAs made the following recommendations to the Commission:

• the introduction of a product classification system, based on regulatory categories and/or sustainability indicator(s), to help consumers navigate the broad selection of sustainable products and support the full transition to sustainable finance;
• the categories should be simple, with clear objective criteria or thresholds, to identify which category a product falls into;
• options for product categorisation and /or sustainability indicator(s) should be consumer tested and consulted on, and enhanced clarity would remove the need for detailed and extensive disclosures;
• the Commission could revisit the coexistence of the two parallel concepts of: (i) "sustainable investment," as defined in the SFDR; and (ii) Taxonomy-aligned investment, as defined in the EU Taxonomy; and
• the Commission could reflect on whether to include other products within the scope of the SFDR regime.

CS3D

On 24 April 2024, the amended text of the Corporate Sustainability Due Diligence Directive (the "CS3D"), which was proposed by the Council on 15 March 2024 (see Q1 2024 - European Regulatory Update for Funds), was adopted by the European Parliament (the "EP"), and on 24 May 2024, the Council formally adopted the directive, marking the final steps in the adoption process.

CS3D will now be published in the Official Journal of the European Union in the coming weeks and will enter into force on the 20th day following publication. Member States of the European Union ("Member States") will have two years from such date to adopt and publish regulations and administrative provisions to implement the directive into domestic law. Additionally, certain provisions of CS3D will have staggered implementation depending on the size of the companies concerned.

Private Fund Adviser Rules Vacated

As reported in our recent client alert "5th Circuit Vacates Private Fund Adviser Rules," on 5 June 2024, the United States Fifth Circuit Court of Appeals vacated in full the package of rules known as the Private Fund Adviser Rules ("PFAR"), citing a lack of statutory authority on the part of the US Securities and Exchange Commission when it adopted the PFAR in August 2023. This decision will be a relief to US investment advisers, but also represents good news for non-US managers, whether themselves registered investment advisers or reliant on "exempt reporting adviser" status (to whom certain of the PFAR provisions would otherwise have applied).

CSSF Circular 24/856

CSSF Circular 02/77 has been a longstanding and, since its inception in 2002, much-supplemented set of CSSF rules and guidance designed to ensure investor protection by setting out minimum rules of conduct applicable in instances of errors in the administration and/or management of funds in Luxembourg.

CSSF Circular 24/856 (the "Circular"), which is currently only available in French, was published by the CSSF earlier this year and, with effect from 1 January 2025, will repeal and replace CSSF Circular 02/77 with a new, broader set of rules relating to NAV calculation errors, non-compliance with investment rules and other errors. The updated regime is intended to reflect the seismic developments in the fund industry since 2002, particularly with respect to administrative practices and the coming into force of European regulations such as the AIFMD and the UCITS Directive, as well as to consolidate in one place the disparate FAQs, activity reports, rules and guidance issued by the CSSF in the intervening period.

The Circular will apply only in respect of certain designated types of funds, and in each case only to the extent that the CSSF is responsible for regulating the relevant fund under applicable law. Specifically, it will apply in respect of regulated funds (UCITS, UCI Part IIs, SIFs and SICARs), as well as to unregulated funds qualifying for certain regulatory designations ( ELTIFs , MMFs, EuVECAs and certain EuSEFs).

In addition to the broadening of the scope of the Circular to encompass new fund structures, the Circular:

• institutes detailed rules regarding the occurrence of NAV calculation errors (including a requirement to notify the CSSF of such errors in certain instances);
• clarifies the responsibilities of stakeholders such as the auditors, administrators, managers and investment managers;
• requires offering documentation to include a notice to investors that they may not be fully indemnified in case of errors; and
• draws a distinction between active and passive breaches of investment restrictions.

The existing regime under Circular CSSF 02/77 continues to apply until 1 January 2025. Fried Frank will continue to monitor developments in respect of the Circular, in particular the anticipated publication of an official English translation by the CSSF, and will provide further updates as we approach its effective date.

PRA Thematic Review of Private Equity-Related Financing Activities

On 23 April 2024, the UK's Prudential Regulation Authority ("PRA") published its letter (the "Dear CRO Letter") to the Chief Risk Officers of certain regulated banks setting out its findings following the thematic review of private equity-related banking financing activities that it conducted in 2023 (the "Thematic Review").

By way of background, in August 2023, the PRA launched the Thematic Review to assess the adequacy of the risk management frameworks employed by banks to govern their private equity linked financing businesses and related derivatives exposures. This was driven by the recent increase that the PRA has seen in banking exposures to various 'non-traditional' forms of financing linked to sponsors and the private equity fund sector in general (e.g., Net Asset Value ("NAV")-based loans secured against private equity fund assets and facilities backed by limited partner interests).

In the Dear CRO Letter, the PRA states that it identified a number of thematic gaps in the overarching risk management frameworks that control banks' aggregate private equity-related exposures, and sets out its expectations for banks to better manage such risks. These expectations relate to:

• data aggregation and a holistic approach to risk management;
• credit and counterparty risk interlinkages;
• stress testing; and
• board-level reporting.

Whilst the specifics of the PRA's expectations on the regulated banking sector in relation to the above is not relevant to this update, the key takeaway for private fund sponsors and managers is to expect increased regulatory scrutiny around financing services provided by regulated banks to the private equity sector. Given the focus of global regulators on managing systemic risk connected to the funds sector (particularly with the surge in private credit strategies), this scrutiny could lead to changes in the way that sponsors are able to access financing, which could potentially make obtaining NAV-based finance and other forms of fund finance more difficult.

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