In this issue we consider ESMA’s supervisory briefing on undue costs, the Central Bank’s expectations around on-site due diligence visits during COVID-19, the European Commission’s review of AIFMD, some sustainable finance developments and ESMA’s consultation on cloud outsourcing guidelines.

If you would like to discuss any of the topics covered, please feel free to contact a member of our team.

Investment Fund Fees: ESMA Issues Supervisory Briefing on “Undue Costs”

The reporting on, and monitoring of, costs and their impact on retail investors’ returns is a key element of ESMA’s work under its investor protection mandate. ESMA’s first statistical report (2019) on the cost and past performance of retail investment products in the EU, including UCITS and AIFs, found that costs had a significant impact on the final returns that retail investors make on their investments.

Following the publication of this report, ESMA conducted a survey among national regulators on the approaches taken to supervising the cost-related provisions under the AIFMD and UCITS Directive. Both of these frameworks require fund management companies to ensure that no undue costs are charged to investors.

The results of this survey demonstrated a lack of convergence in the interpretation of undue costs and the supervisory approaches taken by national regulators in supervising the cost-related legislative provisions. To promote supervisory convergence, on 4 June, ESMA issued a supervisory briefing (“Briefing”) to support national regulators in their assessments of “undue costs” and supervising the obligation to prevent such undue costs being charged to investors.

Assessing “undue costs”

Whether a cost is “undue” should be assessed primarily against what is considered to be in the best interests of the fund or its unit holders. Therefore, the costs charged must be consistent with the investment objective of the fund and must not prevent the fund from achieving this objective, particularly where such costs are paid to third parties, including depositaries.

In addition, to avoid hidden costs, the fund management company’s pricing process must clearly identify and quantify all the costs charged to the fund including, whether those costs are paid to the fund management company or to third parties (for example, depositaries, brokers, external valuers) and/or paid directly by the investors (for example, entry and exit costs).

ESMA expects national regulators to require fund management companies to develop and periodically review a structured pricing process. In order to determine that undue costs are not charged to investors, fund management companies will need to consider the following factors in a pricing process:

• whether the costs are linked to investors’ best interests;
• whether the costs are proportionate compared to market standards and the type of service costs provided;
• if the costs are consistent with the characteristics of the fund;
• if the costs are sustainable taking into account the returns;
• whether the costs ensure equal treatment between shareholders and are not materially prejudicial to any class of shareholders;
• there should be no duplication of costs; and
• any cap on fees must be clearly disclosed.

Preventing the charging of “undue costs”

ESMA expects national regulators to review a fund management company’s pricing process at different supervisory stages as appropriate including:

• at authorisation;
• off-site supervision;
• on-site inspections;
• approval of material changes to the fund;
• thematic reviews; and
• assessment of investor complaints.

Regulators should ensure that the following matters are included in these reviews:

• cost disclosure and transparency; and
• business conduct, strategic risk and reputational risk.

If undue costs have been charged to investors, the outcome of any supervisory action is expected to include the possibility to request:

• investor compensation;
• a reduction of fees;
• a review of disclosure documents; and
• an industry letter outlining good and poor practices.

Although the Briefing is non-binding, ESMA has stated that it will closely cooperate with national regulators to promote its application and will review the level of convergence reached across the EU in 2021.

If you have any questions on, or would like to discuss the foregoing in more detail, please do not hesitate to contact a member of our team, or click here to request a recording of our recent Webinar on this topic.

European Commission Completes its Review of AIFMD

On 10 June, the European Commission published its report (“Report”) on the operation of the Alternative Investment Fund Managers Directive (EU/2011/61) (“AIFMD”).

The Report’s key findings relate to:

• the functioning of the marketing passport;
• investor impact;
• systemic risk; and
• the impact on investment in private companies.

The Report has been submitted to the European Council and Parliament as required under the AIFMD. The Commission may make proposals, including legislative amendments to the AIFMD, on foot of its review. It is expected that the Commission will issue a consultation on the AIFMD in Q3 2020 and any subsequent legislative proposals are likely to follow in mid-2021. Based on the findings in the Report the consultation and any subsequent legislative proposals are likely to be focused on:

• marketing and distribution including, NPPRs;
• leverage and liquidity;
• depositary passport;
• reporting; and
• supervisory convergence.

For more information, please see our more detailed article here.

Central Bank’s COVID-19 Flexibility Measures: Statement Regarding On-site Due Diligence Visits

The Central Bank has published a statement setting out its expectations as regards due diligence arrangements and periodic on-site visits to outsourcing service providers and delegates in the context of COVID-19.

In its statement, the Central Bank has reminded Fund Service Providers (“FSPs”) of the importance of maintaining strong ongoing oversight of any outsourcing/delegation arrangements. As part of their ongoing oversight, FSPs should take into account the location of the relevant service provider(s) and ensure that controls are in place to identify and address the material challenges facing such location(s) during the current COVID-19 crisis. It remains a matter for the relevant FSP to ensure that they are satisfied with the due diligence arrangements in place pertaining to their delegates. Nonetheless, the Central Bank considers that whilst the relevant COVID-19 related travel restrictions are in place, due diligence monitoring may be carried out remotely using the technology available to, insofar as possible, achieve the same result.

FSPs should:

• conduct a risk assessment to identify aspects of the outsourcing relationship where appropriate due diligence may be difficult or unfeasible to achieve remotely;
• where a risk is identified following this assessment, consider what other steps can be taken to mitigate the risk until an on-site review is completed having regard to the scale and materiality of the outsourced activity;
• formulate a plan to carry out an on-site visit when appropriate taking into account travel and other legal restrictions; and
• ensure proactive engagement with Central Bank supervisors on these matters. This may include informing supervisors if a delay is likely to persist for an extended period of time beyond the typical process for completing on-site visits, setting out the reasons for the delay, why they believe the delay is reasonable in the circumstances and any mitigating actions which have been taken.

The statement was included on the Central Bank’s webpage on COVID-19 Flexibility Measures. For more information on the Central Bank’s flexibility measures, please see our previous briefing here.

Sustainable Finance Update

Taxonomy Regulation Published

On 18 June, the European Parliament adopted a regulation setting out an EU-wide classification system, or “taxonomy”, which will provide businesses and investors with a common language to identify those economic activities that are considered environmentally sustainable (“Taxonomy Regulation”).

The Taxonomy Regulation sets out six environmental objectives and allows economic activity to be labelled as environmentally sustainable if it contributes to at least one of the objectives without significantly harming any of the others.

These environmental objectives are:

• climate change mitigation and adaptation;
• sustainable use and protection of water and marine resources;
• transition to a circular economy, including waste prevention and increasing the uptake of secondary raw materials;
• pollution prevention and control; and
• protection and restoration of biodiversity and ecosystems.

The Taxonomy Regulation also supplements the disclosure requirements prescribed in the Disclosures Regulation. (For more information on the Disclosures Regulation, please see our previous update here).

The Taxonomy Regulation was published in the Official Journal of the EU on 22 June 2020 and will enter into force on 12 July 2020.

The taxonomy should prove very helpful for investment funds wishing to develop sustainable products or pursue ESG-related strategies.

Consultations on integrating sustainability factors into AIFMD and the UCITS Directive

On 8 June, the European Commission (“Commission”) published draft texts of the delegated acts to integrate sustainability risks and factors into the AIFMD and the UCITS legislative frameworks. The Commission is consulting on these proposals and feedback can be provided until 6 July 2020.

The proposals will require UCITS management companies and AIFMs to:

• take sustainability risks into account when complying with organisational requirements and environmental, social and governance considerations should be integrated into organisational requirements;
• have expertise for the effective integration of sustainability risks and senior management’s responsibility includes the integration of sustainability risks;
• include sustainability risks in the identification of any conflicts of interest;
• consider the principle adverse impacts of investment decisions on sustainability factors;
• integrate sustainability risks into the investment due diligence process; and
• include procedures relating to sustainability risks in their risk management policies.

Calls for a centralised register for ESG data in the EU

EFAMA has joined with a number of industry bodies in calling for the creation of a centralised electronic register on ESG data in the EU. The letter notes that recent regulatory developments in the context of the EU Sustainable Finance agenda, including compliance with the Disclosures Regulation create an urgent need for publicly available ESG data.

ESMA Consults on Cloud Outsourcing Guidelines

On 3 June, ESMA issued a consultation paper on guidelines on outsourcing to cloud service providers (“Guidelines”).

The Guidelines provide guidance on the outsourcing requirements applicable to financial market participants including, AIFMs, UCITS management companies, depositaries and investment firms when they outsource to cloud service providers. They are also intended to help firms and regulators to identify, address and monitor the risks and challenges that arise from cloud outsourcing arrangements.

The Guidelines specify the:

• governance, documentation, oversight and monitoring mechanisms that firms should have in place;
• assessment and due diligence which should be undertaken prior to outsourcing;
• minimum elements that outsourcing and sub-outsourcing agreements should include;
• exit strategies and the access and audit rights that should be catered for;
• notification to competent authorities; and
• supervision by competent authorities.

The consultation on the Guidelines is open for feedback until 1 September 2020 and ESMA aims to publish its final report on the Guidelines in either Q4 2020 or Q1 2021.