Capital Markets Newsletter February 2024

Capital Markets Regulatory Newsletter: February 2024

Welcome to the latest edition of our compliance newsletter aimed at capital markets firms, including wholesale buy and sell-side firms, wealth managers and corporate finance firms. Before looking back at a very busy last quarter of, let’s take a forward glance at 2024.

If the regulation of financial services is ultimately driven by politics, 2024 must surely be a pivotal year. In the US, there is the small matter of a presidential election: the current high energy of the SEC in progressing its regulatory agenda is, to a considerable extent, dependent on the re-election of President Biden, with many initiatives likely to be paused or reversed by a Trump administration.

In the UK, a general election is a near certainty, with October seemingly Prime Minister Sunak’s preferred option. Although the Edinburgh Reforms, announced in December 2022, are still very much in play, time is fast running out for the current Conservative administration. This is having the effect of speeding up a host of initiatives that might otherwise have unfolded over a longer time span. Quite what the impact of an incoming Labour administration will be is a moot point. For now, Labour is anxious to promote their pro-business credentials, but whether this will survive the first big scandal or crisis in financial services that comes along remains to be seen.

Divergence between the UK and Europe will continue to present challenges for firms straddling these jurisdictions notwithstanding last year’s slight thaw in UK/EU relations and the FCA’s stated commitment to international co-operation in financial services regulation. The recent Mutual Recognition agreement with Switzerland is evidence of a UK eagerness to strike deals where possible.

Alongside politics, there are longer-term secular trends impacting regulatory developments – the growing interest in cryptoassets plus the use of Artificial Intelligence in financial services – both these are topics that we will doubtless hear more of in 2024.

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UK News

Updating the regime for asset management

The FCA published a Discussion Paper (DP23/2) back in February 2023 floating various policy proposals such as creating a coherent rule book that could be applied to different sets of investment managers. One example given was that conflicts of interest which contains subtly different standards depending on whether you are managing a UCITS, an alternative investment fund or a segregated portfolio.

The DP was followed up with a speech in October by FCA Chair Ashley Alder which the FCA’s priorities. Although the concept of a coherent rule book has receded somewhat, one set of proposals likely to emerge is the distinction between categories of Alternative Investments Fund Managers (AIFMs) - full-scope AIFMs, small authorised AIFMs and small registered AIFMs, with the FCA expressing a desire for at least a consistent set of rules across all three. Although no specific details were provided, the DP had previously suggested changing the criteria for being considered a small AIFM (including criteria based on the AIFM's strategy or type of client) and possibly abolishing the small registered AIFM regime altogether.

These proposals are likely to be fed into the UK’s revised AIFMD, known as UK AIFMD II, which we expect to be consulted on towards the end of 2024. We anticipate amendments to regulatory reporting requirements including new AIF(s) under management, material changes to an AIF, the acquisition or disposal of major holdings, and changes to the control of non-listed companies.

Open and honest? Timely reminder on submissions to the FCA

The FCA’s ban on James Staley, former CEO of Barclays Bank hit the headlines because of the nature of his relationship with Jeffrey Epstein and what he had disclosed (or not disclosed) to the regulator. There is a wider lesson here, in terms of individuals being absolutely open and honest in their submissions to the FCA, be they new applications for approval, or responses to questions. Read our article and advice on the matter here…

Insider dealing risks around market soundings

The EU Market Abuse Regulation which came into force in 2016 brought with it new Guidelines for buy-side firms receiving market soundings, designed to minimise the risks of insider dealing inherent in this practice. Fast forward seven years: the FCA observes in its latest Market Watch 75 that some are playing fast and lose with the guidelines. In particular, it believes some firms are making “educated guesses” based on disclosures made at the start of a market sounding approaches and taking market positions accordingly. Read on for our summary of the FCA’s warning and its recommendations on good practice.

Updating quantitative criteria for high net worth and sophisticated investors

In November, the Treasury announced the outcome of its own Consultation on the financial promotion exemptions for high-net worth individuals and sophisticated investors, first launched back in December 2021. Although the Treasury’s conclusions took two years to come to fruition, the new thresholds will apply from 31 January 2024. Read on for why these reforms were needed and a summary of the new quantitative criteria.

Lighter touch UK short selling regime in sight?

There can be fewer pieces of regulation more unpopular in the buy-side community and less grounded in academic research than the Short Selling Regulation which was first introduced by the EU back in 2012. As such, it has always featured prominently in lists of reforms made possible by the UK’s exit from the EU, and in November, the Treasury published its proposed revisions in a draft Statutory Instrument. The main elements which had already been signalled last July include:

• Replacing public disclosure of individual short positions in shares, with an aggregate disclosure regime;
• Returning the threshold for reporting short positions from 0.1% back to its original 0.2% (effective 5 February 2024); and
• Abolishing the short selling regime for UK sovereign debt and credit default swaps.

Final rules on SDR and investment labels

At the end of November, the FCA published PS23/16, its final rules on Sustainability Disclosure Requirements and investment labels (“SDR”). This measure introduces a range of requirements on firms, aimed at informing and protecting consumers and improving trust in the market for sustainable investments. The main elements of SDR are as follows:

• Anti-greenwashing rule: implemented through the ESG Sourcebook, this requires that sustainability-related claims made by all FCA authorised firms about their products and services are fair, clear, not misleading, and consistent with the sustainability profile of the product or service. It applies all financial promotions and other communications about financial products or services which refer to the environmental, social or sustainability characteristics. The FCA is simultaneously consulting on new guidance to support the anti-greenwashing rule.
• Investment labels - principles and general criteria: SDR introduces four labels to enable consumers to differentiate between products with different sustainability objectives and investment approaches. Firms will be able to choose one of these labels for products with sustainability objectives, provided they meet the qualifying criteria (with at least 70% of the product’s assets meeting the standard of that label):

                 - Sustainability focus

                 - Sustainability improvers

                 - Sustainability impact

                 - Sustainability mixed goals (essentially, a combination of the other 3)

• Product naming and marketing: sustainability-related terms for product names and marketing materials are only permitted if they use one of the above labels (and even then, only Sustainability Impact products may use the word “impact”).

• Consumer-facing information: SDR introduces onerous disclosure requirements to provide accessible information to retail investors and further detail to those who want to know more, covering consumer-facing, pre-contractual, ongoing product-level and entity (i.e. firm)-level disclosures.
• Distributors: SDR requires distributors of sustainability products to communicate the above labels and provide access to up to date consumer facing disclosures to retail. Distributors of overseas products (i.e. recognised schemes including ETFs) must clearly state that they are not subject to SDR and investment labelling requirements.

SDR will apply initially only to financial firms authorised in the UK, although the Overseas Fund Regime (see further down in the newsletter) is likely to have similar requirements. While the anti-greenwashing rules apply to all firms, the full SDR requirements will apply only to UK UCITS managers and AIFMs in the first instance.

Timetable: the anti-greenwashing rule comes into effect on 31 May 2024. The main sustainability labels regime applies from 31 July 2024, with the product naming and marketing rules (and accompanying disclosure requirements) coming in from 2 December.

Consumer duty – managing ongoing obligations

2023 was a headline year for the introduction of the FCA’s Consumer Duty but the regulator has warned firms that there is still much to be done. In two recent articles, we looked at the FCA’s Dear CEO letter to Wealth Managers and Stockbrokers published in November, and a Consumer Duty Webinar in December, to dissect the latest on FCA guidance in this important area.

Introducing the Overseas Funds Regime

The best way to think about the Overseas Funds Regime is that it takes over from where the Temporary Marketing Permissions Regime (TMPR for short) left off – in other words, distributors with products such as EEA UCITS that once could be freely marketed in the UK, have been able to avail themselves of the TMPR since 2021.

Once in force (the OFR consultation closes on 12 February and a Policy Statement is expected in early summer), jurisdictions will need to be deemed equivalent before access to the UK is allowed. Applications for recognition will be made electronically through an online application form with details of recognised schemes then published on the FCA register. On 30 January 2024, the Treasury confirmed a positive equivalance assessment for the EU/EEA.

Valuation of private markets assets – FCA review imminent?

Concerns around the valuation of assets in private markets is also very much on the regulatory agenda. It was the subject of an IOSCO report published in September 2023 and this was closely followed by comments from FCA CEO Nikhil Rathi (reported in the FT) that they were looking to launch a "sweeping review" of valuations in private markets and that this exercise would start by the end of the year.

As it happens, the year-end has come and gone, but the FCA’s thinking in this area appears well advanced and we still think an announcement is imminent.

UK links its AML high-risk 3rd country list with that of FATF

In early January, the UK Treasury published Guidance on its Money Laundering and Terrorist Financing (High-Risk Countries) (Amendment) Regulations 2024, which amends the definition of high-risk third country (“HRTC”) to align it with the Financial Action Task Force (“FATF”). The statutory instrument which came into force on 22 January 2024 now defines an HRTC as “a country named on either of the following lists published by the Financial Action Task Force as they have effect from time to time - (i) High-Risk Jurisdictions subject to a Call for Action; (ii) Jurisdictions under Increased Monitoring”. Firms must therefore now refer directly to these FATF lists which are updated three times a year.

This change of definition is timely: in its most recent update last October, FATF announced that the Cayman Islands had been removed from its list of jurisdictions under increased monitoring (commonly referred to as the “grey” list). Cayman had been added to the FATF grey list in February 2021 – a development that was problematic particularly for firms wishing to market Cayman AIFs in the EU.

EU News

EU Council publishes final AIFMD II text

The final compromise text of the EU’s revised AIFMD agreed in November will likely come into force in March or April 2024, with the main provisions actually coming into effect two years later. Although EU AIFMD II is to be clearly differentiated from the UK version expected to be consulted on in the second half of 2024, some of the main provisions will have a direct impact on UK managers:

• Enhanced delegation requirements for third country firms including managers based in the UK providing portfolio management to an EU entity.

And for firms marketing in the EU

• additional Annex IV disclosure requirements (applicable to firms marketing in the EU under the National Private Placement Regime);
• and new obligations on loan origination.

SEC news

The SEC’s examination priorities for 2024

In a break with previous practice, the SEC Division of Examinations published its 2024 priorities last October (it was February in previous years). The stated objective of the exam priorities is to inform investors and registrants of the key risks, examination topics, and priorities that the Division plans to focus on in the upcoming year.

For investment advisers, the focus will be on reviewing adherence to duty of care and duty of loyalty obligations, including investment advice provided to clients, processes for determining that investment advice is in clients' best interests, economic incentives for advisers and disclosures made to investors. These will include:

• Compliance programs, policies, and procedures;
• Marketing practices, compensation arrangements, and valuation assessments;
• Safeguarding client information, assets, and records;
• Disclosure assessments and regulatory filings accuracy; and
• Oversight of third-party and affiliated service providers, branch offices, and informed consent processes.

Specific focus areas for investment advisers to private funds will include:

• Portfolio management risks;
• Adherence to contractual requirements regarding limited partnership advisory committees (e.g., advisory boards);
• Calculation and allocation of private fund fees and expenses;
• Due diligence practices;
• Conflicts, controls, and disclosures regarding private funds managed side-by-side with registered investment companies and use of affiliated service providers;
• Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor, and distribution of private fund audited financial statements; and
• Policies and procedures for reporting on Form PF.

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