Overview of the ESG Driven Amendment to AIFMD and the UCITS Directive
What is the law/regulation?
As part of a number of regulatory initiatives being implemented in the European Union, under its action plan for financing sustainable growth, proposed amendments to AIFMD1 and the UCITS Directive2 are being considered by the European Commission. Following the technical advice published by ESMA in April 2019, the European Commission issued its proposed drafts in June 2020.
The proposed amendments would require sustainability risks to be taken into account in organisational procedures, the management of conflicts of interest and risk management policies, in addition to placing an obligation on Alternative Investment Fund Managers (AIFMs) and UCITS management companies to consider sustainability risks and factors when undertaking investment due diligence.
What is its scope and impact?
Who is in Scope?
These amendments will apply directly to all EEA AIFMs (excluding small or ‘sub-threshold’ AIFMs3) and UCITS management companies.4
Save for any member state specific “gold-plating," the proposed amendments will not apply to non-EEA managers. However, where a non-EEA manager acts as a delegate to an EEA AIFM or a UCITS management company, the EEA AIFM or the UCITS management company may require that the non-EEA manager complies with certain of the new rules under the terms of its delegation agreement (particularly where portfolio management is delegated given the rule related to investment due diligence, as described below).
What are the Key Amendments?
The key amendments under the proposals are outlined below.
- AIFMs and UCITS management companies will be required to take into account sustainability risks as part of their existing obligations in relation to their decision-making procedures and organisational structure, and to retain the necessary resources and expertise to achieve the effective integration of sustainability risks.
- AIFMs and UCITS management companies must also ensure that senior management is responsible for the integration of sustainability risks in the performance of their existing activities.
- Corporate UCITS that do not have a separate management company and UCITS management companies will be required to integrate sustainability risks into the management of their UCITS, taking into account the nature, scale and complexity of the UCITS. Under the draft amendments, this obligation does not extend to AIFMs, and notably was not proposed by ESMA in its technical advice.
- When identifying the types of conflicts of interest that may damage the interests of a fund, AIFMs and UCITS management companies will be required to take into account those that may arise as a result of the integration of sustainability risks in their processes, systems and controls. Greenwashing, mis-selling and misrepresentation of investment strategies are all identified as potential sources of conflicts in the draft recitals.
- AIFMs and UCITS management companies will be required to take into account sustainability risks and, where applicable,5 the principal adverse impact of investment decisions on sustainability factors when complying with their existing obligations regarding investment due diligence. The manner in which this is achieved will need to be disclosed in accordance with the Disclosure Regulation.6
- An AIFM’s and a UCITS management company’s risk management policy will need to cover sustainability risks.
What are “Sustainability Risks” and “Sustainability Factors”?
The draft amendments incorporate the definitions of sustainability risks and sustainability factors from the Disclosure Regulation. Sustainability factors are defined as “environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters." A sustainability risk is defined as an “environmental, social or governance event or condition that, if it occurs, could cause an actual or potential material negative impact on the value of the investment.”
What is the timeline?
The European Commission published draft proposals on 8 June 2020 and the consultation period for feedback closed on 6 July 2020. The European Commission has not yet published its final proposals for review by the Council of the EU and the European Parliament. Under the current drafts, the new requirements will apply one year after their publication in the Official Journal.
What are the key considerations for asset managers?
Given the current progress of the legislative process, managers may be reluctant to incur implementation costs at this stage. That said, a number of managers may find that their existing structures and processes already take into account a number of the new requirements, whilst starting to incorporate some of these changes now may also help managers provide more substantive disclosures in response to their obligations under the Disclosure Regulation.
- Governance structures and organisational policies will need to be reviewed and, where necessary, updated, to ensure that they take into account sustainability risks. Corporate UCITS that do not have a separate management company and UCITS management companies will need to undertake a more holistic review given the obligation which will apply to them to integrate sustainability risks into the overall management of their UCITS.
- The sufficiency of current resources and personnel will need to be considered. This may require additional staff training and investment in ESG resources.
- Firms that haven’t already done so may want to consider designating an individual or a committee with responsibility for sustainability matters.7
- To the extent not already in place, reporting lines to senior management will need to be implemented.
- Conflicts of interest policies will need to be reviewed and, where necessary, updated, with managers promoting funds with ESG characteristics taking particular care to ensure that they are managing the risks of mis-selling these products.
- Investment due diligence processes will need to be reviewed to ensure that they take into account sustainability risks. As part of its technical advice, ESMA acknowledged that the due diligence requirements should be applied in a manner that is appropriate to the investment strategy of the relevant portfolio and recognised the challenges involved with obtaining reliable data on sustainability risks and factors, noting that this will be a continually evolving area.
- Firms which delegate portfolio management should consider imposing an obligation on their delegates to comply with the investment due diligence requirements under their delegation agreements.
- Risk management policies and processes will need to be reviewed and, where necessary, updated, to ensure that they take into account sustainability risks.
Impact Outside the EU
It is worth emphasising what is mentioned above, that although the principal impact of the proposed amendments will be felt directly as a regulatory matter by all EEA AIFMs (excluding small or ‘sub-threshold’ AIFMs) and UCITS management companies, non-EEA managers may also be indirectly in scope of the amendments if they act as a delegate to an EEA AIFM or a UCITS management company. This is because the EEA AIFM or the UCITS management company may require that the non-EEA manager complies with certain of the new rules as a contractual matter under the terms of its delegation agreement, particularly where portfolio management is delegated given the rule related to investment due diligence, in order for the EEA AIFM or UCITS management company to be able in turn to meet its regulatory obligations.
- The proposed amendments would be made to “Commission Delegated Regulation (EU) No 231/2013 of 19 December, 2012 supplementing Directive 2011/61/EU of the European Parliament (AIFMD) and of the Council with regard to exemptions, general operating conditions, depositaries, leverage, transparency and supervision” (the “Organisational Regulations”). The current draft of the proposed regulation is available here.
- The proposed amendments would be made to “Commission Directive 2010/43/EU of 1 July, 2010 implementing Directive 2009/65/EC of the European Parliament and of the Council (UCITS Directive) as regards organisational requirements, conflicts of interest, conduct of business, risk management and content of the agreement between a depositary and a management company” (the “Organisational Directive”). The current draft of the proposed regulation is available here.
- That is AIFMs whose assets under management do not meet threshold set out in Article 3 of AIFMD.
- These amendments will apply to all firms currently in scope of the Organisational Directive and/or the Organisational Regulation. To the extent that a member state has gold-plated the Organisational Directive and/or the Organisational Regulation to apply them to entities that would otherwise be out of scope (e.g. small or ‘sub-threshold’ AIFMs in respect of the Organisational Regulation), such “gold-plating” is also expected to apply in respect of these amendments.
- This will apply to AIFMs and UCITS management companies which consider the principal adverse impacts of investment decisions on sustainability factors under the Disclosure Regulation.
- Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November, 2019 on sustainability‐related disclosures in the financial services sector (the “Disclosure Regulation”). For further information on the Disclosure Regulation, please see our publication “Disclosure Regulation – What Is It and Who Is Impacted?” available here.
- As part of its technical advice, ESMA elected not to include a legal obligation on firms to do this, with it being left to firms to determine how best to incorporate responsibility within their own organisational setup.
Authored by the Dechert ESG working group. For additional information, including guidance for asset managers, please visit www.dechert.com/esg.