Preparing for Brexit’s Impact on Capital Market Operations in the United Kingdom

 

Overview

The United Kingdom made headlines when it voted to leave the European Union in June 2016. Popularly named “Brexit”, the move began a tumultuous four-year voyage that seemingly came to completion on January 31, 2020 when the UK’s withdrawal became official. However, as many are coming to realise, the nation is just now beginning to face some of its biggest challenges yet.

While the UK may be officially out of the EU, the European Union Withdrawal Agreement Act of 2020 (EUWA) called for a transitory implementation period that will end on December 31st of this year. Until that deadline, the UK will largely be treated as a Member-state of the EU while trade negotiations are underway. However, the agreement period largely prevents an extension beyond the fast-approaching 11-month deadline, making this the country’s last chance at striking a satisfactory trade deal with the EU.

The EUWA currently provides that directly applicable and operative EU laws such as the Market Abuse Regulation, the Transparency Directive, and the Prospectus Regulation will be converted into UK law at the end of the year. However, this does not amount to a workable level of certainty, in that such regulation, once converted, would be exposed to domestic revision or amendment.

Impact on Capital Market Regulation

The potential failure to achieve a trade deal presents particularly significant issues concerning, firstly, the “passporting” system (i.e. the system that enables banks and financial services firms that are authorised in any EU or EEA state to trade freely with minimal regulatory oversight – thereby serving as the foundation of the EU single market for financial services) and, secondly, the creation of a new EU Capital Markets Union, of which the UK has traditionally been a strong supporter.

More specifically, the UK will no longer be a part of the EU’s single-market system and will be treated as a third-party country lacking passporting or equivalence rights in the EU. This could be detrimental to both the EU, who relies on UK’s economic activity to bring revenue into the EU, and for the UK, a hub for international transactions instigated by firms that capitalise on the minimal red-tape requirements made possible by the Capital Markets Union. Abdication of the passporting and equivalence practices in the UK could particularly affect instances where there are lower numbers of retail investors in more than one Member State, as individual approvals would be required in each such Member State due to the absence of said practices.

What Practitioners Need to Know

As it stands, the presumption is that the UK will be considered a third-party country at the end of the implementation period. Consequently, some UK firms with operations in the EU are relocating to EU member-states (or are considering doing so) in order to preserve their passporting rights. EU regulators and supervisors are monitoring this activity, and it is important for professionals at every level to stay updated on the various guidelines and resources released by authorities to assist practitioners during the transition period.

With the potential failure to achieve a free trade deal still on the table, businesses and their advisors need to be prepared to reckon with its consequences. For example, the European Central Bank has been pressuring banks to accelerate their Brexit strategy plans and implement a substantial portion of its policies by the time the withdrawal deadline occurs. If firms cannot rely on regulatory equivalence, firms may have to incur significant costs that could affect their financial stability, hence why they should be considering potential mitigating mechanisms to counteract such effects.

Furthermore, on February 4, 2020, the Statutory Auditors and Third Country Auditors published their regulatory amendments to address deficiencies of retained EU law arising from the withdrawal of the UK from the EU in relation to the regulatory oversight and professional recognition of statutory auditors and third country auditors in the UK. In addition to updating the adequacy standards of nations such as China and South Africa, the amendments also provided an assessment framework for the equivalence of third countries’ audit regulatory frameworks and enabled the audit exemption currently available to subsidiaries of UK and EEA parent undertakings to continue to be available to those subsidiaries where their financial years have already begun.

While players across the board are giving their best efforts to deliver a smooth and fair transition of the UK out of the EU, only time will tell how complicated and contentious the terms of such transition will be. With or without a free trade arrangement, it is especially important for financial professionals, attorneys, and other advisory professionals to be vigilant in their assessment of regulatory developments as they are released.

The Continued Rise of Sustainable Finance in the UK and EU

 

The present and future impacts of climate change, human rights violations, environmental, labor and regulatory violations and poor corporate governance on the quality of investments and credit risks have spurred widespread recognition for the importance of environmental, social and governance (ESG) considerations in lending and investment activities.

The rapid development of the sustainable finance sector seen in 2019 has continued into 2020. “Sustainable finance” is a very broad term, but in short, it is any form of financial service and/or product which integrates ESG criteria into business, financing or investment decisions. The financial markets are now starting to possess a range of tools in the “sustainable finance” space.

The value ascribed to robust ESG credentials also continues to grow. Companies and financial institutions are increasingly seeking ways in which they can conduct business in an environmentally-conscious manner and minimize ESG risks. Attention is coming from all sides – from activists such as Greta Thunberg; from regulators, with Mark Carney recently pronouncing on the integration of climate-related financial risks into day-to-to-day supervisory work of the regulators of the financial sector; and from investors such as BlackRock. Also, in the “BNP Paribas ESG Global Survey 2019” 78% of respondents stated that ESG is either playing a growing role or becoming integral to what they do as an organization (including in respect of what they investor in and/or who they lend to).

With the focus on sustainability and ESG only increasing, the appetite for sustainable finance products is set to continue to increase in 2020 and beyond.

Rise in Popularity of Sustainability-Linked Debt Products

There have always been compelling environmental reasons for sustainability-linked financial products and yet it is only recently that the economic rationale for such investments has come to the forefront. 2019 was a record year for sustainable finance, with more sustainable debt issued globally than ever before. The total raised was US$465bn globally, up 78% from US$261.4bn in 2018, according to Bloomberg data.

The key instruments from a pure financing perspective currently appear to be “Green Loans/Bonds” and “Sustainability-Link Loans/Bonds”.

It is important to know that “Green Loans/Bonds” and “Sustainability-Link Loans/Bonds” are different.

  • “Green Loans/Bonds” use the proceeds of such instruments to finance green projects or related capital expenditure (e.g. renewable power generation, carbon reduction and waste reduction).
  • “Sustainability-Link Loans/Bonds” do not have a dedicated use of proceeds and are not linked to green projects or green business (more flexible than “Green Loans/Bonds” but nevertheless, a good way for a company to demonstrate its ESG credentials). Rather, they include performance criteria linked to sustainability or ESG criteria/targets. Such criteria/targets can be measured by way of a general ESG rating or specific agreed criteria/targets. If the borrower hits the relevant sustainability or ESG criteria/targets, the loan will be cheaper. Recent deals have also adapted a two-way pricing structure, with the price of the loan increasing if the borrower fails to meet its ESG targets, further incentivizing the borrower to meet its ESG targets.

However, “Sustainability-Link Loans” are a relatively recent development in Europe. For example, it was reported that:

  • in May 2019, Masmovil Group, the Spanish telecom operator, was the first European borrower to include an ESG-linked margin ratchet in leveraged loan facilities, being a 15 basis point pricing adjustment linked to its third party ESG score (but noting that the pricing adjustment only applied to the capex and revolving credit facilities and not the much larger term loan debt); and
  • in December 2019, Jeanologia, a Spanish developer of eco-efficient technologies for the apparel & textile industry, completed the first sponsor-backed (Carlyle) ESG-linked term loan. The margin is directly linked to a sustainability performance indicator produced by the borrower, related to its water-saving processes. If the borrower meets its targets, the margin tightens, while if the target is missed by 15% or more, the margin ratchets upwards.

In addition, the Loan Market Association (LMA) published the Sustainability Linked Loan Principles (SLLP) in March of 2019, which provide suggested criteria for setting and monitoring sustainability targets of “Sustainability-Link Loans”. The criteria are meant to be ambitious and meaningful to the borrower’s business. The metrics vary and there is no market standard, from ESG scores (provided by third party ESG rating agencies) to borrower led / specific targets (as seen in the examples above). As such, the SLLP recommend they should be negotiated on a deal-by-deal basis. However, on a related point, the European Leveraged Finance Association (ELFA) has started, together with the LMA, to engage with borrowers, private equity sponsors, arrangers, rating agencies and others in order to develop a standard set of the most relevant disclosures for the purpose of making informed ESG-related investment decisions.

Legislative Change on the Horizon

There are many legislative changes on the horizon in relation to the development of robust sustainable lending products and sustainable finance more generally. These include: (i) the Taxonomy Regulation, which is expected to be formally adopted, introducing an EU-wide classification of environmentally sustainable activities; (ii) the Disclosure Regulation (main provisions coming in to force from March 2021), which will impose new transparency and disclosure obligations on certain firms; (iii) the Low Carbon Benchmark Regulation, effective as of December 10, 2019, which will continue to set out minimum requirements for EU climate transition benchmarks and ensure that these benchmarks can work alongside other pre-existing ESG objectives; and (iv) the development of technical standards by the ESMA on disclosure provisions for sustainable investments during 2020. From an investor/lender perspective, the Disclosure Regulation (noted at (ii) above) will be key, as it will require certain firms, including asset and fund managers, to comply with new rules on disclosure, as it regards to sustainable investments and sustainability risks.

Furthermore, it was reported this week that the current European Commission is prioritizing climate change in all sectors, including in financial services. An update to the law known as the “Green Taxonomy” would require banks, insurers, and listed companies with more than 500 staff members to report how much of their expenses are put towards environmental initiatives such as reduction of greenhouse-gas emissions. In a quest to widen its net, the European Commission is hoping to broaden the scope of the non-financial reporting even further in the legal proposal that is due by the end of 2020. The proposal likely seeks to cover asset managers, as well as large unlisted companies. Although some unlisted companies, such as Ikea, already do produce voluntary reports on sustainability, these new requirements may come less favorably to those companies seeking to avoid higher reporting burdens by staying off the public markets or to companies headquartered in more climate-skeptic countries.

Although changes to the regulatory capital treatment of sustainability linked debt are in contemplation at both a European and UK level, they are in their infancy. Currently, the focus of regulators appears to be on driving a conscious governance and disclosure framework and on integrating ESG risks into the management policies of regulated firms.

Recent Reports and Strategy Statements

Several reports and strategy statements have been published in recent weeks by a variety of prominent industry regulators and trade bodies in respect of ESG. Some highlights include:

The European Securities and Markets Authority (ESMA) published its Strategy on Sustainable Finance on February 6, 2020, setting out how ESMA will prioritize sustainability by embedding ESG factors in its work. The key priorities for ESMA include transparency obligations, risk analysis on green bonds, ESG investing, convergence of national supervisory practices on ESG factors, taxonomy and supervision. Steven Maijoor, Chair, said: “The financial markets are at a point of change with investor preferences shifting towards green and socially responsible products, and with sustainability factors increasingly affecting the risks, returns and value of investments. ESMA, with its overview of the entire investment chain, is in a unique position to support the growth of sustainable finance while contributing to investor protection, orderly and stable financial markets.”

The Investment Association (IA), the trade body that represents UK investment managers, published its Shareholder Priorities for 2020 report in January of this year. In the report, the IA noted its support for the recommendations made in the Green Finance Strategy released in early July 2019 by the UK government. Such recommendations set out two objectives: 1) to align private sector financial flows with environmentally sustainable growth that is supported by government action; and 2) to increase the competitiveness of the financial sector in the UK.

The UK Sustainable Finance and Investment Association (UKSIF) published a report on February 6. The report found that pension scheme trustees are failing to comply with their investment duties. Following a change to the law in 2019, trustees must publish their approach to protecting people’s pension savings from the financial risks of climate change and other ESG issues. UKSIF report: 1) found that only one third of a representative sample of trustees have complied with the legal transparency requirements and are calling for the Pensions Regulator to carry out a review to investigate levels of compliance across the UK’s pensions sector; and 2) looked at the different policies trustees have adopted to comply with the new regulations. It found that although most trustees say they believe ESG issues will affect the financial performance of their scheme’s assets, most trustees have adopted “thin and non-committal” policies to manage ESG financial risk.

Summary

In short, ESG is no longer a peripheral exercise thanks to investor demand, regulation and greater certainty about the link between ESG risks and long-term financial performance. And as noted above, the focus on sustainability and ESG is only increasing.

SEC Office of Compliance Inspections and Examinations Publishes Observations on Cybersecurity and Resiliency Practices

 

On January 27, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) issued observations gleaned from its examinations related to cybersecurity and operational resiliency practices taken by market participants (the “Observations”). The Observations impact the entire securities industry because OCIE conducts examinations of SEC-registered investment advisers, investment companies, broker-dealers, self-regulatory organizations, clearing agencies, transfer agents, and others. It uses a risk-based approach to examinations to fulfill its mission to promote compliance with U.S. securities laws, prevent fraud, monitor risk, and inform SEC policy.

The Observations cover a broad range of operations in the areas of governance and risk management, access rights and controls, data loss prevention, mobile security, incident response and resiliency, vendor management, and training and awareness. They highlight specific examples of cybersecurity and operational resiliency practices and controls that organizations have taken to safeguard against threats and respond in the event of an incident.

Organizations subject to examination by OCIE should expect that the primary elements highlighted will be a focus of routine, as well as targeted examinations. The Observations are best regarded as a set of “best practices” that should be considered by regulated organizations in developing, implementing and monitoring the effectiveness of their own compliance programs.

The following are selected excerpts from the Observations that we believe are the most significant. A complete copy of the Observations can be found here.

Governance and Risk Management

OCIE emphasized that effective compliance programs “start with the right tone at the top.” As a top priority of any examination, senior leaders should be committed to improving their organization’s cyber posture through working with others to understand, prioritize, communicate, and mitigate cybersecurity risks.

OCIE observes that a key element is the incorporation of a governance and risk management program that generally includes, among other things: (i) a risk assessment to identify, analyze, and prioritize cybersecurity risks to the organization; (ii) written cybersecurity policies and procedures to address those risks; and (iii) the effective implementation and enforcement of those policies and procedures.

Access Rights and Controls

OCIE observes that “access rights and controls” are used to identify and determine who are the appropriate users within an organization who should have access to organization systems based on job responsibilities. Access controls generally include: (i) understanding the location of data, including client information, throughout an organization; (ii) restricting access to systems and data to authorized users; and (iii) establishing appropriate controls to prevent and monitor for unauthorized access.

Data Loss Prevention

“Data loss prevention,” as conceived by OCIE, typically includes a set of tools and processes an organization uses to ensure that sensitive data, including client information, is not lost, misused, or accessed by unauthorized users.

Mobile Security

Mobile devices and applications may create additional and unique vulnerabilities. Examples of the mobile security measures OCIE has observed include the following elements: (i) establishing specific policies and procedures for the use of mobile devices, including managing the use of mobile devices., e.g., the compliance program addresses the special concerns that are presented when employees are permitted to use their own mobile devices in performing business functions; (ii) implementing security measures; (iii) training employees, including training employees on mobile device policies; and (iv) effective practices to protect mobile devices.

Incident Response and Resiliency

OCIE notes the importance of a compliance program including the following elements: (i) the timely detection and appropriate disclosure of material information regarding incidents; and (ii) assessing the appropriateness of corrective actions taken in response to incidents. OCIE emphasized that an important component of an incident response plan is a business continuity plan and resiliency plan that addresses how quickly the organization could recover and again safely serve clients if the operations of the organization were materially disrupted.

Vendor Management

OCIE found that practices and controls related to vendor management generally include policies and procedures related to: (i) conducting due diligence for vendor selection; (ii) monitoring and overseeing vendors, and contract terms; (iii) assessing how vendor relationships are considered as part of the organization’s ongoing risk assessment process as well as how the organization determines the appropriate level of due diligence to conduct on a vendor; and (iv) assessing how vendors protect any accessible client information.

Training and Awareness

Training and awareness are key components of cybersecurity programs. Training provides employees with information concerning cyber risks and responsibilities and heightens awareness of cyber threats.

OCIE has observed the following practices used by organizations in the area of cybersecurity training and awareness: (i) training staff to implement the organization’s cybersecurity policies and procedures and engaging the workforce to build a culture of cybersecurity readiness and operational resiliency; (ii) providing specific cybersecurity and resiliency training, including preventive measures in training, such as identifying and responding to indicators of breaches, and obtaining customer confirmation if behavior appears suspicious; (iii) monitoring to ensure employees attend training and assessing the effectiveness of training; and (iv) continuously re-evaluating and updating training programs based on cyber-threat intelligence.

SEC Proposes Amending the Definition of “Accredited Investor”

 

On December 18, the Securities and Exchange Commission by a three to two vote, voted to propose amendments to the definition of “accredited investor,” one of the principal tests applied under the federal securities laws for determining who is eligible to participate in transactions that are not required to be registered with the SEC. Such transactions are commonly referred to as “private capital markets” transactions. In the words of the SEC, the proposal “seeks to update and improve the definition to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in our private capital markets.”

In announcing the proposal, Jay Clayton, Chairman of the SEC, asserted that: “The current test for individual accredited investor status takes a binary approach to who does and does not qualify based only a person’s income or net worth. . . The proposal would add other means for natural persons to qualify to participate in our private capital markets based on established, clear measures of financial sophistication . . . .” For example, natural persons could qualify as accredited investors based on their professional knowledge and experience, as evidenced by them having obtained professional certifications. Another welcomed aspect of the proposal highlighted by the Chairman is that it “specifically recognizes that certain organizations, such as tribal governments, should not be restricted from participating in private capital markets” transactions if they meet certain investment thresholds. Proposed Rule.

 

Posted in SEC

Treasury Releases Final Regulations to Reform National Security Reviews for Certain Foreign Investments and Other Transactions in the United States

 

On January 13, the U.S. Department of the Treasury issued two final regulations that aim to modernize the investment review process to address national security issues posed by certain foreign investments and real estate transactions. The regulations implement the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) and broaden the authority of the CFIUS to review even non-controlling foreign investments into U.S. businesses that are involved in critical technology, infrastructure, or personal data. Release.

 

CFTC’s Division of Market Oversight Supplements No-Action Relief to SEFs and DCMs from Certain CFTC Regulations for Correction of Errors

 

On January 8, the Commodity Futures Trading Commission (CFTC) Division of Market Oversight issued a no-action letter that provides an alternative error correction process by which swap execution facilities (SEFs) and designated contract markets (DCMs) may permit counterparties to determine that an error has occurred and correct the error, subject to ex post facto review by the SEF or DCM. The no-action letter supplements the relief provided in CFTC Letter 17-27, which provided relief from certain CFTC regulations to permit SEFs and DCMs to correct clerical or operational errors discovered after a swap has been cleared. CFTC Release.

HUD Releases Proposed Affirmatively Furthering Fair Housing Rule

 

On January 7, the Department of Housing and Urban Development (HUD) published its proposed Affirmatively Furthering Fair Housing rule (AFFH Rule). The proposed AFFH Rule would replace the AFFH Rule that was finalized in 2015 to provide a process for evaluating local jurisdictions’ compliance with the Fair Housing Act’s requirement that HUD funding be used to affirmatively further fair housing. The proposed AFFH Rule revises the 2015 definition of “affirmatively furthering fair housing”, develops metrics to compare jurisdictions and requires jurisdictions to identify steps they will take over five years to comply with AFFH Rule requirements. Comments on the proposed AFFH Rule are due 60 days after publication in the Federal Register. HUD Release. Proposed Rule.

SEC Office of Compliance Inspections and Examinations Announces 2020 Examination Priorities

 

On January 7, the SEC Office of Compliance Inspections and Examinations announced its 2020 examination priorities, which include a focus on risks related to retail investors (including seniors and those saving for retirement), market infrastructure, information security, anti-money laundering programs and financial technology (including digital assets and electronic investment advice), among others. The SEC publishes its examination priorities annually to enhance the transparency of its examination program and to provide insights into its risk-based approach, including the areas it believes present potential risks to investors and the integrity of the U.S. capital markets. SEC Release.

 

 

CFTC Issues Advisory Regarding Chief Compliance Officer Annual Report Requirements

 

On December 4, the CFTC issued an advisory (Staff Advisory 19-24) providing further guidance on certain requirements applicable to swap dealers, futures commission merchants and major swap participants (collectively, Registrants) in connection with the preparation and submission of chief compliance officer annual compliance reports (CCO Annual Reports) pursuant to CFTC Regulation 3.3. The CFTC had previously issued: (i) a final rule governing CCO Annual Reports in 2012; (ii) a related staff advisory in 2014; (iii) a final rule modifying certain regulations related to the CCO Annual Report requirements in December 2018; and (iv) guidance focused on certain of those requirements in December 2018.

After reviewing CCO Annual Reports submitted for the 2018 fiscal year, the Division of Swap Dealer and Intermediary Oversight (DSIO) of the CFTC issued Staff Advisory 19-24 to provide additional guidance to Registrants regarding the CCO Annual Report requirements. Staff Advisory 19-24 addresses the following areas of the CCO Annual Report: (i) areas for improvement; (ii) financial, managerial, operational, and staffing resources; (iii) material non-compliance issues; (iv) furnishing the annual report and related matters; (v) the certification requirement; (vi) compliance with the Volcker Rule; and (vii) other miscellaneous items. The Advisory also notes that, if a Registrant files a CCO Annual Report that DSIO staff determines is noncompliant, the Registrant may be required to file a corrected CCO Annual Report pursuant to CFTC Regulation 3.3(f)(4). Release.

CFTC Unanimously Passes Final Rule Affecting Formulation, Amendment or Repeal of Commission’s Rules and Regulations

 

On December 10, the U.S. Commodity Futures Trading Commission (CFTC) approved a final rule eliminating the provisions of the Commission’s Regulations that established the formulation, amendment or repeal of its rules or regulations. The CFTC unanimously passed the final rule, with rule makers stating these provisions were unnecessary because the CFTC’s rulemaking process is governed by the Administrative Procedure Act. Rule.