Investment Funds 2023

Introduction

Upon entering 2022, the global economies lived in hope of balancing the damage brought by the COVID-19 pandemic, normalising business cycles and putting economic growth back on track. However, 2022 has again reshaped the way global markets function, in particular with the war in Ukraine. The implications of the Ukrainian crisis for the global economy and financial markets mainly come from three channels: economic sanctions, commodity prices, and supply-chain disruptions.  

Although the assets under management (AUM) in Luxembourg slightly increased in 2021, by 31 October 2022 the total net assets of undertakings for collective investment (UCIs) – comprising UCIs subject to the 2010 Law, specialised investment funds and SICARs – amounted to EUR5,064.782 billion, meaning that the volume of net assets has decreased by 11.43% over the last 12 months. That said, an increase was again seen (of 0.53%) from September 2022 to October 2022 (source: CSSF press release 22/28).

Continued emphasis on sustainable finance

The European Climate Law proposal published in March 2020 came into force in July 2021, with the following objectives (Regulation (EU) 2021/1119):

• setting the European long-term vision for meeting the 2050 climate-neutrality objective through all policies, in a socially fair and cost-efficient manner;
• setting a more ambitious EU 2030 target, to keep Europe on the right track towards becoming climate-neutral by 2050;
• creating a system for monitoring progress towards these goals and taking further actions if needed;
• providing predictability for investors and other economic actors, to ensure a gradual reduction of greenhouse gas emissions over time; and
• ensuring that the transition towards climate neutrality is irreversible.
  
   

Latest ESMA consultation

In November 2022, the European Securities and Markets Authority (ESMA) published a consultation paper about its draft guidelines on the use of ESG or sustainability-related terms in funds names. The name of a fund can often have a significant influence on the investment decisions of the investors. The use of ESG or sustainability-related terms in the fund name may catch investors’ attention, but can also pose a threat of potential greenwashing. ESMA, by publishing the consultation paper, wished to ensure that behind the fund name there is material evidence of sustainability characteristics or objectives that are reflected fairly and consistently in the fund’s investment objectives and policy. 

The draft guidelines aim to ensure protection of investors and provide national competent authorities and asset management with coherent and measurable criteria that will allow them to assess fund names that include ESG or sustainability-related terms. 

For making ESG work and overcoming its associated challenges, more emphasis is expected to be placed on tackling the practice of so-called greenwashing. The primary example of this practice is the use of vague or even blurred labels, such as “ESG-integrated”. The issue has already found its way to the attention of the regulators. Thus, some investment management firms now conduct sweeping checks of their marketing materials to reveal statements that could be considered greenwashing. The possibility of high-stakes litigation for damages on these grounds should have a tangible impact on market players resorting to greenwashing, and quickly nudge them into compliance. 

The topic is likely to have a snowball effect in the sense that the ESG disclosures imposed on investment objects (eg, industrial companies) will probably be clarified and tightened as well. Without comprehensive disclosures at the level of the investment objects, asset managers are in a very difficult position when expected to make reliable disclosures themselves. Efforts might be needed in the so-called Scope 3 emissions (ie, indirect greenhouse gas emissions stemming from the value chain of the entity).

Further disclosure requirements – SFDR

Following the publication of Delegated Regulation (EU) 2022/1288 and the confirmation of the application date of the SFDR Level 2 provisions (SFDR RTS), the CSSF has outlined the procedure for filing of the issuing document of the fund in view of the SFDR RTS. 

In its communication of 27 July 2022, as detailed further in a communication of 6 September 2022, the CSSF underlined the deadline of 1 January 2023 and introduced an accelerated procedure for the submission of updated pre-contractual documents for undertakings for collective investment in transferrable securities (UCITS) and regulated alternative investment funds (AIFs). 

The CSSF also released an FAQ on 2 December 2022, which provides additional explanations on SFDR and the SFDR RTS. The FAQ applies to the following financial market participants (FMPs):

• alternative investment fund managers (AIFMs);
• management companies of undertakings for collective investment in transferable securities (UCITS Management Companies);
• managers of a qualifying venture capital fund (EuVECA); and
• managers of a qualifying social entrepreneurship fund (EuSEF).

The CSSF has clarified the notion of a “material change” as defined by Circular CSSF 14/591. In the event of a material change, investors must either grant their consent to such change or otherwise be notified one month in advance of the change and be permitted to request a repurchase of their interest during that period. The FAQ has also confirmed that amendments to Article 8 and Article 9 SFDR RTS pre-contractual templates follow the same regime as any other changes made to the prospectus, including those changes considered material in light of CSSF Circular 14/591. 

The FAQs further address the website disclosure requirements of Article 10 SFDR by confirming that even if a Luxembourg investment fund manager (IFM) has delegated the portfolio management function relating to a fund, it must still comply with the website disclosure requirements of Article 10 SFDR in relation to the relevant fund for which it acts as FMP.

To promote environmental and social characteristics, within the meaning of Article 8 SFDR, the FAQs confirm that it is possible to utilise an exclusion strategy, to the extent that the details on the exclusion strategy allow the investors to understand how this strategy is used to meet the environmental and social characteristics promoted by the product.
The exclusion strategy cannot be used for the disclosure under Article 9 SFDR. Such funds must invest in “sustainable investments”, which require a positive investment selection process to meet the conditions of Article 2(17) SFDR.

In the context of exclusion strategies, the FAQs underline that Recital (16) of the SFDR RTS warns about “greenwashing”. The reliance on the exclusion strategies should be balanced against the right of end investors to be provided with the information necessary to assess the composition of the portfolio of the relevant financial product. To prevent mis-selling and greenwashing, Recital (16) of the SFDR RTS requires FMPs to confirm to investors any commitment in terms of excluded investments, in particular as contractually binding elements of the investment strategy, in the information provided on asset allocation and in the information on the sustainability indicator used to measure the effects of such strategies.

New sustainability standards – CSRD

In line with the European Union’s climate goals and to strengthen the existing rules on non-financial reporting, on 28 November 2022 the Council of the EU formally approved the Directive amending Regulation (EU) No 537/2014, Directive 2004/109/EC, Directive 2006/43/EC and Directive 2013/34/EU as regards corporate sustainability reporting (CSRD). The CSRD has been agreed upon by the European Parliament on 14 December 2022 and entered into force on 5 January 2023. Compared with the previous Non-Financial Reporting Directive (NFRD), the CSRD has significantly expanded the scope of sustainability reporting at both the individual entity and group level. The new directive applies to all large companies, as well as all parent undertakings of a large group, which exceed two of the three following criteria during a financial year over the course of two consecutive financial years: 

• EUR20 million balance sheet in total; 
• EUR40 million of net turnover; or 
• average number of 250 employees. 

The scope also encompasses all listed EU companies (including listed SMEs, but excluding micro-undertakings) and non-European companies generating net annual turnover above EUR150 million in the EU, and which have at least one EU subsidiary or branch exceeding certain thresholds. 

The CSRD obliges businesses to disclose information on their social and environmental impact, with the aim of revealing greenwashing, strengthening the EU’s social market economy and laying the groundwork for sustainability reporting standards at a global level. 

The CSRD also introduces mandatory European Sustainability Reporting Standards (ESRS) which will be based on the European Financial Reporting Advisory Group’s (EFRAG) recommendations and adopted by the European Commission in the form of delegated acts. ESRS will be used for reporting by companies within the scope of the CSRD. 

ESRS mainly focuses on the harmonisation of the existing sustainability frameworks and standards on the European Union level. It aims to harmonise the terminology and structure of the reporting used throughout the current reporting processes. Furthermore, it will clarify the concept of double materiality and the approach to materiality, including those items that must be reported irrespective of materiality. 

EFRAG has submitted the first set of drafts of ESRS, which are expected to be adopted mid- 2023.

Cross-border distribution

The EU framework for the cross-border distribution of collective investment funds (the “CBD Framework”), consists of Directive (EU) 2019/1160 (the “CBDF Directive”), implemented in Luxembourg by the Law of 21 July 2021, and Regulation (EU) 2019/1156 applicable since 1 August 2019 (the “CBDF Regulation”).

On September 2022, the CSSF published a list of questions and answers (CSSF FAQ) regarding the CBD Framework – guidance on marketing communications. The CSSF FAQ focuses on the application of Article 4 of the CBD Regulation as well as the underlying guidelines of ESMA on marketing communication (the “ESMA Guidelines“), which were implemented by the CSSF through Circular 22/795 and have been applicable since 2 February 2022. 

Article 4 of the CBDF Regulation obliges AIFMs, EuVECA managers, EuSEF managers and UCITS Management Companies to ensure that all marketing communications addressed to investors:

• are identifiable as such; and 
• describe the risks and rewards of purchasing units or shares of an AIF or units of a UCITS in an equally prominent manner, and that all information included in marketing communications is fair, clear and not misleading.

The aim of the CSSF FAQ is to provide additional clarifications in respect of Article 4 application and to explain further supervisory expectations of the CSSF.

The CSSF FAQ has confirmed the types of IFMs falling under the scope of Article 4 and enlisted all IFMs in the scope of CSSF Circular 22/75 (which are UCITS Management Companies and authorised AIFMs, and UCITS- or AIF-internally managed, meaning those which have not designated a management company or an external AIFM, as well as EuVECA and EuSEF managers). Regarding funds, Article 4 applies to UCITS and AIFs including those set up as EuVECAs, EuSEFs, ELTIFs and Money Market Funds managed by an IFM listed in Section 2 of CSSF Circular 22/795.

Article 4 is further to be applied to all marketing communications addressed to all types of investors or potential investors, even those targeting professional investors. The marketing communications which are addressed to investors or potential investors that are not resident in the EEA are not in scope. 

As regards the governance and organisation of an IFM, the CSSF FAQ explains that the IFM must implement measures that allow it to identify and flag marketing communication as such. Through the senior management of the IFM and/or its internal functions, the IFM should be involved in the process of preparation and validation of marketing communication. It may also appoint a third-party service provider to perform required tasks in the preparation and validation of marketing communication. Adequate oversight is to be ensured over such delegates. 

IFMs with an MiFID top-up licence should also provide information on marketing communications in relation to the services of discretionary portfolio management and investment advice. 

In addition, from 1 April 2023, IFMs within the scope of Article 4 must also be able to link the aforementioned information to the relevant funds or sub-funds they manage. IFMs are obliged to identify whether the marketing communications include information with regards to ESG in the context of the application of Article 13 of the SFDR and of the ESMA supervisory briefing on sustainability risks and disclosures in the area of investment management.

Lastly, the CSSF clarified that as part of the verifications of compliance with Article 4 of the CBDF Regulation, it may ask the IFM for legal and regulatory documents of the funds they manage. This includes PRIIPs, KID or the Article 23 AIFMD disclosure. Any non-compliance with the requirements of Article 4 and the ESMA Guidelines is considered a breach of Article 4.

ELTIFs

Regulation (EU) 2015/760 of 29 April 2015 (the “ELTIF Regulation”) pertaining to European long-term investment funds (ELTIFs) was developed for AIFs engaged in long-term investments such as social and transport infrastructure projects, real estate and SMEs. As ELTIFs were designed to channel long-term investments, the framework is supposed to be an additional springboard for sustainable growth in the EU. The framework regulates the authorisation, investment policies, operating conditions and marketing of ELTIFs throughout the EU. However, the number of ELTIF vehicles in Europe remains low, in spite of the pressing need to promote long-term, sustainable financing in the EU. By the end of  2022, 84 ELTIFs had been launched, in four different member states of the EU (source: ESMA Register of Authorised European Long-Term Investment Funds, as of 3 January 2023). 

In November 2021, the EU Commission pro¬posed an amendment to the ELTIF Regulation, with the intention to overcome a number of supply-side and demand-side limitations and to make the ELTIF Regulation more attractive for investors and fund managers. The amendments further aim at simplifying the ELTIF investing process for retail investors while ensuring a strong investor protection. Following the legislative process, a provisional agreement was reached on the ELTIF review on 19 October 2022. 

As a consequence of these discussions, on 15 February 2023, the European Parliament has voted in favour of a major update to the ELTIF Regulation, commonly known as ELTIF 2.0.

• Among other changes set out in the provisional agreement, the pool of assets eligible for ELTIFs will now offer more flexibility, and include the following provisions. 
• The portfolio composition of the ELTIF has been amended, changing the minimum eligible assets threshold from 70% to 55% of the whole portfolio with individual diversification limits on investments set at 20%. 
• The notions of “real assets” and “simple, transparent and standardised securities” (STS) has been adjusted, and meeting the con¬ditions for real assets is now easier for the following reasons: (a) the minimum value threshold for real assets, from the current EUR10M, has been removed; and (b) the market capitalisation threshold for investment in listed portfolio undertakings has been set at EUR 1.5 billion (instead of the current EUR 500 million).  
• It is now possible to invest in licensed financial undertakings younger than five years. 
• A master-feeder structure is now accessible to ELTIFs. A feeder-ELTIF would be an ELTIF investing at least 85% of its assets in another ELTIF. A retail ELTIF would also be able to act as a feeder-ELTIF, subject to specific disclosure and co-operation duties. 
• Fund of funds arrangements has also become a more common feature in ELTIFs’ strategies, as the maximum limit on investments in funds, other than ELTIFs and UCITs, has been increased. ELTIFs will therefore also be able to invest in other EU AIFs managed by EU AIFMs subject to the condition that the investments of these target AIFs are eligible investments for ELTIFs. 

Outsourcing arrangements

In April 2022, the CSSF published Circular 22/806 on outsourcing arrangements, creating a unique and uniform framework on outsourcing arrangements (including business process, ICT & Cloud outsourcing) for entities supervised by the CSSF, including IFMs that have not previously been in scope of the EBA Guidelines on outsourcing arrangements.

The CSSF expects all in-scope entities to review their existing outsourcing arrangements to comply with the new provisions of the Circular in terms of central administration, internal governance, and risk management, proportionally to the nature, scale and complexity of their activities or services.

The Circular imposes ongoing obligations relating to governance, risk management, conflicts of interests, internal controls, professional secrecy, data protection, business continuity and exit planning. Entities that intend to outsource a critical or important function must notify their plans in advance to the CSSF using the instructions laid down in the Circular and, where available, the forms on the CSSF website.

The CSSF has stressed that the outsourcing arrangements shall be subject to appropriate oversight and may in no circumstances lead to the circumvention of the spirit and letter of regulatory requirements or prudential measures. When outsourcing operational tasks to a service provider, the entities in scope must ensure that those operational tasks are effectively performed and appropriately monitor and audit the outsourcing arrangement.

Entities in scope remain fully responsible for compliance with regulatory requirements, including in the case of sub-outsourcing, as sub-outsourcing can change the risk and reliability of outsourcing arrangements.

Virtual assets and cryptocurrency

The development of virtual assets and cryptocurrency as an asset class has been exponential over the last few years, even though 2022 has been a turbulent one in demonstrating that the crypto market contains numerous challenges and legal uncertainties.

The CSSF seems committed to promoting an open, technology-neutral and prudent risk-based regulatory approach towards this type of asset. The CSSF issued guidance and an FAQ on virtual assets (for both UCI and credit institutions) in November 2021. The latest communication regarding cryptocurrency investments has opened the possibility for UCITS and AIFs reserved to professional investors to invest directly into crypto-related assets. 

One of the major topics discussed regarding investments into crypto-related assets is the AML/CFT implications and performance of due diligence on these types of assets. In its latest update in the FAQ on virtual assets, the CSSF underlined that depending on the type of investment (direct or indirect), the type of virtual assets (cryptocurrency, utility token, etc) and the acquisition method of the assets, the level of money laundering or terrorist financing risk and the due diligence will vary. 

The bottom line of the due diligence obligation for funds and IFMs is to understand where the virtual assets are coming from and/or where they are going (buy/sell side) in order to mitigate the risk of the investment fund being abused by money launderers or terrorist financing. The CSSF has further communicated that it is essential that any investor considering the acquisition of virtual assets understands the risks they present and the regulatory framework that applies to them. In this regard, virtual assets are governed in Luxembourg by the Law of 12 November 2004 on the fight against money laundering and terrorist financing. 

In terms of regulation on the European level, the EU recently took numerous actions to establish rules for all players of the crypto sphere. In particular, the EU is bringing crypto-assets, crypto-asset issuers and crypto-asset service providers under a uniform regulatory framework, and reached a provisional agreement on the markets in crypto-assets (the “MiCA”). 

The main aim of the MiCA is to protect consum¬ers against the risks associated with investment in crypto-assets and help them avoid fraudulent schemes. The new regulation will introduce an obligation for crypto-asset service providers to respect requirements to protect consumers’ wallets, and they will be liable in cases where they lose investors’ crypto-assets. The MiCA will also cover any type of market abuse related to any type of transaction or service, notably for market manipulation and insider dealing. 

The MiCA will also oblige participants of the crypto-assets market to declare information on their environmental and climate footprint. 

The prospective regulation has also introduced an authorisation requirement for crypto-asset service providers seeking to operate within the EU. In Luxembourg, the CSSF has already introduced a regulatory regime for virtual-asset service providers. 

The MiCA is expected to come into force in the first quarter of 2023 and will create a single EU-wide framework for all players in the crypto-asset sector. However, a transitional period of 12 to 18 months will likely be established, and therefore the regulation is not expected to fully take effect until the end of 2024.

Furthermore, in an effort to remain resilient in the event of a serious operational disruption as well as to prevent and mitigate cyber threats, the Digital Operational Resilience Act (“DORA”) was published on 27 December 2022. This European regulation entered into force on 17 January 2023 and will apply as of 17 January 2025. DORA has in particular created a regulatory framework on digital operational resilience whereby all businesses must ensure that they can resist, respond to and recover from all types of ICT-related disruptions and threats. DORA further sets uniform requirements, consistent across the whole of the EU, for the security of the networks and information systems of financial sector institutions, as well as critical third party-providers that offer them with information and communication technology (ICT) services, such as cloud computing platforms (PaaS) or data analysis services.

Conclusion

The year 2022 saw numerous regulatory changes and developments, which will continue into 2023. It is evident that there is a global and general willingness to undergo a transformation of the fund industry and alternative investments towards more sustainability, transparency, stability and security.

In view of some recent steps taken by Luxembourg actors in the fund industry, there is no doubt that Luxembourg will strive to make the most of this transformation and turn the challenges into opportunities for market players.