Investment Funds in Luxembourg: Trends and Developments

Introduction

Following the turmoil of the past few years, 2023 saw increased activity pushing forward new regulatory measures in the funds industry and preparing for the future of several key regulations. Those regulations in the pipeline seek the right balance between encouraging investments in Europe on the one hand and protecting investors on the other hand.

2024 promises to be as busy as 2023 on the regulatory front, bringing the EU fund industry to a new level of sophistication.

One step closer to AIFMD 2

Following the end of their trilogue, an agreement was reached in October 2023 between the European Parliament (the Parliament), the European Commission (the Commission) and the Council of Europe (the Council) in relation to the proposed revision of two EU directives:

• Directive 2011/61/EU of 8 June 2011 on Alternative Investment Fund Managers (AIFMs) (AIFMD) and its associated annexes (the revised AIFMD, AIFMD 2); and

• Directive 2009/65/EC of 13 July 2009 on Undertakings for Collective Investment in Transferable Securities (UCITS) (UCITS Directive).

The adoption of the final text is still pending, and the Parliament has set an initial date for a plenary sitting on 5 February 2024. Accordingly, the final text could be published in the Official Journal in February or March 2024 and the new rules should come into effect around Q1 2026 (ie, two years after adoption).

The key changes will be on the following topics.

• AIFM and management company (ManCo) governance: AIFMs and ManCos will require at least two full-time employees/executive members domiciled in the European Union (the EU) and will be encouraged to appoint one independent director when managing investment funds open to retail investors. Furthermore, ESG parameters will be integrated into the governance and risk management rules supporting investment decisions (especially when managing alternative investment funds (AIFs) or UCITS with sustainable strategies).
• Depositary: if opened at the discretion of the EU member states when transposing AIFMD 2, it will be possible to have a depositary in a different country than that of the relevant investment fund under certain conditions, notably:

a) if there is a lack of relevant depositary services in the country of the investment fund;

b) if the depositary assets in the country of the investment fund are under EUR50 billion;and

c) on a case-by-case basis.

• Leveraged AIFs: a common definition of a leveraged AIF will be introduced – ie, “an AIF whose exposures are increased by the AIFM that manages it, whether through borrowing of cash or securities, or leverage embedded in derivative positions or by any other means”.
• Loan originating funds: loan originating AIFs are defined in AIFMD 2, together with accompanying rules, with flexibility for nations to enforce stricter rules. In particular, AIFMD 2 contains a prohibition of loans to certain entities (the AIFM, its delegates, depositaries, custodians, etc) and demands full disclosure as to the value of the loan. If the borrower is itself an AIF/UCITS, an investment limit of 20% will be set and a leverage cap for open/closed ended funds will be introduced (175% or 300%, respectively). All of the changes introduced by AIFMD 2 on this topic will benefit from a grandfathering clause.
• Delegation: AIFMD 2 introduces a stronger supervision of delegated functions, with requirements for the entire delegation structure to be objectively justified, and for the delegation requirement to be automatically applied mutatis mutandis to the entire chain of delegation. However, these requirements are not applicable to distributors marketing the investment funds under their own MIFID licence or through insurance-based products.
• Reporting and disclosure requirements: the new reporting and disclosure requirements will be applicable to all markets, all exposures, all instruments and all assets, risk profiles and liquidity arrangements, where marketed. For delegates, disclosures will consist in particular of identity, links to the AIFM/ManCo, authorisation (or lack thereof) and applicable supervisory authority. For AIFM/ManCo, the disclosures will consist in particular of employees, qualification, how the percentage delegation of portfolio management is made, resources, due diligence performed, and the same information outlined above on delegates.
• New requirements on costs borne by investors: there will be new requirements with regard to what is charged by the AIFM/ManCo directly/indirectly to the investment fund/investors. This will need to be provided with a report explaining the reasons of the level of costs and the differences between them. Further reporting to the national authority and the European Securities and Markets Authority (ESMA) will be due, to develop a common understanding of the costs.

EU member states will have to transpose AIFMD 2 and changes to the UCITS Directive into their national legislation, raising interest as to how they will implement it domestically (for example, with or without gold-plating) and how they will make the most of it for the fund industry.

The new EU AML Package

On 20 July 2021, the European Commission presented an ambitious package of legislation to strengthen the EU AML and CFT rules (the AML Package). The aim and content of this AML Package is to remedy the gaps of the 5th AML Directive of 2018, which was not implemented equally or in full by all member states, as well as the lack of serious consequences in the event of non-compliance. This AML Package is based on four pillars that aim to correct existing deficiencies and raise the level of global response with respect to the fight against AML/CFT; they consist of the following.

• The EU “Single Rulebook” Regulation: an EU-wide mandatory instrument applying within the scope of AML obligations, which contains provisions on conducting due diligence on customers, the transparency of beneficial owners and the use of anonymous instruments such as crypto-assets, and new entities such as crowdfunding platforms. The regulation also includes provisions on so-called “golden” passports and visas.

• The 6th AML Directive contains national provisions on supervision and Financial Intelligence Units (FIUs), as well as access for competent authorities to necessary and reliable information – eg, beneficial ownership registers and assets stored in free zones.

• The regulation establishing the European Anti-Money Laundering Authority, which will operate with an independent executive board and will have direct supervisory powers over some financial entities, including both financial and non-financial entities within the scope of AML obligations. It will also have regulatory powers to issue guidelines, technical standards and opinions, and will furthermore support the already existing national FIUs. Following the 2022 invasion of Ukraine, it has been suggested that the role of the European Anti-Money Laundering Authority should be expanded to playing a part in the enforcement of financial sanctions adopted by the EU.

• The amendment of the EU Transfer of Funds Regulation will update the existing regulation to bring crypto-assets service providers (CASPs) within the scope of the AML/CFT framework. It is the only element of the AML Package that was adopted earlier in 2023 together with the Market in Crypto Asset Regulation (MiCA). As a result, newly obliged CASPs should urgently update their AML/CFT processes to bring them in line with the regulation and the overall AML/CFT framework. However, CASPs that are already subject to AML/CFT rules should implement adjustments, if necessary.

On 28 March 2023, the Parliament adopted its position on the AML Package and on 17 April 2023 initiated a trilogue, which concluded on 17 January 2024. The final vote on the AML Package is expected to occur during the first half of 2024.

Towards ESG compliant fund names

In November 2022, ESMA published a consultation paper about its draft guidelines on the use of ESG or sustainability-related terms in fund names. The consultation closed on 20 February 2023, after an open hearing consultation held on 23 January 2023.

The consultation seems to have been far-reaching among participants, and ESMA received (and published) a wide range of responses. Whereas consensus emerged on the overarching objective of the consultation, which sought to limit greenwashing risks, increase legal certainty and avoid misleading information for investors, many questioned the ESMA approach, both in terms of the suitability of associating specific thresholds with name-associated sustainability claims and also in consideration of this issue on a standalone basis.

This consultation preceded the publication on 2 October 2023 of an ESMA Trends, Risks and Vulnerabilities Risk Analysis on ESG names and claims in the EU funds industry, with findings relevant for its context. The ESMA announced on 14 December 2023 that it was delaying the adoption of its guidelines to fully consider the outcomes of the current review of AIFMD 2, while also taking the opportunity to fine-tune them.

Taxonomy and new technical screening criteria

Commission Delegated Regulation (EU) 2023/2485 (CDR 1) and Commission Delegated Regulation (EU) 2023/2486 (CDR 2) were published on 21 November 2023 in the Official Journal. CRD 1 amends the “Climate Delegated Regulation” (ie, Commission Delegated Regulation (EU) 2021/213 of 4 June 2021 establishing technical screening criteria in relation to the contribution to climate change mitigation or climate change adaptation). These regulations add technical screening criteria with respect to economic activities not previously included under Regulation (EU) 2020/852 of 18 June 2020 on the establishment of a framework to facilitate sustainable investment (Taxonomy) (notably manufacturing activities in relation to key components for low carbon transport and electrical equipment). In addition, CDR 2 establishes technical screening criteria for economic activities making a substantial contribution to non-climate environmental objectives of Taxonomy, namely:

• the transition to a circular economy;

• control, or protection and restoration of biodiversity;

• pollution prevention; and

• the use and protection of water and marine resources.

The measures under CRD 1 and CRD 2 apply as of 1 January 2024.

Fine-tuning the Sustainable Finance Disclosure Regulation (SFDR) regulatory technical standards (RTS)

Following a mandate received by the Commission on 11 April 2022 to review and revise the SFDR RTS, the European Supervisory Authorities (the European Insurance and Occupational Pensions Authority, the European Banking Authority and ESMA – together, the ESAs) jointly published a consultation paper on 12 April 2023, titled “Review of SFDR Delegated Regulation regarding PAI and financial product disclosures” (the Consultation Paper). The SFDR Delegated Regulation under review was Commission Delegated Regulation (EU) 2022/1288 of 6 April 2022 (the so-called SFDR RTS, which provides technical regulatory standards for the application of the SFDR). A consultation period, which opened with the expectation of a final report being submitted to the Commission by October 2023, together with draft amendments to the SFDR RTS, closed on 4 July 2023.

The ESAs took the opportunity, beyond their initial mandate, to:

• open a discussion on the “Do No Significant Harm” principle (DNSH) and extensively revisit the templates provided by the SFDR Delegated Regulation;

• propose an extension of, and enhancements to, the list of indicators for principal adverse impacts (commonly referred to as PAIs);

• introduce new mandatory decarbonisation disclosures; and

• propose adjustments to all existing disclosure templates under the SFDR Delegated Regulation.

The future of the SFDR regime

On 14 September 2023, the Commission launched a consultation on the functioning of SFDR, aimed at gathering feedback on its implementation and objectives, and questioning how it should evolve, particularly by opening the door to what is perceived as an alignment with the Sustainability Disclosure Requirements developed in the United Kingdom (the SDR), through the use of a labelling regime overlapping with the SDR regime.

This consultation was open until 15 December 2023 and involved two publications:

• one focused on how the SFDR is working in practice and the issues of its implementation; and

• one focusing on identifying the shortcomings of the SFDR and exploring options to improve the regime.

No related amendments to the SFDR or the SFDR RTS have been proposed by the Commission, the focus of which, for now, is to find solutions to perfect the SFDR regime.

ESG ratings providers

In response to the recent (over) development of ESG rating providers, and noting that “the ESG ratings market currently suffers from a lack of transparency”, the Commission published a set of rules on 13 June 2023, aimed at regulating their activities by:

• improving the reliability and transparency of ESG ratings activities;

• setting out organisational principles and clear rules on the prevention of conflicts of interest; and

• enabling investors to make better informed decisions regarding sustainable investments, which the Commission will now discuss with the Parliament.

European Sustainability Reporting Standards

In November 2022, the European Financial Reporting Advisory Group (EFRAG) submitted the first set of drafts of mandatory European Sustainability Reporting Standards (ESRS), which are the rules and requirements for companies to report on sustainability-related impacts, opportunities and risks under 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). These drafts are in the form of technical standards, based on the initial draft standards used in the public consultation run earlier in the year.

In June 2023, the Commission released a proposed version of the final ESRS, with a number of its own changes. The most notable proposed change was that all disclosure requirements, with the exception of a set of general disclosures, will be subject to materiality assessments. This allows companies to focus reporting on sustainability factors that they consider material to their businesses. In addition, the Commission further converted several mandatory datapoints proposed by EFRAG into voluntary datapoints. The datapoints concerned are those considered most challenging or costly for companies, such as reporting a biodiversity transition plan and certain indicators about self-employed people and agency workers in the undertaking's own workforce.

In relation to the above, on 31 July 2023 the Commission adopted a draft delegated regulation (not yet published in the Official Journal), which supplements the CSRD (the ESRS Delegated Regulation). The ESRS that are to be used by entities in scope of the CSRD for their sustainability reporting are set out in Annex I and Annex II.

Annex I contains two sets of standards:

• ESRS 1 (“General Requirements”), which set out general principles to be applied when reporting according to ESRS; and

• ESRS 2 (“General Disclosures”), which specify essential information to be disclosed irrespective of the sustainability matter under consideration, and which are mandatory for all companies within scope of the CSRD.

In addition, Annex I contains a set of specific standards on:

• environmental disclosures covering climate change, pollution, water and marine resources, biodiversity and ecosystems, and resources and the circular economy;

• social disclosures, covering an organisation's own workforce, workers in the value chain, affected communities and customers and end-users; and

• governance, covering business conduct.

These specific standards and the individual disclosure requirements and related data are subject to a materiality assessment. However, disclosure requirements subject to a materiality assessment are not optional, but subject to a disclose or explain mechanism.

The ESRS Delegated Regulation was passed along to the Parliament and the Council for a two-month scrutiny period, which ended in October 2023.

EU Retail Investment Strategy (RIS)

In continuation of the 2020 Capital Markets Union action plan (aimed at improving access for retail investors to financial markets and ensuring investor protection), the Commission published the final version of the RIS on 24 May 2023. The Commission’s proposal of the RIS package includes a proposal for an Omnibus Directive amending the UCITS Directive and the AIFMD (among others), therefore requiring that it be considered and voted on by the Parliament and Council before becoming applicable.

This package sets out new requirements and enhancements to the investor protection framework in a wide range of areas, such as:

• a ban on inducements paid by manufacturers to distributors for execution-only sales, and rules to “further substantiate” the need for firms to act in their clients' best interests, while introducing new tests for advisers to consider when recommending products;

• stricter rules on marketing communications, with new obligations such as the requirement for management bodies to define, approve and oversee a policy on marketing communications and enhanced record keeping requirements;

• changes to Directive 2014/65/EU on Markets In Financial Instruments, for clients requesting to be treated as “professional”, including reducing the minimum wealth criterion from EUR500,000 to EUR250,000 and adding a new criterion around professional experience or education; and

• in furtherance of ESMA's recent opinion on considering “undue” costs in UCITS and AIFs, giving a mandate to ESMA (notably) to regularly update cost and performance benchmarks against which manufacturers would need to compare their products before offering them to the market.

The Commission's RIS package is currently being discussed between the Parliament and the Council and should not enter into force before 2025.

Modernisation of the Luxembourg toolbox

On 11 July 2023 (ie, at the same time as the adoption of the revised – and more accessible – regime on the European Long Term Investment Fund label, available as of 10 January 2024), the Luxembourg legislature adopted the bill of Law No 8183 introduced by the Ministry of Finance on 27 March 2023 (the Law) and amended the following laws:

• the Law of 15 June 2004 relating to the investment company in risk capital (SICAR), as amended;

• the Law of 13 February 2007 relating to specialised investment funds (SIFs);

• the Law of 17 December 2010 on undertakings for collective investment (UCIs);

• the Law of 23 July 2016 on reserved alternative investment funds (RAIFs), as amended; and

• the AIFM Law.

The Law was published in the Official Journal on 24 July 2023 and entered into force on 28 July 2023, modernising the Luxembourg investment funds toolbox by introducing the following adjustments to the above-mentioned laws:

• the threshold to qualify as a well-informed investor has been lowered from EUR125,000 to EUR100,000;

• SICARs, SIFs and RAIFs now have 24 months to reach their applicable minimum capital, and UCIs subject to Part II of the UCI Law (the UCI Part II) now have 12 months;

• European long-term investment funds qualifying as SICARs, SIFs, RAIFs or UCIs Part II are exempt from the subscription tax;

• AIFMs now have the possibility to appoint tied agents (alignment on UCITS);

• SICARs and SIFs can be marketed in Luxembourg to retail investors that are “well-informed investors”, and also to RAIFs; and

• the second notarial deed for the incorporation of RAIFs (ie, the constat de constitution) has been removed when the relevant RAIF has been incorporated by way of a notarial deed.

The Law irons out several inconsistencies in and between the above-mentioned laws and is a welcomed improvement for the Luxembourg investment funds industry.

Conclusion

Luxembourg is in the middle of a regulatory wave, caused partly by the current economic, political and financial environment and partly by the need to fill certain gaps and establish a complete and strong harmonised framework in this maturing industry (in particular on the alternative investment side), not to mention the overarching necessity to do business in a more sustainable and responsible manner. One of the biggest challenges for market players will be to find opportunities and gains within this framework for change.