To help firms manage the greenwashing risk, fund service providers will play a more important role in validating ESG funds. Our Luxembourg panel discusses this ‘watchdog’ role, as well as the need for quicker opening of bank accounts.
- Frederic Van Ingelgom, continental Europe head of business development and client management Luxembourg, asset owners and managers, HSBC Securities Services
- Silke Bernard, global head of investment funds practice, Linklaters Luxembourg
- Cuan Coulter, Global Head of Asset Managers and Head of UK and Ireland, State Street
- Chrystelle Veeckmans, head of asset management EMA, partner, KPMG in Luxembourg
Regulations around sustainable investing are becoming clearer and could lead to an increase in the number of ‘Article 9’ funds – investment funds with the strongest ESG credentials – a Funds Europe Luxembourg panel heard.
“We are much further down the road than we were,” said Silke Bernard, a Luxembourg-based funds lawyer at Linklaters.
Bernard, who is global head of Linklaters’ investment funds practice, said several fund managers had been reticent about claiming Article 9 status under the EU’s Sustainable Finance Disclosure Regulation (SFDR) and instead had opted to self-classify funds as Article 8, which carries less onerous ESG investing criteria and – consequently – pose less risk of becoming embroiled in greenwashing accusations.
“A lot of our clients probably might have qualified their funds for Article 9. But they shied away from it – and they still do – because they were afraid that they could not obtain the data needed to prove Article 9 status, which could land them with sanctions. But I think we are getting closer to a clearer view now.”
Bernard – who said recent FAQs and guidance statements issued at the regulatory level had helped clarify the EU’s sustainable investment rules – was speaking at the ‘Luxembourg’ roundtable hosted by Funds Europe recently.
“A lot of our clients probably might have qualified their funds for Article 9. But they shied away from it – and they still do – because they were afraid that they could not obtain the data needed to prove Article 9 status.”
According to Morningstar, 307 Article 9 funds were downgraded to Article 8 in the fourth quarter of 2022, with combined assets under management of €170 billion. The trend continued into 2023, with €99 billion of ESG funds downgraded to Article 8 in the first month of the year.
Bernard added that the CSSF, the financial regulator of Luxembourg’s €5 trillion cross-border funds industry, was trying to reach a profound understanding of how fund providers are running ESG products, including the operational and technical aspects.
Some administration firms that provide services to fund manager clients were also “really struggling”, said Bernard. This is due to the different interpretations of rules around sustainable investment funds.
Cuan Coulter, Global Head of Asset Managers and Head of UK and Ireland at State Street, said this was a result of EU regulators entering “unknown territory” with the SFDR, which had served to give the EU a first-mover advantage globally at implementing a sustainable investment regime. However, he agreed that there were problems with interpretation in the industry.
Referring to details that funds must disclose under the SFDR, Coulter added: “I welcome all the work that’s going on with the regulatory authorities around interpretive issues. There are various consultations – for example, on what ‘principal adverse impact’ (PAI) means, and ‘do no significant harm’.”
The PAI, for instance, refers to any negative impact of an investment decision on sustainability, employee concerns, human rights and other matters.
Yet Coulter also argued that third-party administrators had the scale and resources to ensure fund providers’ “product roadmaps” would not be dramatically thwarted by regulatory change.
“Third-party fund administrators have the ability to engage with regulators directly, and we have the advantage of seeing large swathes of market practice through talking to a wide range of clients about their aspirations. Convening these groups of people, it sort of creates a common – or a consensus – practice.”
‘Watchdog’ depositary banks
Another panellist agreed there was a retreat from self-classifying funds as Article 9 and that Article 9’s aspirations were impeded by a lack of quality data to support fund managers’ objectives.
The panel heard also that depositary banks – usually an entity affiliated with a fund administration and custody banking firm – have a role in providing due diligence services around SFDR compliance.
Firms are placing thresholds in their fund prospectuses, and it is the depositary that provides independent monitoring to ensure portfolio managers are in compliance with investment policies. Depositaries are asked to give validation, and this will become a part of depositary bank reporting, the panel heard.
Frederic Van Ingelgom, a business development and client management lead at HSBC Securities Services in Luxembourg, agreed and said HSBC’s depositary bank was closely working with its fund administration unit.
“The depot bank is the gatekeeper when it comes to carrying out regulatory checks and understanding regulation.”
He added that many clients had sought advice about progressing from Article 8 to Article 9 status. “They want to do that from a distribution standpoint, they want to reach that milestone, and it is the depositary that helps them understand how to do what they need to do. There is a unique contact between the client’s distribution business and the depot bank.”
Chrystelle Veeckmans, EMA head of asset management at KPMG, said validation functions like this would likely increase in the years to come, with a continuous focus on substance and controls to ensure funds complied with the EU’s Green Taxonomy, where there is currently little alignment.
“Regulators at the global level are making sustainable finance a top priority, but their approaches are divergent, which is a difficulty. For example, they are seeking to address the concern of greenwashing in fundamentally different ways.”
“Third-party fund administrators have the ability to engage with regulators directly, and we have the advantage of seeing large swathes of market practice through talking to a wide range of clients about their aspirations.”
More broadly, initiatives relating to enhanced reporting aim to capture more firms and products in the capital market and to increase the flow of information from companies to stakeholders, Veeckmans added.
“So, in terms of complying with the different regulations, I anticipate that in the years to come, there will be more assurance services required from service providers,” she said.
Veeckmans pointed out that the position in Germany is “unique” in that the periodic reports for Article 8 and Article 9 funds are included in funds’ annual statements and are, therefore, subject to audit requirements.
“This brings benefit of additional assurance over the included disclosures but adds to operational costs and concerns about data gaps.”
She added: “Really, the challenge here is to work on a cross-border basis with several asset managers because it means there is a need to understand the distinct rules and manage the complexity from it.
“To respond effectively to these challenges, asset managers need robust and flexible business models, with strong governance, intelligent risk management frameworks, state-of-the-art technology, good oversight of service providers and appropriate distribution strategies. Firms need to manage their own costs and ensure that the costs and charges borne by investors are transparent and justifiable.”
Bernard agreed that a depositary bank served as a kind of ‘watchdog’ over regulatory compliance, but ultimately portfolio managers had to drill into each asset to determine whether it was appropriate for a particular ESG strategy.
However, she added: “Strangely, even though we are lawyers, we have become involved in assessing the profile of individual assets in order to determine whether asset managers can buy them. This is a very new approach.”
Cash accounts
The Luxembourg panel added perspective to a clarification issued by the CSSF last October, which required alternative investment funds (AIFs) to review their depositary arrangements. The CSSF had found that a number of AIFs – or their appointed ‘professional depositary of assets other than securities’ – were using either electronic money institutions or payment institutions for the purpose of holding cash. The CSSF was keen to ensure cash for AIFs was being held with eligible entities within the meaning of relevant laws and gave the industry until June 30 to solve the issue.
Van Ingelgom of HSBC said the CSSF recognised a “systemic issue” on cash accounts in Luxembourg and has already taken measures. Commercial banks such as HSBC have even strengthened and further developed their capacity to offer these services.
Another panellist pointed out that the clarification said that an AIF’s cash has to be held with an eligible entity and that the eligible entity is a financial institution rather than an electronic intermediary, which some funds were using.
“Regulators… are seeking to address the concern of greenwashing in fundamentally different ways.”
Aligned with this point, the panel heard that greater awareness had arisen among private-market fund managers about the role fund administration firms from large custodian banking groups can play. The larger administrators have always been more associated with high- and fast-volume transactions for traditional mutual funds. The rise of alternative investments in the mainstream has seen bigger profiles for specialist fund administration firms, who typically hail from offshore jurisdictions where much private markets and activity traditionally exist.
Bank accounts are important in Luxembourg – particularly in the private-market space to quickly create special purpose vehicles (SPVs) and various other structures that can be used to acquire assets.
Bernard at Linklaters said: “In the larger picture, we as an industry need to ensure that bank accounts can be opened in reasonable timeframes so that businesses can start their operations.”
And Veeckmans added: “The challenge in the alternative investment space is that there are many, many SPVs, which require a lot of work to set them up, which is a real challenge for many of the banks. This clarification is useful – but we still need to work on a solution that allows cash accounts to be opened quicker.”
The panel pointed to the friction created by onerous know-your-customer – or ‘KYC’ – processes in the process of opening a bank account. KYC processes are part of anti-money laundering due diligence requirements.
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