On 25 May 2022, the European Commission published its responses to questions raised by the European Supervisory Authorities (ESAs) in relation to the interpretation of the EU Sustainable Finance Disclosure Regulation (SFDR) and the EU Taxonomy Regulation (Q&A).
Investment managers in scope of the SFDR should pay close attention to the Commission’s responses which appear to diverge from current market practice in certain areas. We have summarised the five most important takeaways for investment managers.
The Q&A also addresses queries relating to financial advisers, but that is beyond the scope of this note.
1. Periodic SFDR disclosures do apply to funds that closed before SFDR came into force.
First, consistent with current market practice, the Commission confirms that pre-existing financial products that continued to be available to end investors on or after 10 March 2021 are subject to the SFDR.
However, the Commission also indicates that financial products that were no longer made available to end investors as of 10 March 2021, but that are still subject to an obligation to prepare a periodic report (e.g., an annual report under Article 22 of the Alternative Investment Fund Managers Directive (AIFMD)), are required to ensure that such periodic report complies with Article 11 of the SFDR. The Commission also indicates that such financial products are subject to the product-level website disclosure obligations under Article 10 of the SFDR.
This guidance would appear to diverge from the current approach taken by many financial market participants (FMPs) with financial products that closed to new investors before SFDR came into effect.
Given that the periodic reporting templates set out in Regulatory Technical Standards (RTS) adopted by the Commission distinguish between Article 8 and Article 9 financial products, it would appear that the Commission expects investment managers with closed (but continuing) funds to classify such funds according to the SFDR categories to determine the nature of the financial product’s ongoing reporting requirements.
While financial products that do not make any environmental, social, or governance (ESG) claims would likely fall within Article 6 of the SFDR and therefore be out of scope of the obligations in Articles 10 and 11, any continuing financial products with an ESG element or impact investing element would be subject to Article 10 and 11 on the basis of the Commission’s guidance, as such funds would likely fall within Article 8 or 9 when classified in accordance with the SFDR.
As a result, such funds will, in effect, be subject to a direct comparison against post SFDR ESG funds and may therefore compare unfavourably on ESG performance metrics, as they may not have been designed in an era during which the same level of scrutiny applied to ESG funds.
FMPs that utilise close-ended fund structures (for example, private equity fund managers) should consider the impact of this guidance on their current product ranges as the Commission’s guidance will require that funds marketed into the EU with an ESG or impact element that closed prior to 10 March 2021 should comply with SFDR reporting for the remainder of the fund’s life.
Investment managers that identify funds that are in scope of this guidance will need to incorporate SFDR reporting in their upcoming AIFMD annual reports for 2021, due 30 June 2022 (assuming a 31 December year-end).
2. It is permissible to consider PAI at product-level without considering PAI at an entity level.
FMPs that fall below the 500-employee threshold set out in Articles 4(3) and 4(4) of the SFDR that choose not to consider the principal adverse impacts of their investment decisions (PAI) at an entity level can nonetheless choose to consider PAIs at a product level for certain financial products they manage, where such product pursues a reduction of negative externalities caused by the investments underlying that product.
3. Article 8 and 9 funds — All portfolio companies must follow good governance practices.
In addition, the EU Commission confirms that the good governance requirement relates only to “companies” for Article 8 products and “investee companies” for Article 9 products. As such, a financial product falling within Article 8 or Article 9 investing only in government bonds does not need to apply the requirements related to good governance practices.
4. Taxonomy-alignment disclosures are required for all Article 8 products that promote environmental characteristics regardless of whether they commit to partially investing in sustainable investments.
Article 6 of the Taxonomy Regulation requires financial products falling within Article 8 of the SFDR to disclose a prescribed statement where the financial product promotes environmental characteristics.
In addition, Article 6 of the Taxonomy Regulation applies Article 5 of the Taxonomy Regulation to such financial products “mutatis mutandis.” Article 5 of the Taxonomy Regulation relates to the Taxonomy alignment of a financial product falling within Article 9 of the SFDR — that is, the Taxonomy alignment of financial products that have sustainable investment as their objective.
The Commission further notes that if, as a matter of fact, a financial product is invested in a Taxonomy-aligned economic activity, then the financial product’s periodic report should also reflect the extent of its Taxonomy alignment even where the financial product has not committed to promoting an environmental characteristic. In such circumstances, the FMP may need to revise its pre-contractual disclosures to ensure consistency with the updated information in the periodic report.
5. Taxonomy-alignment disclosures must be made only on the basis of reliable data, failure to collect data must be expressed clearly, and a lack of data should not be explained away by narrative explanations.
Issues with data availability and reliability have been a common topic of discussion in relation to the SFDR and Taxonomy Regulation. The Commission’s guidance seeks to address data issues with respect to Taxonomy alignment.
The Commission discourages (but does not prohibit) the use of narrative disclosures of Taxonomy alignment, as such narratives risk contradicting the purpose of the Taxonomy alignment disclosure. The Commission states that any such narratives should not leave room for any ambiguity about the Taxonomy alignment of the financial product and narratives should not include negative justifications, such as explaining a lack of alignment by a lack of data.
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