The Corporate Sustainability Due Diligence Directive (CS3D) introduces far-reaching due diligence requirements. In-scope companies need to identify, prevent, mitigate, and remediate actual and potential adverse impacts on people and the environment and also put in place a transition plan for climate change mitigation which aims to ensure, through best efforts, that the business model and strategy of the company are compatible with the transition to a sustainable economy and with the limiting of global warming to 1.5°C. Failure to meet CS3D requirements may trigger state powers to impose fines of up to 5% of annual net worldwide turnover, as well as civil liability.
In a piece published last week (EU Corporate Sustainability Due Diligence Directive – Implications for the Asset Management Sector), we examined closely the scoping provisions of CS3D. When it comes to investors, CS3D does not apply to all financial sponsors in the same way, and where it does, the obligations may be more limited than for corporates. Below, we provide an introduction to determining whether your organisation is in scope and the key obligations relevant to financial sponsors.
Scoping
General financial thresholds applying to all entities
The scoping aspects of the legislation are highly technical. There is a general financial threshold: EU companies must have more than 1,000 employees and a net worldwide turnover of more than €450 million, while non-EU companies must have “generated” a net turnover in the EU of more than €450 million (with no employee threshold). These thresholds apply on a standalone or a group-wide consolidated basis.
Exemption for funds
However, investment funds structured as alternative investment funds (AIFs), MIFID investment firms and UCITS funds are out of scope entirely.
Applicability to Regulated Financial Undertakings
AIFMs and management companies fall within scope, as long as they meet the above financial thresholds, because “Regulated Financial Undertakings” are caught by CS3D. Accordingly, if a financial sponsor is caught within scope as an AIFM, the net turnover threshold should be understood as capturing what the AIFM generates in the EU (i.e. the management fee).
Financial sponsors will need to consider whether the relationship between an in-scope management company and its underlying portfolio companies qualifies as a parent/subsidiary relationship according to CS3D’s definition of “subsidiary,” as such a company may need to apply their mandatory due diligence policies to the operations of the relevant portfolio company (as its subsidiary). However, in most cases, a parent/subsidiary relationship will not exist where a financial sponsor does not hold shares in an investee company, if the shares are held by a fund (recall that AIFs and UCITS do not fall within scope of CS3D), therefore we anticipate this is mainly relevant to sponsors not structured in that way.
Applicability to financial sponsors not structured as funds
Separately, where a financial sponsor invests directly in the EU from abroad through a group structure akin to a corporate (rather than through a fund, which are exempted), the above general financial thresholds will apply and may take into account all turnover generated in the EU by any entities affiliated with that financial sponsor which are treated by CS3D as being in the same group with it.
Portfolio companies
CS3D applies to any portfolio company/group that meets the above general financial thresholds.
Key CS3D obligations applicable to financial sponsors
When it comes to which obligations do apply, extensive negotiations between the Commission, the European Parliament, and the Member States have meant that CS3D’s due diligence obligations on Regulated Financial Undertakings only encompass upstream business partners (rather than including downstream business partners receiving their services or products). This should not include products offered by financial firms, e.g. loans, equity stakes, partnership stakes. This also means that financial sponsors do not as a rule, other than where subsidiaries may be caught (as explained above), have obligations relating to the activities of their portfolio companies. For Regulated Financial Undertakings that are in scope, this in turn means that most of the obligations likely revolve around their diligence and supplier onboarding processes, e.g. putting in place or updating the supplier DD policy and business partner code of conduct.
A lesser discussed aspect of CS3D is the obligation on in-scope companies (i.e. including Regulated Financial Undertakings such as AIFMs and UCIT management companies (not the relevant funds)) to “adopt and put into effect a transition plan for climate change mitigation” which must aim “to ensure, through best efforts that the business model and strategy of the company” are compatible with, inter alia, the transition to a sustainable economy and the limiting of global warming to 1.5°C in line with the Paris Agreement.
The requirements for the transition plan per CS3D need to be tailored to the business and sector and updated every 12 months to assess progress. For an asset manager that falls within scope, it is worth noting that the transition plan should also address, “where relevant, the exposure of the company [e.g. an AIFM] to coal-, oil- and gas-related activities.” Nevertheless, the recitals of CS3D suggests that such requirements should be understood as an obligation of means (i.e. ensuring that progress is being made), and not of results (i.e. reaching specific targets).
We would be pleased to discuss the impact of CS3D with you further.
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