Banking and Financial Services Update

European Commission Q&A on SFDR - Five Key Takeaways for Investment Managers

June 8, 2022

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.

Sidley comments

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.

Sidley comments

This guidance appears to diverge from the understanding that consideration of PAIs at a product level was preconditioned on an FMP considering PAIs at an entity level.

In previous Q&A guidance published by the Commission in July 2021, the Commission indicated that financial products that fall under Article 8 may pursue reduction of negative externalities caused by the underlying investments, such as principal adverse impacts on sustainability factors. The current guidance appears to clarify that adopting such a strategy will not cause the FMP to be required to consider PAIs at an entity level.

For FMPs managing multiple funds, the ability to selectively opt into PAI compliance at a product level by incorporating an objective to reduce negative externalities caused by the investments underlying that product will be a significant advantage, particularly for FMPs that wish to market an Article 8 or Article 9 fund with PAI disclosures alongside Article 6 funds without PAI disclosures.

3. Article 8 and 9 funds — All portfolio companies must follow good governance practices.

The Commission states that all companies within the portfolio of an Article 8 financial product must be invested in companies that follow good governance practices. To the extent that an Article 8 fund is currently invested in companies that do not contribute to environmental or social characteristics and also do not meet the good governance practice threshold, the EU Commission’s interpretation suggests that such a fund would be in breach of Article 8 of the SFDR.

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.

Sidley comments

This guidance would appear to diverge from current market interpretations that had understood that the good governance requirement applied only to those companies that an FMP has identified as contributing to the environmental or social characteristics of the Article 8 financial product.

The Commission provides equivalent guidance regarding Article 9 financial products. The Commission has previously indicated that all of the investments held by an Article 9 financial product must be sustainable investments, except for investments held in order to meet requirements in accordance with prudential, product-related, sector specific rules (e.g., hedging or liquidity). The Commission also indicated that investments held for hedging and liquidity purposes have to meet minimum environmental or social safeguards, that is, such investments must be in line with the sustainable investment objective of the financial product. Based on the latest guidance, it would appear that if such investments include investments in companies, those companies must follow good governance practices.

This guidance may require FMPs with Article 8 and Article 9 financial products to reassess their current portfolios to confirm that any investments in companies that are not intended to contribute to the promotion of environmental or social characteristics or the attainment of the sustainable investment objective nonetheless meet the good governance requirement.

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.

Sidley comments

The practical effect of the words mutatis mutandis in Article 6 of the Taxonomy Regulation has remained unclear, and the Commission’s guidance does not address this specifically. The view widely held has been that Article 5 of the Taxonomy Regulation only applies if the Article 8 financial product commits to making sustainable investments. Indeed, this interpretation appears to be reflected in the pre-contractual disclosure templates for Article 8 financial products that the Commission recently adopted.

In its current Q&A, the Commission notes that Article 6 of the Taxonomy Regulation applies to financial products falling within Article 8 of the SFDR that promote environmental characteristics and that “it is irrelevant” whether a financial product commits to invest in economic activities that contribute to an environmentally sustainable investment objective; however, this is consistent with the generally held view that it is the prescribed statement set out in Article 6 of the Taxonomy Regulation that applies to environmentally focused Article 8 products.

The Commission’s reasoning does not specifically state that the effect of the words “mutatis mutandis” is to require Article 8 products that do not otherwise make sustainable investments to comply with Article 5 of the Taxonomy Regulation. Nonetheless, this appears to be the effect of the Commission’s guidance, which asserts that such products are required to disclose information “based on an assessment of reliable data with regard to whether investments will be in economic activities that contribute to an environmental 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.

Sidley comments

As noted above, this guidance appears to diverge from basis on which the pre-contractual disclosure templates for financial products falling within Article 8 are set out. In particular, when addressing the disclosure under Article 6 of the Taxonomy Regulation, the guidance notes to those templates refer to the environmental objectives set out in Article 9 of the Taxonomy Regulation to which the “sustainable investment underlying the financial product contributes” (emphasis added). In other words, the question on Taxonomy alignment is to be completed only where the Article 8 product will “partially invest in sustainable investments.”

As a result of the Commission’s position, FMPs may need to revisit their pre-contractual disclosures made under Article 8 of the SFDR, noting that the obligation to disclose under Article 6 of the Taxonomy Regulation came into effect on 1 January 2022 and is not contingent on the pre-contractual disclosure template set out in the RTS adopted by the Commission coming into force (expected 1 January 2023).

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.

Sidley comments

One common criticism of the SFDR and Taxonomy Regulation framework has been that public companies are not yet required to disclose Taxonomy alignment data, making it difficult for FMPs to disclose the Taxonomy alignment of their portfolios. The Commission appears to rebut this criticism by noting that such information “is not a prerequisite information source” as financial products invest “in a myriad of underlying financial instruments,” including in issuers not subject to Taxonomy alignment disclosures.

As such, the Commission emphasises the responsibility of FMPs to collect their own data from issuers as to how and to what extent the investments underlying the financial product are in economic activities that qualify as environmentally sustainable. That is, FMPs cannot rely on the fact that public disclosures may not yet have been made by EU public companies, as they must be proactive collectors of Taxonomy-alignment data anyway.

Accordingly, where an FMP “fails to collect data,” its pre-contractual and periodic disclosures must indicate zero taxonomy alignment.
The Commission acknowledges recital 21 of the Taxonomy Regulation, which refers to companies and issuers that are not required to publicly disclose taxonomy alignment, and the ability to exceptionally use “complementary assessments and estimates” as to Taxonomy alignment “on the basis of information from other sources” (i.e., other than the company); however, the Commission does not extend the scope of this recital to issuers that are otherwise subject to a public disclosure obligation under the Taxonomy Regulation, and so the recital remains narrow in practice.

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