On 26 July 2021, the European Commission (the Commission) published Q&As to provide further guidance on the application of the EU Sustainable Finance Disclosure Regulation (the SFDR). The Q&As seek to respond directly to queries that were raised by the European Supervisory Authorities (the ESAs) in a letter to the Commission on 7 January 2021.
The Q&As relate to fundamental threshold questions and areas of uncertainty in respect of the SFDR, including its application to non-EU alternative investment fund managers (Non EU AIFMs) (see our previous Sidley Update for further discussion). In this Sidley Update, we highlight key aspects of the Commission’s guidance and share our insights as to the implications for U.S. and other Non-EU AIFMs.
Scope — Application of SFDR to Non-EU AIFMs and registered (sub-threshold) AIFMs
As discussed in our previous Sidley Update, the text of the SFDR is unclear in relation to the application of the rules to Non-EU AIFMs; in particular, the industry has had differing interpretations as to whether Non-EU AIFMs are subject to entity-level and/or product-level website disclosures under the SFDR in addition to pre contractual product-level disclosures to investors.
Despite seeming to have provided answers to the respective scoping questions on sub threshold AIFMs and Non-EU AIFMs in the wrong order, the Commission makes clear its view that the provisions of the SFDR are applicable to non-EU AIFMs that market their funds in the EU under the National Private Placement Regimes (NPPRs) provided for in Article 42 of the EU Alternative Investment Fund Managers Directive (2011/61/EU) (AIFMD).
The Commission also confirms that the “entity and financial product related requirements” of the SFDR apply to sub-threshold AIFMs, but because such AIFMs are not subject to the requirements in Articles 22 (Annual report) and 23(1) (Disclosure to investors) of AIFMD, the Commission notes that such AIFMs should apply the references to these AIFMD obligations in Articles 6(3) and 11(2) of the SFDR by analogy, “i.e. information is to be included in pre-contractual and periodic documentation made available to end investors under national law.”
The Commission does not refer to the entity-level website disclosure requirements in Articles 3, 4, and 5 of the SFDR directly, stating only that a Non-EU AIFM must “ensure compliance with” the SFDR, “including the financial product related provisions” (emphasis added). However, the use of the word “including” indicates that all website disclosures do apply to Non-EU AIFMs; it seems unlikely that the reference to “financial product related provisions” is intended to exclude entity-level website disclosures for Non-EU AIFMs.
Firms that have prepared but not yet published their website disclosures may thus wish to consider doing so following the publication of the Commission’s guidance, at least in relation to the firm’s approach regarding the funds that they market in the EU.
Article 8 (“light green”) products
Meaning of “promotion”
Article 8(1) of the SFDR refers to financial products that “promote” one or more environmental or social characteristics.
In their letter to the Commission, the ESAs sought guidance as to the meaning of “promotion” for the purposes of Article 8(1) of the SFDR, and whether, for example, the name of a financial product (i.e., including a reference to ESG or sustainability) could be sufficient to trigger the application of Article 8.
In response, the Commission draws a very wide definition of the term “promotion” so as to include “direct or indirect claims, information, reporting, disclosures as well as an impression that investments pursued by a given financial product also consider environmental or social characteristics in terms of investment policies, goals, targets, or objectives.”
Moreover, the Commission provides a long list of documents or items in which “a general ambition” regarding environmental or social characteristics (which may be enough to trigger the application of Article 8) may be expressed. Aside from including pre-contractual communications and investor documents, the promotion of environmental characteristics may also be found in “information on the adherence to sustainability-related financial product standards and labels” and “use of product names or designations.”
The Commission’s very wide definition of “promotion” would appear to set a low threshold for marketing activity that could trigger the application of the additional disclosure requirements in Articles 8, 10, and 11.
However, there is a high threshold for what can actually be disclosed in the fund’s pre-contractual disclosures. The pre-contractual disclosures to investors for products that fall within Article 8 must refer only to those elements that relate to the environmental or social characteristics of the product that are “binding during the whole holding period” and are used to describe the extent to which the product has met the environmental or social characteristics in the annual reports to investors under Article 11.
This would appear to imply that a financial market participant could trigger the application of Article 8 through its marketing activities but then not be able to repeat such claims in the Article 8 pre-contractual disclosures. This may risk giving a negative impression to investors in respect of the fund manager’s commitment to meeting its purported sustainability goals.
This could be problematic for funds that express an intention to make ESG-style investments but are not strictly bound to do so. It would seem that the Commission’s strategy (consistent with the stated policy objectives of the SFDR) is that such funds would need to introduce binding sustainability criteria into their investment strategies.
More generally, any Non-EU AIFMs marketing to EU investors that wish to remain outside of the Article 8 regime will need to set clear guidelines and expectations for staff undertaking marketing activities so as to avoid the suggestion that they have created “an impression” that the fund’s “general ambition” is to promote environmental or social characteristics when that is not the case.
Environmental and social characteristics
The Commission confirms that in contrast to financial products falling within Article 9 of the SFDR (see below), the SFDR does prescribe the composition of investments or minimum investment thresholds for financial products that promote an environmental or social characteristic under Article 8.
The Commission also confirms that financial products that integrate sustainability risks into their investment decisions (as described under Article 6) will not, for this reason alone, fall within Article 8.
The Commission has recently indicated in its Strategy for Financing the Transition to a Sustainable Economy that it will consider the introduction of “minimum sustainability criteria” for financial products that promote environmental or social characteristics; if so, the requirements for Article 8 products may become tougher in the future.
One continuing area of uncertainty is the effect of the proviso in Article 8(1) of the SFDR that “the companies in which the investments are made follow good governance practices.”
Based on the wide meaning of “promotion” set out by the Commission, it seems unlikely that a financial product that otherwise promotes environmental or social characteristics would fall outside of Article 8 of the SFDR merely because the fund manager claims not to take account of good governance matters in the fund’s investee companies.
Instead, the Commission’s approach would appear to imply that rather the need for investee companies to follow good governance is a qualification as to which of the fund’s investments can be counted as a “light green.”
Article 9 (“dark green”) products — sustainable investment
Article 9 of the SFDR relates to financial products that have a sustainable investment objective (under Article 9(1) or 9(2)) or a reduction in carbon emissions as their objective (under Article 9(3)).
In their letter to the Commission, the ESAs sought guidance as to whether a product to which Article 9 of the SFDR applies must only invest in sustainable investments as defined in Article 2(17) of the SFDR and, if not, whether there is a minimum share of sustainable investments required.
In its response, the Commission confirms that a financial product to which Article 9 applies may “invest in a wide range of underlying assets provided theses underlying assets qualify as ‘sustainable investments’. ” That is, investment in economic activities that contribute to an environmental objective or a social objective, provided that such investments do not significantly harm any other environmental or social objective and that the investee companies follow good governance practices.
Article 9 products may also include investments for certain specific purposes such as hedging or liquidity “in order to meet requirements in accordance with prudential, product-related sector specific rules” that do not meet the definition of sustainable investment in Article 2(17) of the SFDR. However, such investments must still meet minimum environmental or social safeguards, such that they do not derogate from the overall sustainable investment objective of the fund. In this regard, it is not clear whether this means such investments must satisfy the “do no significant harm” requirement. In any event, while an investment for hedging or other specific purposes does not need to be a “sustainable investment,” it cannot be contrary to the sustainable investment objective that the fund is pursuing.
In addition, the Commission confirms that Article 9 remains neutral in terms of the design of the financial product and does not prescribe a specific composition of the financial product, but financial market participants should disclose how the financial product’s investment mix complies with its “sustainable investment” objective and the “do no significant harm” principle.
The Commission’s guidance implies that Article 9 products must effectively be 100% invested in assets meeting the definition of “sustainable investment” in Article 2(17) of the SFDR, save for investments made for hedging or other specific purposes, but that even these investments must be aligned with the sustainable investment objectives of the product.
This requirement potentially introduces an additional challenge for financial market participants and may result in increased demand for high-quality liquid assets with a sustainable profile.
Principal adverse sustainability impacts
Under Article 4(3) of the SFDR, financial market participants with more than 500 employees must consider principal adverse impacts (PAIs) of investment decisions on sustainability factors. Under Article 4(4), financial market participants that are parent undertakings of a large group with more than 500 employees must also consider PAIs.
The Commission clarifies that under Article 4(4), financial market participants must count employees within both EU and non-EU subsidiaries.
Firms with fewer than 500 employees may consider PAIs or explain why they do not consider the adverse impacts of their investment decisions on sustainability factors.
The Commission’s response is not surprising, given that Article 4 of the SFDR does not specify any jurisdictional scope in terms of subsidiaries to be included in the calculation of numbers of employees.
In general, most alternative asset managers in the UK and U.S. are unlikely to exceed either of these thresholds. Notably, funds and the portfolio companies they might own would typically not be considered subsidiaries of the AIFM of the fund, and so employees in such portfolio companies would typically not count towards the 500 employee threshold.
Comply or explain
The Commission offers some unsolicited guidance (i.e., not requested in the ESA’s letter) on the “comply or explain” mechanism under Article 4 of the SFDR on the disclosure of PAIs.
The Commission highlights that although financial market participants that comply with Article 4 must disclose “principal adverse impacts” (original emphasis), financial market participants that choose the “explain” mechanism must provide clear reasons why they do not consider “adverse impacts.” As such, under the “explain” mechanism, financial market participants must address why they do not consider “degradation of the environment or social injustice caused by their investments.”
The Commission’s unsolicited comments appear to be aimed at improving the quality of disclosures from financial market participants applying the “explain” mechanism under Article 4(1)(b) of the SFDR.
In particular, it would seem that it will not be sufficient merely to disclose why the financial market participant does not consider the list of principal adverse impacts that are set out in the current drafts of the SFDR Level 2 regulatory technical standards (e.g., greenhouse gas emissions, negative impacts on biodiversity, emissions to water), and instead the financial market participant must disclose why it does not consider the adverse impacts of its investment decisions more generally.
This guidance could be challenging for firms that may have been providing a somewhat technical explanation under Article 4 as to why the proposed PAI framework was not compatible with their investment approach, for example.
For Non-EU AIFMs, the most notable part of the Commission’s Q&A is the apparent confirmation that both product-level and entity-level disclosures will be required. As noted above, Non-EU AIFMs that have prepared but not yet published their website disclosures may wish to consider doing so following the publication of the Commission’s guidance.
For firms that already have, or are exploring, offering a fund with sustainability aspects, the Commission’s guidance provides important clarifications as to the scope and extent of the additional obligations and restrictions that will apply under the SFDR.
Unfortunately, not all of the Commission’s responses provide sufficient clarity to the topics at issue. Following the publication of the Commission’s interpretations, the ESAs or national competent authorities may decide to issue further useful material by way of their own guidance or Q&A.
Sidley Austin LLP provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship.
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