The European Commission has published its long-awaited guidance regarding some of the Sustainable Finance Disclosure Regulation's (SFDR) known unknowns. The Guidance provides some additional clarity on the application of the SFDR, but unfortunately does not clearly answer all the outstanding questions. Firms will need to continue to navigate uncertainty in the absence of clear law, guidance or a developed market practice.
- Status of the Commission Guidance
- The application of SFDR to non-EU AIFMs
- The application of SFDR to sub-threshold AIFMs
- Principal adverse impacts (PAIs)
- The scope of Article 8: a product which "promotes environmental or social characteristics"
- The scope of Article 9(1): a product which has "sustainable investment as its objective"
- Article 10 SFDR website disclosures for Article 8 and Article 9 products
- SFDR known unknowns not addressed by the Guidance
- Next steps
The European Supervisory Authorities wrote a letter to the Commission on 7 January 2021 expressly seeking guidance on some—but not all—of SFDR's known unknowns. The Commission has purported to answer those questions with the Guidance.
The Guidance covers the following key topics:
- The application of SFDR to non-EU AIFMs and sub-threshold AIFMs.
- Principle adverse impacts: - The application of the "Comply or Explain" principle. - The calculation of the "500 employee test".
- The scope of Article 8: a product which "promotes environmental or social characteristics".
- The scope of Article 9: a product which has "sustainable investment as its objective".
- Article 10 SFDR website disclosures for Article 8 and Article 9 products.
Importantly, the European Supervisory Authorities' letter did not cover all of the SFDR known unknowns, and those which were not included in the letter have not been answered by the Guidance. We have briefly described these other known unknowns below.
2. Status of the Commission Guidance
The Commission has emphasised in its covering letter to the Guidance that its intention is only to clarify the application or implementation of SFDR. In particular, it is not intended to authoritatively interpret EU law (which is the preserve of the Court of Justice of the European Union) or to extend any of the rights or obligations of SFDR, or to introduce any new requirements. It will nonetheless be persuasive in some respects, and national regulators will no doubt take note of it.
3. The application of SFDR to non-EU AIFMs
It is widely accepted that the SFDR applies to non-EU AIFMs and MiFID firms when they establish a nexus with the EU. A common example is a non-EU AIFM marketing funds under EU national private placement regimes (NPPRs). It is unclear from the legislation how SFDR should apply in this context. Should SFDR apply at both firm and product level, to the AIFM and its fund? Or should SFDR apply at product level only, just in respect of the fund?
The Commission has sought to address this point:
"Where an AIFM from a third country enters the market of a given Member State by means of a National Private Placement Regime, that AIFM must ensure compliance with Regulation 2019/2088, including the financial product related provisions."
Unfortunately, this is not a clear answer to the question. Firms will need to continue to form their own conclusions, though we do not expect many to change their existing positions.
4. The application of SFDR to sub-threshold AIFMs
It is unclear from the legislation whether SFDR should apply to sub-threshold EU AIFMs—who are not required to comply with the detailed requirements of the Alternative Investment Fund Managers Directive (AIFMD)—and to date we have not observed a market consensus or consistency of approach.
The Commission has clarified the uncertainty: SFDR applies to sub-threshold EU AIFMs and their funds. This may be an unwelcome clarification for affected firms.
5. Principal adverse impacts (PAIs)
"Comply or explain"
Many firms (those below the 500-employee threshold) will have already chosen whether to opt in or out of PAI reporting at firm level under Article 4 (and then, at product level, under Article 7). Article 4 embeds a "comply or explain principle", which is broadly phrased as follows:
- Firms may elect to consider the principal adverse impacts of their investment activity and report prescribed information on their website, and financial market participants must additionally report such information to investors; or
- If firms elect not to do this—if they opt out—they must explain that they do not consider the adverse impacts of their investment activity on sustainability factors, again reporting this on their website and (for financial market participants) also to investors.
The Commission has sought to emphasise the distinction between firms which opt in, which must consider the principal adverse impacts of investment activity, and those which opt out, which must explain that they do not consider adverse impacts of such activity (i.e. adverse impacts rather than principal adverse impacts). This is surprising, as firms and practitioners have not generally focussed on this distinction; considering the difference in terminology to be incidental, or at least not viewing the choice in such binary terms. Several firms have instead charted a third course: explaining that whilst they do not consider PAIs within the meaning of SFDR, they nonetheless give serious thought to the negative externalities of their investment activity, including potentially reporting meaningful ESG data to their investors.
It is unclear what the Commission is intending to achieve with its new emphasis. Importantly, we do not think it changes the current considerations which firms have weighed up, or are weighing up, with respect to the PAI regime and do not expect firms to change their existing approach in response.
"500 employee test"
Our view is that financial market participants, including AIFMs, will be required to consider the PAIs of investment activity if they exceed an average of 500 employees on their balance sheet, including if they prepare consolidated financial statements which includes subsidiaries. The Guidance adds that such subsidiaries should be included regardless of whether they are domiciled in the EU or not. i.e. perform the analysis from the level of the financial market participant down, agnostic to subsidiaries' domicile. There is no suggestion that the analysis requires financial market participants to "look up" and apply the analysis to their own holding structure.
(For completeness, firms will only be considering the 500 employee test to determine whether they are obliged to consider the PAIs of their investment activity for the purposes of Article 4 SFDR, which is a firm-level obligation. Non-EU firms may have taken the view that firm-level obligations are not applicable to them (see Section 3 above), in which case it follows that the 500 employee test would not be relevant.)
6. The scope of Article 8: a product which "promotes environmental or social characteristics"
Firms and trade associations have grappled with considerable uncertainty regarding when a product "promotes" environmental or sustainable characteristics since SFDR's inception. Is Article 8 an (unofficial) label to which products may aspire, requiring positive and meaningful steps to be taken by the firm for the product to qualify? Or is Article 8 a categorisation which may be engaged inadvertently because the bar is set so low? In the absence of clear guidance, firms have taken their own views as to where to draw the line.
The Guidance makes the following comments regarding the scope of Article 8:
"Article 8 means that where a financial product complies with certain environmental, social or sustainability requirements or restrictions laid down by law, including international conventions, or voluntary codes, and these characteristics are “promoted” in the investment policy the financial product is subject to Article 8 of Regulation (EU) 2019/2088.
The term ‘promotion’ within the meaning of Article 8 of Regulation (EU) 2019/2088 encompasses, by way of example, direct or indirect claims, information, reporting, disclosures as well as an impression that investments pursued by the given financial product also consider environmental or social characteristics in terms of investment policies, goals, targets or objectives or a general ambition in, but not limited to, pre-contractual and periodic documents or marketing communications, advertisements, product categorisation, description of investment strategies or asset allocation, information on the adherence to sustainability-related financial product standards and labels, use of product names or designations, memoranda or issuing documents, factsheets, specifications about conditions for automatic enrolment or compliance with sectoral exclusions or statutory requirements regardless of the form used, such as on paper, durable media, by means of websites, or electronic data rooms."
Firms have awaited clarification on the threshold for triggering an Article 8 classification for some time, but the Guidance does not address all of the remaining uncertainty. The Commission has confirmed that, in order for a product to qualify as Article 8, it must promote environmental and/or social characteristics and such promotion can arise from statements (or impressions) included in a wide variety of documents or communications. They make clear that mere compliance with voluntary codes or legal requirements–if promoted as an environmental or social characteristic "in the investment policy"–can trigger Article 8. However, it is still not clear what will constitute a relevant characteristic whose "promotion" will trigger the application of Article 8 and firms will have to continue to take their own views on this.
It also remains unclear whether the mere existence of a norms-based or industry-standard screen is a "characteristic" which is sufficient to make a product engage Article 8. Some recitals in the draft SFDR Regulatory Technical Standards could be read in different ways, and only add to the confusion, which was not clarified by the Guidance.
The Guidance does, however, clarify the following points:
- Article 6 sustainability risk disclosures will not trigger Article 8. The Guidance confirms that making mandatory, product-level Article 6 disclosures regarding the integration of sustainability risks will not, without more, trigger Article 8.
- Consideration of PAIs will not necessarily trigger Article 8. The Commission appears to recognise that consideration of PAIs at product level (Article 7) will not, without more, trigger Article 8.
- Article 8 is a flexible concept. It does not:
"…prescribe certain elements such as the contribution of investments or minimum thresholds,…eligible investment targets, and neither does it determine eligible investing styles, investment tools, strategies or methodologies to be employed.
Therefore, nothing prevents financial products subject to Article 8…not to continue applying various current market practises [sic.], tools and strategies and a combination thereof such as screening, exclusion strategies, best-in-class/universe, thematic investing, certain redistribution of profits or fees."
7. The scope of Article 9(1): a product which has "sustainable investment as its objective"
The scope of Article 9 has received less attention than the equivalent question for Article 8. A key SFDR known unknown, however, is whether such a product is required to make 100% or some other prescribed percentage of its investments in "sustainable investments" (as such term is defined by SFDR). The Guidance notes the following in this respect:
"A financial product to which Article 9(1), (2) or (3) of Regulation (EU) 2019/2088 applies may invest in a wide range of underlying assets, provided these underlying assets qualify as ‘sustainable investments’"
"A financial product, in order to meet requirements in accordance with prudential, product-related sector specific rules may next to ‘sustainable investments’, also include investments for certain specific purposes such as hedging or liquidity which, in order to fit the overall financial product’s sustainable investments’ objective, have to meet minimum environmental or social safeguards, i.e. investments or techniques for specific purposes must be in line with the sustainable investment objective…the product documentation must include information how the given mix complies with the ‘sustainable investment’ objective of the financial product in order to comply with the “no significant harm principle” of Article 2(17) of Regulation (EU) 2019/2088."
This appears to indicate that, subject to the exception in the following paragraph, an Article 9 product must invest exclusively in "sustainable investments" (including that such investments do not significantly harm environmental or social characteristics). This is consistent with the draft SFDR Regulatory Technical Standards, which note at recital 23 that Article 9 products are "expected to make only sustainable investments."
An exception appears to be for investments which are peripheral or supportive to the product's core investments, being made for hedging or liquidity purposes, for example. These do not appear to need to qualify as a sustainable investments, but must nonetheless not significantly harm environmental or social characteristics.
This is likely be a sub-optimal clarification for firms which had intended to apply an Article 9 categorisation to products which will invest a material—but not 100%—portion of their capital in SFDR "sustainable investments". Similarly, some firms with ambitions to transition non-sustainable investments within an Article 9 product to become SFDR "sustainable investments" may be disappointed and may seek to pursue this point with trade associations or through advocacy. The Guidance suggests that the Commission's view is that such products would be better categorised as Article 8:
"…where such financial products do not have 'sustainable investment' as their objective…they are considered to fall under Article 8."
Article 9(3) products: reduction in carbon emissions
The Guidance appears to confirm that an Article 9(3) product, which has an objective of a reduction in carbon emissions, is a specific type of Article 9 product rather than an independent category in its own right.
8. Article 10 SFDR website disclosures for Article 8 and Article 9 products
We noted in our flyer of 12 February 2021 that there have been some concerns about private funds making public website disclosures pursuant to Article 10 SFDR in relation to Article 8 and Article 9 products. Some trade associations have argued that this obligation ought not to apply to products where information is not otherwise made available to the public or to retail investors. For example, such publication could be in tension with global securities offering laws. The ESAs did not address this point specifically in the draft SFDR Regulatory Technical Standards. They did, however, make some remarks about confidentiality, which are echoed by the Commission in the Guidance:
"Transparency of the promotion of environmental or social characteristics and of sustainable investments on websites in accordance with Article 10 of Regulation (EU) 2019/2088 must ensure compliance with Union and national law governing the data protection, and where relevant, also ensure confidentiality owed to clients."
9. SFDR known unknowns not addressed by the Guidance
The Guidance does not address the following known unknowns, where firms will continue to need to take their own view. We have formed views on a number of these questions and advised clients on them in the context of their own particular facts and risk appetite.
- "Light" and "Mid Green" Article 8 products. Our 12 February 2021 briefing noted that the draft Regulatory Technical Standards, produced by the European Supervisory Authorities but not yet endorsed by the Commission, divides the Article 8 category in two, setting up two new product categories: "light green" and "mid-green"/"Article 8+" products (the latter being a product which commits to make a sustainable investment). One consequence of such a distinction between light and mid green Article 8 products would be that a light green product would not be required to report under the Taxonomy Regulation. In the Guidance, the Commission neither dismisses nor endorses this distinction and does not comment on when or to what extent an Article 8 product must report whether an economic activity is environmentally sustainable within the meaning of the Taxonomy Regulation.
- Is the manager of an Article 9 product required to consider PAIs? We think this cannot be the intention, but it is ambiguous whether the ESAs are suggesting in recital 19 of the draft Regulatory Technical Standards that an Article 9 product and its manager must necessarily also fall within Articles 7 and 4, respectively.
- Translations. The draft Regulatory Technical Standards propose a requirement for disclosures to be made available in "a language of all the Member States where the financial market participant's financial products are marketed". It is not known whether the Commission will endorse that approach in the final Regulatory Technical Standards.
10. Next steps
This client briefing assumes a certain familiarity with SFDR and its known unknowns, and it does not cover all of the issues our clients currently face. If you would like to discuss the implications of the Guidance, please speak to your usual contact or any of the lawyers below.