The Sustainable Finance Disclosure Regulation (Regulation (EU) 2019/2088) (SFDR) came into effect on 10 March 2021 on a phased basis. It introduced entity and product level sustainability-related disclosure requirements for financial market participants (FMPs) and financial advisers. FMPs include AIFMs, UCITS management companies and MiFID investment firms. Non-EU fund managers may also be impacted.
SFDR high-level requirements
Fund managers in the EU and certain non-EU fund managers were required to comply with SFDR Level 1 principle-based entity and product level disclosure requirements by 10 March 2021. These requirements include implementing a policy on integration of sustainability risks into the investment decision making process, updating remuneration policies to integrate sustainability risks, making sustainability related disclosures on websites and in fund offering documents, and periodic reporting in annual reports.
The pre-contractual disclosures for financial products with or without an ESG focus, include:
disclosure on the integration of sustainability risk in investment decisions or an explanation where not deemed relevant; and
disclosure of principal adverse impacts on a comply or explain basis.
Additional disclosures are required in respect of Article 8 and Article 9 products with an ESG focus.
See our previous briefing outlining the requirements of the SFDR and Central Bank filing process for Level 1 SFDR prospectus updates.
Level 2 RTS delayed to 1 July 2022
Level 2 Regulatory Technical Standards (RTS) have been developed by the European Supervisory Authorities (the ESAs) and relate to several SFDR disclosure obligations. The RTS contain detailed specifications for the content, methodology and presentation of SFDR disclosure requirements and mandatory templates for pre-contractual and periodic reporting disclosures. The ESAs are also preparing draft RTS on Taxonomy Regulation (Regulation (EU) 2020/852) product disclosures, with certain provisions of the Taxonomy Regulation due to apply from 1 January 2022.
On 8 July 2021, the European Commission (the Commission) wrote to the Chair of the Committee on Economic and Monetary Affairs and the Council of the European Union confirming its intention to bundle all 13 of the RTS into a single delegated act, and defer the dates of application of the RTS from 1 January 2022 to 1 July 2022.
The delay gives time to prepare for the next level of pre-contractual and website disclosures. However, it also means that fund managers must continue their SFDR implementation in the absence of final RTS, which are at various stages of completion.
The Taxonomy Regulation creates additional SFDR disclosure obligations. The initial product disclosure and periodic reporting requirements relate to the Taxonomy Regulation environmental objectives of climate change mitigation and climate change adaptation and enter into force on 1 January 2022. In summary:
Article 9 financial products must disclose information on the environmental objectives of the Taxonomy Regulation to which the investment underlying the financial product contributes. A description of how and to what extent the investments underlying the financial product are in economic activities that qualify as environmentally sustainable under the Taxonomy Regulation must also be included.
Article 8 financial products must disclose information on the Taxonomy Regulation environmental characteristics which the product promotes and a description of how and to what extent the underlying investments qualify as environmentally sustainable for the purposes of the Taxonomy Regulation and the proportion of investments which are environmentally sustainable. These products must also include a prescribed “do no significant harm principle” statement.
All other financial products not subject to Article 8 or Article 9 of the SFDR must include a prescribed disclaimer that: “The investments underlying this financial product do not take into account the EU criteria for environmentally sustainable economic activities”.
The Central Bank has confirmed to Irish Funds that it will put in place a form of fast-track process for filing the 1 January 2022 Taxonomy related prospectus updates. The details of the filing process are expected to be confirmed shortly.
UCITS Directive, AIFMD and MiFID 2 delegated acts
In addition to the SFDR, sustainability related amendments to the UCITS Directive, AIFMD and MiFID 2 will apply to UCITS managers and AIFMs from August 2022 and to MiFID firms from 22 November 2022.
The requirements relate to investment due diligence, resources, conflicts of interest, risk management, organisational and operating policies and procedures, senior management responsibilities, investment suitability and product governance. The Level 2 texts of these measures were published in the Official Journal of the EU on 2 August 2021.
Commission’s Q&A guidance on SFDR disclosures
In July 2021, the Commission issued a decision adopting answers to questions of interpretation sought by the ESAs on the application of the SFDR. While largely welcomed, aspects of the Commission’s Q&A guidance have raised additional issues.
Non-EU AIFMs and registered (sub-threshold) AIFMs
The SFDR applies to non-EU AIFMs entering the market of a Member State by means of a National Private Placement Regime (NPPR). However, the Commission’s response that non-EU AIFMs must ensure compliance with the SFDR, “including” the financial product related provisions, clarifies that non-EU AIFMs, in addition to applying the SFDR to products marketed under the NPPR, must comply with the entity level requirements.. In addition, the Commission confirmed that both entity-level and product level requirements of the SFDR apply to registered (sub-threshold) AIFMs.
Principal adverse sustainability impacts (PAIs)
From 30 June 2021, FMPs which are parent undertakings of large groups within the meaning of Directive 2013/34/EU (the Accounting Directive), exceeding a 500 employee threshold, must publish and maintain on their websites a statement of their due diligence policies with respect to the PAIs of investment decisions on sustainability factors.
The Commission confirmed that the 500 employee threshold for FMPs which are parent undertakings of a large group, includes the parent undertaking and subsidiary undertakings established inside or outside the EU. However, it stated that the due diligence statement for such FMPs should only cover the activities of the parent undertaking and not of the group as a whole.
Note that EU FMP subsidiary undertakings with more than 500 employees might still qualify as FMPs subject to Article 4(3) of the SFDR or opt to be FMPs that consider PAIs of investment decisions on sustainability factors.
Financial market participants that decide not to apply the “comply mechanism” under the Article 4(1) SFDR comply or explain mechanism, must provide clear reasons for why they do not consider “adverse impacts” of investment decisions on sustainability factors.
Article 8 financial products
The Commission’s Q&A gives guidance on the classification of financial products promoting environmental or social characteristics under Article 8, including:
The integration of sustainability risks into financial products is not sufficient for Article 8 to apply to a product. Note however, the Commission has indicated in its Renewed Sustainable Finance Strategy that it intends to introduce minimum sustainability requirements for Article 8 financial products.
Article 8 does not specify the composition of investments or minimum investment thresholds and eligible investment targets. Neither does it determine investment strategies, tools or methodologies and it may apply various market practices, tools and strategies, or combination thereof.
An Article 8 financial product may comply with the PAI regime but it is not a requirement. Note that the Q&A does not however state that compliance with the PAI regime will bring a financial product within Article 8.
‘Promotion’ is broadly defined. It extends to giving the impression to investors that the financial product considers environmental or social characteristics in its investment policies, goals, targets, or objectives. The Commission confirmed that product names can be enough to form the basis of an Article 8 financial product. This will require careful consideration for products that wish to remain outside of Article 8.
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 they are “promoted” in the investment policy, the product is subject to Article 8.
Article 9 financial products
The Commission’s Q&A gives guidance on the classification of financial products having a sustainable investment objective, including:
In addition to sustainable investments, Article 9 financial products may invest in other investments for certain specific purposes such as hedging or liquidity. However, these investments have to meet minimum environmental or social safeguards to fit the overall sustainable investment objective. The product documentation must explain how the “mix” complies with the sustainable objective of the financial product.
An Article 9(3) financial product with a reduction in carbon emissions objective, must track an EU Climate Transition Benchmark (EU CTB) or EU Paris-aligned Benchmark (EU PAB), where that benchmark exists. Further clarification on this from the Commission would be welcomed. This is because it would appear to exclude actively managed funds with an objective of a reduction in carbon emissions, for which an EU CTB or EU PAB exists, from the scope of Article 9(3).
The benchmark administrators must ensure that the benchmark complies with the SFDR definition of “sustainable investment”.
SFDR product rules applying to MiFID portfolios and tailored products
The Commission confirmed that the SFDR does not distinguish tailored financial products from other financial products. This means that SFDR product-level requirements apply at the level of each portfolio under management.
In response to confidentiality concerns, the Commission confirmed that financial product website disclosures must comply with data protection laws and client confidentiality. The Commission added that where a FMP makes use of standardised product solutions, transparency of those solutions might be a way for complying with the SFDR’s website disclosure requirements.
Navigating and implementing the SFDR and Taxonomy Regulation RTS will be challenging for fund managers. Firms should continue their preparations for the Level 2 implementation of the SFDR’s prospectus and website disclosure requirements ahead of the 1 July 2022 deadline. Firms should also plan for compliance with the Taxonomy related prospectus updates in advance of the Central Bank filing deadline of 1 January 2022. Registered AIFMs will need to ensure that they have taken steps to comply with the SFDR, given the recent confirmation from the Commission that they are in scope. Non-EU fund managers should also assess the extent to which they are in scope by virtue of registering or marketing funds subject to Ireland’s private placement regime.