SFDR – IMPLICATIONS FOR EU AND NON-EU FUND MANAGERS

Beginning on March 10, 2021, EU fund managers and certain non-EU fund managers became subject to various new sustainability-related rules, by virtue of the EU’s Sustainable Finance Disclosure Regulation (SFDR).^[1]

Over the coming months and years, other obligations will be imposed on managers both by the SFDR itself (as those obligations phase in) and by the EU’s separate Taxonomy Regulation.^[2]

The SFDR and the Taxonomy Regulation (collectively, the “ESG Regulations”) form part of a package intended to move sustainable investment objectives to the core of the financial system in the EU, and to help end investors analyze and judge financial products by reference to social and environmental impact and sustainability.

Which Managers are Affected?

• All EU-domiciled Alternative Investment Fund Managers (AIFMs), MiFID^[3] investment firms and UCITS^[4] management companies providing investment management and/or investment advisory services are in scope, as are managers of European Venture Capital Funds (EuVECAs) and European Social Enterprise Funds (EuSEFs).
• All Alternative Investment Funds (AIFs), UCITS funds, MiFID portfolio accounts, EuVECAs and EuSEFs under management by the Managers listed above are in scope.
• All EU-domiciled managers managing accounts, or managing a fund under delegation from an AIFM, are in scope.
• Non-EU fund managers (including U.K. fund managers) will be in scope to the extent that they register any of their funds for marketing under Article 42 of the AIFMD^[5]—i.e., private placement—in any EU member state. They are also potentially in scope to the extent that they manage or advise EU-domiciled funds, even if those funds are not privately placed in the EU.
• At the time of writing, EEA managers that are not also EU managers (i.e., managers in Norway, Iceland and Liechtenstein) are not automatically in scope. Like many pieces of EU legislation, the SFDR will need to be brought into the remit of the EEA Framework Agreement^[6] before those managers are automatically subject to the SFDR.

The primary focus of this note will be on the main rules applicable to AIFMs.

ESG Regulations – Disclosures

For fund managers, the required disclosures can be bundled into three separate categories:

• Pre-Contractual Disclosures – the intention is that these ESG-related disclosures will effectively supplement the existing pre-contractual disclosures that are already required under the relevant regulatory framework (AIFMD, UCITS, etc.).
  For example, for AIFMs the pre-contractual disclosures will be made alongside the pre-investment disclosures referred to in Article 23(1) of AIFMD. These need to be provided to EU investors before they invest in a fund and typically appear in, or accompany, the relevant fund’s offering documents.
  For MiFID investment firms providing portfolio management or investment advice services, the SFDR pre-contractual disclosures will be provided at the same time as the relevant information on the firm and its services is provided to a client, or potential client, in accordance with Article 24(4) of MiFID.
• Disclosures on Manager’s Website – this requires website publication of certain ESG policies and statements by the Manager.
  On the face of the SFDR, the website disclosure obligations only clearly apply to EU fund managers. Nevertheless, the consensus is that they also apply to non-EU fund managers marketing their funds in the EU.
• Additional Disclosures in Periodic Report – this requires disclosure of:
  • if the fund or account holds itself as promoting “environmental” or “social” characteristics (also known as “Article 8” or “light green” financial products), the extent to which those characteristics have been met; and
  • if the objective of the fund or account is “sustainable investment” (also known as “Article 9” or “dark green” financial products), the sustainability-related impact of that fund or account.

Again, the intention here is that these disclosures will effectively supplement the existing disclosures required to be made in a manager’s periodic report under the relevant regulatory framework. For AIFMs, these disclosures will be made in the annual report required under Article 22 of AIFMD, and for MiFID investment firms they will be made in the periodic reports provided to clients in accordance with Article 25(6) of MiFID.

As with the website disclosures, these periodic report disclosures only clearly apply to EU fund managers, but it would be somewhat anomalous if they did not also apply to non-EU fund managers that are required (e.g. by virtue of AIFMD) to prepare periodic reports anyway.

ESG Regulatory Technical Standards – Content, Methodology & Presentation

The Final Report on the draft Regulatory Technical Standards published on February 4, 2021^[7] provides in draft form the regulatory technical standards described in the SFDR (the “ESG Disclosures RTS”).

The ESG Disclosures RTS prescribe, in granular detail, how certain of the disclosures under the SFDR have to be made: in content, methodology and presentation. Originally, it was intended that the ESG Disclosures RTS would apply from March 10, 2021. However, the ongoing Covid-19 pandemic has resulted in a delay finalizing the draft ESG Disclosures RTS.

The ESG Disclosures RTS provide very useful guidance for managers on how to comply with the SFDR disclosure obligations that come into application on March 10, 2021, but the detailed templates contained in the ESG Disclosures RTS will not strictly be required to be used until (at the earliest) January 1, 2022.

Through necessity, this note refers to obligations contained in the draft ESG Disclosures RTS as at the date of this note, and to the currently expected timeline for their application. This is, unfortunately, subject to change and potential delay.

Pre-Contractual (Product-Level) Disclosures

The Integration of Sustainability Risk into Investment Decisions – All Financial Products

From March 10, 2021, Managers must include in their pre-contractual disclosures for each fund or account:

• both:
  • a description of how “sustainability risks”^[8] are integrated into the Manager’s investment decisions; and
  • the results of the Manager’s assessment of the likely impacts of sustainability risks on the potential returns of the fund or account; or
• if the Manager considers that sustainability risks are not relevant, a clear and concise explanation setting out the reasons why this is the case.

Additional Disclosures for “Light Green” Financial Products

Sadly, there is no clear explanation in the SFDR as to when a particular product will be considered to be promoting “environmental” or “social” characteristics. Greater clarity may well come from the EU Commission or from ESMA. Broadly, at this stage, it is fair to assume that this will capture products which apply ESG strategies in their investment process, including investment selection, but do not commit to having ESG objectives.

From March 10, 2021, if a fund or account is promoted as having environmental or social characteristics, the Manager must include in its pre-contractual disclosures:

• information on how these environmental or social characteristics are met; and
• if an index has been designated as a reference benchmark, information on whether and how this index is consistent with the environmental or social characteristics, and where the methodology used for assessing/calculating the index can be found.

From January 1, 2022, this information must specifically follow the content, methodology and presentation prescribed by the ESG Disclosures RTS.

Additional Disclosures for “Dark Green” Financial Products

From March 10, 2021, where a fund or account has “sustainable investment” as its stated objective, the Manager must include in its pre-contractual disclosures:

• if an index is designated by the fund or account as a reference benchmark, information on how the designated index is aligned with the sustainable investment objective and an explanation of why and how that designated index differs from a broad market index;
• if there is no designated index used as a reference benchmark, a clear explanation of how the sustainable investment objective will be obtained; and
• if the fund or account has the specific objective of a “reduction in carbon emissions,” further detail on this objective of low carbon emission exposure including, (i) if the fund or account uses a designated benchmark as a reference benchmark, a clear explanation that the benchmark qualifies as an EU Climate Transition Benchmark or an EU Paris-aligned Benchmark and an indication of where the methodology used for that benchmark can be found, or (ii) where no EU Climate Transition Benchmark or EU Paris-aligned Benchmark is available, an explanation of that fact and how the continued effort of attaining the objective of reducing carbon emissions is ensured in view of achieving the global warming objectives of the Paris Agreement.^[9]

From January 1, 2022, this information must specifically follow the content, methodology and presentation prescribed by the ESG Disclosures RTS.

Taxonomy Regulation Disclosures and Disclaimers

Taxonomy Regulation Disclosures – “Light Green” and “Dark Green” Financial Products

From January 1, 2022 or January 1, 2023 (see below), for Managers whose funds or accounts promote “environmental” or “social” characteristics, or that have “sustainable investment” as their objective, the Manager must additionally include in its pre-contractual disclosures:

• information on any Environmental Objective(s)^[10] to which the investment underlying the financial product contributes; and

• a description of how (and to what extent) the product’s investments are in economic activities that qualify as “environmentally sustainable.”

For this purpose, “environmentally sustainable” investments are those that:

• make a substantial contribution to at least one of the Environmental Objectives;
• do no significant harm to any of those Environmental Objectives;
• are carried out in compliance with minimum social and governance safeguards; and
• comply with technical screening criteria, which will flesh out in detail what it means for an economic activity to substantially contribute to an Environmental Objective.

The technical screening criteria will be developed via delegated acts, the first of which will be in relation to the two Environmental Objectives “climate change mitigation” and “climate change adaption”—and is expected to come into effect on January 1, 2022. The Taxonomy Regulation disclosures are thus expected to apply to funds and accounts that make investments with “climate change mitigation” and/or “climate change adaption” objectives from this date.

The technical screening criteria for the remaining four Environmental Objectives is expected to come into effect from January 1, 2023. Funds and accounts that make investments with any of the remaining four Environmental Objectives will therefore be expected to make the Taxonomy Regulation disclosures from this date.

Taxonomy Regulation Disclaimers – All Financial Products

From January 1, 2022 or January 1, 2023, as applicable, Managers of “light green” or “dark green” financial products must include the following specific disclaimer in their pre-contractual disclosures and periodic reports:

“The ‘do no significant harm’ principle applies only to those investments underlying the financial product that take into account the EU criteria for environmentally sustainable economic activities.

The investments underlying the remaining portion of this financial product do not take into account the EU criteria for environmentally sustainable economic activities.”

From January 1, 2022, other financial products captured by the SFDR that are not classified as “light green” or “dark green” must include the following disclaimer in their pre-contractual disclosures and periodic reports:

“The investments underlying this financial product do not take into account the EU criteria for environmentally sustainable economic activities.”

Consideration of Sustainability Factors in the Investment Process – All Financial Products

From December 30, 2022, the Manager must include in its pre-contractual disclosures for each fund or account:

• if the Manager takes into account principal adverse impacts (PAI) on sustainability in the relevant product’s investment processes:
  • a clear and reasonable explanation of whether (and, if so, how) it takes into account PAI when taking investment decisions; and
  • for “light green” or “dark green” products, a statement that information about PAI is available in the Manager’s periodic reports; or
• if the Manager does not consider PAI, a statement setting out the reasons why it does not.

Website Disclosures

Website (Manager-Level) Disclosures

The Integration of Sustainability Risks into Investment Decisions

From March 10, 2021, Managers must publish on their website information about their policies on the integration of sustainability risks in their investment decision-making process (or upload the entire policy).

The Integration of Sustainability Risks into the Remuneration Process

From March 10, 2021, Managers must publish on their website information explaining how their remuneration policies are consistent with the integration of sustainability risks, including with respect to:

• promotion of sound and effective risk management with respect to sustainability risks;
• no encouragement of excessive risk-taking with respect to sustainability risks; and
• the link between remuneration and risk-adjusted performance.

Principal Adverse Impacts of the Manager’s Investment Decisions on Sustainability Factors

From March 10, 2021, Managers who take into consideration the PAI of investment decisions on sustainability factors must publish a statement on the firm’s due diligence policies with respect to PAI when making investments, including:

• information about their policies on the identification and prioritization of PAI and indicators (taking into account the size of their organization, stakeholder expectations and long-term strategy);
• a description of the PAI and of any actions taken in relation thereto or, where relevant, planned to be taken; and
• a reference to their adherence to responsible business conduct codes and internationally recognized standards for due diligence and reporting and, where relevant, the degree of their alignment with the objectives of the Paris Agreement.

Managers who do not take into consideration the PAI of investment decisions on sustainability factors must publish clear reasons as to why they do not do so, including, where relevant, information as to whether and when they intend to consider PAI.

From June 30, 2021, Managers with more than 500 employees (including as a parent of a group) will have no choice but to take PAI into consideration. Others below this threshold may still choose not to do so.

At the time of writing, it is unclear whether this 500-employee threshold is assessed only by reference to EU entities in the group, or by reference to both EU and non-EU group entities. Further clarification from the EU Commission has been sought.

From January 1, 2022, the website disclosures must follow the specific content, methodology and presentation prescribed by the ESG Disclosures RTS.

The ESG Disclosures RTS establish a framework of reporting on PAI by June 30 each year, requiring (except in the first year) some of the information to be disclosed by way of reference to the previous calendar year(s), including a historical comparison covering up to five reference periods. The result is, for Managers who either opt in to consider PAI from March 10, 2021 or are required to publish a PAI statement from June 30, 2021:

• The first PAI statement must be published on their website by March 10, 2021 or June 30, 2021 (as applicable) using a principles-based approach to disclose the high-level SFDR disclosures described above.
• The following PAI statement, which must be made in accordance with the ESG Disclosures RTS, must be published on their website by June 30, 2022, but is not required to include the information relating to a reference period.
• The next PAI statement must be published on their website by June 30, 2023 and will need to include the information relating to the reference period of 2022.
• Then, by June 30, 2024, the PAI statement would also have to include the completed “historical comparison” section of the PAI annex, comparing the first reference period (2022) with the second reference period (2023). By June 30, 2028, the historical comparison section would include a comparison of the five previous reference periods.

Website (Product-Level) Disclosures – “Light Green” and “Dark Green” Financial Products

From March 10, 2021, Managers with “light green” or “dark green” products in their portfolio must publish and maintain on their websites:

• a description of the “environmental” or “social” characteristics or (as applicable) the “sustainable investment” objective of the relevant fund or account;
• information on the methodologies used to assess, measure and monitor environmental or social characteristics or (as applicable) the impact of the sustainable investments selected for the relevant fund or account, including its data sources, screening criteria for the underlying assets and the relevant sustainability indicators used by the Manager for measurement purposes; and
• the information set out under sections II and III in “Pre-Contractual Disclosures” above, as applicable.

From January 1, 2022, the above information must follow the content, methodology and presentation prescribed by the ESG Disclosures RTS.

Website Disclosure: Between a Rock and a Hard Place?

Many Managers do not make any meaningful information publicly available on their websites, and for good reason—in many jurisdictions, doing so potentially infringes restrictions on marketing and public solicitation.

The SFDR obligation to publish detailed disclosures relating to the Manager and its financial products on the Manager’s website, therefore, puts the Manager in a potentially difficult situation.

In the absence of clear guidance or rulemaking from relevant EU supervisory bodies, we consider that making the SFDR-required information available only behind a password-protected firewall (or putting behind that firewall at least any of the SFDR-required information that would, if made public, jeopardize the Manager’s ability to retain its “no public solicitation” stance) is a reasonably justifiable position for a Manager to take.

Additional Disclosures in Periodic Reports

From January 1, 2022, Managers with “light green” or “dark green” products in their portfolio will need to include the following additional information in their periodic reports:

• for a fund or account that promotes “environmental” or “social” characteristics, a description of the extent to which these environmental or social characteristics are met, using quantitative and qualitative indicators; or
• for a fund or account with “sustainable investment” as its objective, a description of the overall sustainability-related impact of that fund or account, using quantitative and qualitative indicators (by reference to the relevant sustainability indicators/benchmark index);
• the proportion of sustainability-related investments held by the product, and how the indicators in the PAI statement have been taken into account; and
• the actions taken to attain the environmental or social characteristics or (as applicable) the sustainable investment objective.

This information should be included in a separate annex to the Manager’s periodic reports, and the main body of the reports should include a statement that information on the environmental or social characteristics, or the sustainable investment objective (as applicable), is available in that annex.

The annex to the periodic report must follow the specific content, methodology and presentation prescribed by the ESG Disclosures RTS.

Conclusion

The intention behind the ESG Regulations is not just to add yet more regulatory burden, but to seemingly force fund managers to gradually take ESG considerations into account in their investment processes. By requiring Managers to make advance disclosures to investors explaining how they take ESG factors into account, and then report how successful they were in achieving their goals by way of reference to these disclosures, the EU is ensuring fund managers are held accountable for their ESG-driven decisions or lack thereof.

While these rules do not currently automatically apply to U.K. fund managers, the world is increasingly becoming more ESG-focused, and the U.K. can be expected in the near future to impose ESG-driven requirements on its own fund managers.

Special thanks to Shearman & Sterling trainee Fraser Padmore for his contribution to this client publication.