A simple guide to the EC’s clarifications of the SFDR
The first stage of SFDR implementation was on 10 March 2021. Compliance with the remainder of the rules as set out in the regulatory technical standards (many of which are due to be published by the end of 2021) has been delayed by six months to 1 July 2022.
The EC’s Q&A provides helpful clarification on several issues, although some of the answers are somewhat inscrutable. We have sought to provide a summary of the document in plain English and to offer our view on its implications for asset managers.
Summary of the Q&As
The SFDR applies to “financial market participants” and AIFMs are a type of financial market participant. Consequently, the EC clarifies that the SFDR’s requirements apply to both sub-threshold AIFMs and to non-EU AIFMs.
(We note the EC’s letter appears to contain a mistake in which the application of SFDR to non-EU AIFMs is referred to in response to the question about sub-threshold AIFMs and vice versa.)
The Q&As specify that both the entity-level and product-level disclosure requirements apply to sub-threshold AIFMs. In addition, that sub-threshold AIFMs which are not directly subject to AIFMD disclosure requirements should apply those requirements by analogy, i.e. including information in equivalent documents required under national law.
The response also states that where a non-EU AIFM markets a fund to EU investors via a National Private Placement Regime, that AIFM “must ensure compliance with [the SFDR], including the financial product related provisions”. This language differs from the response given in respect of sub-threshold AIFMs (which explicitly refers to both the entity and financial product related requirements of SFDR) and could be interpreted as requiring non-EU AIFMs to comply with the entity-level disclosures. However, our interpretation is that the language is intended to capture other product-level requirements in SFDR, such as Article 13 (marketing communications should be consistent with disclosures made under SFDR).
Firms should include EU and non-EU entities when calculating the firm’s headcount to determine whether this threshold is met. However, principal adverse impact reporting should only be undertaken on behalf of the EU-domiciled entity (i.e. firms are not required to report on behalf of a non-EU parent entity or group).
The legislation distinguishes between “principle adverse impacts” and “adverse impacts”.
Firms with more than 500 employees or parent undertakings of a large group must comply with the disclosure of principal adverse impacts of their investment decisions.
Firms that opt not to disclose principal adverse impacts, should explain why they do not consider adverse impacts of their investment decisions on sustainability outcomes and whether and when they intend to consider such adverse impacts.
Article 9 products must have “sustainable investment” as their objective. However, this does not mean that all an Article 9 product’s investments need to meet that definition. For instance, it is acceptable to have “other” investments for specific purposes such as liquidity or hedging. Managers of Article 9 products should disclose the mix of investments within the portfolio to explain how that mix complies with the “sustainable investment” objective of the product and with the principle of “do no significant harm” (in relation to that objective). The EC does not propose that a minimum level of sustainable investments is required in order to describe a product as having a sustainable investment objective.
In respect of benchmarks, an Article 9 product must track a Climate Transition or Paris-aligned benchmark if one exists that is relevant to the product’s sustainable objective (i.e. if the product has a climate objective). The language in the Q&A could be interpreted as applying solely to passive or index-tracking products. This would imply that actively managed products cannot pursue a carbon reduction objective. This outcome does not appear to be the intent of the legislation, and so the EC’s clarification could be interpreted as suggesting that a fund must make use of the relevant benchmark if one exists. In practice, this could mean using the benchmark as a reference for the fund’s portfolio composition, or as a target or comparator for investment performance.
The EC states there are no specific naming and investment criteria with respect to Article 8 products. However, the naming convention and proportion of sustainable investments should reflect the environmental and/or social characteristics that the product promotes.
The way in which the product is promoted to investors is fundamental to the definition of an Article 8 product. The EC adopts the natural definition of “promotion”; namely, a wide array of ways in which a manager might make direct or indirect claims about the product’s consideration of environmental and/or social outcomes. This could bring a product in scope of Article 8.
Practically, this might comprise references in marketing materials, pre-contractual disclosure documents such as a Key Investor Information Document or a fund prospectus, adverts, factsheets, the fund’s name, or other indicators. In terms of content, references could be made to environmental and/or social characteristics in respect of the product’s objectives, goals, investment strategy, portfolio composition or asset allocation, general ambitions, product categorisation, or adherence to certain labels or standards (including national labels or regimes). The EC does not seek to limit the ways and methods in which environmental or social characteristics might be promoted to investors.
This clearly casts a wide net over the types of products which may be determined as in scope of Article 8, aligning with the intention of the legislation which, in part, aims to tackle greenwashing, but which is primarily concerned with the information that is disclosed to investors.
The SFDR requirements apply at the level of each mandate. Although if a manager makes use of standardised portfolio solutions, disclosures in respect of those solutions might fulfil the SFDR product-level disclosure requirements (including the website disclosures).
The EC specifies that website disclosures must comply with applicable data protection and client confidentiality requirements. This does not solve the practical challenge as to how firms should achieve this (and also avoid breaching local marketing rules) while still meeting the specific product-level requirements of SFDR. There are imperfect solutions in the market which intend to achieve the aims of SFDR, such as password-protected websites and data rooms.
The implications for asset managers
The EC’s guidance follows sensibly from the SFDR’s Level 1 text and the co-legislators’ intentions.
Despite the ambiguity that remains in some areas, the EC’s guidance supports our previous suggestion that firms should strive to comply with “the spirit” of the rules in SFDR. The general intention should be to increase transparency to investors in respect of the ESG characteristics of a product, and ensure that where any ESG-related promotional claims are made, these are substantiated with specific features of the investment strategy and robust processes for the integration of ESG considerations into the firm’s business model.
A practical example of this can be given in relation to the scoping of product within Article 8. The EC’s response makes clear that “good” ESG governance comprising identification, tracking, and management of ESG risks, however sophisticated, is not sufficient on its own to qualify a product as Article 8 (which requires the promotion of environmental and/or social characteristics). The FCA has drawn similar conclusions in its recent guiding principles for ESG funds and strategies.
While the EC’s guidance is not prescriptive, it should help firms avoid the perception of greenwashing and encourage firms to consider how they substantiate their promotions of products as “sustainable”. Conversely, firms that comply with green standards such as TCFD may do so without necessarily falling in scope of SFDR’s Article 8 requirements. Again, the EC’s guidance does not offer complete clarification, but it does set some boundaries and aid firms in understanding the “spirit” of the rules.