On 26 July 2021, the European Commission published its long-awaited Q&A on the EU Sustainable Finance Disclosure Regulation (SFDR), in response to queries raised by the European Supervisory Authorities (ESAs) (i.e. ESMA, EBA and EIOPA).
Overall the Q&A is not very clearly drafted, and in many cases the Commission has not answered the specific question put to it, responding with just a summary of the Level 1 rules. However, there are some unhelpful implications from the Q&A – in particular, the Commission has put forward a very broad definition of “promotion” for Article 8 classification purposes (suggesting that even ESG-like exclusions mandated by law could be enough to amount to promotion) and the guidance could be read as suggesting that Article 42/non-EU AIFMs should be in scope of both the entity and product level SFDR requirements. Some of the Q&As also appear to contradict guidance provided by the ESAs previously in the SFDR RTS and final report.
Please see our summary below for further details.
1. FMP Scoping - application of SFDR to registered (sub-threshold) AIFMs and non-EU AIFMs?
This is probably the most confusing part of the Q&A, as it seems that the Commission has actually put the responses to Questions 1 and 2 in the wrong places (i.e. the answer to Question 1 is under Question 2, and vice versa).
- Non-EU AIFMs: The Commission (as expected) confirms that the SFDR does apply to non-EU AIFMs. However, it is notable that the Q&A says “that AIFM must ensure compliance with [SFDR], including the financial product related provisions”. No mention is made of the entity level SFDR requirements, although equally the guidance says “including” the product related provisions, which leaves the application of the entity level requirements to non-EU AIFMs ambiguous.
- Registered/sub-threshold AIFMs: In contrast, the Q&A explicitly says both the entity and product related provisions apply to such registered/sub-threshold AIFMs (which again, might support the reading above that the omission of the entity level requirements from the answer on non-EU AIFMs was deliberate). The Commission says provisions should be applied “by analogy” where the relevant requirements referred to in the SFDR do not actually apply to such registered/sub-threshold AIFMs.
2. PASI (principal adverse sustainability impacts)
- Comply vs Explain Statements: As part of the response (even though this was not one of the questions asked), the Commission clarifies that there is a distinction between the “comply” “principal adverse impacts” disclosure and the “explain” “adverse impacts” disclosure under Article 4. This is, in their words, to introduce a more stringent disclosure mechanism. The practical consequence of this seems to be that an “explain” statement under Article 4 should go beyond a mere statement that the specific PASIs are not considered and should provide clear reasons on why the financial market participant (FMP) does not consider the degradation of the environment or social injustice through its investments.
- 500 employee criteria and groups: The Commission helpfully clarifies that the PASI disclosure for large groups should cover the activities of the parent undertaking only and not the entire group (i.e. the group is only relevant to the calculation of headcount) – unless the group includes subsidiaries that are themselves large FMPs.
3. Design and minimum criteria for Article 8 / 9 products?
Contrary to what we were expecting, the Q&A does not specify minimum sustainable investment or ESG investment thresholds/percentages for Article 9 or 8 products. The Commission has also noted that both Article 8 and 9 are neutral in terms of product design, investment strategies or methodologies.
In terms of key points to note:
- Article 9 products - The Commission clarifies that alongside sustainable investments, these products may also include investments “for certain specific purposes such as hedging or liquidity”, which “in order to fit the overall…sustainable investments’ objective, have to meet minimum environmental or social safeguards”. This seems to suggest, as we have previously advised, that the large majority of investments in an Art. 9 product must be in sustainable investments, but that there is room to include other investments that meet environmental or social safeguards (presumably the DNSH test) and “neutral investments”. However this guidance is unhelpful as it appears to suggest that even neutral instruments (e.g. hedging or liquidity trades) must be assessed against minimum environmental or social safeguards and so can’t be truly neutral.
- Article 8 products – The Q&A largely repeats previous guidance and confirm again that the integration of sustainability risks is not sufficient to create an Article 8 product.
However, it is worth noting that in its Renewed Sustainable Finance Strategy, the Commission had indicated that it will be looking to introduce minimum sustainability requirements for Article 8 SFDR products to guarantee minimum sustainability performance (see our client alert here).
4. Article 9 products and LCBR benchmarks
- In the Commission’s view, it follows from Article 9(3) of the SFDR that implementation of the Low Carbon Benchmark Regulation (LCBR) criteria by benchmark administrators “must ensure compliance with [the SFDR sustainable investments definition]”. However, they then state that the requirements of the LCBR must “be applied in conjunction with SFDR”, and in particular the sustainable investments definition. This seems to indicate that both the LCBR criteria, and the SFDR sustainable investments test, should be applied for Article 9 products using an EU Paris Aligned or Climate Transition Benchmark. This would be a very unhelpful outcome, as there was nothing to suggest this conclusion previously – however, the guidance suggests that the responsibility for this would fall on the benchmark administrator and not the FMP.
- On the question of whether an Article 9 product with a reduction in carbon emissions objective must track an EU Climate Transition or Paris Aligned Benchmark, the Commission has noted that Article 9(3) of the SFDR would require the product to track these benchmarks if they exist. The Commission has not specifically commented on whether this should be the case for all funds or just passive funds – it would be odd if the conclusion is not limited to passive funds only, as otherwise there could be no actively managed funds in the EU with the objective of reducing carbon emissions.
5. What constitutes promotion of environmental or social characteristics under Article 8 of SFDR? Can baseline sectoral exclusions (e.g. tobacco) or exclusions imposed by law (e.g. cluster munitions) result in an Article 8 product?
- Unhelpfully, the Commission has taken the view that compliance with restrictions laid down by law can result in an Article 8 product, if they are “promoted” in the investment policy of the product.
- The Commission then defines “promotion” as: “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.”
- This is a very broad definition and there is no reference to materiality/significance which is unhelpful with respect to products that apply only baseline sector exclusions and wish to avoid becoming Article 8. However, there may be scope to make an argument based on the language above which indicates that there must be an impression that the product considers environmental or social characteristics – as the use of disclaimers etc. by products applying baseline exclusions and/or exclusions by law should help dispel that impression (provided the product isn’t otherwise promoted as having ESG aims).
6. Website disclosures for separate accounts/managed portfolios
- The Commission notes that the SFDR does not distinguish between tailored and standardised products. But states that website disclosures “must ensure compliance with Union and national law governing the data protection, and where relevant, also ensure confidentiality owed to clients”. This seems to indicate that keeping website disclosures confidential in some way (e.g. behind logins) may be acceptable if there are confidentiality/privacy concerns.
- Further, the Commissions says that FMPs that make use of “standardised product solutions” could give transparency on these and that “might be a way” for complying with the website disclosure requirement. Whilst the Commission has largely failed to make a clear statement on this, this seems to provide some grounds for providing standardised website disclosures where possible (e.g. at centrally managed strategy level), even with respect to individual services like managed accounts.