I. Background
While Level 1 of the Sustainable Finance Disclosure Regulation (“SFDR”) has been applicable for over a year, the investment funds managers have been facing uncertainties with regards to the timing and interpretation of the SFDR Level 2 requirements, set out as regulatory technical standards (“RTS”).
On 14 July 2021, the European Commission (“EC”) answered four questions that were submitted by the European Supervisory Authorities (“ESAs”) in relation to SFDR[1], which clarified namely the application of SFDR to sub-thresholds’ AIFMs and the concept of “promotion of environmental and social characteristics” under Article 8 SFDR.
Further guidance was brought by the European Commission’s approval of the RTS into a single Delegated Regulation, on 6 April 2022. As the RTS are expected to enter into force on 1 January 2023, the ESAs submitted further SFDR queries to the Commission on 13 May 2022, expecting to receive more clarifications prior the application of the RTS[2].
On 25 May 2022, ESMA published the answers received from the EC on the questions raised, the key points of which are developed below.
II. Key takeaways
The ESAs submitted nine questions, with the aim of helping the market preparing for the formal application of the Level 2 requirements. The EC quickly provided the ESAs with answers, to provide guidance to the investment funds managers who want to anticipate the implementation of the RTS regarding (i) the PAIs consideration, (ii) the application of SFDR to financial advisors, (iii) the application of SFDR to closed-ended funds, (iv) the good governance criteria and (v) the taxonomy-related disclosures.
1) Question on PAI
The first question relates to the consideration of principal adverse impacts on sustainability factors (the so-called “PAI”) at product level, when the PAIs are not considered at the level of the investment fund managers subject to SFDR (“IFMs”).
In its answer, the EC clarifies that IFMs which are not considering PAIs at entity level may, notwithstanding the criteria of Article 7(1), still manufacture financial products for which PAIs are considered. The EC further specifies that there is a need to distinguish the information to be disclosed on the website of the entity in accordance with Article 4(1), which should only cover the entity level, and the information in the pre-contractual documents and periodic reports of the product.
This answer seems to enlarge the possibility for IFMs to manufacture financial products falling into the scope of “sustainability preference” of investors under Directive 2014/65/EC (“MiFID II”), as the consideration of PAI is one of the three alternative criteria to meet the definition of “sustainability preference” within the meaning of MiFID II. As of 2 August 2022, MiFID investment firms, would indeed have to comply with additional obligations in relation to the integration of sustainability factors and the “sustainability preference” of their clients into their operational and advice activities, and the clarification brought by the EC is therefore well received.
In addition, this flexibility around PAI consideration given to IFM is mostly welcomed within the Luxembourg market, as a large proportion of fund promoters engage with an external AIFM to manage their products, which may or may not consider PAI at the level of the entity.
2) Questions related to Financial Advisors
Where the provisions on financial advisers were previously rather minimal in the different publications from the ESAs and the European Commission, today the ESAs are requesting clarification on their activity under SFDR by dedicating four questions to financial advisors.
The questions namely relate to (i) the provision of investment advice under MiFID II and the disclosures obligation under Art 6(2) SFDR, (ii) the scope of application of SFDR to some financial advisors, (iii) the level at which the PAIs must be considered and (iv) the exempted insurance intermediaries covered by Article 17 SFDR.
By answering the questions related to financial advisors, the EC clarifies the scope of application of SFDR to financial advisors, with regards to the products they advise on.
According to the EC, the SFDR provisions are applicable, unless otherwise specified in the text, to all investment firms and credit institution providing investment advice, as defined by Article 4(1) point 4 of MiFID II, without being limited to investment advice given about financial products defined in Art 2(12) SFDR. It would therefore include investment advice given about all financial instruments within the meaning of MiFID II. However, it is to noteworthy that the disclosure obligation under Art 4(5) a SFDR, related to the consideration of PAIs depending on the size, nature and scale of their activities and the types of financial products they advise on, is only applicable with regards to financial products as defined under Art 2(12) SFDR, as the text refers explicitly to these financial products.
3) Questions related to products no longer made available
When SFDR Level 1 entered into force, the question was asked by IFMs whether they were expected to comply with the SFDR requirements at the level of their products which were no longer made available on 10 March 2021.
While most of the market players agreed that the disclosures related to these funds did not have to updated, today the ESAs are seeking clarity on (i) the application of Article 6 and 7 with regards to these products and (ii) the update and delivery of their pre-contractual, website and periodic disclosures under Articles 6, 7, 10 and 11 SFDR to existing investors.
While the EC indirectly confirms that the pre-contractual documents for closed-ended funds no longer open to market do not have to be updated in line with SFDR, the same is not applicable for periodic reports and website disclosures which must be drawn-up in accordance with the requirements laid down in Articles 10 and 11 SFDR, for the relevant products.
IFMs managing financial products no longer made available to investors must therefore prepare the periodic reports and update the relevant website disclosures on time for the application of Level 2 requirements with respect to products referred to in Article 8 and 9 SFDR.
4) Questions on good governance
The ESAs asked clarification on the application of good governance practice criteria with respect to the underlying investments of Article 8 products.
The EC confirms that, to the extent that the funds in scope of Article 8 SFDR pursue investments in companies, such investee companies must follow good governance practices. This is also applicable to sustainable investments made by Article 9 funds, as good governance practices are one of the criteria of a “sustainable investment” within the meaning of Article 2(17) SFDR. Failure to comply with good governance practice criteria will trigger a breach of Article 8 or Article 9 SFDR.
However, the EC notices that good governance practices are only relevant where the investments are made in companies. Therefore, Article 8 or Article 9 products investing only in government bonds or in the real estate sector do not need to comply with this requirement.
5) Question related to the Taxonomy disclosures
The ESAs are requesting clarification on the application of the Taxonomy-related disclosures[3], to (i) Article 8 products which are not investing in “sustainable investments” under Article 2(17) SFDR and (ii) Article 9 products which only commit to invest in economic activities contributing to social objectives.
By definition, those two types of products are indeed not investing in economic activities which would be eligible to align with EU Taxonomy.
Disclosures should be made only for which they have reliable data, otherwise they risk the infringement of SFDR and Taxonomy.
When fails to collect the data, the proportion should indicate zero.
The use of narrative explaining the zero alignment in relation to the reliable data related to the lack of data available risk contradicting the purpose of Article 5 and 6 of the Taxonomy Regulation and must therefore be avoided.
Applicable to all Article 8 funds.
Report must indicate the proportion of the taxonomy-alignment regardless the commitment in the pre-contractual document. The changes in the investments should be reflected in the pre-contractual document.
Art 9 funds with a social objective are in the scope if investment in economic activities contributing to an environmental objective.
- Zero-alignment and reliable data onlyThe EC confirms that the Taxonomy-related disclosures must only be made in accordance with the available reliable data to avoid breaching the provisions of SFDR and Taxonomy Regulation. When IFMs fail to collect reliable data, or when the intention is not to have investments aligned with EU Taxonomy, the proportion of such investment must indicate zero (0%). In addition, the EC underlines that any narrative explanation regarding the zero-alignment related to the lack of data available risks contradicting the purpose of Article 5 and 6 of the Taxonomy Regulation and must therefore be avoided.This position may challenge the current position adopted by national authorities, notably the Central Bank of Ireland, for which no minimum proportion (including 0%) had to be included in the pre-contractual documents if there was no intention to align with EU Taxonomy.
- Scope of application of Art 5 and Art 6 Taxonomy RegulationIn its answer, the EC begins by reminding that under the current regulatory framework, it is not required for funds framed within Article 8 SFDR and Article 9 SFDR, to invest in economic activities qualifying as environmentally sustainable under EU Taxonomy.In that context, all Article 8 funds are subject to the obligation to disclose the alignment of underlying investments with EU Taxonomy, pursuant to Article 6, including Article 8 funds which do not invest in sustainable investments. The latter will have to disclose a zero-alignment with EU Taxonomy.Regarding Article 9 funds with a social objective, the EC confirms that they are expected to disclose their alignment with EU Taxonomy to the extent that they invest in sustainable investments with environmental objective(s).
- Periodic reportsThe EC addresses the question on the Taxonomy-alignment in the financial reports, even for funds which did not commit to any alignment with EU Taxonomy. The EC confirms that, if the proportion and types of investments change over time, pre-contractual disclosures must be updated to reflect the accurate asset allocation with the relevant proportion of sustainable investments and Taxonomy-aligned investments.
III. Conclusion
As the date of application of Level 2 requirements approaches, the investment fund managers IFMs are facing several difficulties related to the interpretation of some SFDR provisions and the questions sent by the ESAs would address most of them. Answers from the European Commission in a timely manner would be are appreciated by investment fund managers IFMs who intend to tackle the implementation of Level 2 SFDR in due course.
[1] https://www.esma.europa.eu/sites/default/files/library/sfdr_ec_qa_1313978.pdf
[2] https://www.esma.europa.eu/sites/default/files/library/jc_2022_26_union_law_interpretation_questions_forwarded_to_the_commission.pdf
[3] As contained in the Taxonomy Regulation https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex:32020R0852
