The Sustainable Finance Disclosure Regulation (SFDR)

The SFDR is part of a package of measures introduced to implement the EU action plan on sustainable finance^(*) which aims to push more capital towards sustainable activities.

The SFDR introduces various mandatory disclosure-related requirements for financial market participants and financial advisors at entity, service and product level in relation to the firm’s approach to ESG matters, covering “Sustainability Risks”, defined as any environmental, social or governance events or conditions, including but not limited to climate change, which could cause a material negative impact on the value of an investment; “Principal Adverse Impacts”, defined as any negative effects that investment decisions or advice could have on sustainability factors; and additional requirements for products that promote ESG characteristics or that have sustainable investment objectives.

The aim of the new regulation is to provide transparency on sustainability within the financial markets in a standardized way in order to reduce greenwashing and facilitate comparability, thus supporting increased sustainable investment. However, SFDR disclosures will not remove the risk of greenwashing nor replace appropriate due diligence by investors seeking sustainable/impact investments. The requirement to classify financial products into one of three categories - those which pursue sustainability objectives (Article 9), those which promote environmental or social characteristics (Article 8), and those which do neither - is raising concerns that such classifications may draw investors away from products which are not within Article 8 or 9. As a result, managers could be incentivized to categorize all funds which do not invest in ESG-focused businesses under Article 9 as falling within Article 8 even if not actually managed against ESG criteria.

The SFDR applies to all financial market participants and financial advisers based in the EU and also applies to investment managers or advisers based outside of the EU who wish to market their products in the EU under the Alternative Investment Fund Managers Directive (AIFMD).

As a result of Brexit, the UK is out of the scope of the SFDR. At this point, there is no indication that SFDR will be applied in the UK.

The bulk of the SFDR’s operative provisions came into force on 10 March 2021. However, further detailed requirements are still being finalized and certain disclosure requirements do not kick in until January 2022 and January 2023.

As there is currently no convergence globally, or even within the EU itself, across disclosure and reporting standards relating to non-financial metrics such as ESG and sustainability, SFDR compliance by financial services organizations will be necessary but not sufficient to satisfy all ESG-linked requirements in all jurisdictions. Global organizations operating within the EU should ensure their compliance with SFDR in addition to other sustainability reporting requirements applicable to their business with respect to operations both in the EU and elsewhere.

^(*) See https://ec.europa.eu/info/publications/sustainable-finance-renewed-strategy_en

Proposed Directive on Corporate Due Diligence and Corporate Accountability throughout the Supply Chain

On 10 March 2021, the European Parliament voted in favor of recommendations and a draft directive to implement mandatory human rights, environmental and good governance due diligence. The proposals respond to a perceived lack of progress achieved to date by voluntary initiatives in these areas.

The directive would apply to large organizations, all publicly listed small and medium undertakings and high-risk small and medium sized undertakings. The scope also extends to non-EU undertakings in high risk sectors which sell goods or provide services into the EU. Non-EU entities within the value chain of organizations within the scope of the proposed directive are also likely to be impacted.

The proposed directive requires in-scope organizations to take all proportionate and commensurate measures and efforts to prevent adverse impacts on human rights, the environment and good governance from arising within their value chains and to properly address any such adverse impacts when they occur. In-scope organizations would be required to maintain and publish a due diligence strategy, including risk-based monitoring and value chain due diligence, and carry out stakeholder engagement and operate stakeholder grievance mechanisms, unless the organization concludes that it does not cause any adverse impact on the environment, human rights or good governance. Any organization claiming no such adverse impacts would be required to publish (and keep up-to-date) a statement to that effect and the risk assessment that led to this conclusion.

Affected entities would be required to, among other actions, (i) undertake value chain due diligence on a scale proportionate to the risk of potential or actual adverse impacts, (ii) ensure that business counterparties implement environmental, human rights and good governance policies that are in line with such entity’s due diligence strategy, and (iii) regularly verify that suppliers and subcontractors comply with their obligations.

In order to create clarity and certainty, the European Union Agency for Fundamental Human Rights, the European Environment Agency and the Executive Agency for Small and Medium-sized enterprises will assist the EU Commission in the development of general guidelines providing practical guidance on the application of proportionality and prioritization in terms of the impact, sector and geographical areas and having regard to the sector and size of the undertaking. Sector specific guidelines may also be published.

Proposed sanctions for failure to comply with the directive include fines based on an undertaking’s “turnover” (which term has yet to be defined) and exclusion from public procurement and state aid. Undertakings may also face civil liability in respect of harm arising out of adverse impacts on the environment, human rights or good governance caused by them or undertakings under their control. In order to be discharged from any such liability, undertakings would be required to prove that they had taken all due care in line with the directive to avoid the harm in question, or that the harm would have occurred even if all due care had been taken.

If implemented, the proposals will have a far-reaching impact on in-scope businesses and their supply chain, wherever the elements of the supply chain may be situated, and will require organizations to conduct thorough reviews of their business processes and relationships on an ongoing basis.

The EU Commission is now expected to publish its legislative proposal (which may diverge from that proposed by Parliament) by June 2021. This will start the formal legislative process. Member States would have two years to transpose the Directive into national law, once it comes into force.