Amid a rise of environmental, social, and governance (ESG) investing and initiatives, the European Union and United Kingdom have set their sights on efforts to combat greenwashing in the financial sector. Regulations implemented for this purpose—from the EU’s 2021 Sustainable Finance Disclosure Regulation (SFDR) governing disclosures made by Article 6, 8, and 9 financial products to the upcoming UK Financial Conduct Authority (FCA) Anti-Greenwashing Rule and Sustainability Disclosure Requirements and Labelling Regime—come with responsibilities for fund managers.

Below we delve into the regulations and ways in which fund managers can navigate the complex, multijurisdictional regulatory framework that shapes ESG investing in Europe.

EU DISCLOSURES

The EU’s SFDR is seen as a key element in the EU’s plan to engage the private sector in efforts to meet various government-backed climate targets. The regulation seeks to combat greenwashing through mandating transparency provisions and increasing the comparability of disclosures for investors. Under the regulation, managers and financial advisors must disclose how they integrate sustainability risk and principal adverse impacts in their processes.

The regulation comes with three categories of obligations: (1) rules that impose manager-level obligations, (2) rules that impose obligations that apply to all funds whether or not they have a sustainability focus, and (3) rules that set obligations applicable only to funds which promote a specific environmental or social characteristic or have sustainable investment or a reduction in carbon emissions as their objective. An EU-based manager will be subject to all of these obligations. Non–EU-based managers that market a fund into an EU country, and cannot rely on reverse solicitation in doing so, are also in scope.

A fund that promotes an environmental or social characteristic is considered an Article 8 fund. To be considered an Article 9 fund, it must have a sustainable investment objective. Funds that do not promote an environmental or social characteristic or do not have a sustainable investment objective are considered Article 6.

Fund managers should be aware of the EU’s Corporate Sustainability Reporting Directive (CSRD). Beginning in 2025, large private EU companies will be required to include sustainability information in their annual reporting in accordance with the detailed European Sustainability Reporting Standards developed by the European Financial Reporting Advisory Group. The CSRD requires “assurance” of the information and a “double materiality” assessment, requiring companies to report on sustainability matters if a topic is material either from a financial and/or impact perspective.

While multinational companies will not be subject to the new EU reporting requirements until 2025 and global reporting until 2028, non-EU companies with a subsidiary or branch in the EU should begin preparing for the CSRD now by conducting an analysis to determine whether and, if so, when they will be subject to the CSRD reporting requirements and preparing for a double materiality assessment.

Fund managers should identify any of their portfolio companies in scope of the CSRD, given the coming expansion of its application.

UK FOCUS

The new anti-greenwashing rule from the FCA takes effect May 31, 2024 and applies to all firms regulated by the FCA. The rule targets communications in the United Kingdom about the financial products or services that refer to environmental and/or social characteristics of those products or services. The FCA recently consulted on guidance setting out their expectations for any FCA-regulated firm that makes claims about the sustainability of a product or service.

In brief, sustainability references should be correct and capable of being substantiated; clear and presented in a way that can be understood; complete—they should not omit or hide important information and should consider the full lifecycle of the product or service; and fair and meaningful in relation to any comparisons to other products or services.

The FCA’s new Investment Label and Sustainability Disclosure Requirements (UK SDR) can be seen as the UK’s answer to the EU’s SFDR. The regime will have a phased-in approach starting July 31, 2024, through December 2, 2026. At this stage the requirements will have a fairly limited scope, applying only to managers of private funds and managers of UK-authorized retail funds and to their distributors. The FCA has confirmed the UK SDR will not apply to non-UK funds or their non-UK managers for now.

The regime consists of labels, mainly to protect retail investors. There are four labels: (1) sustainability focus; (2) sustainability improvers, which is for transitioning from not sustainable currently toward sustainable later; (3) sustainability impact; and (4) sustainability mixed goals, which is a blend of all the three labels.

Managers can choose whether to use a label for products seeking to achieve positive sustainability outcomes, provided that they meet both general and label-specific qualifying criteria. For example, under the general criteria, at least 70% of the value of any type of labeled fund’s assets must be invested in accordance with its sustainability objective, with reference to a robust evidence-based standard, and key performance indicators to measure progress against the sustainability objective must be identified.

Disclosure requirements include one aimed at fund managers with at least £5 billion assets under management to produce annual disclosures about how they are managing sustainability risks and opportunities in a so-called “sustainability entity report.”

ENFORCEMENT AND LITIGATION

In terms of enforcement, each EU member state’s relevant financial services regulator is responsible for regulation/enforcement of matters concerning funds within their jurisdiction, including breaches of the relevant EU ESG regulations where such breaches are found to have occurred.

In the United Kingdom, FCA enforcement action against funds for greenwashing is still in its infancy. However, with the anti-greenwashing rule soon to take effect and applying to FCA-authorized firms, there may be more greenwashing investigations, followed by regulatory enforcement.

Currently, private litigation in the EU/UK against funds for greenwashing is not common. Where claims have been brought for greenwashing, these tend to be made against corporates, not funds, and many such actions have been initiated by climate-based activist organizations.

Future stakeholders that may seek to bring a claim against a fund might include the following:

• Investors, if they are concerned that their fund managers are not investing in line with their ESG investment strategy or where they become aware that misstatements have been made in prospectus and offering materials
• Other stakeholders may seek to bring an action against a fund if they become aware that a fund is not investing in line with its investment strategy or has overstated its “green” credentials. However, given the confidential nature of private funds’ offering and prospectus materials, this may prove challenging to access unless such material was leaked externally or otherwise made available inadvertently.

KEY TAKEAWAYS

• When considering the fund category, be it Article 6, 8, or 9, drill down to learn the parameters and requirements of each, whether it is possible to meet those requirements, what benefit such a classification can bring a fund, and what the market appetite is for a particular classification.
• Understand regulatory regimes in the EU and UK and work with trusted counsel to ensure that compliance is handled appropriately.
• To mitigate the risk of greenwashing allegations, ensure that statements can be justified and there is evidence that supports claims. Review statements on a regular basis to ensure information is up to date.

LEARN MORE

To learn more about the ESG and sustainability regulatory landscape around the globe, please check out Morgan Lewis’s ESG Investments: Global Regulatory Series.

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