A brief recap - ESAs' letter to the EU Commission January 2021
On 7 January 2021 – less than eight weeks before the Sustainable Finance Disclosure Regulation (SFDR)1 ‘go live’ date – the Chair of the Joint Committee of the European Supervisory Authorities (ESAs)2 wrote to the EU Commission highlighting that the ESAs have encountered several important areas of uncertainty in the interpretation of SFDR and that there are “certain priority questions pertaining to the SFDR that would benefit from a more urgent clarification to facilitate an orderly application of SFDR from 10 March 2021.”3
The questions raised by the ESAs encompassed many of the questions that market participants were grappling with as they tried to prepare for 10 March 2021.
The ESAs raised questions in the following areas, and which are covered in detail in our OnPoint “Preparing for SFDR”
- Does the provision of SFDR apply to non-EU AIFMs and registered AIFMs?
- How should you apply the 500-employee threshold for principal adverse impact reporting at entity level to parent undertakings of a large group?
- What is the meaning of “promotion” in the context of products ‘promoting’ environmental or social characteristics?
- How should you apply Article 9 of SFDR?
- How should you apply SFDR product rules to MIFID portfolios and other tailored products?
On 26 July 2021, the EU Commission published its long-awaited Q&A4 which attempts to respond to the ESAs’ specific questions. Unfortunately, rather than providing the desired clarity, in many areas, the EU Commission merely repeats the ESAs’ questions or cites sections of SFDR Level 1 text, without adding substantive detail on important matters pertaining to the interpretation of SFDR.
That is not to say that the Q&A is without merit, and in this Newsflash, we highlight some key areas of the Q&A that are of particular relevance to asset managers.
More Qs than As?
Application of SFDR to non-EU AIFMs and sub-threshold AIFMs
SFDR applies to financial market participants (FMPs) and financial advisers, which are defined to include AIFMs. An ‘AIFM’ is further defined by reference to Article 4(1)(b) of AIFMD,5 meaning that SFDR applies to AIFMs in general by virtue of the reference to Article 4(1)(b).
The ESAs ask:
i) whether the provisions of SFDR apply to non-EU AIFMs, for example when they market a sustainable EU Alternative Investment Fund under a National Private Placement Regime (NPPR)?
ii) whether, notwithstanding the general application of SFDR to AIFMs, the SFDR apply to ‘sub-threshold’ AIFMs referred to in Article 3(2) of AIFMD?
The EC’s response to the first question confirms that the SFDR does apply to third country AIFMs that are marketing in the EU by way of the NPPR. What is less clear is whether the third country AIFM needs to comply with both the financial product level requirements (for example the provisions of Articles 6, 8, 10 and 11 of SFDR) and the entity level requirements of SFDR (for example, Articles 3 and 5 of SFDR).
The Q&A says that AIFMs “must ensure compliance with [SFDR], including the financial product related provisions” leaving FMPs in no doubt that the financial product level requirements apply but the statement is not definitive on the application of the entity level requirements. The words “including the financial product related provisions” could be read to infer that other obligations (such as entity level obligations) might also apply.
However, we believe the stronger argument is that the firm level obligations will not apply to AIFMs availing themselves of the NPPR. A point to keep in mind however is that the requirements of the NPPR vary between jurisdictions, and it may be the case that individual National Competent Authorities could make it a requirement in their jurisdiction that the entity level requirements of SFDR are also to apply to third country AIFMs using the NPPR.
In response to the second question raised in relation to ‘sub-threshold’ AIFMs, the Q&A is clear in that it states, in relation to “AIFMs subject to registration referred to in point (a) of Article 3(3) of Directive 2011/61/EU”, that “entity and financial product related requirements of [SFDR] apply to such AIFMs”. On a practical level there is a question as to where a sub-threshold AIFM should make the relevant disclosures. The SFDR requires that information disclosed by AFIMs should be made “in the disclosures to investors referred to in Article 23(1) of AIFMD”, however, sub-threshold AIFMs are not in scope of Article 23 of AIFMD. The Q&A does give some guidance as it says that sub-threshold AIFMs “should apply those provisions by analogy, i.e. information is to be included in pre-contractual and periodic documentation made available to end investors under national law”.
Application of the 500-employee threshold for principal adverse impact reporting at entity level to parent undertakings of a large group
Since 30 June 2021, Article 4(4) of SFDR has required FMPs “which are parent undertakings of a large group as referred to in Article 3(7) of the Directive 2013/34/EU6 exceeding on the balance sheet date of the group, on a consolidated basis, the criterion of the average number of 500 employees during the financial year shall publish and maintain on their websites a statement on their due diligence policies with respect to the principal adverse impacts of investment decisions on sustainability factors.”
The ESAs have asked:
i) Must the calculation of the 500-employee threshold to the parent undertaking of a large group be applied to both EU and non-EU entities of the group without distinction as to the place of establishment of the group and/or subsidiary?
ii) Does the due diligence statement include impacts of the parent undertaking only, or must it include the impacts of the group at a consolidated level?
The EC’s response is that “[T]he 500-employee criterion, as laid down in Article 4(3) of Regulation 2019/2088, relates to a financial market participant.” Going on to say that as laid down in Article 4(4) of SFDR relates to “the large group, as referred to in Article 3(7) of Directive 2013/34/EU, in its entirety; the calculation of the headcount takes into account the number of employees of a parent undertaking and of subsidiary undertakings regardless whether they are established inside or outside the Union…Subsidiary undertakings might still qualify as financial market participants subject to Article 4(3) of [SFDR]”.
This response clearly links the headcount to having the status of an FMP. Consequently, to the extent that the parent undertaking is not an FMP within the meaning of SFDR, the EC’s response indicates that there is no need to look at the headcount of the parent undertaking. Rather the headcount would be focused on the employees of the subsidiary undertaking that is the FMP. The EC’s response also makes clear that it is the FMP that is subject to the disclosure obligations – not the entire group.
Meaning of “promotion” in the context of financial products promoting environmental or social characteristics
Article 8 of SFDR applies: “Where a financial product promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics.”
The ESAs note that an orderly application of SFDR would be helped if examples of different scenarios that are within, and outside, the scope of Article 8 of SFDR were provided.
The EC’s response to this question confirms that financial products that fall under Article 8 may, in part, be invested in ‘sustainable investments’ as defined in Article 2(17) of SFDR and that integration per se of sustainability risks, as defined by Article 2(22) of SFDR is not sufficient for Article 8 to apply.
The EC’s Q&A response provides some indication as to what is meant by “promotion”. The Q&A states that promotion “encompasses, 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….” which are disclosed in a long list of mediums, such as “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….regardless of the form used, such as on paper, durable media, by means of websites, or electronic data rooms”.
Whilst this wide definition focusing on the holding out of the product as a green product may be greeted well by FMPs wishing to create Article 8 financial products, FMPs need to keep in mind that while the bar may be relatively low in terms of when a product might be seen to be holding itself out as an Article 8 financial product, the financial product then still needs to comply with the full set of obligations under SFDR and also the regulatory technical standards (RTS) that are associated with Article 8 financial products. As a practical example, labelling a fund ‘sustainable’ or “applying various current market practices, tools and strategies and a combination thereof such as screening, exclusion strategies” may be sufficient to bring the financial product in scope of Article 8, but the FMP would also need to meet the associated obligations under SFDR and the RTS.
Application of SFDR product rules to MiFID portfolios and other tailored products
SFDR applies to FMPs that are ‘an investment firm which provides portfolio management,’7 which is further defined by reference to MiFID.8 SFDR also applies to financial advisers that are ‘an investment firm which provides investment advice.’9 One of the questions that the ESAs asked was if the disclosure requirements of SFDR apply at the portfolio level, how is it possible to maintain confidentiality obligations to the client of an individual portfolio in view of the disclosures required, especially the website disclosures required by Article 10 of SFDR?
The Q&A provides that “[T]ransparency of the promotion of environmental or social characteristics and of sustainable investments on websites in accordance with Article 10 of [SFDR] must ensure compliance with Union and national law governing the data protection, and where relevant, also ensure confidentiality owed to clients.” This would seem to imply that confidentiality and data protection requirements under EU and national laws owed to the individual client may prevail over the requirement to disclose information pursuant to Article 10 of SFDR on a public part of the FMP’s website. Depending on the jurisdiction of the FMP and the applicable statutory level of protection, this may well require the portfolio manager mandate to include strong language as to confidentiality owed to clients.
The responses provided by the EU Commission in their Q&A have not provided the ESAs nor FMPs with the much-needed guidance that they were seeking and many of the questions raised remain unanswered or answered in such a way as to be open to interpretation. They do, however, provided further insight into the rationale and overall direction of the SFDR. It remains to be seen how FMPs and NCA’s interpret the EU Commission’s answers.
We discuss the issues raised in relation to the ESAs’ initial questions and much more in our webinar “EU ESG Regulatory Developments: SFDR Phase 2”, which can be accessed here.
1) Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector (SFDR), as amended by Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment (Taxonomy Regulation).
2) European Supervisory Authorities being ESMA, EBA and EIOPA.
3) To access the letter from the ESAs, please click here.
4) To access the EC’s Q&A, please click here.
5) Directive 2011/61/EU (the Alternative Investment Fund Managers Directive (AIFMD).
6) Directive 2013/34/EU of the European Parliament and of the Council of 26 June 2013 on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings, amending Directive 2006/43/EC of the European Parliament and of the Council and repealing Council Directives 78/660/EEC and 83/349/EEC.
7) Article 2(1)(b) of SFDR.
8) point (1) of Article 4(1) of Directive 2014/65/EU.
9) Article 2(11)(d) of SFDR.