SFDR – the ESAs look to the Commission for urgent clarification

The Joint Committee of the European Supervisory Authorities (the body responsible for preparing the draft Level 2 measures under SFDR and submitting them to the European Commission for consideration) has written to the Commission seeking ‘urgent clarification’ on a number of key issues where the Level 1 text of the SFDR is somewhat ambiguous.

The questions cover:

• how far SFDR applies to non-EU AIFMs and to sub-threshold (or registered) AIFMs

• how SFDR applies the 500-employee threshold for principal adverse impact (PAI) reporting on parent undertakings of a large group

• the meaning of "promotion" in the context of products promoting environmental or social characteristics

• the application of Article 9 of SFDR and

• the application of SFDR product rules to portfolios and dedicated funds.

What's the background to this?

The letter (published by ESMA on 14 January but dated 7 January 2021) flags up difficulties that the ESAs have encountered in several important areas because of uncertainty as to how SFDR should be interpreted.

It also notes that the ESAs are currently finalising the draft regulatory technical standards (RTS), which will form the Level 2 measures under SFDR. These, of course, were originally due to have come into effect on 10 March 2021 but, late last year, the Commission accepted that they would have to be delayed - to a date not yet specified.  It is thought that an updated draft of the RTS is likely to be published by the end of January 2021 and is rumoured to come into force at the start of January 2022.

Don't forget that in-scope firms will still be expected to comply with the high level, principles-based provisions in Level 1 of SFDR, which will still apply from 10 March 2021. For more information, see our Insights note here.

For additional information on the SFDR, including the Level 2 measures, please see our ESG client notes here.

For more information on the EU's ESG Action Plan initiative in general, please see our Sustainable Financing and ESG investment resource here.

What does the letter say?

The letter identifies a number of 'priority questions' where the ESAs feel they need a more urgent clarification from the Commission to facilitate an orderly application of SFDR from 10 March 2021.

The questions themselves - which we look at in more detail below - will already be familiar to many in the asset management industry. Indeed, several are included in AIMA's Q&As document, available to members on the AIMA website - Simmons & Simmons has been an active member of the AIMA working group which produced the Q&As.

While there's no doubt a steer from the Commission will help remove much of the uncertainty, there's always the danger with such things that the steer might not always be in the direction that everyone is hoping for!

What are the questions?

1. Application of SFDR to non-EU AIFMs and registered AIFMs

SFDR applies to 'financial market participants' (FMPs).

These include AIFMs as defined in Article 4(1)(b) of AIFMD.

The Article 4(1)(b) definition, though, is broad and includes all AIFMs (EU or non-EU, above threshold as well as below). As a result, the starting point must be that SFDR applies to all AIFMs. However, this leaves the questions

Does SFDR apply to

• Sub-threshold (or 'registered') AIFMs referred to in Article 3(2) of AIFMD and

• Non-EU AIFMs - for example when they market "a sustainable EU AIF" (or, indeed, any other EU or non-EU AIF) in the EU under a National Private Placement Regime (NPPR)?

The Simmons & Simmons view:

We have consistently taken the view that non-EU AIFMs should assume that they will be within scope of SFDR, in respect of each AIF (EU or non-EU) which is actively marketed in the EU under AIFMD NPPRs (regardless of whether the AIF is "sustainable" or not).  We are currently working with many non-EU AIFMs to update AIFMD pre-investment disclosures for such funds.  We expect that the Commission is likely to confirm that such non-EU AIFMs are in-scope and the global funds industry should continue to prepare on that basis.

2. Application of the 500-employee threshold for PAI reporting at entity level to parent undertakings of a large group

Article 4(4) SFDR requires FMPs to publish and maintain on their websites a statement on their due diligence policies with respect to the PAI of investment decisions on sustainability factors from 30 June 2021 where the FMP is a parent undertaking of a large group [ ... ]

"exceeding on the balance sheet dateof the group, on a consolidated basis, the criterion of the average number of 500 employees during the financial year".

The ESAs are querying the following:

• When calculating the 500-employee threshold, must this 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?

• Does the due diligence statement include (a) only impacts of the parent undertaking or (b) those of the group at a consolidated level?

The Simmons & Simmons view:

We have noted, since the publication of SFDR, that the 500 employees test in Article 4 had the potential to be subject to "clarifications" from European regulators.  The current consensus view in the industry is that Articles 4(3) and 4(4) should be straightforwardly interpreted in line with their clear drafting, which limits the 500 employee test either to the EU FMP itself on a standalone basis, or to a large consolidation (sub-) group of which the EU FMP is the parent undertaking.  There is no legislative basis in SFDR for taking a more expansive reading.  We would encourage the Commission to apply a formal legal reading to this provision, and not take a purposive or policy-driven approach to bring other group structures into scope of SFDR.  If policy changes are required to the firms caught by Article 4 on a mandatory basis, this should be achieved via changes to the legislation.

3. Meaning of "promotion" in the context of products promoting environmental or social characteristics

Article 8 of SFDR aims to increase pre-contractual transparency where products (Article 8 products) promote "environmental or social characteristics" and applies where a financial product "promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics".

The ESAs' letter seeks both

(a) general clarification on "the level of ambition of the characteristics" through examples of different scenarios that are within, and outside, the scope of Article 8 and

(b) specific answers to the following questions:

• Can a product's name (which might include words like "sustainable", "sustainability", or "ESG") be considered to be promoting an environmental or social characteristic or to be having sustainable investment as its objective?

• While an Article 8 product does not need explicitly to promote itself as targeting sustainable investments, would a reference to taking into account a sustainability factor or sustainability risk in the investment decision be sufficient for Article 8 to apply? If so, how can FMPs which disclose mandatory information under Article 6(1) or Article 7(1) of SFDR ensure that this is not automatically considered as "promoting environmental or social characteristics"?

• Does an Article 8 product have to invest a minimum share of its investments to attain its designated environmental or social characteristic for it to be considered to be promoting environmental or social characteristics?

• In the absence of active advertising of a product's environmental or social characteristic, would an intrinsic characteristic of the product (such as a sectoral exclusion, e.g. tobacco, which is not advertised) also qualify as "promotion"?

• Would compliance a national legal obligation, which applies to the FMP (such as a ban on investment in cluster munitions) also bring the product into the scope of Article 8?

The Simmons & Simmons view:

We have shared the ESAs' frustrations at a lack of clear guidance on products in-scope of article 8, and we would welcome formal clarification on its scope.  In the absence of a formal definition, we have advised the asset management industry to rely on the recitals to the Draft RTS, in which the ESAs provided their own commentary on products in-scope.  We would encourage the Commission to use the recitals to the Draft RTS as a starting point when providing guidance.

4. The application of Article 9 of SFDR

Article 9(1) and (2) of SFDR apply "where a financial product has sustainable investment as its objective".

Where a financial product's objective is a reduction in carbon emissions, Article 9(3) requires information to be disclosed which includes the objective of low carbon emission exposure in view of achieving the long-term global warming objectives of the Paris Agreement.

However, where no EU Climate Transition Benchmark (EU CTB) or EU Paris-aligned Benchmark (EU PAB) is available, the information must include a detailed explanation as to how the continued effort of attaining the objective of reducing carbon emissions is ensured in view of achieving the long-term global warming objectives of the Paris Agreement.

The letter poses the questions:

• Must an Article 9 product only invest in sustainable investments as defined in Article 2(17) of SFDR?

• If not, is a minimum share of sustainable investments required (or a maximum limit to the share of "other" investments)?

• Where an EU CTB or EU PAB exists, must a product track it on a passive basis for Article 9(3) of SFDR to apply to it?

• If the answers to the above questions are 'yes', and if the minimum standards of an EU PAB or an EU CTB do not require the index components to be sustainable investments, can the product fall within the scope of Article 9(3) of SFDR?

The Simmons & Simmons view:

As with the previous question, we would welcome formal clarification on its scope of Article 9.  Again, in the absence of a formal definition, we have advised our clients to rely on the recitals to the Draft RTS, in which the ESAs provided their own commentary on products in-scope.  We would encourage the Commission to use the recitals to the Draft RTS as a starting point when providing guidance.

5. Application of SFDR product rules to MIFID portfolios and other tailored products

Where a MiFID investment firm provides portfolio management, SFDR will apply to it as an FMP. Where a MiFID investment firm provides investment advice, SFDR will apply to it as a financial adviser.

The ESAs are seeking clarity from the Commission on the following points:

• For portfolios, or other types of tailored financial products managed in accordance with mandates given by clients on a discretionary client-by-client basis, do the disclosure requirements in SFDR apply

• At the level of the portfolio only or

• At the level of standardised portfolio solutions?

• If the SFDR disclosure requirements apply at the portfolio level, how can confidentiality obligations to the client be maintained in view of the disclosures required, especially the website disclosures required by Article 10 of SFDR?

The Simmons & Simmons view:

We have heard many clients express serious concerns about confidentiality in respect of Article 10 website disclosures for managed accounts.  We would encourage the Commission to formally confirm that there is no requirement to provide client-specific information on a public website, such that Article 10 does not apply to bespoke portfolios.

Last word

Two points are clear as a result of the letter.

First, if the Commission responds on these points, much of the debate that has been going on among in scope firms as to the interpretation of SFDR requirements should be resolved one way or another.

Second, there isn't much time left before 10 March! Even if the Commission responds swiftly to the ESAs' letter - and one can imagine that its contents won't come as a surprise to the Commission - there still won't be much time for firms to assess the views given and make adjustments, where necessary to their policies and procedures.

We will be keeping a close eye on developments and will report back as soon as there is a significant change - in the meantime, if you wish to speak to one of our ESG team on this or any other issue, please contact us.