‘Dear AFM chair’ – the FCA gets tough on UK funds’ ESG-related claims

On 19 July 2021 the FCA published a letter to the Chairs of authorised fund managers (AFMs), having received, in its words, a number of "poorly drafted" applications for authorised funds, which have fallen below its expectations.

In response, the FCA has clarified its expectations and set out new guiding principles as to how its existing rules and other regulatory requirements (in particular, those relating to product disclosure) should be applied in the context of authorised funds which pursue a responsible or sustainable investment strategy and claim to pursue ESG/sustainability characteristics, themes or outcomes.

In some respects, the letter can be seen as the FCA effectively creating a UK domestic version of Article 8 / 9 SFDR (although it’s not expressed in that way in the letter).

What next?

The FCA has made it clear that it expects improvements in the quality of investor-facing documentation relating to funds with a sustainability and ESG focus. The FCA appears to be particularly concerned that potential "greenwashing", as well as a lack of clear and sufficient disclosure for funds making ESG related claims, may lead to poor investor outcomes and distrust in the sector.

Since the FCA's letter relates to existing regulatory requirements applicable to AFMs, AFMs should be immediately applying the FCA's expectations -- there is no lead-in time. Whilst the FCA's commentary focusses on the applications it has received for new funds and changes to existing funds (e.g. where ESG/sustainability related language has been introduced into investment policies), AFMs should also be considering whether improvements should be made to their existing funds documentation and marketing materials in order to meet the expectations that have now been clarified in detail.

What funds and products are affected?

The guiding principles contained in the annex to the FCA's letter set out the FCA's detailed expectations. The guiding principles are relevant where each of the following apply:

• the AFM is operating an FCA authorised fund,

• the fund pursues a responsible or sustainable investment strategy, and

• claims are made in relation to ESG/sustainability characteristics, themes or outcomes.

The FCA clarifies that the principles are targeted at funds which make specific ESG-related claims and not those that integrate ESG considerations into mainstream investment processes. As such, the FCA appears only to be concerned with those funds that include ESG/sustainability related language in fund offering documentation and marketing communications.

It is clear from the letter that the FCA has not decided to implement rule changes at this stage (although please also see our commentary below under the heading 'How does this link to existing ESG and other disclosure regimes?') and is, instead, seeking to rely on clarifying the application of existing FCA rules and regulatory requirements. In this regard, the FCA's view is that there are already clear requirements on firms that they should be meeting in respect of the funds they provide, although the FCA acknowledges that some firms might find it helpful to have more clarity on how these requirements apply in the context of ESG investments. 

Whilst some AFMs may find the additional clarity helpful, we anticipate that a number of AFMs may see the guiding principles as, in effect, imposing additional obligations on them with respect to their operation of UK authorised funds -- a number of which will be particularly onerous to discharge.

A wider concern for other product providers is whether the FCA may expect the guiding principles to be applied in relation to other products or services, given the FCA's reference in the letter to the clear, fair and not misleading communication requirement and, in the context of the specific fund rules referenced, the potential for a read across to equivalent rules for other products/services. In our view, other UK manufacturers of financial products (including in particular UK AIFMs) should look very carefully at the principles in the letter, and consider to what extent they could reasonably be applied to the marketing of other products and funds which fall outside the UK authorised fund regime. 

What's covered by the guiding principles? 

There are three principles, each of which is to be applied alongside an overarching principle of consistency -- that a fund's ESG/sustainability focus should be reflected consistently in its design, delivery and disclosure (i.e. in its name, stated objectives, fund documentation, strategy and holdings). 

We summarise each of these principles and the key considerations identified by the FCA below:

Principle 1: The design of responsible or sustainable investment funds and disclosure of key design elements in fund documentation

References to ESG (or related terms) in a fund’s name, financial promotions or fund documentation should fairly reflect the materiality of ESG/sustainability considerations to the objectives and/or investment policy and strategy of the fund.

• The use of ESG-related language in a fund name should not be misleading. It is the FCA's view that the use of such terms may be misleading unless the fund pursues ESG/sustainability characteristics, themes or outcomes in a way that is substantive and material to the fund's objectives, investment policy and strategy. Based on the illustrative examples provided, there are a number of indications that the FCA does not consider limited exclusions to be sufficient to justify the use of ESG/sustainability related terms in a fund's name.

• Where funds are designed to deliver a measurable non-financial impact alongside their financial objective (e.g. for "impact" funds), the firm should clearly state the intended "real-world" outcome and be able to measure and monitor it in practice. There are a number of indications that the FCA is looking more specifically at "real-world" outcomes in its approach to ESG. By "real world", we understand the FCA to mean a sustainability-related outcome, rather than an economic or monetary outcome for the fund. For example, we think this means that a climate change impact fund, which will invest in renewable energy infrastructure, must be able to demonstrate a specific contribution to investment in renewable energy.

• Where a fund claims to pursue ESG/sustainability characteristics, themes or outcomes, these should be appropriately reflected in the fund's objectives and/or policy. 

• In addition, the FCA has also clarified that the prospectus of the fund should include key elements of the fund's strategy that relate to the ESG/sustainability characteristics pursued. This is an interesting development as authorised fund prospectuses often fall short of including strategy specific information, on the basis that this is not explicitly required by the key prospectus disclosure requirements (see, in particular, COLL 4.2.5R[1]). In support of this expectation, the FCA invokes the general rule requiring an AFM to disclose information about a fund in its prospectus which investors would reasonably require for the purpose of making an informed judgement about investing in the fund (see COLL 4.2.5R (27)(a) and COLL 8.3.4R (19)).

• Strategy level information should assist investors in comparing funds. This should include an explanation of how ESG/sustainability related considerations feature in asset selection -- e.g. through (i) negative screens, (ii) positive screens, or (iii) impact investing.

• For AFMs which rely exclusively/largely on ESG data provided by third-parties (e.g. to determine which securities qualify to be included in an index the fund is tracking or to make ESG related judgements), then this should be disclosed in the prospectus.

• Where stewardship forms part of a fund's responsible or sustainable investment strategy, the AFM should develop a policy identifying how stewardship contributes to relevant characteristics, themes or outcomes the fund seeks to pursue or achieve.

Principle 2: The delivery of ESG investment funds and ongoing monitoring of holdings

The resources (including skills, experience, technology, research, data and analytical tools) that a firm applies in pursuit of a fund’s stated ESG objectives should be appropriate. The way that a fund’s ESG investment strategy is implemented, and the profile of its holdings, should be consistent with its disclosed objectives on an ongoing basis.

• AFMs are expected to maintain effective resources to ensure a fund’s aims are reasonably capable of being achieved. This includes resources to oversee the use of research, data and analytical tools. The FCA also indicates that an AFM should due diligence any such sources relied upon to ensure that it is confident that it can validate the claims it makes In this respect, it appears that the FCA would challenge AFMs which, in practice, rely on the veracity of third party data without further enquiry.

• AFMs should take into account whether a reasonable investor would consider a fund’s holdings reflect any ESG/sustainability characteristics, themes or outcomes that have been disclosed or claims that have been made. Where this is not the case, an AFM should consider explaining any apparent inconsistencies to end investors.

Principle 3: Pre-contractual and ongoing periodic disclosures on responsible or sustainable investment funds should be easily available to consumers and contain information that helps them make investment decisions.

ESG/sustainability-related information in a KIID/KID should be easily available and clear, succinct and comprehensible, avoiding the use of jargon and technical terms when everyday words can be used instead. Funds should disclose information to enable investors to make an informed judgement about the merits of investing in a fund. Periodic fund disclosures should include evaluation against stated ESG/sustainability characteristics, themes or outcomes, as well as evidence taken in pursuit of the fund’s stated aims.

• Information on a fund’s ESG/sustainability focus should be made available in fund documentation (e.g. marketing materials) accompanying regulatory documents (e.g. the prospectus and KIIDs/KIDs).

• Firms should take appropriate steps to ensure disclosures are presented in such a way that can readily be interpreted by consumers – again, the focus is expected to be on “real-world” impacts.

• The FCA also expects ongoing performance reporting to be undertaken where a fund applies quantifiable targets or pursues non-financial outcomes. In the former case, the reporting should include relevant key performance indicators, as well supporting information to assist investors in interpreting the information. In the latter case, the FCA expects performance against the relevant outcomes to be reported (as far as reasonably feasible) in a measurable and quantifiable way using relevant standards/frameworks and methodologies, whilst acknowledging that for less measurable non-financial aims the focus should be on evidencing the actions taken in pursuit of the relevant aims.

How does this link to existing ESG and other disclosure regimes?

The FCA’s letter and the guiding principles link to a number of related FCA initiatives/regimes, as well as EU ESG regimes. These links include:

EU SFDR

As noted by the FCA in its letter, there are links between the guiding principles and the EU's Sustainable Finance Disclosure Regulation (SFDR), the main aspects of which have applied since March of this year. 

The FCA acknowledges that, whilst the SFDR was not on-shored in the UK, some firms may be complying with the SFDR in respect of their cross-border business. For this reason, the FCA's intention is for its guiding principles to be "complementary" to the SFDR requirements. 

There are clearly a number of parallels which can be drawn between the FCA's guiding principles and SFDR including, as regards the specification of investment objectives, how objectives are expected to have a key impact on a fund's strategies, as well as the nature and extent of the pre-contractual disclosures and periodic reporting required to be provided.

A number of AFMs may take the view that the FCA is seeking, through its guidance, to establish a disclosure and reporting regime equivalent to that applicable for SFDR in-scope funds categorised as Article 8 (funds promoting environmental or social characteristics) or Article 9 (funds with the objective of sustainable investments) products. In some respects, the proposals may be viewed as an attempt to surpass the SFDR requirements, taking into account the FCA's apparent focus on "real-world" outcomes, criticism of limited ESG exclusions and challenging holdings (i.e. those which might appear inconsistent with a fund's stated objectives, policy or strategy). 

Whether this proves to be the case may, however, depend on how rigorously the FCA seeks to enforce its expectations in the authorised fund applications it receives from AFMs going forwards, as well as how closely the guiding principles are adopted by the market in practice (given their status as guidance, rather than explicit rules).

FCA proposals for climate-related disclosures by asset managers

On 22 June the FCA published its consultation paper, CP21/17, on climate-related disclosures by asset managers (including AFMs), life insurers, and FCA-regulated pension providers. Please see our briefing note for asset managers.

In CP21/17 the FCA sets out its proposals to implement a new climate-related disclosure regime for managers, based on the recommendations published by the Task Force on Climate-related Financial Disclosures (TCFD).

Whilst the proposals only apply to climate risk (and therefore the "E" of ESG), parallels can be broadly drawn in terms of, in particular, the product specific reporting information which it is proposed firms will be required to provide.

The FCA's Asset Management Market Study

The FCA's Asset Management Market Study (including the guidance issued by the FCA on fund objectives) did not specifically cover ESG/sustainability focussed funds, the outcomes that the FCA was seeking as part of that initiative are similar in many respects to those outlined in the guiding principles. This latest articulation of the FCA's expectations can therefore be viewed as a continuation of the regulator's focus on improving the quality of fund objectives and related information. Please see our article relating to PS19/4, issued in relation to the Asset Management Market Study.

In both cases the FCA's expectation is for AFMs to provide investors with clearer information which enables them to understand what a fund does, how it seeks to achieve its objectives and to enable them to compare funds and assess their performance (including against non-financial objectives). 

FCA value assessments

The FCA also mentions the separate value assessment requirements applicable to AFMs in the context of the guiding principles, taking into account its discussions with firms following a recent review of value assessment reports. Please see our recent article on this topic.

The FCA makes it clear that where firms are providing an ESG service as part of a fund's offering, it expects them to be able to explain how they have considered the quality of this service in the context of their fees.

[1] Although note that pre-contractual disclosure requirements for AIFs (i.e. excluding UK UCITS) set out in FUND 3.2.2 include a disclosure item relating to the ‘investment strategy and objectives’ of the AIF. See also COLL 8.3.4R in relation to qualified investor schemes.