ESG – ESMA Supervisory Briefing sets out guidance on the SFDR

Between them, the EU’s SFDR and Taxonomy Regulation set out a range of disclosure obligations on financial market participants, financial advisers and financial products with additional disclosure requirements where financial products make sustainable investments with environmental objectives.

In addition, the Level 2 measures under the AIFMD and UCITS Directive were amended to integrate sustainability risks and factors by the relevant fund managers. (For more on this, see here.)

On 31 May 2022, ESMA published a Supervisory Briefing, “Sustainability risks and disclosures in the area of investment management” (the Briefing). While primarily aimed at NCA’s, the Briefing’s content will be of interest to investment managers and their funds.

(While the Briefing is also applicable to UCITS ManCos, the focus of this note is on its key messages as far as AIFMs are concerned.)

Why has ESMA published the Briefing?

The purpose of the Briefing is to promote common supervisory approaches and practices across EU Member States in order to minimise the risk of different levels of investor protection depending on where the relevant fund is domiciled or marketed on a cross-border basis.

ESMA’s expectation is that having a common approach will help increase transparency for investors as well as avoid the practice of “greenwashing”.

ESMA, though, makes clear that the content of the Briefing

• is not subject to any ‘comply or explain’ mechanism for NCAs
• is non-binding
• is not exhaustive
• does not constitute new policy and
• may be updated to reflect regulatory developments or supervisory experiences.

Why should I read the Briefing?

The Briefing provides a useful summary of ESMA’s views on compliance with the various obligations under the SFDR and Taxonomy Regulation - while not binding in itself, as various aspects of the SFDR RTS have proved tricky to interpret definitively, any guidance at this stage is welcome.

The Briefing

• contains suggested supervisory approaches for NCAs to take, especially in identifying greenwashing and areas of over-disclosure
• sets out ESMA’s commentary on permitted use of ESG-terminology in fund names
• suggests verification checklists for NCAs to use to assess AIFMs’ compliance with their disclosure requirements
• suggests that NCAs should review fund portfolios to check they align with disclosed investment strategy
• reminds NCAs of their duty to take enforcement action as relevant for breaches of the rules and sets out a non-exhaustive list of areas (see section C, Regulatory interventions in case of breaches, below) where this might be especially pertinent.

In short, managers would be well advised to review the Briefing and take note of its contents.

What does the Briefing cover?

A. Guidance for the supervision of fund documentation and marketing material

1. Fund documentation and marketing material

Information provided to investors to evaluate proposed funds must be accurate, fair, clear, not misleading, simple and concise.

An important aspect of this information is the proportion of the non-financial characteristics (such as environmental and social characteristics). With respect to Article 8 funds, for example, Recital 11 of the proposed SFDR RTS (the SFDR RTS) notes that disclosure of criteria for the selection of underlying assets should be limited to those criteria that are binding on the fund manager in the investment decision-making process.

Recital 16 of the SFDR RTS warns against greenwashing risks where funds apply “non-binding” exclusion strategies.

2. Verifying compliance with pre-contractual disclosures

For Article 8 and Article 9 funds which are AIFs, precontractual information which must be disclosed should be included in an annex to the information required to be disclosed to investors under Article 23 of AIFMD (‘Article 23 AIFMD information’) and should follow the templates at Annexes II and III of the SFDR RTS.

ESMA suggests NCAs create a checklist of information to be provided to help assess compliance by funds. NCAs should verify, among other things, that:

• a prominent statement referring to the sustainability information to be found in an annex has been included in the main body of the Article 23 AIFMD information
• a description is included of how sustainability risks are integrated in the investment decisions and the results of the assessment of the impact of these risks on the returns of the fund
• the environmental and/or social characteristics promoted by funds disclosing under Article 8 of the SFDR and the sustainable investment objectives pursued by funds disclosing under Article 9 of the SFDR are clearly stated and adequately explained in the annex referred to in the first bullet point above
• where relevant, the Principal Adverse Impact (PAI) indicators from Table 1 of Annex I of the SFDR RTS have been considered for the purpose of the PAI disclosures under Article 7 of the SFDR. (Even though it is not mandatory, ESMA considers that NCAs can expect Article 9 funds to disclose the PAI of investment decisions referred to in Article 7 of the SFDR.)
• the taxonomy alignment disclosures have been included for funds making disclosures under Articles 5 or 6 of the Taxonomy Regulation.

3. Verifying the consistency of information in fund documentation and marketing material

When assessing whether sustainability-related disclosures made are consistent across the fund documentation and the marketing material, ESMA recommends that NCAs first review that the information in each document is accurate and then review the content for consistency with the sustainability-related disclosures in the fund documentation.

When assessing consistency, NCAs should address the following:

Presentation of disclosures

Information must be disclosed in an accessible way that is clear, succinct, fair and not misleading, meaning that, among other things:

• boilerplate language and technical jargon that might not be understood by the average investor should be avoided
• cross-references and hyperlinks should be limited to the ones set out in the Sections “Where can the methodology used for the calculation of the designated index be found?” and “Where can I find more product specific information online?” in Annexes II and III of the SFDR RTS
• links to other information should go to the exact place where the relevant information may be found and hyperlinks should be maintained over time.

Principles-based guidance on fund names

The Briefing states that funds’ names should not be misleading - ESG-related terms such as “ESG”, “green” or “sustainable” should be used only when materially supported by evidence of sustainability characteristics that are reflected in the fund’s investment objectives, policy and strategy.

The Briefing sets out general principles which NCAs should consider when assessing funds’ names and offers a number of examples of acceptable and non-acceptable fund names.

Sustainable investment policy and objectives

The fund documentation should contain a sustainable investment policy and/or objectives and the fund should be managed according to this.

Sustainable objectives or characteristics should be clearly identified and avoid expressions such as “the fund pursues ESG objectives in general”.

Investment strategy

Again, this should be clearly identified in the relevant fund documentation and should clearly state how the strategy is linked to the formulated sustainable objectives or characteristics and how it helps to achieves this.

The Briefing contains a non-exhaustive list of some of the key elements which should be disclosed.

4. Verifying compliance with website disclosure obligations

Managers should

• clearly identify the financial product to which the information in the sustainability-related disclosure section (see Article 23 of the SFDR RTS) relates and
• display the fund’s environmental or social characteristics or its sustainable investment objective prominently.

The Briefing then sets out a number of items which NCAs should verify in relation to the manager’s compliance.

5. Verifying compliance with periodic disclosure obligations

Article 11 SFDR refers to the periodic disclosure obligations and Article 50 and 58 of the SFDR RTS refer to the presentation and content requirements for periodic reports for financial products as per article 8(1) and 9(1)-(3) SFDR.

Information to be provided under Article 11 of the SFDR (the periodic disclosure obligation) and Articles 50 and 58 of the SFDR RTS (the presentation and content requirements for periodic reports for Article 8 and Article 9 financial products) should be included in an annex to the AIF’s annual report in line with the templates set out in Annex IV and V of the SFDR RTS.

The Briefing suggests that NCAs could create checklists of the information to be provided in periodic reports in order to help them assess whether funds disclosing under Article 8 or Article 9 of the SFDR (and Article 5 or 6 of the Taxonomy Regulation) are complying with their obligations.

As a minimum, NCAs should ensure that the main body of the annual report contains a prominent statement referring to the information to be found in the annex and that the periodic report has been properly completed in full.

Additional supervisory actions

NCAs should be prepared to make use of any further available information (such as media reports or whistle-blower notifications as well as adverse findings reported by internal control functions, external auditors or depositaries) in their ongoing supervision. Adverse findings could lead to further supervisory investigations, including on-site visits.

NCAs should further ensure that AIFMs provide all relevant information and data to the appointed depositary so it is able to perform its relevant depositary functions effectively.

Portfolio analysis

Given that responsibility for portfolio analysis lies primarily with the AIFM, the Briefing recommends that NCAs

• should consider “different types of supervisory actions to ensure that portfolio holdings reflect the name, the investment objective, the strategy and the characteristic displayed in the documentation to investors” and
• might complement the portfolio analysis by involving the funds’ depositaries and/or assessing the reporting from management companies, AIFMs, external auditors and internal control functions.

B. Integration of sustainability risks by AIFMs and UCITS managers

From 1 August 2022, all authorised fund managers are required to integrate sustainability risks in their portfolio and risk management processes and overall governance structure, even where the fund manager does not offer sustainable funds.

The Briefing notes that “many smaller and mid-sized fund managers (especially those that do not provide sustainable funds) may struggle to comply with these new rules”.

As it result, it states that NCAs should verify AIFMs’ compliance with the new requirements by

• checking the description how sustainability risks are integrated in the AIFM’s investment decisions in precontractual fund disclosures under Article 6 of the SFDR and
• ensuring that the AIFM reviews relevant internal policies and procedures on a periodic basis.

To verify compliance with disclosure of sustainability risk integration on websites (under Article 3 of the SFDR), NCAs are encouraged to perform sample checks based on surveys and questionnaires relating to the integration of sustainability risks.

Such supervisory controls should involve risk-based desk-based and/or on-site reviews of how the relevant policies and procedures are being implemented and applied by the AIFM in areas such as (but not limited to) investment due diligence; risk management; remuneration; conflicts of interest and monitoring of delegation.

C. Regulatory interventions in case of breaches

The Briefing reminds NCAs of their obligation to take appropriate enforcement action where the requirements under the SFDR have been breached.

It notes that “administrative measures, including enforcement, may be appropriate to consider in the following (non-exhaustive) examples of cases, in order to combat greenwashing”

• where SFDR disclosures have not been made following the application of the new rules;
• where disclosures are severely misleading - particularly where there is a significant discrepancy between what the fund actually invests in and what has been disclosed to investors in pre-contractual disclosure documentation
• where sustainability risks have not been integrated throughout the organisation
• where an Article 9 product’s periodic disclosure fails to match (or fulfil) the characteristics or objectives shown in the fund documentation and
• where the periodic disclosures of an Article 9 product with a sustainable investment objective show that significant proportions of investments do not comply with the sustainable investment criteria set out at Article 2(17) of the SFDR.

The Briefing makes clear that, at the end of the day, NCAs remain fully responsible for determining

• the appropriate course of action to take in order to mitigate the supervisory risks and regulatory breaches which they identify and
• what administrative measures to adopt after further investigation.