Earlier this week, the European Commission issued a decision, annexed to which was a Q&A document which provides answers to questions raised by the ESAs on the interpretation of certain provisions of Regulation (EU) 2019/2088 (SFDR) in a letter dated 7 January 2021 (Commission Q&A). This follows its confirmation earlier this month that delegated acts prepared under the SFDR will now not apply until 1 July 2022.

While the Commission Q&A provides welcome clarity on certain provisions of the SFDR, some responses have raised additional questions for financial market participants. In this client briefing, we outline some of the key takeaways for financial market participants from the Commission Q&A.

1. Scope of Article 8 of the SFDR

Perhaps the biggest challenge faced by fund management companies, as financial market participants, in the lead up to the SFDR Level 1 compliance deadline of 10 March 2021 was the need, in the absence of clear parameters being set down in the legislation itself or in guidance provided by the European Commission, to classify funds as:

• “Article 6” funds (being those funds which do not fall within the scope of Article 8 or Article 9 of the SFDR, also referred to as “non-ESG funds”);
• “Article 8” funds (being those funds which fall within the scope of Article 8 of the SFDR); and
• “Article 9 funds” (being those funds which fall within the scope of Article 9 of the SFDR)

In the Commission Q&A published this week, the European Commission provided the following clarity on the scope of Article 8 of the SFDR.

1.1 Integration of sustainability risk into the investment decision-making process

The European Commission has confirmed that the integration of sustainability risk into the investment decision-making processes of a fund will not, in and of itself, render that fund an Article 8 fund.

Extract from Commission Q&A: “Integration per se of sustainability risks, as defined by point 22 of Article 2 of Regulation (EU) 2019/2088, is not sufficient for Article 8 to apply”

1.2 Consideration of principal adverse impacts of investment decision-making on sustainability factors

The European Commission has indicated in its response that a fund may use its consideration of principal adverse impacts of investment decision-making on sustainability factors as a means of promoting environmental or social characteristics.

Consistent with the approach taken by the ESAs in preparing draft Level 2 measures published in February 2021, the European Commission makes clear that an Article 8 fund is not required to consider principal adverse impacts on sustainability factors in order to classify itself as an Article 8 fund.

It is also worth noting that the wording of the Commission Q&A suggests that the consideration of principal adverse impacts on sustainability factors will not automatically render a fund an Article 8 fund.

Extract from Commission Q&A: “Financial products that fall under Article 8 may pursue reduction of negative externalities caused by the underlying investments, such as principal adverse impacts on sustainability factors referred to in point (a) of Article 7(1) of Regulation (EU) 2019/2088”

1.3 No specific minimum sustainability criteria or minimum investment thresholds must be met by a fund in order to be classified as an Article 8 fund

The Commission Q&A confirms that the SFDR does not prescribe any minimum investment thresholds, eligible investment targets or criteria relating to composition of investments which must be observed by a fund in order to be categorised as an Article 8 fund. Helpfully, the European Commission confirms that the SFDR is agnostic as to the type of investment tools or strategies which are used by a portfolio manager in managing the assets of a fund which is categorised as an Article 8 fund, listing screening, exclusion strategies, best-in-class/universe, thematic investing and certain redistribution of profits and fees as current market practices, tools and strategies being used by Article 8 funds.

While the Commission Q&A provides comfort to market participants for the moment, it is worth noting that in its recently published renewed strategy for sustainable finance, the European Commission stated that it intended to consider “minimum sustainability criteria for financial products that promote environmental or social characteristics”. Therefore we may see a change in this position in the future.

Extract from Commission Q&A: “Article 8 of Regulation (EU) 2019/2088 remains neutral in terms of design of financial products. It does not prescribe certain elements such as the composition of investments or minimum investment thresholds, the eligible investment targets, and neither does it determine eligible investing styles, investment tools, strategies or methodologies to be employed. Therefore, nothing prevents financial products subject to Article 8 of Regulation (EU) 2019/2088 not to continue applying various current market practises, tools and strategies and a combination thereof such as screening, exclusion strategies, best-in-class/universe, thematic investing, certain redistribution of profits or fees. Certainly, many of those market practises, tools and strategies are also available to financial products subject to Article 9 of Regulation (EU) 2019/2088, provided the investments qualify as ‘sustainable investments’, as defined in point 17 of Article 2 of Regulation (EU) 2019/2088”.

1.4 Using terms such as “sustainable”, “sustainability” or “ESG” in the name of a fund may amount to the “promotion” of environmental or social characteristics within the meaning of Article 8 of the SFDR

Article 8 of the SFDR applies to any financial product which “promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics [….]”

The Commission Q&A suggests in its explanation of the term “promotion” that the choice of name of a fund could bring it within the scope of Article 8 of the SFDR (and its related disclosure obligations) to the extent that such name claims or gives “an impression” that investments pursued by the fund consider environmental or social characteristics in terms of its investment policies, goals, targets or objectives.

Extract from Commission Q&A: “Article 8 means that where a financial product complies with certain environmental, social or sustainability requirements or restrictions laid down by law, including international conventions, or voluntary codes, and these characteristics are “promoted” in the investment policy the financial product is subject to Article 8 of Regulation (EU) 2019/2088. The term ‘promotion’ within the meaning of Article 8 of Regulation (EU) 2019/2088 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 in, but not limited to, 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, use of product names or designations, memoranda or issuing documents, factsheets, specifications about conditions for automatic enrolment or compliance with sectoral exclusions or statutory requirements regardless of the form used, such as on paper, durable media, by means of websites, or electronic data rooms”.

1.5 Compliance with requirements set down by law, including international conventions, or voluntary codes

In its letter to the European Commission in January 2021, the ESAs asked whether complying with a “legal obligation, which applies to the financial market participant, such as a ban on investment in cluster munitions, also bring the product into the scope of Article 8 of Regulation (EU) 2019/2088”.

Although not entirely clear, the European Commission suggests in its response that in order for a fund which complies with certain environment, social or sustainability requirements or restrictions which are laid down by law or in voluntary codes to be brought within the scope of Article 8 of the SFDR (and its related disclosure obligations), the fund must also “promote” such characteristics in its fund documentation¹.

The response provided by the European Commission suggests that to the extent that a fund complies with restrictions laid down by law or voluntary code, this may not, in and of itself, amount to “promotion” of environmental or social characteristics and trigger the application of Article 8 of the SFDR.

However, the Commission Q&A seems to suggest that to the extent that the relevant fund complies with environmental, social or sustainability requirements or restrictions laid down by law or voluntary code and the fund documentation claims or gives the impression that investments pursued by the fund consider environmental or social characteristics in terms of investment policies, goals, targets or objectives, such a fund does fall within the scope of Article 8 of the SFDR and consequently must comply with its enhanced disclosure obligations.

The relevant provision of the Commission Q&A is set out under Section 1.4 above.

1.6 Application of sectoral exclusions which are not promoted or advertised by the fund

The Commission Q&A suggests that to the extent that a fund applies a sectoral exclusion (such as tobacco), this could trigger the application of Article 8 of the SFDR (and its related disclosure obligations) to the extent that environmental or social characteristics are also “promoted” by the fund in its fund documentation.

The wording used by the European Commission indicates that in order for a fund which complies with sectoral exclusions to fall within the scope of Article 8 of the SFDR, the fund documentation should report, claim or give an impression that the investments pursued by the fund also consider environmental or social characteristics in terms of investment policies, goals, targets or objectives.

The relevant provision of the Commission Q&A addressing this scenario is set out in the section above entitled “Using terms such as “sustainable”, “sustainability” or “ESG” in the name of a fund may amount to the “promotion” of environmental or social characteristics within the meaning of Article 8 of the SFDR”.

It is worth remembering that in each case, in order to comply with its obligations under Article 8 of the SFDR, an Article 8 fund must ensure that “the companies in which the investments are made follow good governance practices”². Furthermore, the Commission Q&A also confirms that only those criteria relating to environmental and/or social characteristics which are binding on the investment decision-making process of the relevant fund are permitted to be referenced in the pre-contractual disclosures.

2. Clarifications relevant to Article 9 funds

2.1 Ability of Article 9 funds to invest in investments which do not constitute “sustainable investments”

The Commission Q&A also provides some clarity on the extent to which an Article 9 fund can invest in investments which do not constitute “sustainable investments” within the meaning of Article 2(17) of the SFDR.

Although the European Commission has stopped short of imposing investment restrictions on the extent to which an Article 9 fund can invest in investments other than “sustainable investments”, the Q&A makes clear (consistent with the approach taken by the ESAs in their draft Level 2 measures) that to the extent that an Article 9 fund invests in investments other than “sustainable investments”, such investments should only be used for “specific purposes such as hedging or liquidity”.

Furthermore, the European Commission indicates that any such investments should meet minimum environmental or social safeguards so that they are in line with the sustainable investment objective.

Extract from Commission Q&A: “A financial product, in order to meet requirements in accordance with prudential, product-related sector specific rules may next to ‘sustainable investments’, also include investments for certain specific purposes such as hedging or liquidity which, in order to fit the overall financial product’s sustainable investments’ objective, have to meet minimum environmental or social safeguards, i.e. investments or techniques for specific purposes must be in line with the sustainable investment objective. Since Article 9 of Regulation (EU) 2019/2088 remains neutral in terms of the product design, or investing styles, investment tools, strategies or methodologies to be employed or other elements, the product documentation must include information how the given mix complies with the ‘sustainable investment’ objective of the financial product in order to comply with the “no significant harm principle” of Article 2(17) of Regulation (EU) 2019/2088.”

2.2 Article 9 funds which pursue an objective of a reduction in carbon emissions

The European Commission also provides a response to the question raised by the ESAs as to whether it is necessary for a fund to track an EU Climate Transition Benchmark or EU Paris-aligned Benchmark (where such a benchmark exists) in order to be able to categorise a fund as an “Article 9(3)” product.

The response provided by the European Commission in the Commission Q&A is unfortunately not entirely EU Paris-aligned Benchmark does exist, “a financial product must be tracking these”.

This suggests that any passively managed fund which pursues an objective of a reduction in carbon emissions must track an EU Climate Transition Benchmark or an EU Paris-aligned Benchmark in order to be categorised as an “Article 9(3)” product once such benchmarks are available.

However, the response provided by the European Commission raises a question as to whether it is possible for an actively managed fund which pursues an objective of reduction in carbon emissions to categorise itself as an “Article 9(3)” product. Further clarity on this from the European Commission would be welcomed.

Separately the Commission Q&A confirms that benchmark administrators of EU Climate Transition Benchmark or an EU Paris-aligned Benchmark must ensure that the constituents included in any such benchmarks must themselves constitute “sustainable investments” within the meaning of Article 2(17) of the SFDR.

Extract from Commission Q&A: “The first subparagraph of Article 9(3) of Regulation (EU) 2019/2088 lays down that the objective of ‘a reduction in carbon emissions’ includes the objective of low carbon emission exposure in view of achieving the long‐term global warming objectives of the Paris Agreement. The second subparagraph takes into consideration two situations, namely where an EU Climate Transition Benchmark or EU Paris‐aligned Benchmark does not exist and where an EU Climate Transition Benchmark or EU Paris‐aligned Benchmark exists: where an EU Climate Transition Benchmark or EU Paris‐aligned Benchmark does not exist, the pre-contractual information must include a detailed explanation of 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; where an EU Climate Transition Benchmark or EU Paris‐aligned Benchmark exists, a financial product must be tracking these. It follows from Article 9(3) of Regulation (EU) 2019/2088 that the implementation of minimum standards, as laid down in Commission Delegated Regulation (EU) 2020/1818,4 by benchmark administrators, for the construction of EU Climate Transition Benchmarks and EU Paris-aligned Benchmarks, must ensure compliance with point 17 of Article 2 of Regulation (EU) 2019/2088. The two EU Climate Benchmarks include as minimum standard the reduction of carbon emissions from one year to the other and the reduction of GHG intensity compared to a parent benchmark. The respective requirements of Regulation (EU) 2016/1011 must, therefore, be applied in conjunction with Regulation (EU) 2019/2088, in particular point 17 of Article 2”.

3. Application of SFDR to non-EU AIFMs

The responses to the questions posed by the ESA relating to the application of SFDR to non-EU AIFMs seem to (mistakenly) appear in the response to questions relating to the application of the SFDR to registered AIFMs.

Leaving this aside, the European Commission has confirmed in the Commission Q&A that where a non-EU AIFM markets the shares of an AIF within the EEA under the national private placement regime applicable in the relevant jurisdiction, the AIFM must “ensure compliance” with the SFDR, “including the financial product related provisions”.

While many in the industry had, in the lead up to 10 March 2021, taken the view that a non-EU AIFM marketing an AIF in the EEA would need to comply with the disclosure obligations under the SFDR applicable to financial products, the fact that the European Commission’s response appears to apply entity-level disclosure obligations set down in the SFDR to such non-EU AIFM may come as a surprise to some market participants.

The response provided in the Commission Q&A will mean that to the extent that a non-EU AIFM has not already done so, it should now take appropriate action to ensure compliance with all obligations imposed on AIFMs under the SFDR. In addition to the disclosure obligations relating to each AIF being marketed in the EEA, the Commission Q&A seems to indicate that this will also involve the non-EU AIFM updating its website to provide information on the manner in which sustainability risks are integrated into its investment decision-making process and to clarify its approach to principal adverse impact reporting under Article 4 of the SFDR. This will require the non-EU AIFM to consider whether it comes within the mandatory principal adverse impact reporting regime due to the number of its employees.

Extract from Commission Q&A : “It follows from points (1) and (4) of Article 2 Regulation 2019/2088 that for the purposes of the Regulation a ‘financial market participant’ comprises an ‘alternative investment fund manager’, as defined in point (b) of Article 4(1) of Directive 2011/61/EU1, including those which have their registered office in a Member State (EU AIFMs) and those which have their registered office in a third country (non-EU AIFMs). Directive 2011/61/EU lays down the conditions under which a non-EU AIFM, i.e. an AIFM from a third country, may carry out its activities within the Union. Given the absence of the activation of the AIFM third country passport under Article 67(4) and (6) of that Directive, access to end investors in individual Member States may be on the basis of national laws set out in National Private Placement Regimes. Where an AIFM from a third country enters the market of a given Member State by means of a National Private Placement Regime, that AIFM must ensure compliance with Regulation 2019/2088, including the financial product related provisions”.

4. Application of SFDR to registered AIFMs

In an unsurprising move, the European Commission has confirmed that registered (or “sub-threshold”) AIFMs must comply with both “entity and financial product related requirements” of the SFDR, noting that the prospectus and annual reports of their AIFs should contain the information required to be disclosed in such documentation under the SFDR.

Relevant extract from Commission Q&A: “The reference in point (4) of Article 2 of Regulation 2019/2088 to point (b) of Article 4(1) of Directive 2011/61/EU means that ‘financial market participant’ also comprises AIFMs subject to registration referred to in point (a) of Article 3(3) of Directive 2011/61/EU. Article 17 of Regulation 2019/2088 on exemptions from that Regulation and any other provision in that Regulation, lay down neither exemptions nor derogations from obligations under that Regulation for AIFMs subject to registration referred to in point (a) of Article 3(3) of Directive 2011/61/EU. In consequence, entity and financial product related requirements of Regulation 2019/1088 apply to such AIFMs. Since disclosures to investors referred to in Article 23(1) of Directive 2011/61/EU and annual reports referred to in Article 22 of Directive 2011/61/EU, as referred to in point (a) of Articles 6(3) and point (a) of Article 11(2) of Regulation 2019/2088 respectively do not apply to AIFMs subject to registration referred to in point (a) of Article 3(3) of Directive 2011/61/EU, such 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. Managers of qualifying venture capital funds and qualifying social entrepreneurship funds registered in accordance with Article 14 of Regulation (EU) No 345/2013 or Article 15 of Regulation (EU) No 346/2013 must include the relevant information in documents referred to in points (d) and (e) of Articles 6(3) and points (d) and (e) of Article 11(2) of Regulation 2019/2088 respectively”.

5. Principal Adverse Impact Reporting

The European Commission has confirmed the following which will be of relevance to financial market participants when calculating the “employee” criteria which must be used in order to determine whether or not they fall within the scope of the mandatory PAI reporting regime set down under Article 4 of the SFDR:

• Financial market participants are not required to take into account those employed by parent companies when calculating the number of employees within their organisation; and

• Financial market participants who are themselves a parent undertaking of a large group (within the meaning of Article 3(7) of Directive 2013/34/EU) must take into account not only those employed by that financial market participant but also those employees of any subsidiary undertakings regardless of where those subsidiary undertakings are located (e.g. within the EU or outside of the EU). This clarification may bring certain financial market participants within the fold of the mandatory PAI reporting regime who, to date, did not include employees of subsidiary undertakings when calculating their employee numbers. The European Commission does confirm however that the due diligence statement to be published by any such financial market participants should only cover the activities of the parent undertaking and not the group as a whole.

Relevant extract from Commission Q&A: The 500-employee criterion, as laid down in Article 4(3) of Regulation 2019/2088, relates to a financial market participant. The 500-employee criterion as laid down in Article 4(4) of Regulation 2019/2088 relates to the large group, as referred to in Article 3(7) of Directive 2013/34/EU2, 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. Article 4(4) of Regulation 2019/2088 sets out obligations on financial market participants that are parent undertakings which in that capacity, set the group wide policies, including due diligence policies. Therefore, such financial market participants publish and maintain the requested information, adapted to the specific situation of the parent undertaking and not to the group as a whole. The criterion of a group is just relevant for the headcount that triggers the reporting obligations by a financial market participant. Subsidiary undertakings might still qualify as financial market participants subject to Article 4(3) or might be financial market participants that consider principal adverse impacts of investment decisions on sustainability factors as described in point (a) of Article 4(1) of Regulation 2019/2088.

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

The European Commission notes in the Commission Q&A that the SDFR disclosure obligations apply at the level of the portfolio rather than at the level of standardised portfolio solutions. However it does confirm that the website disclosure obligations set down under Article 10 of the SFDR must comply with applicable data protection law and, where relevant, ensure client confidentiality. This suggests that the information disclosed on websites can take a standardised form in order to protect client confidentiality , thus avoiding the need to disclose on the website terms negotiated with individual clients. The European Commission has not clarified whether, in such a scenario, tailored disclosures satisfying the requirements of Article 10 of the SFDR would then need to be provided to individual clients.

Conclusion

Financial market participants should now consider the contents of the Commission Q&A to assess any potential implications for their business and funds under management. Please contact your usual contact in Dillon Eustace for further assistance in this regard.

1 Reference to “fund documentation” should be read in light of the very broad definition of “promotion” provided by the European Commission in its Q&A.

2 Article 8(1) of the SFDR