Legal Updates

Key Points to Note:

The Guidance issued addresses:

• The scope of disclosure obligations under the Taxonomy Regulation and good governance requirements under the SFDR
• How NCAs should supervise compliance with the SFDR and upcoming changes to UCITS and AIFMD frameworks
• PAI disclosures, consideration of DNSH and pre-contractual and periodic reporting disclosures

Introduction

Over the past three weeks, the European Commission, the European Supervisory Authorities (ESAs) and ESMA have issued much awaited guidance on key components of the SFDR¹ and upcoming changes to the UCITS and AIFMD framework.

In the case of the European Commission, this took the form of a Q&A document published on 25 May 2022 in which it responded to queries raised by the ESAs in November 2021 (Q&A).

ESMA has also published a supervisory briefing on sustainability risks and disclosures in the area of investment management (Supervisory Briefing). While the Supervisory Briefing is addressed to national competent authorities, it indirectly provides guidance to fund management companies on supervisory expectations of national competent authorities as regards compliant practices under the SFDR and the integration of sustainability risk into the UCITS and AIFMD frameworks.

On 2 June 2022, the ESAs subsequently published a clarification statement on the draft RTS which they prepared under the SFDR (ESA Clarification Statement)² in which they provided clarity on certain provisions, including principal adverse impact (PAI) disclosures, financial product disclosures and “do not significantly harm” (DNSH) disclosures.

The Q&A, Supervisory Briefing and ESA Clarification Statement (together “Guidance”) should now be used by fund management companies to assess whether their existing sustainable finance frameworks and disclosures are adequately robust to withstand the scrutiny of a national competent authority. If necessary, appropriate action should then be taken to address any identified shortcomings. In this briefing, we provide an overview of some of the key take-aways for fund management companies arising from the Guidance.

Sustainable Investment Framework

(i) Enhanced Regulatory Framework

Notwithstanding that the Supervisory Briefing notes that it is non-binding, the Central Bank is likely to analyse the sustainable investment framework of individual fund management companies more closely in order to assess whether the constituents of a portfolio constitute a “sustainable investment” within the meaning of Article 2(17) of the SFDR. This may involve the Central Bank raising questions on the criteria used by a fund management company to categorise an investment as a “sustainable investment” and seeking supporting documentation on such categorisation. The Supervisory Briefing notes that the supervisory actions described therein can be carried out at any stage of the life of a fund.

It is also worth noting that ESMA recommends to national competent authorities (NCAs) that enforcement measures should be used by them in circumstances where the periodic report of an Article 9 fund shows that “significant proportions” of investments do not comply with the “sustainable investment” criteria set down in Article 2(17) of the SFDR.

Given the broad definition of “sustainable investment” under the SFDR, coupled with the lack of supplementary guidance from the European Commission, the ESAs or ESMA on what further criteria should be complied with in order to constitute a “sustainable investment”, the sustainable investment framework is likely to vary between fund management companies. However, the Supervisory Briefing has put fund management companies on notice of the need to have a documented and structured sustainable investment framework in place.

(ii) Assessment of DNSH for Sustainable Investments

According to the finalised draft regulatory technical standards issued under the SFDR and adopted by the European Commission on 6 April 2022 (Finalised Level 2 Measures)³, fund management companies are required to disclose in the relevant pre-contractual disclosures how they “take into account” the PAI indicators contained in Annex 1 thereto (PAI Indicators) when assessing whether or not an investment does any significant harm to any environmental or social objectives. To date, there has been a lack of regulatory clarity as to what was meant by “taking such PAI Indicators into account” in any such assessment.

In the ESA Clarification Statement, the ESAs have suggested that best practice could be to disclose DNSH for sustainable investments by extracting the PAI Indicators from Table 1 of Annex 1 to the Finalised Level 2 Measures (as well as any additional relevant PAI Indicators from Table 2 and 3 of Annex 1) and showing the impact of the sustainable investments against those indicators. The ESAs also suggest that such best practice could include assessing the impacts of the relevant investments against similar metrics set down in the Climate Delegated Act⁴ and the Complementary Climate Delegated Act⁵ to be satisfied that the investment do not significantly harm any environmental or social objectives.

The ESA Clarification Statement re-confirms that this DNSH assessment must be carried out on all investments claiming to be “sustainable investments”, regardless of whether or not such investments constitute taxonomy-aligned investments under the EU Taxonomy framework. In addition, the DNSH assessment must incorporate an assessment as to whether the investments are aligned with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights.

The ESA Clarification Statement may prompt some fund management companies to revisit their sustainable investment framework to update the manner in which the PAI Indicators are taken into account to determine that an investment does not do any significant harm to environmental or social objectives.

Taxonomy-related Disclosures

(i) Clarification on scope of Taxonomy pre-contractual and periodic report disclosures

In a change to the approach previously proposed by the ESAs as to the scope of the disclosure obligations arising under Article 6 of the Taxonomy Regulation⁶, the European Commission has confirmed in its Q&A that all funds falling within the scope of Article 8 of the SFDR which promote environmental characteristics must comply with the Taxonomy-related disclosure obligations. The European Commission Q&A also confirms that funds falling within the scope of Article 9 of the SFDR which have a social objective should make Taxonomy-related disclosures if the fund in question invests in taxonomy-aligned investments.

(ii) Clarification on pre-contractual disclosures to be made where no reliable data is available

Where an in-scope fund fails to collect required reliable data to disclose the expected minimum taxonomy alignment in its pre-contractual disclosures, it must include a figure of 0% for taxonomy alignment in the pre-contractual disclosures. Furthermore, no “negative justifications” (explaining for example that it was not possible to disclose a figure other than 0% due to lack of available reliable data) can be included.

The European Commission also indicates in its Q&A that if such a fund subsequently acquires taxonomy-aligned investments, updates to the pre-contractual disclosures should be considered in accordance with the UCITS/AIFMD rules.

(iii) Use of estimates

Notwithstanding the advices provided by the ESAs in their revised supervisory statement published earlier in March 2022⁷ where they indicated that estimates were not permitted (while acknowledging that “equivalent information” could be used in certain circumstances), the European Commission has confirmed in its Q&A that estimates can be used in “exceptional cases” where complete, reliable and timely information could not be obtained provided that complementary assessments and estimates should “only compensate for limited and specific parts of the desired data elements”.

(iv) Binding nature of taxonomy figures disclosed in pre-contractual disclosures

The ESA Clarification Statement confirms that the “minimum proportion” of Taxonomy-aligned investments disclosed in the pre-contractual disclosures should be considered binding commitments and notes that penalties for failing to respect such commitments should be imposed where relevant in accordance with the UCITS/AIFMD frameworks.

(v) Taxonomy disclosures in periodic reports

The European Commission notes that the annual reports of any fund falling within the scope of Article 5 or Article 6 of the Taxonomy Regulation must disclose taxonomy-related information in the periodic report if the investments held by the portfolio during the reference period included taxonomy-aligned investments (based on assessment of reliable data), regardless of what has been disclosed in the pre-contractual disclosures.

This means that where an in-scope fund discloses a figure of 0% taxonomy-alignment in its pre-contractual disclosures but subsequently invests in taxonomy-aligned investments, a figure disclosing the actual figure of taxonomy alignment during the reference period should be disclosed in the annual report.

Consideration of PAI at fund level

(i) The European Commission has confirmed in its Q&A that subject to certain disclosure obligations being satisfied, it is possible to consider PAI at fund level without triggering a reporting obligation at entity level under Article 4 of the SFDR.

(ii) The ESA Clarification Statement suggests that where a consideration of PAI on sustainability factors is implemented as part of the investment strategy of a fund, that fund should consider the PAI Indicators.

This clarification will need to be taken into account by any management company which integrates PAI into the investment process.

Good Governance

The European Commission confirms in its Q&A that the investee companies held by a fund falling within the scope of Article 8 of the SFDR must comply with the good governance practices (which include sound management structures, employee relations, remuneration of staff and tax compliance). The Q&A also confirms that this good governance requirement only applies to companies with investments in government bonds falling outside of the scope of this requirement.

Role of the Depositary

Until now, there had been some uncertainty as to how the ESG-related investment restrictions disclosed in the fund supplements should be treated by the fund’s depositary as part of its oversight monitoring framework.

However, the ESMA Supervisory Briefing has indicated that the role of the depositary should “include all ESG-related investment restrictions in the monitoring of the compliance of the instructions coming from the management company or the investment manager”. ESMA also recommends that NCAs should rely on adverse finding reports made by the fund’s depositary (as well as any adverse findings reported by internal control functions or external auditors) as part of their ongoing supervision framework.

Closed Funds

The European Commission Q&A confirms that where a fund is no longer available for investment (Closed Fund), it does not need to comply with the pre-contractual disclosure obligations set down in the SFDR and Taxonomy Regulation. As expected, the European Commission has confirmed that the periodic reports of any Closed Fund which falls within the scope of Article 8 or Article 9 must comply with the disclosure obligations imposed under the SFDR, and where relevant, the Taxonomy Regulation. Similarly, the management company of any such Closed Funds should ensure that its website complies with all applicable website disclosure obligations imposed under the SFDR in respect of such funds.

Naming Convention

The ESMA Supervisory Briefing provides useful guidance to NCAs on the use of fund names, including for example confirming that the terms “sustainable” or “sustainability” should only be used by certain categories of funds, namely (i) funds falling within the scope of Article 9 of the SFDR, (ii) funds which fall within the scope of Article 8 of the SFDR and which invest in part either in sustainable investments or taxonomy-aligned investments.

Upcoming changes to the UCITS and AIFMD frameworks

The ESMA Supervisory Briefing highlights the importance of management companies ensuring that sustainability risks are appropriately integrated into their portfolio and risk management processes and overall governance structure. It recommends that the NCAs carry out necessary “risk-based desk-based and/or on-site reviews of the adequate implementation and effective application” of the new rules which come into force on 1 August 2022. It also recommends that NCAs consider taking enforcement action against fund management companies where sustainability risks have not been integrated throughout the organisation “despite an appropriate period of time after entry into force of the AIFMD and UCITS amendments”.

Conclusion

Given the increasing regulatory scrutiny on greenwashing and the planned themed inspection expected to be carried out by the Central Bank in Quarter 3 of this year, fund management companies should carefully review the Guidance to:

(i) assess any changes that may need to be made to (i) their sustainable finance frameworks, (ii) the disclosures contained in all fund documentation and marketing materials and (iii) fund names; and
(ii) inform the manner in which sustainability risk is integrated into their portfolio and risk management processes and overall governance structure.

Should you have any queries arising from this briefing, please get in touch with your usual Dillon Eustace contact.

1 Regulation (EU) 2019/2088
2 The ESA Clarification Statement notes that the ESAs do not refer to the text containing finalised RTS adopted by the European Commission on 6 April 2022 in the statement, instead referring to the draft RTS prepared by the ESAs as published in February 2021 and October 2021
3 Available from https://ec.europa.eu/finance/docs/level-2-measures/C_2022_1931_1_EN_ACT_part1_v6%
4 Commission Delegated Regulation 2021/2139 which is accessible from https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32021R2139&from=EN. This sets down the specific technical screening criteria which must be satisfied in order for an economic activity to be considered environmentally sustainable under the EU Taxonomy framework
5 https://ec.europa.eu/info/publ... . For further information on the Complementary Climate Delegated Act, please refer to our recent briefing.
6 Regulation (EU) 2020/852
7 Available from https://www.esma.europa.eu/sites/default/files/library/jc_2022_12_-_updated_supervisory_statement_on_the_application_of_the_sfdr.pdf