_March 10th sees the introduction of the EU’s Sustainable Finance Disclosure Regulation, one of the pillars – alongside the taxonomy regulation, the low carbon benchmarks regulation and the amendments to the AIFMD, UCITS and MiFiD regimes – of the bloc’s sustainable finance agenda. The regulation is designed in part to ensure that investment product which the manager is representing as ‘ESG’ products are actually taking ESG considerations into account on a substantive basis, thereby minimizing ‘greenwashing’. AlphaWeek’s Greg Winterton spoke to Mark Shaw, a Partner at law firm Wildgen, about why non-EU managers of investment funds that they market into the EU need to get their act together – and quick.
GW: Mark – thanks for taking the time to talk. To start us off, explain to us the two ways that the EU’S SFDR apply to non-E.U.-based investment managers that market their funds into the EU.
MS: Hi, Greg. The first way is that they apply directly to managers which market alternative investment funds into the EU under AIFMD national private placement rules, and the second is that they apply indirectly to managers providing portfolio management and/or investment advice services to EU firms that are themselves subject to the new rules.
GW: OK. So, many non-EU-based investment firms would seem to fall under the jurisdiction of the new rules. Are there any situations where the new disclosure regulation might not apply?
MS: SFDR does not apply to a non-EU AIFM which sells funds in the EU in response to reverse enquiry only. I’d like to stress, however, that relying on reverse solicitation is under the regulatory spotlight and should not form the basis of an EU distribution strategy.
GW: Indeed. So, back to a non-EU manager marketing a non-EU AIFM to investors in the bloc. Many investment funds will not be ‘ESG’ in the sense that they are not deliberately representing themselves as ESG-focused funds. Why should they care?
MS: The key point to note on this is that document disclosures are required under the SFDR even where the strategy is not "ESG”. If you’re caught under the rules as a non-EU manager, the good news is that it does not cause you to have to comply with provisions of SFDR concerning the policies and procedures of the manager ; for example, there is a requirement to publish website information about the manager's policies on the integration of sustainability risks in their investment decision-making process, but again, this wouldn’t apply in this situation.
The content of the fund-level disclosures depends on whether or not the fund has an ESG focus. And from there, there is a further breakdown.
GW: OK, let’s take a quick step back here. How does a manager know if they have an ‘ESG fund’ or not?
MS: One other quick point to note is that the EU uses the term “sustainable finance” rather than “ESG”. This should not simply be considered a series of green measures, but also a wider consideration of sustainability in corporate governance and risk management, increased transparency and a drive away from short-termism in capital markets.
This distinction is more important for other aspects of the SFDR, where there are rules around firms that integrate sustainability risks into their wider decision making process. But as I’ve mentioned, the rules apply to all financial market participants providing products or services in the EU, but there are indeed provisions specific to “ESG-focused” funds.
For these purposes “ESG-focused” funds are those which either:
- have sustainable investment as an objective (these are known as " Article 9" funds – this is the meatier regulatory requirement); or
- otherwise promote environmental or social sustainability (these are known as " Article 8" funds).
The third category is one of having no ESG focus at product level, though it should be noted that a firm may incorporate sustainability risks into its decision making processes without its products falling under Article 8 or 9. The SFDR has quite nuanced definitions for these terms, so you should engage local counsel to help you analyse which category your fund falls into.
GW: Right. So, a non-EU manager, marketing a non-EU “ESG” AIF to EU investors – what do they need to know?
MS: In addition to complying with the updated disclosure requirements for all of their funds marketed in the EU (even if non-ESG ), managers will also need to provide further pre-contractual disclosures relating to how environmental or social characteristics are met or how the sustainable investment objective is obtained (depending on classification). This includes details of benchmarks used (if relevant). In addition, certain fund-specific information must be posted on the manager's website and also in the fund's AIFMD annual report.
It's worth noting that some of the granular requirements are contained within the Level 2 Regulatory Technical Standards (RTS). While the immediate compliance deadline is 10 March 2021, the draft of these RTS have only just been published. These are expected to come into force from 1 January 2022; however, firms are expected to comply with them on a “principles-based” basis until that point. The key area where these draft RTS will apply to non-EU managers is if they have Article 8 or 9 products, and if they have these products they should also consider how they will comply with these draft rules on a “principles-based” basis. At the very least they should be prepared for EU investors enquiring about this point.
The fun will continue next year, as the RTS come into force and if the fund has an environmental focus, then from 1 January 2022 further detailed disclosures may need to be made under the EU Taxonomy Regulation (also known as the “Framework Regulation”).
GW: There’s a lot to take in here. Anything else?
MS: Yes. If you provide portfolio management to an EU entity that itself is subject to the rules, then the EU entity is likely to seek contractual commitments from the non-EU delegate to enable it to comply with its own obligations. This would apply, for example, if you are a delegate of an EU AIFM for an EU AIF.
These commitments might include things like the provision of information and data by the non-EU manager for the purposes of the European manager complying with its disclosure requirements; certain duties and responsibilities from the non-EU investment manager as may be required by the European manager's policies and procedures, driven by SFDR and the Taxonomy Regulation (if applicable).
Similarly, there may be instances where investors in funds or segregated accounts managed are themselves subject to SFDR. In such instances, those investors may for the purpose of fulfilling their own SFDR obligations require commitments from the non-EU investment manager to provide information and/or carry our certain duties and responsibilities.
In these cases, since we are looking at the client firms’ own regulatory obligations, it is incumbent on them to be compliant, not you.