1. New EU and UK disclosure requirements
The new disclosure requirements for investment managers and advisers1 with respect to their environmental, social and corporate governance (ESG) policies will apply in the European Union from 10 March 20212. New climate-related disclosures will apply to investment managers in the United Kingdom under a UK disclosures regime that is expected to be phased in from 2022. Although the finer details implementing the new frameworks have not yet been finalised, or in the case of the UK, have not yet been published, it is clear that the EU and the UK have ambitious plans for enhancing ESG disclosure in the financial sector.
We outline below the key provisions under the Sustainable Finance Disclosure Regulation3 (SFDR) and, at a more high level, the Taxonomy Regulation4,5. We also outline the key principles of the proposed UK mandatory climate-related disclosures regime for investment managers, which will be based on the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD).
Certain key terms used in this alert are defined in Annex 1.
2. What is the background to the new rules?
The new rules are part of the EU's Sustainable Finance Action Plan6 and the European Green Deal7 which seek to transition the EU to a more resource-efficient and sustainable economy, and to build a financial system that supports sustainable growth. In the UK, the new rules will form part of the Government's Green Finance Strategy8 and the "Roadmap towards mandatory climate-related disclosures"9. These requirements are complementary to the disclosure requirements regarding governance and shareholder engagement introduced by the second Shareholder Rights Directive10, and echoed in the revised UK Stewardship Code11. These initiatives seek to direct investment flows to issuers and sectors with more sustainable business and operational models, and to place ESG at the forefront of the investment process, alongside returns.
Further, with a specific focus on environmental issues, the Taxonomy Regulation establishes a harmonised system for the classification of environmentally sustainable activities in the EU. It aims to facilitate investors comparing the sustainability of investments against a consistent set of standards. The Taxonomy Regulation enhances the existing corporate disclosure requirements and introduces product labelling and disclosure requirements for a wide range of entities and financial products12.
3. When do the new requirements apply?
Application of the EU rules
The SFDR will apply in the EU in phases from 10 March 2021, and the Taxonomy Regulation will apply in the EU in phases from 1 January 2022. Annex 2 sets out the applicable commencement dates of the specific requirements in more detail.
Application of the UK rules
The UK has stated that climate-related disclosure rules developed in accordance with the TCFD recommendations are expected to apply in the UK from 2022 for the largest investment managers (those with assets under management in excess of £50 billion) and from 2023 for other investment managers. The Financial Conduct Authority (FCA) is currently developing detailed policy proposals with a view to publishing a consultation paper in the first half of 2021.
Delays and regulatory forbearance due to COVID-19
The European Commission has postponed13 to a "later stage" the deadline for the drafting of secondary legislation implementing the SFDR disclosure requirements ("Draft ESG Disclosures RTS"14). However, despite this delay, the Commission stated that there will be no regulatory forbearance for market participants in relation to complying with the SFDR's general principles of sustainability-related disclosures in three specific areas, as these requirements are not "conditional on the formal adoption and entry into force or application" of the secondary legislation.
The three main disclosure requirements specified by the European Commission are: (a) the disclosures related to the integration of sustainability risks in the investment decision-making process; (b) the pre-contractual disclosure requirements applicable in the case of financial products that are promoted as having an ESG-focus or that have ESG as an investment objective; and (c) the disclosures related to whether the investment manager (or the financial product) considers the principal adverse impacts of investment decisions on sustainability.
The European Commission also made an important clarification about its expectations of market participants (including investment managers) under the current regulatory frameworks (which includes the AIFMD, MiFID II and the UCITS Directive), as it stated that market participants are already required to integrate sustainability into their investment decision-making processes and that product manufacturers (such as investment managers) are already expected to disclose information to investors on how the level of sustainability of an ESG-focused product is achieved.
4. Which investment managers are in-scope of the new rules?
The SFDR and the Taxonomy Regulation apply to "financial market participants" and "financial products", each of which is defined by reference to EU legislation and includes MiFID investment firms, alternative investment fund managers (AIFMs) and UCITS management companies and the funds and portfolios they manage (e.g. AIFs, UCITS and managed/segregated accounts)15. The SFDR will also be relevant to "financial advisers", including investment advice provided by AIFMs, MiFID investment firms and UCITS management companies.
The UK disclosures regime will apply to seven "categories of organisation", which includes FCA-authorised investment managers (defined to include AIFMs, MiFID investment firms providing portfolio management services and UCITS management companies) as one of those categories.
5. What are the new EU and UK requirements?
UK Disclosures Regime
The UK will introduce new disclosure requirements for FCA-authorised investment managers based on the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD). The UK's Joint Government-Regulator TCFD Taskforce, which includes the FCA, has stated that the proposed UK rules are anticipated to include "disclosure of strategy, policies and processes at the firm level, covering relevant recommended disclosures; complemented by more targeted disclosures at the fund or portfolio level."16
The Taskforce also stated that the proposed UK disclosure requirements will "interact with related international initiatives, including those that derive from the EU's Sustainable Finance Action Plan", such as the SFDR. While the UK will adopt a similar regime, the rules are unlikely to be identical. As such, UK investment managers will need to consider the requirements they would have to comply with under the SFDR were that Regulation to apply.
SFDR and the Taxonomy Regulation
The SFDR imposes transparency and disclosure obligations on investment managers, including in relation to their policies on sustainability and remuneration, marketing communications, pre-contractual disclosures and periodic reporting to investors. The requirements are set out in more detail in Annex 2 of this client alert.
The SFDR imposes requirements on all investment managers, irrespective of whether the manager manages or markets funds or portfolios with an ESG-focus. The requirements include disclosures by the investment manager on how it integrates sustainability into its decision-making processes, how its remuneration policy is consistent with such requirement, and ensuring that its marketing communications do not contradict the disclosures under SFDR. Some SFDR requirements apply on a "comply-or-explain" basis, meaning that an investment manager must decide whether to comply with the applicable requirement or not, and in the absence of compliance, must publish its reasons for such decision on its website and disclose such fact to investors in pre-contractual documentation. The requirements which apply to all managers regardless of whether the products they market have an ESG focus are set out in Part I of Annex 2.
The SFDR also introduces additional requirements which apply to financial products that have an ESG-focus, i.e. where the product promotes environmental or social characteristics ("light green"), or has sustainability as an investment objective ("dark green"). The Taxonomy Regulation provides an additional overlay of requirements, principally for "light green" and "dark green" financial products. These additional requirements are set out in Parts II and III of Annex 2 respectively.
Proposed amendments to AIFMD, MiFID II and the UCITS Directive
In addition to the requirements under the SFDR, there are proposed changes to the suitability assessment requirements under the second Markets in Financial Instruments Directive17 (MiFID II), and to the risk management policies, organisational requirements and operating conditions applicable to investment managers authorised under MiFID II, the Alternative Investment Fund Managers Directive18 (AIFMD) and the Undertakings for Collective Investment in Transferable Securities Directive ("UCITS Directive")19 The proposed amendments to the AIFMD20, MiFID II21and the UCITS Directive22 (the "Sustainability Amendments") have not yet been adopted by the European Commission. Once adopted, the Amendments are expected to apply from the second half of 2021, though further delays are possible.
The proposed amendments to the AIFMD, MiFID II and the UCITS Directive complement the manager-level requirements under the SFDR by clarifying and setting out in more detail the manner in which an investment manager must integrate sustainability into its internal policies, procedures and organisational arrangements. The key requirements will impact a firm's investment due diligence policies, conflicts of interest requirements, organisational and risk management policies and arrangements, suitability assessments and the product governance rules.
6. What is the impact of Brexit?
The requirements of the SFDR and the Taxonomy Regulation will apply after 31 December 2020. This means that for the purposes of the European Union (Withdrawal) Act 2018 (as amended), the EU Regulations are not "operative" and will therefore not automatically form part of English law after 31 December (a process that is referred to as "onshoring"). It has also become clear from the Brexit Statutory Instruments published during the onshoring process, that the UK will not implement SFDR into English law. The latest example is the omission from the English version of the law of the only few sections of the SFDR which are currently in force and that relate to the drafting of secondary legislation23. This means that FCA-authorised investment managers will not be subject to a UK-equivalent version of the SFDR on 10 March 2021.
7. Do the EU rules have an extraterritorial reach?
The extraterritorial application of the SFDR to UK and other non-EU investment managers is currently unclear, but the broad drafting of the SFDR and certain guidance provided by the European Commission suggest the possibility that "financial markets participants" and "financial products" could also include non-EU investment managers, such as when marketing a non-EU fund under the national private placement regime in the EU.
Guidance issued by the European Commission and the Technical Expert Group on Sustainable Finance in relation to the Taxonomy Regulation24 notes that the disclosure obligations for financial market participants in the Taxonomy Regulation apply to "anyone offering financial products in the EU, regardless of where the manufacturer of such products is based". The guidance goes on to state that this approach "is not different to other corporate or financial product disclosure obligations already in place in the EU. The international influence of the EU Taxonomy will exist despite there being no intention to bind third countries on their own sustainability or sustainable finance activities." By analogy, the existing product governance rules under the revised Markets in Financial Instruments Directive require EU firms to provide certain disclosures with respect to funds they market, regardless of where the fund or its manager is located. The rules do not, however, apply directly to non-EU managers.
In the absence of definitive guidance regarding the extraterritorial application of the disclosure requirements under the SFDR and the Taxonomy Regulation, certain EU jurisdictions may apply the EU rules more widely, e.g. by requiring non-EU fund managers to comply with the disclosure requirements as an additional condition for marketing under the applicable private placement regime in that jurisdiction. Accordingly, it is useful to distinguish between requirements that apply to the financial product and those that apply to the investment manager. The European Supervisory Authorities have published draft "product disclosure templates" intended to standardise the format of product-level disclosure25.
In any event, SFDR will be relevant to all investment managers marketing to EU investors as they will be expected to disclose information that allows EU investors to carry out appropriate due diligence and make investments consistent with their regulatory obligations.
Further, the EU-wide application is also likely to have an impact on the delegated portfolio management arrangements where non-EU investment managers provide investment management services to EU AIFMs, UCITS management companies and MiFID investment firms.
8. Next steps
Investment managers will need to assess the direct and indirect application of the SFDR on their operations. A first step for many investment managers is to consider the ability and willingness of the business to comply with the requirements and the extent to which compliance is possible. This will require the involvement and input of management, and it is clear that meaningful compliance with the SFDR is not an exercise confined to the legal and compliance function.
In the first instance, investment managers should assess their existing ESG policies and practices and assess these against the SFDR requirements in order to identify gaps. Investment managers will need to be mindful of the potential divergent approaches, particularly in the detailed application of the rules, taken by the EU and the UK in developing their own ESG-disclosure standards.
The compliance exercise may require the introduction or revision of ESG policies, and extend to other policies and procedures, including in respect of remuneration practices, investment due diligence, portfolio review and investment decision-making processes. This may require the development of additional benchmarks or investment criteria, the introduction of additional data providers or new technology in order to provide the business with the means required to implement the new policies in practice. Additionally, the marketing communications and pre-contractual disclosures may need to be reviewed to ensure that these include the requisite disclosures and are consistent with the updated policies and practices.
The contribution of Andrea Gonzaga and Sophie Pridgeon is gratefully acknowledged.
1. AIFMs, MiFID investment firms and UCITS management companies providing investment management and/or investment advisory services.
2. With some of the requirements taking effect at a later date, from 2022.
5. This note only covers the disclosure requirements for fund/portfolio managers – a sub-set of these rules also apply to firms which that provide investment advice, which we have not detailed in this note.
12. The discussion of the corporate disclosure requirements is beyond the scope of this note.
14. Draft Regulatory Technical Standards (RTS) with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a, Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088 (here).
15. "Financial advisers", which includes MiFID investment firms providing investment advice, and AIFMs and UCITS management companies providing investment advice under their MiFID top-up permissions, are subject to a sub-set of the new disclosure requirements in relation to the "investment advice" provided to clients.
17. Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments (here) and Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments (here).
19. Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) (here).
20. Commission Delegated Regulation amending Delegated Regulation (EU) No. 231/2013 as regards sustainability risks and sustainability factors to be taken into account by alternative investment fund managers (here).
21. Commission Delegated Directive amending Delegated Directive (EU) 2017/593 as regards the integration of sustainability factors and preferences into the product governance obligations (here) and Commission Delegated Regulation amending Delegated Regulation (EU) 2017/565 as regards the integration of sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms (here).
23. The Financial Services (Miscellaneous Amendments) (EU Exit) Regulations 2020 (here) and the Draft Securities Financing Transactions, Securitisation and Miscellaneous Amendments (EU Exit) Regulations 2020 (here).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.