‘SFDR must be viewed as an ongoing process’

The first stage of the Sustainable Finance Disclosure Regulation requiring manager compliance kicked off on 10 March. But questions remain about proper disclosure and the effectiveness of complying with EU green initiatives.

The Sustainable Finance Disclosure Regulation (SFDR) requires managers marketing funds, or those with affiliates in the EU, to make pre-contractual and website disclosures on their sustainability risk by 10 March.

But even US fund managers without “direct” affiliates within the bloc and those not explicitly marketing funds may need to comply with some level of disclosure.

“The expectation in the market is that at least parts of SFDR will apply to a US manager that is marketing its fund into the EU, on the basis of the private placement regime.” says Eve Ellis, partner at Ropes & Gray. Funds with EU parallel funds, for example, will likely be captured by the regulation.

“For a fund manager, being from the US, UK and EU, the next step will be to amend their pre-contractual disclosures or documents, typically the PPM or LPA that introduces policies or any information related to how the fund manager considers or not, integrates or not, any sustainability risks in their investment decisions,” says Francesco Cavallino, client director and head of the ESG practice at IQ-EQ.

But as of now, the regulation offers no formal penalties for those who fall short of disclosure rules for their non-ESG funds. The potential downfalls of not complying, or even of registering as a non-ESG fund, will be on the marketing side, Cavallino added.

This only marks SFDR’s initial compliance date for “level one” of the regulation, with additional provisions requiring compliance by early next year.

“ESA has recently issued a supervisory statement that indicates that national competent authorities are encouraged to refer firms to the requirements set out in the draft RTS for compliance with SFDR,” says Dani Williams, principal consultant at ACA Compliance Group. “We recommend firms look to start complying with level two requirements as soon as possible.”

The second leg of SFDR

On 4 February, the European Supervisory Authorities (ESAs) published their final report on the draft regulatory technical standards (RTS) on the detailed disclosure obligation under “level two” of SFDR, set to take effect 1 January, 2022.

The European Commission is expected to endorse the RTS within three months, according to law firm Kirkland & Ellis, which generally requires “firm-level website disclosures to principal adverse impacts of investment decisions made by a fund manager on sustainability factors,” in addition to “product-level pre-contractual disclosures for those financial products that promote environmental or social characteristics, but that aren’t explicitly ‘ESG’ funds, (“Article 8 Funds”) or have sustainability as their investment objective (“Article 9 Funds”).

Identifying which article a particular fund falls under may be a good place to start, but even with pending approval from the European Securities and Markets Authority (ESMA), several European regulatory bodies are advising firms to get a jump on full “level two” compliance, even before the regulator formally approves it, says ACA’s Williams.

But even when ESMA has rubber stamped the RTS, the legislation is still subject to change, and many provisions require further clarification.

For one, there is a large discrepancy in required disclosures between Article 6 funds (non-ESG funds) and Article 8 funds. The former need hit a much lower bar of disclosure than the latter. That means eligibility for Article 8 status may come down simply to the amount of ESG data available on underlying investments, which is already proving itself as a point of contention among managers.

According to Williams, many firms are noticing the still-persistent gaps in sourcing ESG data in many sectors, causing confusion as to how to disclose certain information when the information is not available.

This, too, is sure to cause some friction in ultimately reaching the EU’s stated goals, as the regulation hopes to incentivize manager behavior toward sustainability targets by dispensing with regulatory classifications, even though some well-meaning managers may not be able to obtain an Article 8 designation, for example, because of the lack of underlying data in their investments.

“Although SFDR is framed as a disclosure framework, compliance with its sustainability-related disclosures is intended (and expected) to have behavioral effects on fund managers,” Kirkland & Ellis said.

For “level one” compliance this year, making the necessary pre-contractual and website disclosures may be a one-off exercise, but it begins a longer process of orienting the European asset management industry towards sustainability targets, which in the years ahead will require constant upkeep.

“The whole SFDR must be viewed more as an ongoing process rather than a piece of regulation that stands alone,” Cavallino said. “It’s definitely a discussion topic that will follow us as a service provider and our clients as fund managers for at least a couple of years ahead.”