SFDR and Asset Allocators. The European Green Deal declared climate change and environmental degradation as existential threats to Europe and the world. The European Union (EU) has set out to mobilize private financial capital flows to green investments under its 2018 Sustainable Finance Action Plan. One prong of the EU Action Plan is “SFDR” or the “Sustainable Financial Disclosure Regulation”, initially adopted in November 2019, with the publication of general regulations (so called Level 1 regulations).
January 1, 2023 Full Effect of SFDR. From January 1, 2023 the SFDR transition period comes to a close, a second round of regulation then comes into effect (Level 2), and the full weight of SFDR will be felt on asset allocators, fund managers and portfolio companies.
US Fund Managers Raising Capital in the EU for Deployment in the US. US fund managers raising capital in Europe now need to make disclosures as to just how “green” and/or “social” they are. In the funds industry, mandatory disclosures under SFDR should be made on the management company level (for example, by the asset managers about their own policies) and on the product level (for example, funds’ investment strategies) through several channels: the manager’s website; pre-contractual disclosures made to investors, such as those in the private placement memorandum; and periodic reports, such as the annual financial statements of a fund. SFDR may be looked at as having two objectives: (1) to preclude “greenwashing” and (2) to encourage “green” and/or “social” investing. SFDR encompasses a broad range of entities and products well beyond the investment management industry (including insurance and banking).
Article 6. While Articles 3 and 4 deal with management company disclosures, and Article 5 relates to the management company’s remuneration policies, Article 6 of SFDR operates as a product level disclosure regime. Under Article 6, it is permitted to disclose that a firm, product or fund has no aspirations to contribute to the EU’s efforts to combat climate change. While all financial services firms or funds must make their level of commitment to sustainability transparent under Article 6 of SFDR, those firms that do not aspire to combat any adverse environmental, social or governmental impacts are now identified as “Article 6” firms. While Article 6 declaration of sustainability risks deemed “not relevant” (and why they are not relevant) was a way forward for firms at the advent of SFDR, the “not relevant” position has quickly become unattractive to institutional investors within the EU. US fund managers raising capital in the EU and EU asset allocators are looking for a commitment to “ESG”.
Principal Adverse Impacts (SFDR Article 7). At the heart of the SFDR initiative is the concept of identifying and disclosing whether and how a financial product (including a fund) considers principal adverse impacts (“PAIs”) on sustainability factors. After a series of delays, PAI reporting comes into effect from January 1, 2023.
Absent a statement that PAIs are not considered (and this alternative is available for funds), there are substantial tasks ahead for products or fund that do consider PAIs: the EU has implemented a mandatory reporting template and has defined a core set of 32 mandatory indicators (including a formula for measurement of greenhouse gas emissions) plus 18 optional environmental or social factors.
Article 8. Article 8 firms seek to promote always good governance, and promote one or more social or environmental characteristics, report on those characteristics and quantify their commitment to those characteristics by completing a disclosure form adopted pursuant to Annex 2 of Revised Technical Standards implementing SFDR.
Article 9. Article 9 products and funds have sustainable investment as part of its objective and they include an explanation of that objective is to be obtained. Benchmarking to the EU Climate Transition Benchmark is expected, absent benchmarking to the EU Paris-aligned benchmark.
Taxonomy. The Taxonomy Regulation establishes the criteria for determining whether an economic activity qualifies as environmentally sustainable for the purposes of establishing the degree to which an investment is environmentally sustainable. The Taxonomy Regulation sets out a definitional and disclosure regime to give meaning to specified environmental objectives: (a) climate change mitigation; (b) climate change adaptation; (c) the sustainable use and protection of water and marine resources; (d) the transition to a circular economy; (e) pollution prevention and control; (f) the protection and restoration of biodiversity and ecosystems.
What does it Mean? Recall that Article 8 and Article 9 funds must invest in portfolio companies that engage in good corporate governance. Good corporate governance is not specified in SFDR itself. It would appear, however, that “good corporate governance” may find some of its meaning in a new proposed regulation on corporate sustainability due diligence.
Operating Companies will become subject to the EU Corporate Sustainability Due Diligence Directive. On December 1, 2022 the European Council adopted its proposed framework for a directive of the European Parliament that would implement a new definition of corporate fiduciary duty (the “Corporate Sustainability Due Diligence Directive”). Incorporation of sustainability factors and risks in corporate due diligence is a long-standing objective of the EU’s Sustainable Financial Action Plan.
Summary. The Corporate Sustainability Due Diligence Directive will lay down rules and obligations on private companies regarding actual and potential human rights adverse impacts and environmental adverse impacts. While directly affecting companies in their own right, the Directive will also compel subject companies to consider upstream and downstream impacts within their value chains, or “chain of activities” or more precisely “the value chain operations carried out by entities with whom the company has an established business relationship.” The impact of the inevitable implementation of this Corporate Sustainability Directive will be felt world-wide, and will affect any US company doing business in Europe or that is a business partner of a European company.
Mandatory Climate Changes Initiatives. Large EU companies with 500 employees and worldwide turnover of €150 million will be required to combat climate change: that is, these companies must ensure that the business model and strategy of the company are compatible with the transition to a sustainable economy and with the limiting of global warming to 1.5 °C in line with the Paris Agreement and the objective of achieving climate neutrality by 2050.
Some Non-EU Companies are In Scope. Non-EU companies will be in scope, if they generated €40 million of which at least €20 million in revenue from “high impact sectors” or €150m generated in the EU in the last preceding fiscal year for two years in a row.
Basics of Mandatory Due Diligence. The due diligence process set out in this Directive should cover the six steps defined by the OECD Due Diligence Guidance for Responsible Business Conduct, which include due diligence measures for companies to identify and address adverse human rights and environmental impacts. Under the draft Article 4 of the new Directive this encompasses the following steps: (a) integrating due diligence into policies and management systems, (b) identifying actual or potential adverse human rights and environmental impacts, (c) preventing and mitigating minimizing actual and potential adverse impacts and brining adverse impacts to an end, (d) establishing a complaints procedure, and (e) monitoring the effectiveness of measures.
Business Partners to be Subject to Contractual Obligations. The obligations on companies within scope appear formidable in terms of those imposed on their own operations with their own policies, but also their obligation to impose contractual obligations on their business partners. Article 12 proposes the EU Commission should develop model contractual clauses for implementation by EU firms with their business partners.
Liability Imposed on EU Companies. Liability to regulators and civil liability is contemplated, with respect to a large EU company’s own activities that intentionally or negligently failed to take appropriate measures to prevent or adequately mitigate potential advisers impacts or to bring identified adverse impacts to an end.
Financial Undertakings: Funds, their Managers and Asset Allocators will Also Be Subject to the New Sustainability Directive. It is not clear if all Member States will have to apply the Corporate Sustainability Directive to financial services firms, as the council’s draft text provides that “Member States may decide to apply this Directive to pension institutions” (Draft Article 2(6)) and to “regulated financial undertakings…” (Draft Article 2(8)) implying a degree of “opting in” or “opting out” that may take place across the EU.
If made subject to the new Directive by a Member State, it is plain that large fund managers will have to consider recipients of their financial services as within the manager’s “chain of activities,” and that larger enterprises in receipt of financial services, will be in scope of the Corporate Due Diligence Directive. Borrowers, for example, would be in a lender’s “chain of activities.”
“Regulated financial undertakings” that may be caught up in the new Corporate Due Diligence Directive, include credit institutions, fund managers (referred to as AIFMs), insurance and reinsurance companies, pension funds. This would appear likely to affect the allocation of assets by subject companies to portfolio companies, for example. It would appear, that if the draft text is adopted as proposed, the decision to apply or disapply the new Directive to financial services firms will be left to the Member States as part of their transposition process.
Next Steps. While the current text drafted by the Council is a “negotiating position”, it would appear to be one that is well advanced and likely to emerge from the Parliament, for transposition into local law in the foreseeable future: See here.