Recently, the European Commission wrote a letter to the Chairs of ESMA, EBA and EIOPA on timing for implementation of the EU Sustainable Finance Disclosure Regulation (SFDR). We would like to clarify below the situations in which this is likely to be an issue, and explain how this may also affect Swiss firms.
SFDR: March 2021 implementation date
The "Level 1" text of the SFDR, which is stated to apply from 10 March 2021, was finalised and published some time ago. However, as with many EU Regulations, the SFDR requires a number of detailed "Level 2" Delegated Regulations or "RTS" to be put in place before market participants have a complete picture of how the legislation is intended to apply. Although draft RTS have been consulted on by the European Supervisory Authorities, they have not yet been finalised.
As many had suspected would be the case, the European Commission (EC)'s letter makes clear that implementation of the RTS will be delayed "to a later stage." However, the EC's letter also makes clear that the Level 1 text of the SFDR will continue to apply from 10 March 2021. This has, understandably, caused concern amongst both EU and non-EU firms that could be caught by the broad scope of the SFDR, given that it would require them to comply with what is effectively an incomplete set of rulemaking by the EU. We have therefore set out some comments on the current state of play below, in an attempt to clear up some of the uncertainty that this development has generated.
Background: which firms will this be an issue for?
In summary, the SFDR will apply directly to any EU regulated firm that:
- manages money in some way, e.g. a bank or investment firm providing single managed account services, an asset manager (i.e. AIFM or UCITS ManCo), a pension provider or an insurance undertaking which provides insurance‐based investment products (IBIPs); or
- advises on investments or investment strategy, e.g. a bank, investment firm or asset manager that provides investment advice, or an insurance firm that provides advice on IBIPs.
These firms are described in the SFDR as "financial market participants" and "financial advisers" respectively. Once the SFDR is in force, they will be required to make certain pre-contractual disclosures on ESG ("product level disclosures"), along with relatively detailed public disclosures to be uploaded onto their websites ("entity level disclosures").
Swiss firms and other non-EU firms
There are broadly two ways in which the SFDR could impact Swiss firms any other non-EU firms:
A. Directly, through national private placement regimes: The SFDR makes clear that required pre-contractual disclosure requirements on sustainability will be baked into disclosures required to be made under national private placement regimes. In other words, where Swiss (or other non-EEA) investment fund managers market funds to EEA investors under a local private placement regime, they will be required to make SFDR-compliant disclosures. There is some debate in the market around whether these disclosures will be limited to pre-contractual / product-level disclosures, or whether they will extend to entity-level / website disclosures. Our view is that the former position is the better view, but we cannot exclude that EU Member States will go further in practice and seek to apply entity level disclosures to non-EU firms. The disclosures should not, however, apply where non-EU managers rely on reverse solicitation.
B. Indirectly, through relationships with regulated EU firms: As noted above, the SFDR will apply to EU regulated firms including pension providers and insurance firms. Swiss firms and other non-EU firms should therefore bear in mind that this will be a live issue for European institutional investors and any regulated EU clients, who may well begin to expedite conversations around ESG disclosure in light of the EC's letter. Other relationships with EU regulated firms should also be considered; for example, Swiss firms (and other non-EU firms) that sub-manage for EU AIFMs or UCITS management companies will likely need to feed into SFDR disclosures required to be made by the EU asset manager. Finally, relationships with regulated EU product distributors may be affected (e.g. EU banks involved in placing or advising on the sale of fund units or other financial instruments).
What does the EC's letter say?
The EC's letter makes the following points on how the SFDR will be phased in from March next year:
- The substance of the SFDR is not conditional on the formal adoption and entry into force of the RTS.
- Therefore, all application dates are being maintained as laid down by the SFDR, which will apply with effect from 2021 so "financial market participants and financial advisers subject to the Regulation will need to comply with its high level and principle based requirements from that time."
- In order to provide financial market participants and financial advisers with adequate time for implementation, the RTS will become applicable "at a later stage."
(i) Sustainability risk disclosure: Under the SFDR, firms will need to make certain public disclosures on their approach to sustainability risk. The EC notes on this point that:
"With regard to the integration of sustainability risks in the investment decision‐making process, financial market participants must, in accordance with the applicable sectoral legislation, already consider sustainability risks in their internal processes. The Regulation requires transparency in this respect, with no further details necessary in the regulatory technical standards."
(ii) Article 8 and 9 products: Article 8 products are described in the SFDR as products which actively promote environmental or social characteristics, while Article 9 products are products which have sustainable investment as their objective. Both categories are subject to higher standards of disclosure under the SFDR. The EC makes the following statement in relation to these products:
"As regards financial products that qualify under Articles 8 and 9 of the Regulation, in accordance with applicable sectoral legislation, product manufacturers must already describe in the product documentation how the levels of sustainability are achieved. This means that the manufacturers must comply with the disclosure principles set out in Articles 8 and 9 of the Regulation."
(iii) Adverse sustainability impacts: Firms within scope of the SFDR will be required to publish "entity-level" data on whether, and if so how, they have regard to the "principal adverse impacts" on sustainability of investment decisions or investment advice. The EC notes on this point as follows:
"In relation to transparency of adverse sustainability impacts, numerous financial market participants currently comply with the non-financial reporting requirements under Directive 2013/34/EU or adhere to international standards and might consider using that information. Even without the full regulatory technical standards, there are no impediments to financial market participants and financial advisers complying with the Level 1 requirements laid down in the Regulation."
Why has the EC taken this approach?
Rushing through implementation of the Level 1 text of a Regulation in advance of the necessary technical standards is far from ideal from the market's perspective, and arguably also from the perspective of local EU regulators attempting to supervise compliance with the new framework. While such a step is not unprecedented, it is unusual, and we believe that it is a reflection of the general political pressure on the EC in this area. It is certainly clear that the EC does not want to concede on the ambitions that it originally set out in its sustainable finance action plan.
Can market participants expect to see any additional guidance on implementation?
The EC notes in its letter that it is "ready to coordinate with the ESAs and national competent authorities on this approach and a number of trade associations in the financial services sector have indicated that they have initiated targeted actions to assist their membership with implementation." We may, therefore, see some guidance from ESMA, EIOPA and the EBA on implementation before March next year. We are also aware that trade associations are discussing the letter and considering coordination, which may result in some level of industry guidance on the application of the rules.
Approach of national Member State regulators
One of the difficulties with the EC's approach is that, in the absence of detailed technical guidance, national Member States may take divergent approaches to supervising compliance with the SFDR from March next year. We understand that certain EU Member State regulators are intending to accept “self certification” by in-scope firms (i.e. in the sense that firms will have the ability to certify that they have assessed their disclosures against the Level 1 text of the SFDR and are confident that they are compliant with its high-level principles. Nonetheless, there is a risk that other EU Member State regulators may take a more restrictive approach.
What does FINMA say?
We don’t know yet. However, it is in our view likely that sooner or later FINMA will require Swiss financial institutions to comply with ESG principles to a certain extent. Note that the UK regulator has taken the decision to require firms to comply with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) created by the Financial Stability Board rather than with the SFDR, and FINMA may ultimately take a similar approach given that the TCFD is a well-respected set of international principles.
What should Swiss firms do between now and March?
There are two key steps that we recommend Swiss firms to take in good time before March 2021 as a result of these developments:
a. Scoping exercise: To the extent that they have not already done so, Swiss firms will need to review the SFDR's scope of application against their business. This will mean assessing their European footprint (whether in terms of EU regulated entities and activities, or in terms of EU investors and clients), and considering how that footprint aligns with the SFDR. In-scope Swiss firms will also need to take a view on whether their products are likely to fall within scope of Article 8 of the SFDR, which remains subject to some uncertainty (particularly in relation to investment strategies that simply incorporate screens or exclusion strategies).
b. Implement any required revisions to ESG disclosures: Swiss firms will need to consider how they currently articulate ESG and sustainability risk to their investors or clients, and whether this matches up with the overall standards set by the SFDR. In particular, they may need to update their current disclosures in line with SFDR principles by 10 March 2021, potentially followed by a further set of updates in Q1 2022 (i.e. to reflect the detailed disclosure standards set out in the RTS).