Takeaways

The key terms of the SFDR are applicable on 11 March 2021.
Financial firms will have entity level and financial product level disclosures.
This is a key step towards standardizing ESG terminology and reporting.

Europe is considered to be leading the charge on the incorporation of environmental, social and governance (ESG) considerations into its regulatory framework. The SFDR came into force on 19 December 2019 and its key terms started to apply on 10 March 2021. This marks an important milestone in the clarification of ESG disclosure requirements.

The disclosure regime is governed by Regulation (EU) 2019/2088, which places a requirement on certain regulated firms in the EU to disclose information relating to ESG factors on their websites and to potential investors. The aim of the SFDR is to:

“Achieve more transparency regarding how financial market participants and financial advisers integrate sustainability risks into their investment decisions and investment or insurance advice.”

Who Does the SFDR Apply To?

The entities that fall within the scope of the SFDR disclosure requirements are “financial market participants” and “financial advisers”. Both of these terms are defined in Article 2 of the SFDR. This means that most EU regulated entities will be captured, including, by way of example, MiFID investment firms and Alternative Investment Fund Managers licensed under the AIFMD.

The SFDR applies to firms in the EU, and this territorial scope means that it will generally not apply to third country firms. It has not been incorporated into UK legislation post-Brexit and therefore will not apply in the UK (which plans to establish its own domestic regime). However, firms that are marketing products in the EU or have some other EU nexus may be caught within the regulation’s remit.

What are the New Disclosure Obligations?

The disclosure obligations under the SFDR are broadly broken down into (1) entity level disclosures, and (2) financial product level disclosures.

Entity level disclosures–Financial market participants and financial advisers are required to publish details on their websites relating to:

  1. Their consideration and due diligence of “principal adverse impacts” (PAIs) on the sustainability of their investment decisions and advice on a “comply or explain” basis (Article 4(1)). The PAI statements must include both qualitative and quantitative disclosures (Article 4(2)); and
  2. How their remuneration policies are consistent with the integration of sustainability risks (Article 5).

Financial product level disclosures–There is a requirement for enhanced disclosures in pre-contractual documentation in relation to the following financial products:

  1. Products that promote environmental or social characteristics (Article 8); and
  2. Products that have sustainable investment as an objective (Article 9).

In each case, there is a requirement to disclose the ESG performance and how the relevant objective is met in relation to any in-scope financial products. These disclosures must be published on websites (Article 10) and are subject to periodic reporting (Article 11). However, Article 11 of the SFDR will only come into effect on 1 January 2022, which will give firms some time to prepare.

To comply with their obligations, firms will need to make changes to their internal procedures and policies to comply with the new requirements. They may also need to invest in training staff in relation to the new obligations.

The SFDR does not set out the technical details on what must be disclosed and this is developed further through draft regulatory technical standards, a first draft of which was published on 4 February 2021 (The Level 2 SFDR: ESMA Final Report on draft Regulatory Technical Standards). The European Commission is expected to endorse the Level 2 SFDR within three months of its publication date and it is broadly expected that these standards would apply on 1 January 2022. In implementing changes to comply with the SFDR obligations, firms should therefore take in account the fact that Level 2 SFDR will come into force in due course.

Conclusion

The coming into force and application of the SFDR is a positive step in an area that has long been known for the multiplicity of reporting standards. In time, one might expect that other market participants may start making similar market disclosures, even if these are not mandatory. In addition, the SFDR may help standardize ESG terminology and disclosure requirements and rules beyond the EU, as other nations look towards the EU standards when developing their own proposals for disclosures.

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