Environmental, social and governance (ESG) issues have been front of mind for fund managers, particularly due to recent legislative changes, often focused on disclosure. On the latest episode of “The Preferred Return” co-hosts Greg Norman and Abigail Reeves guide managers through some of the ESG considerations that need to be taken into account when marketing a fund in the U.K. or EU.
Voiceover (00:03):
Welcome to the Preferred Return, Skadden’s Investment Management podcast covering legal and regulatory developments in the UK and Europe.
Abigail Reeves (00:15):
Hi, and welcome back to The Preferred Return. I’m Abby Reeves, and I’m here with my co-host Greg Norman. The Preferred Return is a Skadden podcast series providing short summaries of legal, regulatory, or other topical developments in the UK and European investment management space.
Greg Norman (00:30):
Our podcasts are intended to be accessible by professionals across the sector. We welcome any feedback, particularly if there are topics people would like us to discuss. In today’s episode, we’re going to talk about environmental, social, and governance or ESG considerations for fund managers. In doing so, we’ll discuss the legislative changes that have occurred over the past few years and what impact they’ve had on managers who are looking to market a fund in the UK or EU. So Abby, can you help us take a step back and provide some background as to how the ESG regulatory regimes have impacted fund managers?
Abigail Reeves (01:02):
Sure. ESG regulations impacting fund managers have primarily been focused on disclosure. Broadly speaking, the regimes have two objectives. First, to reduce or eliminate greenwashing, and second, to promote particular behaviors by imposing additional obligations where a product promotes a particular strategy. This means that fund managers need to factor ESG considerations into all parts of a fund’s lifecycle. At the conception stage, a manager considering a new fund should be mindful of the regulatory implications of using messaging or promoting strategies that use ESG elements.
Greg Norman (01:35):
That’s right. And that shows how the second objective you mentioned has an impact. Given the focus on ESG related products over the last few years, it’s understandable that some fund managers have wanted to say positive things about their impact on the environment or society. Regulation has sought to keep up with these changes. For instance, the SFDR imposed additional requirements, meaning that fund managers had to take further steps to back up that kind of marketing. Fast-forward to 2025 and sentiment around ESG seems to be in reverse, with many fund managers shying away from ESG themes and many investors slimming down their expectations. So if market sentiment is going in that direction, why are we still talking about it?
Abigail Reeves (02:13):
Well, one reason is that these rules have to be factored into product development. This includes simple things like fund names. Even where a fund is not pursuing an ESG objective, they will have disclosure and reporting obligations under the ESG rules if they market in the EU or UK. A second reason is that when a fund begins investing, its underlying portfolio companies may have ESG related disclosure obligations. For example, under the CSRD. We aren’t going to try and tackle that point today, but it illustrates the extent to which ESG considerations permeate the private capital sector. Our focus today is going to be the fund level regulation, specifically the EU Sustainable Finance Disclosure Regulation or the SFDR, and the UK Sustainability Disclosure Regulation or the SDR.
Greg Norman (02:57):
Great. So we’ll start with the SFDR. The SFDR is a comprehensive regulatory framework introduced by EU regulators in December, 2019. It introduced ESG and sustainability related disclosures for financial markets participants with a stated aim to enhance the transparency and disclosure of sustainability information for financial products. The regulation is supplemented by regulatory technical standards, which set out more detail on the SFDR’s requirements. In the scope, financial market participants such as fund managers have had to comply with the SFDR since January, 2023.
Abigail Reeves (03:30):
Thanks, Greg. It’s important to highlight that any fund manager planning to market their funds in the EU, regardless of where they are based, will need to comply with the SFDR. This means having the necessary disclosures in their pre-contractual documentation, typically through the offering memorandum or private placement memorandum. There are two primary types of disclosures under the SFDR. Entity level disclosures and product level disclosures. Greg, would you mind outlining the difference?
Greg Norman (03:55):
Entity level disclosures are disclosures about the fund manager itself, outlining its approach to sustainability. This includes how the manager incorporates sustainability risks into its decision-making processes, its due diligence policies for identifying principal adverse impacts and the alignment of remuneration policies with sustainability integration. Product level disclosures, on the other hand, focus on the individual investment products and their sustainability features. Unlike the entity level disclosures, which apply universally across financial market participants, the product level disclosures vary depending on a fund’s specific ESG characteristics or category.
Abigail Reeves (04:31):
Great, thanks. In terms of product categorization, the SFDR split these into three tiers based on their sustainability focus, with the disclosure requirements varying between the tiers. Article nine funds have sustainable investments as their core investment objective. Article eight funds promote environmental or social characteristics, but do not have a sustainability built into their investment objective. Funds that do not fit into either of these categories are often referred to as article six funds. Article eight and nine funds must stick to prescribed disclosure templates of pre-contractual and periodic disclosures set out in the regulatory technical standards you mentioned, Greg. These detail the investment approach, methodology, and impact. Article eight and nine funds also have detailed website disclosure requirements. Article six funds are not subject to these requirements, but they still need to disclose the relevant sustainability risks and related adverse impacts as set out in article six and seven of the SFDR.
Greg Norman (05:26):
While the SFDR’s primary goal was to enhance transparency and disclosure, the existence of the three tiers inadvertently created a categorization system for financial products. Although this categorization can be beneficial in providing investors with a clearer understanding of a fund’s sustainability focus, there has been a growing concern amongst regulators that categorization has been counterproductive.
(05:47):
Their concern is that there’s been too much focus on the categorization rather than on promoting sustainable investment, and that funds may have been exaggerating or misrepresenting their sustainability credentials to fit into one of the greener article eight or article nine tiers. This practice known as greenwashing undermines the intent of the regulation and can mislead investors. So Abby, can you tell us a bit about how the market has responded to the SFDR?
Abigail Reeves (06:12):
As with all the regulation, the private fund market has adapted to it, although there have been some challenges. As you mentioned, while the categorization system fostered some development, concerns about greenwashing and the potential misuse as a marketing tool cannot be ignored. Additionally, data availability and quality remain significant hurdles. The complexity of gathering and reporting ESG data can be burdensome, raising questions around the cost-benefit analysis. Also, the SFDR’s evolving nature, coupled with its relatively complicated structure, has made it challenging for some investors to navigate through, particularly those less familiar with EU financial regulation.
Greg Norman (06:46):
Indeed. And that explains why the EU regulators are considering reform of the SFDR in light of these concerns. A series of consultation papers and joint opinions have been issued by EU regulators since 2023, and these proposed changes can be broadly categorized into two areas: changes to the categorization system, and changes to the content of disclosures. Shall we explore the potential reforms of the categorization system first?
Abigail Reeves (07:11):
Sure. Following extensive consultations with industry stakeholders and the public, the EU regulators are leaning towards adopting a new categorization system. Rather than formalizing and building upon the existing article six, eight, and nine framework, they proposed a new structure based on a different criteria. The core of the new system involves two voluntary product categories, sustainable and transition. Each category will be accompanied by a sustainability indicator, similar to the EPC energy ratings that we’re familiar with, to visually represent a product sustainability profile on an A to E scale. Products that do not meet the criteria for either category or those with no sustainability features will be subject to specific disclaimers in investor documents, and there will be limitations on their names and marketing.
Greg Norman (07:54):
Thanks, Abby. Moving on to the proposed reforms of product level disclosures and the EU regulators are exploring several areas for improvement. First, they’re considering how to simplify, harmonize, and adapt the digital format of existing pre-contractual website and periodic disclosures to enhance consistency in user experience. Secondly, they are assessing whether to introduce a minimum sustainability information disclosure threshold. This would establish a baseline level obligation for all products which could promote transparency and comparability. Finally, regulators are also examining the potential for tailoring disclosures based on investor type, as they have recognized the distinct needs of retail and institutional investors.
Abigail Reeves (08:36):
EU regulators are actively considering revisions to the SFDR framework. However, the timeline for implementing these changes remains uncertain. Until these changes come into force, fund managers targeting the EU market should still adhere to the current SFDR regulations. It is important to note that while the SFDR emphasizes disclosures, fund managers must also be aware of the specific guidelines governing the use of ESG or sustainability related terms in fund names. These rules came into force on the 21st of November, 2024. Greg, could you briefly outline these new naming rules?
Greg Norman (09:09):
Of course. In essence, the proposed naming rules stipulate that funds using ESG or sustainability related terms like environmental, sustainable, impact, green, ESG, transition, social, climate, or similar descriptors must align with specific criteria. The fund must also adhere to the full exclusion list prescribed under the Paris aligned benchmarks, which include the restrictive or prohibitive involvement with controversial weapons, tobacco, violation of UN rules, and so on.
Abigail Reeves (09:38):
Thanks, Greg. Let’s now shift our focus to the UK regulatory landscape. As you may be aware, the UK’s equivalent to the SFDR is the SDR. This was introduced in November, 2023. The UK’s FCA has obviously benefited from the insights gained through the implementation of the SFDR. The SDR is therefore a more ambitious regulatory framework covering anti-greenwashing, labeling, naming, marketing, and disclosure requirements. Unlike the SFDR, which applies to all EU and overseas funds to be marketed in the EU, the SDR only applies to UK domiciled asset managers or FCA authorized funds, such as UK AIFMS. Non-UK funds and portfolio management service providers are currently outside the scope of these rules, though the FCA said that it will broaden the SDR to include both in the future. The SDR covers five key areas. Greg, would you mind setting these out?
Greg Norman (10:28):
Not at all. First, the SDR contains certain anti-greenwashing rules. These rules mandate that any references or descriptions must be consistent with the sustainability characteristics of that product and be fair, clear, and not misleading. Second and third, the SDR contains labeling and naming rules for both labeled products and unlabeled products. The fourth area that product level and entity level disclosure rules cover similar areas as the SFDR, such as the disclosure of adverse impacts and the investment strategy.
(10:57):
However, the SDR rules go a step further by requiring certain additional details. For example, the SDR requires on-demand disclosures for clients who require information for their own sustainability-related disclosure obligations under legal or regulatory requirements, which may include non-UK rules. The last area is on the rules for distributors, and these govern the distribution of retail funds to UK retail investors. The SDR had a staggered implementation during the course of 2024 with the first set of ongoing disclosures for all relevant financial products due by the 2nd of December, 2025. Given the SDR’s relatively recent introduction, the market’s still grappling with understanding these requirements and implementing necessary steps to comply with the new regulations.
Abigail Reeves (11:41):
Thanks, Greg. Unlike the SFDR, the SDR prescribes four product categories of products. These are sustainability focus, sustainability improvers, sustainability impact, and sustainability mixed goals. While using these labels is entirely optional, if a product intends to fall under a category, it must meet the qualifying criteria for that category on an ongoing basis, which includes the 70% asset rule, meaning that 70% of the gross value of the assets must align with its sustainability objective.
(12:11):
There are also certain distinctive qualifying criteria, also referred to as label-specific criteria. For example, for the label of sustainability improvers, the investment may not be sustainable now, but it should have an aim to improve over time, and as such, the firm must identify the period of time in which the product is expected to meet that target. For unlabeled products, which means products that do not qualify for any of the four categories, using ESG or sustainability terminology will be subject to stricter rules.
Greg Norman (12:41):
This remains a dynamic and rapidly evolving sector of the funds industry. It will be interesting to observe the development of new regulations and their impact on the market, particularly given the general move away from the macro-based ESG agenda. Fund managers may be less inclined to advertise a fund’s sustainability credentials, for example. We will continue to track these developments closely and share our insights in upcoming episodes. Thank you all for listening. We hope you found today’s discussion informative. This is the Preferred Return. Stay invested.
Voiceover (13:15):
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