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Labelling of ESG funds: the US, UK and EU approaches

  • Europe
  • USA
  • United Kingdom
  • ESG
  • Investment funds and asset management
  • Financial services

24-01-2023

 

Introduction

To prevent greenwashing and to ensure that the names of funds fairly and accurately describe the ESG and sustainability characteristics of their investment policies and objectives, regulators in the UK, EU and US are in the process of adopting rules relating to labelling.

The UK is currently the furthest along with the labelling rules in its Sustainability Disclosure Requirements (“SDR”), currently the subject of public consultation. However, the EU is moving rapidly to catch up by amending its Sustainable Finance Disclosure Regulation (“SFDR”) to include labelling requirements, possibly out of concern that the UK might otherwise steal a march on it. The US Securities and Exchange Commission (“SEC”) has announced that it too intends to introduce a labelling regime by amending the ‘names rule’ in rule 35d-1 under the Investment Company Act of 1940 (“ICA”). The SEC is also seeking additional disclosure by ESG funds.

While the labelling regimes may be superficially similar, the underlying requirements for using those names are not and the UK SDR rules set a significantly higher standard than the proposed SFDR labels.

Comparison table

US UK EU
Legislative measure

Amendment to Rule 35d-1 Investment Company Act 1940

Sustainability Disclosure Requirements Sustainable Finance Disclosure Regulation
Status Proposal Out for consultation Out for consultation
Consultation closes Closed November 1, 20211 January 25, 2023 February 20, 2023
New rules published Not yet known Expected to be June 2023 Expected to be Q2/Q3 2023
New rules in force Not yet known

12 months after publication

(first implementation date currently anticipated to be June 2024)

We expect FCA to front run the rules for funds seeking authorisation in run up to date new rules in force

3 months after publication on ESMA website for new funds

9 months after publication on ESMA website for existing funds

Category names and how they relate2
Integration funds [No label] Article 6
ESG focused funds Sustainable improvers Article 8
Sustainable focus Article 9
ESG impact funds Sustainable impact
Disclosure

Types:

-registration statements and shareholder reports

-publicly available SEC filings (not sent to shareholders)

Types:

-consumer facing disclosure

-product-level institutional disclosure

-entity level disclosure

Based on TCFD:

-governance on climate risks

-strategy

-risk management

-metrics and targets

Per the SFDR Delegated Regulation
Product naming rule Yes Yes Yes
Restricted words Yes Yes Yes

[1]  The original consultation period closed on August 16, 2022, but due to a technical error at the SEC, the comment period was reopened in October 2022 until November 1, 2022.

[2]  Note that the differences in the criteria for the categories in the three jurisdictions are so different that while this is chart sets out the conceptual equivalence between the categories, there is little substantive equivalence in practice.

US: SEC amendment to the Names Rule (rule 35d-1) of the Investment Company Act 1940 and other rule and form amendments related to ESG disclosures

Overview

Rule 35d-1 under the ICA governs the naming of registered funds in the United States (the “Names Rule”), that requires that any fund with a name suggesting that the fund focuses on a particular type of investment, or investments in a particular industry or group of industries, must adopt a policy to invest, under normal circumstances, at least 80% of the value of the Fund’s net assets (including borrowings for investment purposes) in the investment type or industry suggested by the Fund’s name (an “80% Policy”). For example, a fund named “the equity fund” would need to have a policy to invest at least 80% of its net assets in equities.

In its current form, the Names Rule does not directly address fund names that use ESG terms, which has led to inconsistent application of the Names Rule to such terms. Over the past couple of years, the SEC Staff have generally requested that a fund adopt an 80% Policy when the fund’s name contains an ESG term.

Many funds have pushed back on this request, arguing that ESG terms suggest a specific strategy rather than asset type or industry. The current SEC guidance on the Names Rule states that terms describing a strategy are not covered under the Names Rule. Notwithstanding this guidance and past practice, in recent months, through its disclosure review office, the SEC Staff have not permitted new funds to launch with names that include ESG terms unless the fund has adopted an 80% Policy.

ESG amendment to the Names Rule

On May 25, 2022, the SEC proposed an amendment to the Names Rule to specifically address ESG funds. If adopted, the amended Names Rule would not allow a fund to include ESG terms in its name unless those ESG factors are determinative in making investment decisions.

If ESG factors are determinative, and that fund includes ESG terms in its name, under the amended Names Rule, the fund must adopt a policy to invest at least 80% of its assets in accordance with the ESG focus that the name suggests. For example, a fund with “sustainable” in its name must have a policy to invest at least 80% of its assets in sustainable investments.

As is the case currently, the fund is responsible for defining the parameters of its 80% Policy, and there is no set definition or industry standard stating what constitutes, for example, a “sustainable,” “green” or “diverse” company or investment. The SEC has acknowledged that this could result in inconsistencies across funds, because, for example, multiple “sustainable” funds could each have their own definition of what constitutes a sustainable company or investment for purposes of its 80% policy.

ESG Rules

At the same time as the Names Rule amendment announcement, the SEC proposed enhanced disclosures for funds that engage in any type of ESG strategy, even if that strategy is not part of the fund’s name (the “ESG Rules”). If the ESG Rules are adopted ESG funds will be classified as:

        • integration funds

        • ESG-focused funds

        • impact funds

If the ESG Rules and Names Rule were adopted as proposed the disclosure requirements and Names Rule amendments set out in this table will apply.

Fund Type 

Registration Statement Disclosure Requirements

Integration Fund

Funds that consider one or more ESG factors along with other, non-ESG factors in their investment decisions

 

  •  A description of how the fund incorporates ESG factors into its investmentselection process, including the particular ESG factors it considers
  • If the fund considers greenhouse gas emissions as a factor additionaldetailed disclosures are required
  • The fund name must not contain any ESG terms

ESG Focused Fund

Funds that apply inclusionary or exclusionary screens; funds that focus on ESG-related engagement with the issuers in which they invest; and funds that seek to achieve a particular impact

 

  • An ESG strategy overview table that discloses:

                  o    the fund’s ESG strategy

                  o   how the fund incorporates ESG factors in its investment decisions

                  o  how the fund votes proxies and or engages with companies about ESG issues

  • If the fund considers greenhouse gas emissions as a factor additional detailed disclosures are required
  • If ESG factors are determinative in making investment decisions the fund name may contain ESG terms.  If it does, it must adopt an 80% Policy in accordance with the amended Names Rule

 

Impact Fund

A subset of ESG-Focused Funds that seeks to achieve a specific ESG impact or impacts

 

  • All items required or allowed for an ESG Focused Fund
  • An ESG strategy overview table that discloses:

                  o  the fund’s ESG strategy

                  o  how the fund incorporates ESG factors in its investment decisions

                  o  how the fund votes proxies and or engages with companies about ESG issues

                  o  an overview of the specific impacts that the fund intends to achieve and how it will achieve them

 

  • Disclosure of the fund’s intended ESG impact in its investment objective

 

The comment period for both rules has closed.  Currently it is unknown when, if and in what form final rules will be adopted.

See our previous client briefings:

UK: SDR

Overview

The UK SDR is set out in FCA consultation paper CP22/20.

Over a year in the making, the product categorization and labelling regime is the FCA’s Policy answer to the mounting risk of greenwashing and its response to the EU SFDR.   It is also a spiritual successor to the FCA’s Guiding Principles set out in the Dear Chair letter from July 2021 setting out its guiding principles around design, delivery, and disclosure. (In parallel the FCA is presently undertaking a multi-firm supervisory review of the application of the guiding principles.)

In November 2021, the FCA published discussion paper DP21/4.  This was coordinated with HM Treasury and other Government departments and formed part of the UK Government’s broader COP26 plan to ‘green’ the UK financial system and align it with the UK’s net zero commitment.

The Discussion Paper included a possible new sustainability disclosure regime.  It also set out a ‘strawman’ for the labelling regime and the FCA established and sought views from a group of experts, including the Disclosures and Labels Advisory Group (“DLAG”), which included one of our Partners, Phil Spyropoulos.

On October 25, 2022 the FCA published its consultation paper.  The position on labels has evolved considerably from the Discussion Paper following several months of engagement with the industry by the FCA.  The FCA is clearly trying to raise the bar; something that is evident in comparisons with SFDR and the SEC’s proposed naming rules.  Ultimately the labelling regime reflects the FCA’s vision for the industry, not merely today’s good practice.  If the regime were to be distilled into a single sentence it would be ‘say what you do, then do what you say’.

The labels

The FCA is proposing three labels: sustainable focus, sustainable improvers, and sustainable impact.  Each of these will be sustainable.  Any product not qualifying for these labels will have no label at all.

The labels are intended to be mutually exclusive. None is intended to be more sustainable than the others although the bar is set particularly high for sustainable impact funds.  The regime is intended to be opt-in.  You don’t have to opt in but, if you don’t, and if you sell to retail investors, you are limited in what you can say about a product.  Those funds which do not use a label must meet the naming and marketing rules.

Categorization

Underpinning the labels are five principles:

  • investment objective
  • investment policy and strategy
  • key performance indicators
  • resources and governance
  • investor stewardship

For each of these principles, there are cross cutting considerations that apply to all labelled products and there may be specific considerations for each type of label.  This is rounded out with non-handbook guidance explaining how the FCA expects its requirements to be satisfied.

 

Categorization_FS Briefing

Sustainable focus

Sustainable focus products are those investing in assets that are essentially already sustainable assets.

The FCA’s emphasis on intentionality.  

Similarly to the SEC and EU, the FCA are not seeking to define sustainability but they are asking firms to define what sustainability will mean for them.  

These products must have at least 70% invested in assets that meet a credible standard for environmental or social sustainability or align with a specified environmental and/or social sustainability theme.

They must have a sustainability objective that is linked to that investment policy.  We envisage that this will be a classic combination of a financial objective that is stated to be delivered through investment in a sustainable portfolio.

Sustainable focus products are going to be required to include key performance indicators that will measure the ongoing alignment of the products assets with a target E or S profile and how it adheres to asset level sustainability features.

Sustainable improvers

Sustainable improvers are products with a portfolio that may not yet be sustainable, but whose assets have the potential to become more sustainable over time.  They must have a sustainability objective that is linked to the investment policy.

The emphasis for sustainability improvers is on KPIs that are designed to target and measure improvements and the trajectory of the portfolio over time.  Stewardship will be important for these products as the FCA is looking for the asset manager to do more than carefully select assets on a sustainable trajectory.

Sustainable impact

Sustainable impact products will need a target that is a predefined, positive and measurable with a real-world, environmental or social outcome.

To deliver this sustainable impact products must have a theory of change which explains how the actions the fund will take will deliver real-world outcomes.  They will need to specify a robust method to measure and demonstrate their sustainability impact.  They will also need an escalation plan should they be unable to deliver the intended impact.

KPIs for sustainable impact products will include enhanced impact measurement and reporting which will be based on best industry practice.

Anti-greenwashing rule

The FCA is introducing a new anti-greenwashing rule that will apply to all asset managers, irrespective of their client base.  This rule does not only apply to retail services or products.

The requirement is that if any references to sustainability characteristics are made, these must be consistent with the product or service actually delivered and its claims must be clear, fair and not misleading.

This new rule doesn’t add very much to the existing requirements in PRIN and COBS, but the FCA has stated that it will be useful to have an explicit rule that they can point to for enforcement purposes.

Product naming and marketing rule

Products that do not use one of the FCA’s new labels will not be able to use a variety of ESG and sustainability terms in their product names or marketing. In particular, the word impact will be reserved specifically for sustainable impact products.  The scope of ‘marketing’ here is potentially very broad and firms are understandably keen to understand the guiderails.

The FCA has indicated that non-marketing materials (e.g. prospectus) can refer to factual ESG practices or characteristics of the product.  Again some further clarity as to the boundaries of this would be helpful.

Overseas funds that do not voluntarily comply with SDR, but use prohibited phrases, can only be sold with health warnings.  The FCA intends to consult on the application of SDR to overseas funds in the future.

SDR disclosures

The FCA have based the disclosures on the TCFD requirements:

  • governance on climate risks
  • strategy
  • risk management
  • metrics and targets

Firms are encouraged to consider the sustainability accounting standards board metrics when making disclosures.  There are three potential layers of disclosure:

Consumer facing disclosure

Simple customer facing disclosure which summarises the key sustainability related features of the product being sold.  There is a clear link with the consumer duty and the customer understanding outcome.  This disclosure must be straightforward and simple.  It must be provided by all firms regardless of whether or not they use a label however will be more limited for products that don’t have a label.

Product-level institutional disclosure

More granular disclosure intended for institutions and those retail investors who want more detail.  The disclosures are aligned with the TCFD disclosures e.g., data and methodologies.

Entity level disclosure

There is some similarity with the SFDR entity level disclosure.  Again, this builds on the TCFD requirements and requires firms to disclose how they are managing sustainability risks and opportunities.

The SDR consultation closes on January 25, 2023.

A policy statement with final rules is expected in June 2023, with a 12 month implementation period, although we expect that the rules may be front run for new fund applications during the implementation period.

If you have comments that you want to feed in to the consultation but do not want to make your own submission, we would be happy to include your comments with our submission, on either an attributed or anonymous basis.  Please contact your usual Eversheds Sutherland contact.

EU: EU Guidelines on Funds’ Names Using ESG or Sustainability-related Terms

EU (not) labelling regime and new ESMA rules

Contrary to its UK and US equivalents the SFDR framework is designed as a disclosure regime rather than a labelling regime.  Its primary objective is to formalise principles for products that promote E/S characteristics or have sustainable investment as an objective rather than separating them into one or another category.  Nonetheless, in practice the market uses SFDR as a labelling regime.

Faced with uncertainty around the application of SFDR and Taxonomy Regulation as well as increasing greenwashing risks in the asset management industry, on 18 November 2022 ESMA published a consultation paper “Guidelines on Funds’ Names Using ESG or Sustainability-related Terms” adding rules on the use of fund names that are related to ESG or sustainability to the SFDR framework (the “Guidelines”).  These will apply to AIFMs, UCITS Management Companies, as well as EuSEFs, EuVECAs and ELTIFs Managers.

Naming rules proposed by ESMA

The Guidelines build on the principle that information in marketing communications should be “fair, clear and not misleading”.  ESMA takes the view that funds should be permitted to use ESG and sustainability related words in their names only if there is material evidence that they meet the sustainability characteristics and investment objectives described in the fund documentation.  

The Guidelines set quantitative thresholds for the use of ESG and sustainability fund names: 

 

  • If a fund name contains words related to ESG a minimum 80% of investments must meet the stated investment objective, whether that be promotion of E/S characteristics under Article 8 SFDR or sustainable investment under Article 9 SFDR
  • If a fund name contains words related to sustainability, such as ‘sustainable’, in addition to meeting the 80% threshold, a minimum 50% of the investments used to meet the ESG objective must also qualify as sustainable investments under article 2(17) SFDR

 

An Article 8 SFDR fund which under SFDR is allowed to pursue non-ESG strategies in addition to investments promoting E/S characteristics, will have to meet the 80% threshold to be allowed to use an ESG related name.

ESMA states that the Guidelines are not intended to interfere with SFDR or Taxonomy Regulation and adopt the same concepts and definitions for better coherence.  The relevant definitions and standards used in the Guidelines are the same as for SFDR Delegated Regulation which sets out the template disclosures for Article 8 and Article 9 SFDR funds.

Next steps

The consultation closes on 20 February 2023.

ESMA plans to release final guidelines by Q2/Q3 2023, and currently intends that the naming rules should come into force within three months of publication in the EU’s Official Journal for new funds and six months later (so nine months after publication) for existing funds. 

How can Eversheds Sutherland help? 

Our team have been advising on regulatory interpretation and product development for the fund management industry since the 1980s and we have been at the forefront of new products under European and UK regulation in the period since then. Our in depth understanding of the sector and experience with the practical implementation of new product categories mean that we are very well placed to guide you in complying with the changing product and regulatory environment.

 

 

o    the fund’s ESG strategy