What issues need to be considered when re-categorising a fund from Article 6 to Article 8 under Sustainable Finance Disclosure Regulation (SFDR)?
In 2019, as the Payment Protection Insurance mis-selling scandal came to an end with an estimated cost of £50bn for UK lenders, speculation was rife as to what would be the next source. The accepted thinking was that the contentious areas of payday loans, customer data and pensions would be fertile ground, however a few believed presciently that any future mis-selling scandals may not come from solely banking.
If we fast forward to February 2022 and ESMA’s Sustainable Finance Roadmap, one of the three priorities called out is “tackling greenwashing and promoting transparency”. When talking about greenwashing, the ESMA report carefully distinguishes between the ultimate symptoms and its source which can affect the investment long before the product reaches the final investor.
In addition, Morningstar cut recently 1,200 funds from its sustainability list and as reported “most of the removed funds declared their sustainable credentials under the EU’s “light green” Article 8”. Finally, MIFiD II is going to increasingly drive retail investors into ESG products.
Given the context, it is does not take a great stretch to identify that the reclassification of a fund from Article 6 to 8, will be subject to increased focus and if not done properly will be challenged by stakeholders.
So, what are the issues that need to be addressed to ensure that your fund will surmount any challenges?
The products that are being sold by multiple data aggregators provide you with essential information in meeting your Principal Adverse Impact (PAI) reporting obligations required by SFDR Regulatory Technical Standards (RTS). While an individual SFDR data product provides important information, it is not a ‘one-stop shop’ particularly for non-public funds.
Irrespective of what type of Article 8 fund you are going to be, you will be required to disclose data in relation to mandatory indicators in order to make a PAI statement of your investments on sustainability factors and while there continues to be improvements, there are acknowledged data deficits. Therefore, if you reclassify as an Article 8 fund you need to plan on what data you will need to disclose and how you can surmount the information gaps.
ESMA has indicated that the PAI limb of the Sustainability Preferences definition can be met if the Article 8 fund product considers PAIs in the form of commensurate voting and engagement policies. However, it should be noted that just because a fund starts to consider the PAI indicators on sustainability factors or has general exclusion, voting and engagement policies, these do not mean that the fund is automatically Article 8.
SFDR RTS disclosures extend to both legal entity and fund product levels. SFDR level 2 product requirements have been broadened to include EU taxonomy alignment measures. An Article 6 fund which looks to reclassify, will need to be prepared for the level of ESG reporting disclosures required by an Article 8 fund.
Following the integration of the Taxonomy Regulation into SFDR RTS disclosures and as articulated in the definition of a Sustainability Preference, the European Supervisory Authorities have stated that taxonomy compliant sustainable investments for Article 8 SFDR products, would typically only be a sub-set of investments. There is a clear distinction being created between Article 8 fund products.
This distinction will influence investors when choosing between Article 8 Plus funds (SFDR which has a subset of a minimum proportion of Taxonomy aligned investments with sustainable objectives) and Article 8 (SFDR – promoting ESG characteristics only) and finally, Article 8 fund which consider PAIs in the context of impact on sustainability factors which it incorporates in a voting and an engagement strategy. In my opinion, this adds a new dimension- there is going to be a further tiering within Article 8 products, where an Article 8 Plus fund is going to be considered superior by investors as they are less likely to suffer from greenwashing challenges.
The danger would be to say that in practice there will be no difference between the the first two tiers of Article 8 products given the recognised data deficiency resulting in the inability to obtain the data required for the investments aligned with the Taxonomy. That is not the case as Article 8 Plus funds will become more valuable as the data gap narrows.
The question of whether the resulting Article 8 fund is going to contain any Taxonomy aligned investments is very pertinent to any Article 6 fund looking to switch to Article 8.
Funds governance is going to be critical in providing the evidence in justifying the reclassification switch from Article 6 to Article 8. There will need to be a clear fund governance path, featuring executive review(s) and ultimate approval(s).
- ‘Weakest in the herd’
A fund board is going to need to consider the broader consequences of re-classification to Article 8, including the inevitable additional scrutiny you will face not just from the regulator but also from other stakeholders. Boards will need to have an external view as to the Article 8 competitive landscape and if after switching it will be one of the weaker ones in the herd. This will contribute to the Board assessing the reputational risk from switching classification.
- Board skills and expertise
The Board has collective responsibility over multiple issues and it is rightly considered impossible to cover-off every discipline. As underlined in the CBI Security Markets Risk Outlook Report, boards need to challenge data and reports to effect good governance. However, if you are re-classifying from an Article 6 (non-ESG specialist) fund to an Article 8 Plus fund, and you do not have a Board member with an ESG skillset, it is going to be hard to argue that there is appropriate oversight to effect good governance and the gap is going to be more pronounced as the Social taxonomy is introduced into the EU Taxonomy.
- ESG risk framework
A Board needs to consider if the increased risks have prompted the necessary controls and appropriate due diligence as an evidentiary bedrock to justify any reclassification. The question of whether a specific ESG risk framework is required and needs to be embedded should be considered.
In summary, a Board needs to consider the (non-exhaustive) issues and questions raised above. Please get in contact if you have any questions.
Muiris O’Dwyer is a Co-founder TopRiver Partners, an Independent Directors’ and Consulting office focused on ESG. TopRiver Partners is in a partnership with Gecko Governance rolling out ESG reporting products
 A Sustainability Preference is defined as a client preference for (i) a minimum proportion of EU Taxonomy aligned investments; (ii) a minimum proportion of SFDR sustainable investments (promoting ESG characteristics); or (iii) consideration of principal adverse impacts on sustainability factors set out in the SFDR RTS (“PAIs”) on either a qualitative or quantitative basis
 The European Comission is currently analysing the final report and recommendations from the Platform on Sustainable Finance.