SFDR 2.0 – European Parliament negotiating position: The stage is set for trilogue

Like the Council, the Parliament is proposing an opt-out from the SFDR 2.0 framework for AIFs which are made available exclusively to investors classified as per se professionals under the EU MiFID framework. In practice, that categorisation will broadly cover authorised financial market participants and institutional investors.

Nonetheless, there are important limitations to the proposed opt-out, some of which differ from the Council's proposal. These include the following:

• Like the Council, the Parliament would make the opt-out available only to investments in AIFs. This means that other financial products (such as UCITS funds or investment insurance policies) which are offered exclusively to per se professionals cannot benefit from the opt-out.
  
  
• Again, like the Council, the Parliament would limit the availability of the opt-out to AIFs made available exclusively to per se MiFID professional investors. This means that professional-only funds that are also offered to elective professionals (i.e. investors who do not satisfy the MiFID criteria but who meet certain conditions and have the necessary knowledge and understanding to be considered professional) cannot benefit from the opt-out. Under the current MiFID classification framework, individuals (i.e. natural persons) cannot qualify as per se professionals, but only as elective professionals if the relevant criteria are met. As we noted in our earlier briefing on the Council proposals, one effect of this may be that managers of AIFs which are not intended to be sustainability-related products may be discouraged from making their products available to high-net-worth, sophisticated individual investors, for whom such investments might otherwise be suitable.
  
  
• Somewhat oddly, the Parliament's opt-out also includes wording that states that the opt-out is available provided that no MiFID retail investor has access to the relevant AIF. We assume that "access to" is intended to refer to direct access (rather than, for example, an indirect exposure through some other financial product). If so, this requirement would already seem to be implicit in the restriction noted above that the relevant fund can only be made available to MiFID per se professionals. This might suggest that the Parliament had not really turned its mind to the question of elective professionals, but given that both the Parliament and Council have expressly limited the scope of the opt-out to per se professionals, it now seems unlikely that any institution will be advocating to widen the scope of the opt-out during trilogue.
  
  
• Both the Council and Parliament have structured the opt-out so that it is not a complete disapplication of the SFDR rules. In both cases, the opt-out would disapply the new product categories and the rules in the new Article 6a which relate to disclosures about non-sustainability-related products. The Council opt-out would also have disapplied restrictions on making sustainability-related claims in the names and marketing communications of the relevant AIFs, but the Parliament text does not extend the scope of the opt-out to those requirements. As a result, the Parliament's drafting is unclear as to whether the fund name and marketing restrictions would still apply to opted-out professional-only AIFs which otherwise meet the conditions to be Article 6a products. This means that if the Parliament's version of the opt-out prevails, managers of AIFs that are not intended to be sustainability-related products might still need to consider the name of the fund and the content of any associated marketing materials to ensure that these do not include sustainability-related claims.

The fact that both the Council and Parliament have included broadly similar opt-outs for professional-only funds in their respective texts suggests that there is a reasonably high likelihood of the opt-out surviving into the final SFDR 2.0 legislation. However, as we noted previously, the use of any opt-out in practice is likely to depend upon investor expectations – we anticipate that some EU institutional investors will nonetheless continue to seek to allocate capital to products that are categorised under the new SFDR 2.0 rules in keeping with their existing investment approaches.

It now appears highly unlikely that our preferred solution of exempting all communications directed exclusively at professional investors from the SFDR 2.0 disclosure restrictions will be adopted. The merits of that approach were that fund managers could have open discussions with institutional and sophisticated investors who do not need protections aimed at the retail market, even in relation to funds which might also be available to retail investors. This might also have encouraged some fund managers to adopt the new product categories.

The Parliament has also maintained the exemption from SFDR 2.0 for closed-ended funds which are created and distributed before the date that the new regime comes into effect.

The Council text proposed to clarify the scope of this "grandfathering" treatment by making it clear that the relevant fund had to be fully raised before the entry into force of the new rules. The Parliament text does not include the same wording, but the practical effect nonetheless appears to be similar – i.e. broadly, marketing of the fund will need to have been completed before the SFDR 2.0 framework begins to apply.

However, the Parliament text includes express wording which states that the fund manager will need to continue to comply with any previous "contractual commitments undertaken and sustainability disclosures made" on the basis of SFDR 1.0. Any such commitments or disclosures will, however, not be considered to constitute sustainability-related disclosures for the purposes of SFDR 2.0.

This is a different position from that put forward by the Commission and the Council because it appears designed expressly to preserve the application of SFDR 1.0 requirements in relation to the relevant fund. Nonetheless, in practice, even under the Commission and Council versions, managers of grandfathered funds were still likely to need to comply with existing commitments relating to SFDR 1.0 obligations, but by virtue of their contractual – rather than regulatory – obligations.

There is some ambiguity in the Parliament's text, as it refers to complying with "previous contractual commitments undertaken and sustainability disclosures made" on the basis of SFDR 1.0, rather than directly to the substantive obligations of SFDR 1.0. Where those contractual commitments and disclosures reference the possibility of walking back commitments in the event of a change in regulation, it might be arguable that a fund manager could modify its existing investment approach and still be in compliance with such commitments and disclosures.

Like the Council, the Parliament is not proposing to make any significant amendments to the basic structure of the Commission's proposed new SFDR 2.0 product categories. This means that it now seems highly likely that when SFDR 2.0 takes effect, sustainability-related financial products marketed in the EU will need to be categorised as either Article 7 (Transition), Article 8 (ESG Basics) or Article 9 (Sustainable) products. Conversely, non-sustainability-related products will need to comply with the restrictions in the new Article 6a.

The Parliament has not made any attempt to rename these product categories, despite industry concerns with some of the terminology, especially in relation to the "ESG Basics" label for Article 8 products. However, the Parliament is proposing to expand the Commission's mandate to review the operation of SFDR 2.0 so that this will cover, among other elements, whether the names of the Article 7, 8 and 9 product categories remain "clear, effective and understandable" for investors. If this is retained in the final SFDR 2.0 text, this might open up future opportunities to address some of these potential issues.

In general, across the three "core" product categories of Article 7, 8 and 9 products, the Parliament (like the Commission and the Council) would retain the minimum 70% threshold for investment in underlying eligible investments specified for that product type. It would also maintain the alternative, permitting Article 7 (Transition) products to invest a minimum of 15% of their portfolio in EU Taxonomy-aligned investments instead. However, for Article 9 (Sustainable) products, it would raise that threshold to a minimum of 20% investment in Taxonomy-aligned investments, demanding a higher standard than the other EU institutions.

The Parliament has also retained the Council and Commission provisions which allow an appropriate time-limited "ramp-up" period for Article 7, 8 or 9 products to meet the minimum 70% threshold for eligible underlying investments, provided that this is disclosed to investors in the product's pre-contractual documentation. This is potentially helpful to private funds, given that they typically deploy capital over an extended initial investment period.

The Parliament would amend the scope of the Commission's powers to adopt delegated acts in connection with SFDR 2.0 so that they would include the ability to provide for limited deviations from the investment exclusions applicable to Article 7, 8 or 9 products. The Commission would be permitted to allow such deviations where product providers have taken all reasonable measures within their control to comply with the relevant requirements, provided that the deviation is of limited duration and is disclosed to investors in a transparent manner.

This would be in addition to the limited deviations already permitted by the Commission and Council drafts for hedging purposes. However, unlike the Council, the Parliament text does not expressly envisage the delegated acts permitting limited deviations specifically due to delayed divestment from illiquid assets, which was considered helpful, particularly in relation to private market investments. To the extent that such delayed divestment is not due to factors beyond the provider's reasonable control, the Parliament's text would not appear to empower the Commission to permit such deviations.

The Parliament is largely retaining the restrictions in Article 6a that apply to non-sustainability-related products. Essentially, those conditions would allow a product provider to include information on how the product considers sustainability factors in the product's pre-contractual documentation without triggering any of the obligations in Article 7, 8 or 9, provided that certain conditions are met.

The Parliament has retained the Commission's existing conditions, which include:

• The information not being a central element of the pre-contractual disclosures. Like the Council, the Parliament would retain the unhelpful requirement that any information on consideration of sustainability factors must not exceed 10% of the volume of the material discussing the product's investment strategy, and must be "secondary...in terms of breadth and positioning" in the document.
  
  
• The information not being included in any PRIIPs KID or UCITS KIID.
  
  
• The information not constituting a sustainability-related claim that would fall within Article 7, 8 or 9. This effectively precludes the product provider from claiming the product invests in the sustainable transition, in sustainable companies or assets, or otherwise contributes to sustainability. The Council text would have allowed the product's pre-contractual documentation to include information on how it integrates sustainability factors into its investment strategy (i.e. a claim falling within Article 8), but the Parliament text has maintained that restriction. This is unfortunate because, as we noted in our briefing on the Council's proposals, there are concerns that if a product provider is seeking to explain to investors the extent to which sustainability forms part of its investment approach (beyond merely how it takes into account sustainability risks), this may force it to adopt at least the Article 8 (ESG Basics) product categorisation.

In addition, the Parliament text has also added the following additional requirements:

• Any information must "accurately represent the true composition of the financial product's investments". It is unclear how far this would impose substantive new obligations, given that any information in the product disclosures must in any case avoid being misleading, but arguably this might introduce expectations around giving further detail on underlying investments. If so, that may pose additional challenges, given the 10% volume limit referenced above, and the risk of straying into Article 8 claims around integration of sustainability into the product's investment strategy.
  
  
• The information must not refer to any voluntary sustainability-related labelling scheme with features that "do not exceed those in Articles 7, 8 or 9" in terms of their objectives, investment approaches, governance or transparency requirements. Essentially, the Parliament seems to want to prevent product providers from referencing less onerous non-SFDR labels in the relevant product literature. If this language is retained in the final SFDR 2.0 text, this may raise questions about exactly what is included within the concept of a "labelling scheme" for these purposes.
  
  
• The periodic report for the product would also need to contain a prominent statement which confirms that the product is not categorised under EU standards for sustainable financial products and therefore is not required to disclose its negative environmental impact. This would go somewhat further than the Council's proposal that the pre-contractual disclosures should contain a standardised disclaimer that the product does not meet the minimum criteria under EU to qualify as a sustainability-related financial product, and arguably might be perceived by investors as carrying additional negative connotations.

The Parliament's text has modified some of the eligibility criteria for underlying investments for Article 7 products as follows:

• Unlike the Council, the Parliament has retained the Commission's original exclusion which prevents Article 7 products investing in companies deriving 1% or more of their revenues from the exploration, mining, extraction, distribution or refining of hard coal or lignite.
  
  
• In addition (and in common with the Council), the Parliament also includes an exclusion preventing investment in companies deriving revenues from the exploration, extraction, mining or refining of (essentially) fossil fuels, unless those companies meet certain minimum requirements. These include allocating at least 20% of their capital expenditure to EU Taxonomy-aligned activities and having in place time-bound and measurable strategies to reduce their Scope 1 and 2 greenhouse gas emissions in a way that is compatible with the Paris Agreement and (if they relate to using hard coal or lignite for power generation) to phase-out exploration, mining, extraction, refining and exploitation of hard coal or lignite. However, the Parliament has added a further condition: the relevant company must also allocate, over a rolling three-year period, a higher average proportion of its total capital expenditure to EU Taxonomy-aligned activities than to its development of new projects for exploring, extracting, mining or refining fossil fuels (conceivably above the 20% capex requirement, if new coal, oil and gas projects are above this level). This is notable as the first time that Taxonomy-aligned investments would be mandated (rather than simply reported on).
  
  
• Conversely, the Parliament has taken a slightly different approach in relation to companies which have been found to be in violation of the OECD Guidelines for Multinational Enterprises or the UN Guiding Principles on Business and Human Rights. While the Commission text excludes such companies from being eligible investments if a benchmark administrator has found a violation, the Parliament text states that the exclusion applies if the violation relates to "severe" human rights and humanitarian law abuses which have not been effectively addressed and, where appropriate, remediated. This may provide some additional flexibility in terms of assessing whether a sufficiently severe violation has arisen and, if so, whether it has been adequately resolved.
  
  
• In assessing whether the 70% threshold of eligible investments with a transition objective is met, the Parliament has retained the provision excluding investment in public sector debt issuances, except where certain eligibility criteria are met. However, the Parliament has expanded this to include investment in loan facilities provided by public sector bodies (again, provided they meet the relevant eligibility criteria). In addition to permitting investment in European green bonds and use of proceeds instruments which do not fund certain prohibited activities, the Parliament would also allow investment in general purpose debt issuances or loan facilities of EU public sector bodies, provided that the product provider can demonstrate (using formalised and documented methodologies) that the investment is aligned with the transition objectives of the product and that such investments do not exceed 15% of the portfolio. In common with the Council, the Parliament would also require that any other investments in issuances by public sector bodies outside the 70% threshold must still be consistent with the product's transition objective or strategy.
  
  
• The other eligible investments for the purposes of the 70% threshold for Article 7 products are broadly similar to the Commission's proposed list. However, the Parliament text would tighten the criteria applicable to investments in undertakings or economic activities with a credible transition plan. The Commission and Council texts require that the relevant plan need only relate to "at least one sustainability factor", but the Parliament text deletes this. As a result, it appears that under the Parliament's approach, the transition plan would need to be credible on an overall basis at the level of the undertaking or activity, with a helpful proportionality qualifier being common between the positions.
  
  
• The Parliament would retain the general "catch-all" category of other investments in undertakings, economic activities or other assets that credibly contribute to the transition, provided there is a proper justification for such investments in the product's pre-contractual documentation. However, the Parliament would require this justification to take into account the option to invest in other types of eligible investments recognised for the purposes of Article 7. Accordingly, if the Parliament's text were adopted, this would seem to require the product provider to justify why it is not investing in the other specific types of eligible investments and is instead reliant on the "catch-all" category.
  
  
• In the same way as the Council, except in relation to investments managed by reference to EU climate benchmarks or investments in EU taxonomy-aligned activities, the Parliament would also require the product provider to implement an appropriate documented due diligence process to establish that the investment does contribute to the transition objective, and an appropriate ongoing monitoring process to address underperforming investments or underperformance at the portfolio level. The relevant processes would have to be reviewed at least annually and updated where necessary.

The Parliament would also impose a mandatory requirement on the product provider to report principal adverse impacts (PAIs) on sustainability factors of their investments using appropriate sustainability-related indicators. This must include an indicator on exposure to companies active in the fossil fuel sector and greenhouse gas emissions, as well as at least one additional indicator listed in a delegated act to be adopted by the Commission.

The Parliament has also updated the disclosures required for Article 7 products to:

• Make it clear that the description of the relative share of investments in Article 7 eligible investments must be expressed as a percentage of the product's portfolio; and
  
  
• Require a description of the sustainability-related engagement strategy adopted by the product provider, which must include the proportion of the portfolio covered by the engagement activities and how the strategy has been implemented in line with the product's transition objectives, or otherwise a clear and reasoned explanation of why the provider does not pursue such a strategy.

Many of the changes that the Parliament would make to the Article 8 (ESG Basics) product category are similar (although not always identical) to the changes it has proposed in relation to Article 7 (Transition) products above.

These include the following:

• The Parliament adopts the same modified approach in relation to companies which have been found to be in violation of the OECD Guidelines for Multinational Enterprises or the UN Guiding Principles on Business and Human Rights.
  
  
• The Parliament would also expand the eligible investments for Article 8 products to include investing in use of proceeds loan facilities issued to companies, where the relevant proceeds do not fund a range of prohibited activities. The eligible investments would also be expanded to include instruments issued by public sector bodies which are not use of proceeds EU green bonds and which do not fund certain prohibited activities, provided that they are consistent with the product's stated sustainability-related objective or strategy.
  
  
• For the purposes of the 70% threshold of investments integrating sustainability factors under Article 8, eligible investments would include investments that outperform the average investment universe or reference benchmark, but like the Council, the Parliament would require outperformance in relation to at least two appropriate specific sustainability indicators.
  
  
• The Parliament would also permit investments in general purpose sovereign, sub-sovereign (i.e. regional or municipal) or supranational debt issuances to count towards the 70% threshold, provided that such issuances can be deemed sustainable through the use of appropriate available methodologies.
  
  
• For the "catch-all" bucket which permits investing in other investments integrating sustainability factors beyond the consideration of sustainability risks, the Parliament would require the product provider to give a clear and concise justification in the product's pre-contractual disclosures as to the integration of those factors, including in light of the other permitted eligible investments. Again, as for Article 7 (Transition) products above, this would appear to require an explanation of why the product provider has not invested in the other eligible categories of underlying investments instead.
  
  
• The Parliament would require the product provider to identify and disclose PAI impacts of their investments on sustainability factors and any actions taken to address such impacts, and would mandate that such disclosures must use an indicator on exposure to companies active in the fossil fuel sector. However, they may also disclose other PAIs relevant to the product's sustainability-related objectives.
  
  
• The product disclosures must disclose the relative share of underlying eligible investments as a percentage of the overall portfolio, and must also disclose the proportion of the product's investments in EU Taxonomy-aligned activities.
  
  
• As for Article 7 products above, the product provider must also give a description of the sustainability-related engagement strategy it pursues and the percentage of the portfolio covered by that strategy, or must otherwise give a clear and reasoned explanation as to why it does not pursue such a strategy.

Again, many of the changes relevant to Article 9 (Sustainable) products that are introduced by the Parliament text are similar to the changes for Article 7 and 8 products above.

These include the following:

• The exclusions that apply to the investments made by Article 9 products would be amended. The original Commission proposal excluded any investment in any company excluded from EU Paris-aligned benchmarks. The Parliament would maintain that exclusion, except that its treatment of companies that benchmark administrators have found to be in violation of the UN Global Compact Principles or the OECD Guidelines for Multinational Enterprises is more nuanced – such investments would be permitted except where those violations related to severe human rights and humanitarian law abuses which have not been effectively addressed or remedied.
  
  
• Product providers would be required to disclose PAIs of their investments on sustainability-related factors using appropriate indicators. These must include indicators on exposure to companies active in the fossil fuel sector, exposures to greenhouse gas emissions, exposures to activities negatively affecting biodiversity-sensitive areas, and exposure to companies without processes and mechanisms to monitor compliance with the UN Guiding Principles and the OECD Guidelines for Multinational Enterprises. In each case, the indicators would be set out in a delegated act to be adopted by the Commission. The product provider may disclose other PAI indicators relevant to the sustainability-related objectives of the product.

Article 9a of SFDR 2.0 does not create a freestanding category of financial products, but instead explains how products which are a combination of other financial products can be eligible for categorisation as an Article 7, 8 or 9 product. In practice, such products can include funds of funds, as well as some insurance-based investment products or pension products.

As we explained in our earlier briefing, the Council's proposed text had sought to bring clarity to how Article 9a would operate by expressly adopting a "lowest common denominator" approach in relation to the underlying investments in Article 7, 8 or 9 products.

Unfortunately, the Parliament text has not adopted the same clarity of drafting. The revised text refers to a fund-of-funds or other combination product being eligible for classification as an Article 7, 8 or 9 product if it satisfies the 70% investment threshold for the relevant product category "by way of investments in the underlying portfolio of categorised products" in accordance with the disclosures of the relative share of the portfolios of the underlying product that are invested in eligible investments.

Although the drafting is not entirely clear, this may suggest that the Parliament is envisaging some kind of "look-through" approach, which would be facilitated by the additional disclosure obligations it is seeking to impose on the provider of the underlying Article 7, 8 or 9 products. That would seem to be more onerous and complex than the Council's more pragmatic solution.

The Parliament text would amend the website disclosure obligations for financial market participants (including fund managers) so that in addition to publishing information on how they integrate sustainability-related risks into their investment process, they would also need annually to disclose information on the proportion of their AUM and the proportion of the number of products that they invest in each of the Article 7, 8 and 9 product categories, relative to their total AUM and total number of products.

There appears to be a timing issue with this obligation, as the Parliament text states that this should enter into force immediately when SFDR 2.0 is published. However, as the disclosure obligation refers to the new product categories, and those categories will be subject to an implementation period, we assume that this is a drafting error.

The Parliament would retain the obligation on the Commission to review the application of SFDR 2.0 within three years of the revised rules coming into force (whereas the Council had proposed a five-year deadline). However, the Parliament would extend the scope of the Commission's review so that it also covers:

• Whether the names of the product categories are clear and effective and can be understood by end-investors, taking into account feedback from supervisors, market developments and, if appropriate, consumer testing. As noted above, if this survives into the final SFDR 2.0 text, this might provide another opportunity for the industry to lobby for better terminology.
  
  
• Whether the scope of SFDR 2.0 is appropriate to achieve its objectives. This could imply that the regime could be extended to other products, arrangements or market participants in the future, or conversely, that it could be cut back.
  
  
• Whether the proportion of investments in EU Taxonomy-aligned activities that allows a product to be classified as an Article 7 (Transition) or Article 9 (Sustainable) product should be adjusted. The Commission would also be required to keep this under periodic review. This raises the possibility that product providers who have taken the Taxonomy route to product eligibility could find that requirements get stricter over time. It is unclear what transitional arrangements would apply in such a case.