What is the difference between SFDR and a Dear Chair let from the FCA

The FCA delivered a "Dear Chair" letter to its authorised fund managers on 19 July 2021 (the "Letter"). The Letter includes guidelines in an annex (the "Guidelines") which set out how the FCA believe the current rules applicable to authorised funds should be "interpreted" in respect of ESG and sustainability.

While the guidelines are framed as "interpretation" of existing rules they are detailed and specific in their expectations and much more than a mere clarification of how existing rules apply in the context of ESG.

What we are seeing here is significant steps being taken by the FCA to stem the tide of greenwashing that it perceives to be accompanying the recent deluge of ESG fund offerings and which it considers to be a potential source of consumer harm.

The FCA point out that there are several links between the Guidelines and the Sustainable Finance Disclosure Regulation ("SFDR") and in many ways the Guidelines effectively implement parts of SFDR to UK authorised funds (even if there is a prominent acknowledgement at the front of the Letter that the UK has not onshored SFDR). This is an important development in the UK's regulation of sustainable finance – in our view, the FCA would have gone further and applied the Guidelines more broadly if it could. However, to apply the Guidelines beyond authorised funds would require new primary legislation. Therefore, the Guidelines are potentially indicative of what is to come when the Government kicks off its green finance roadmap in earnest.

Our briefing sets out in details what the new requirements on authorised fund managers are, the practical impact of these changes and where there could be a read across for non-authorised fund managers.

What action should we be taking?

There is a lot to digest in the Letter and the Guidelines. However, as a first step, we consider that in scope authorised fund managers – as well as fund managers of unauthorised funds as a matter of good practice –consider:

1. Assessing (or re-assessing) their fund names / fund strategies against the FCA's criteria. Where a fund does not meet the FCA's expectations in respect of ESG-focussed funds, fund managers should consider what changes to investment objectives or strategies should be made. Alternatively, fund manager's should consider whether the name of the fund would be more appropriate without a mention of ESG or a related term.
2. Fund managers should review their prospectuses, other fund documentation and ongoing reports and disclosures to ensure that these provide all the information that the FCA expects in respect of ESG-focussed funds.
3. Fund managers should review their stewardship policies for their funds and consider whether these require amendments. This is an area that has yet to receive much focus (either under the EU or UK regulatory regime), but it is clear that the FCA is beginning to pay more attention and expects fund's stewardship policies to be consistent with their objectives.
4. Fund managers should consider their use of ESG data/analytics providers and internal ESG resourcing to ensure that their review of third-party data is robust and that their internal resourcing is sufficient. This is of particular importance where a fund manager is looking to apply for authorisation for a new fund in the short-term.

Why is the FCA imposing these guidelines?

In its Letter, the FCA identifies a number of examples of funds which have applied for authorisation and have fallen below its expectations. With interest in ESG products rocketing from clients, retail and wholesale alike, the FCA are keen to ensure that clients are not misled as a result of "greenwashing" on the part of funds. Greenwashing is where a person makes claims in relation to sustainability which are not backed up by action or substance. The guidelines provided in the Letter are focussed on ensuring that funds make accurate disclosures as to their sustainable nature (or lack thereof) and preventing funds using tags such as "green", "impact" and "ESG" as meaningless marketing tools.

As we have pointed out, although described as guidance on the application of existing rules, we consider that the Guidelines go beyond that and are effectively imposing new requirements on authorised funds and their managers.

In some aspects, the Guidelines go beyond the rules implemented by SFDR and provide clear examples of where funds should not be holding themselves out as sustainable. One explanation for this may be that the ambiguity about the threshold between Article 6 and Article 8 funds under SFDR has led to a number of funds holding themselves out as Article 8 (and therefore "sustainable") when in fact their ESG-related characteristics amount to little more than standard exclusions of certain businesses or the integration of sustainability policies on either an aspirational basis or as part of high-level risk analysis. The Guidelines provide much clearer descriptions and examples of funds which should not be classifying themselves as sustainable. (If only the European Commission's clarification on this issue was quite so clear.)

The FCA's guidance focuses on three main areas: design, delivery and disclosure.

Principle 1: the design of responsible or sustainable investment funds and disclosure of key design elements in fund documentation

Fund name
The FCA states in the Guidelines that references to ESG (or a related term) in a fund's name, financial promotions of fund documentation should fairly reflect the materiality of ESG considerations the fund's objectives, investment policy or strategy. In practice, this means that funds should not use "ESG", "green", "sustainable", "responsible", "ethical", "impact" or other related terms unless the fund pursues ESG "characteristics, themes or outcomes in a way that is substantive and material to the fund's objectives, investment policy or strategy". We note that the wording used by the FCA here is similar to that used in SFDR to describe Article 8 and Article 9 funds under SFDR.

Therefore we consider that SFDR classification can be used as a useful litmus test: if a fund would not be classified as an Article 8 or Article 9 fund under SFDR then it is likely that the FCA do not consider it should use "ESG" and related terms. Similarly, the FCA provides some useful real life case studies of funds which had applied for authorisation and, when tested by the FCA, did not have the relevant ESG substance to support their assertions. For example, a proposed passive fund that had an ESG-related name that was found to be misleading as it was looking to track an index that did not hold itself out to be ESG-focused.

The Guidelines make clear that a fund must not use "ESG" or a related terms unless the investment strategy leads to a material difference in how the fund is managed, compared to a fund that does not hold itself out as sustainable. For example, an index-tracking fund that excludes a small number of securities should not use the term "ESG". Similarly, a fund which has holdings that are not materially different to a similar non-ESG index should not use these terms in its name.

The FCA have also stated that where a fund integrates ESG considerations into mainstream investment processes (without a material ESG orientation in the fund's strategy) then it does not expect to see prominent ESG claims in the fund's name or documentation. We consider this to include where a fund only integrates ESG risks into its investment decisions, operates a non-binding ESG screening policy / ESG scorecard, or only carries out negative screening on "mainstream" criteria (e.g. armaments and tobacco only). This is a position that we have also taken in relation to SFDR classification.

Finally, the FCA considers the term "impact" to have specific connotations. A fund should only use this term where the fund is seeking financial (real world) impact, and that impact is being measured and monitored. For example, a fund may be described as "sustainable" if it only invests in companies which emit low levels of carbon. However, this is not an impact fund as the investment does not have a tangible impact which can be measured. In contrast, a fund which provides project finance to clean energy initiatives would be an impact fund – as the fund could point to a number of clean energy plants established as a result of its investment.

Investment objectives and policy
The Guidelines also state that, irrespective of whether a fund uses "ESG" or a related term, if it claims to pursue ESG characteristics, themes or outcomes then these should be reflected in the objectives or investment policy of the fund. In addition, these funds should also include key elements of strategy, for example:

1. the investible universe, including investment limits and thresholds;
2. any screening criteria (positive or negative) that it applies;
3. specific E, S or G characteristics/themes or ‘real world’ (non-financial) impacts that it pursues;
4. the application of benchmarks/indices, including any tilts to mainstream benchmarks, and expected/typical tracking error relative to the benchmark; and
5. the stewardship approach of the fund.

This is a significant clarification from the FCA, as the Guidelines effectively bring authorised UK funds into close alignment with SFDR. An Article 8/9 fund typically discloses 1-3 above (as far as they are applicable – often a fund may only pursue one of these elements of an ESG strategy) in order to meet the SFDR requirements. Similarly, an Article 8/9 fund may be required to disclose its ESG-related benchmark or provide an explanation of how it tracks the ESG-related characteristics or objective.

Interestingly, the FCA appear to have gone one step further, requiring funds to disclose their approach to stewardship. This is not required under SFDR and as a matter of market practice is something that we have often seen neglected in fund documentation. In the context of ESG, stewardship refers to the fund's approach to effectively exercising their rights in relation to its investee companies in such a way as to act as a steward to guide the investee companies towards more sustainable business practices.

The Guidelines provide additional detail, specifying that where a fund claims to be an "impact" fund or promote "social change" it should be specific about what the impact or social change is as well as how it intends to measure the outcomes.

The FCA specify that funds with an ESG focus should make certain disclosures to investors in the investment objectives and/or strategy: (a) where the fund manager relies largely on ESG data provided by a third-party in order to make judgements about ESG matters, it should disclose this in the prospectus; and (b) where a fund might hold securities that an investor might not expect due to the ESG focus of the fund (including where these securities are held at a reduced weighting) then this should be made clear in the prospectus, including the circumstances where such securities might be held and the reasons why.

Principle 2: the delivery of ESG investment funds and ongoing monitoring of holdings

The Guidelines also provide information as to the FCA's expectation on how ESG funds operate.

The FCA have stated that they will only authorise new funds where their ESG aims are reasonably capable of being achieved. If you are a fund manager of an ESG fund, then you need to ensure you have the right staff and resources on board in order to achieve your sustainability claims. Similarly, the FCA expect that where fund managers use ESG research, data and analytical tools to support its fund delivery process, that it employs appropriate resources to oversee this and carry out due diligence in order that it is confident that it can validate the ESG claims it makes. Reading between the lines, we expect to see the FCA taking a more hardline approach to firms which outsource their ESG analysis to a large extent, without robust interrogation of the relevant data or analysis.

Principle 3. pre-contractual and ongoing periodic disclosures on responsible or sustainable investment funds should be easily available to consumers and contain information that helps them make investment decisions

The FCA have made clear in the Guidelines that they expect ESG-focussed funds to make ESG information available and easily accessible to investors. These disclosures should be made in pre-contractual documents, in periodic performance reports and (where possible) on third-platforms through which their funds are distributed. So far, so SFDR.

Significantly, the FCA have provided more detail on how it expects fund managers to report against their ESG strategies, including requiring fund managers to provide ongoing performance reporting against quantifiable ESG KPIs and (if relevant) non-financial (real world) outcomes. We consider that whilst ESG funds may track a relevant benchmark (such as a Climate-Transition Benchmark or Paris-Aligned Benchmark), the FCA also require fund managers to disclose these KPIs on top of this. For example, where a fund investments in companies with "green" characteristics, it should set carbon emission targets and report against relevant KPIs in that regard. Fund managers should also disclose, on an ongoing basis, how its stewardship policy has supported the achievement of its objectives.

This Letter and Annex is a significant step forward for the regulatory who is turning its attention more and more to issues around ESG in financial services.

Author: Henry Glasford, Solicitor