Asset managers that just reclassified hundreds of ESG funds should expect to have to explain themselves to their regulators and investors, according to lawyers advising the industry.
The warning follows the recent redesignation of about 700 funds in the EU to a category known as Article 8, which is seen as offering some environmental, social and governance attributes. The fund class has mushroomed since its introduction in March last year to now make up roughly half the total domiciled in the EU, or $3.8 trillion, analysts at Morningstar Inc. estimate.
Asset managers want Article 8 funds on their shelves in large part “because they feel that there’s pressure from distribution channels, which there absolutely still is,” said Ciara O’Leary, a partner at law firm Dechert LLP who advises the fund industry. But changing the classification of a fund that’s been on the market for a year opens the door to “queries from the regulators” wanting to know the reasons and whether investor approval is needed.
There’s now “a fear” among asset managers over their use of Article 8 given the lack of minimum regulatory requirements, O’Leary said. Some also wonder whether “investors really believe” the designation.
Europe’s investment management industry has struggled to adapt to the region’s ESG rulebook, the Sustainable Finance Disclosure Regulation, which has been undergoing constant adjustments in the almost 1 1/2 years it’s been around. SFDR requires firms to classify their investment products under one of three categories: Article 6, which only looks at potential ESG risks; Article 8, which is supposed to “promote” ESG characteristics; and Article 9, which sets measurable ESG “objectives.”
In the second quarter, well over 600 funds were upgraded by asset managers to Article 8 from Article 6; a further 16 were downgraded to Article 8 from Article 9, Morningstar estimates. The researcher also found that 23% of Article 8 funds, which have been found to include weapons makers, fossil-fuel giants and tobacco companies, don’t deserve to be treated as ESG within its framework.
Meanwhile, fund managers remain under considerable pressure from distributors not just to offer Article 8 but also Article 9 funds. That’s as investment clients start channeling more cash into the stricter category. Last quarter, Article 8 products saw about $30 billion in outflows, while some $6 billion flowed into Article 9, according to Morningstar.
“We have clients that have said they’re being pushed to set up Article 9 funds,” said Ken Rivlin, a partner at Allen & Overy who founded the firm’s environmental law group and now leads it.
But such designations raise the stakes considerably. Getting hold of the right data is a persistent problem, and if a fund manager gets designations wrong, they risk not just having to downgrade their product but also “a claim from an investor, an NGO, from a government regulator who might say, you know, this isn’t completely accurate,” Rivlin said.
“It’s more important than ever that the facts match up with the statements about what a fund is doing,” he said. “And it’s a real challenge for these funds because there is so much demand.”
In Ireland, where O’Leary is based, the financial watchdog has made clear that a “downgrade is something that you need to think about vis-a-vis misrepresentation or mis-selling,” she said.
Asset managers are reclassifying their funds in part because they’ve received more guidance from supervisors. They also need to adapt to regulations that took effect this month, which ensure the industry pays more attention to the needs of retail investors. Due to an amendment to the EU’s revised Markets in Financial Instruments Directive, financial advisers must now make sure they understand the ESG preferences of retail investors, and actually deliver on them.
As a result, “it’s no longer sufficient for products that are aimed at investors with such preferences to simply have an exclusion list,” said Sonali Siriwardena, partner and global head of ESG at Simmons & Simmons. “This has given several fund managers cause for pause, where they’re asking themselves the question as to whether they’re comfortable going a step further to look at principal adverse impacts, sustainable investments and/or taxonomy alignment.”
The three categories refer to the ways in which sustainability can be defined when financial advisers ask investors about their sustainability preferences under the new framework.
O’Leary said that, although clients at Dechert haven’t had to resort to SFDR downgrades, “absolutely we’re hearing within the market” that they’re still happening.
For fund managers, the question arises whether going from Article 9 to Article 8 constitutes “a breach of your offering document or a breach of the terms under which the investors came in,” she said.
In general, asset managers are “a bit nervous because it’s uncharted waters,” O’Leary said. They “don’t want to downgrade if they don’t have to,” but “they’re kind of caught in between a rock and a hard place.”
“Nobody likes to go back to a regulator and say, we’re actually wholesale changing our document in general,” O’Leary said. “It’s a very, very big area and I think people are still struggling and grappling with it.”
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