A couple years ago, asset managers (such as alternative investment fund managers active in the real estate sector) started preparing for a new bundle of compliance obligations arising from the introduction of inter alia Regulation (EU) 2019/2088 on sustainability‐related disclosures in the financial services sector (the SFDR) and Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment (the Taxonomy Regulation). What back then may have been regarded as a complicated set of new rules, raising numerous questions and uncertainties, has now increasingly become a daily attention point of our clients and us. With an increasing number of eligible economic activities and technical screening criteria becoming available under the Taxonomy Regulation, the ESG landscape for real estate fund managers with an ESG ambition becomes increasingly complex.
Have you already assessed if your current approach complies with the EU sustainable finance legislative framework and that you are not making claims that can be considered misleading?
Sustainability disclosure obligations of fund managers
As also set out in one of our previous blogs, the SFDR's main aims are to safeguard transparency of the impact of a financial product from sustainability perspective, counteract "greenwashing" (making an investment product appear more sustainable than it actually is) and harmonise the EU-wide rules in this respect. The SFDR applies to financial market participants and, for the real estate sector very relevant, also alternative investment fund managers ("fund managers") managing real estate alternative investment funds ( "investment funds" or "funds"). The SFDR and Taxonomy Regulation both cover sustainability from an ecological perspective, but unlike the Taxonomy Regulation (for now) the SFDR also covers funds which pursue social objectives. The disclosures related to whether or not sustainable investments also qualify as "taxonomy aligned investments" as referenced to in the Taxonomy Regulation are also part of the SFDR reporting framework. For some further background on the Taxonomy Regulation please also be referred to our previous blog.
SFDR imposes the following core obligations on fund managers:
- providing information on how fund managers take sustainability risks into account when making investment decisions (Article 3 and 5 SFDR);
- publishing the so-called entity PAI statement on their website (Article 4 SFDR, unless a fund manager is exempted;
- Including a product level PAI statement in pre-contractual and periodical disclosures (article 7 SFDR) and
- classifying their investment funds in accordance with their sustainability ambition (Article 6/8/9 SFDR) and making the corresponding disclosures in pre-contractual, periodical and website documentation.
As set forth in our previous blog, the first two obligations are disclosures related to the fund manager (entity-level) whereas the classification obligation relates to the various funds managed by a fund manager (product-level). In this blog we will further the last point, classification of investment funds in accordance with their sustainability ambition.
Classification of investment funds in accordance with their sustainability ambition
When classifying their investment funds, the fund manager can choose from one of the following labels:
- investment fund without a sustainability ambition (Article 6 SFDR);
- investment fund promoting environmental or social characteristics (Article 8 SFDR); or
- investment fund that has sustainable investments as its objective (Article 9 SFDR).
Each classification comes along with its own set of prescribed disclosures and, to the extent environmental aspects are addressed, the EU Taxonomy Regulation requirements will need to be complied with as well. It is therefore important fund managers ensure they are compliant with the SFDR as well as the EU Taxonomy Regulation.
Investment funds without a sustainability ambition (Article 6 SFDR)
While it might be potentially attractive to prospective investors to invest in funds with sustainability ambitions, it is not required by law for an investment fund to have any sustainability ambition whatsoever. Investment funds can, in this case, be labelled as so-called "Article 6 funds" and therefore only need to comply with the limited SFDR disclosure requirements following from such classification. Given the fact investment funds without sustainability ambitions do not address any specific environmental objectives, the EU Taxonomy Regulation only imposes limited additional compliance obligations on Article 6 funds.
Albeit that – in view of the more extensive disclosure obligations associated with the article 8 and article 9 classifications – this classification seems attractive at first glance, we see an increasing market demand for fund managers that offer products that have a sustainability ambition.
Investment funds promoting environmental or social characteristics (Article 8 SFDR)
The fund manager can classify an investment fund under its management as an "Article 8 fund", sometimes also referred to as "light green", if:
- the fund promotes environmental and/or social characteristics (to be determined by the fund manager); and
- to the extent investments in companies are made, such companies follow good governance practices.
Disclosures required to be made in respect of Article 8 funds shall, for instance, include concrete (measurable) information on how the economic and/or social characteristics are achieved, whereby these disclosures shall be made in accordance with the relevant requirements under the SFDR in pe-contractual information (such as a PPM), in periodical information (the fund annual report) and on the website. With respect to the good governance practices, it is noted that where real estate investment funds invest in real estate directly (without intermediate propco's), the good governance practices requirement is in principle not relevant.
Investment funds that have sustainable investments as their objective (Article 9 SFDR)
The third category of funds classified under the SFDR relates to investment funds which have making "sustainable investments" as their objectives. These "Article 9 funds" are sometimes also referred to as "dark green, and only make investments in economic activities that contribute to an environmental or social objective. Moreover, such investments should do no significant harm ("dnsh") to other environmental or social objectives (which dnsh criteria should be determined on the basis of the PAI indicators included in Annex I to the SFDR Level 2). The good governance practices should also be followed by companies into which real estate funds make an investment.
Under article 9, 100% of a real estate investment fund's portfolio need to qualify as "sustainable investments", i.e. which contribute to the environmental or social objective and that satisfy the dnsh-criteria. Accordingly, strategies known as "brown-to-green" are in principle not compatible with an article 9 classification (as a "brown" investment will not qualify as a sustainable investment ab initio and will this not be eligible).
When and how should you disclose?
With respect to article 8 and 9 funds, investors shall be provided with disclosures relating to the classifications of an investment fund prior to making their investment in such fund (such as through a private placement memorandum, prospectus or a separate disclosure letter). Besides these pre-contractual disclosures, the investors shall be updated on this point through the periodical reporting of the investment fund as well as through the relevant website disclosures. The pre-contractual, periodic and website disclosures that are to be made pursuant to the SFDR incorporate, to the extent relevant, also include whether or not a real estate investment fund intends to make EU Taxonomy Regulation aligned investments.
Review by the AFM
Ever since the date the SFDR has come into effect within the EU, the AFM has been annually reviewing fund managers' compliance with the SFDR and, once in force, also the EU Taxonomy Regulation.
In November 2021, the AFM published its first report, noting that several funds appeared to be in in violation of the SFDR classification rules, especially when classifying a fund as an Article 9 fund. In this report, the AFM urged fund managers to look into this matter and, if needed, reclassify.
In the November 2022 report, the findings have shown that several fund managers have indeed reclassified their funds, however, that the documents reviewed by the AFM as part of this evaluation are often not clear enough for the AFM to be able to conduct a proper evaluation. In this report the AFM expressed their hope for this aspect to improve with the introduction of standard formats by the EU Taxonomy Regulation in 2023.
As tool for, amongst others, fund managers to avoid making misleading sustainability claims for their products, the AFM also published guidance for financial market participants when making sustainability claims (Leidraad duurzaamheidsclaims).
A couple weeks ago, in November 2023, the AFM shared a position paper with the European Commission on improving the SFDR. In this paper, the AFM sets out a couple key proposals, such as the abolition of the "Article 8" / "Article 9" labeling in their current form.
Continuous compliance
Given the fact the legislation continues to evolve, both in writing as well as in practice, it is crucial real estate fund managers remain up to date with their obligations under the SFDR and the EU Taxonomy Regulation and have (due diligence) policies in place that enable them to make meaningful disclosures under SFDR and assess whether investments satisfy the technical screening criteria and "do no significant harm" requirement of the various EU Taxonomy identified eligible economic activities.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
