On 25 October 2022, the Financial Conduct Authority ("FCA") announced a series of proposed measures aimed at tackling greenwashing. The proposed rules are designed to complement the FCA's wider commitment to its environmental, social and governance ("ESG") Strategy and Business Plan and ultimately aim to bolster consumer protection.
The FCA follows the upward trend that demonstrates a desire to crack down on greenwashing (see our alert on the CMA's recent action). Recently, the UK's Advertising Standards Authority ("ASA") reprimanded a bank for misleading advertisements about its environmental sustainability commitments, and the ASA took similar action against a number of corporates for exaggerated claims about a positive environmental impact. In the US, the Securities and Exchange Commission ("SEC") has demonstrated a willingness to fine investment advisors for perceived greenwashing violations.
1. New FCA regulations
To prevent similar breaches, the FCA has taken steps in October 2022 to regulate how fund managers and fund marketing approach ESG-related products. The current consultation phase remains open until 25 January 2023. Measures are expected to be implemented gradually between mid-2023 and mid-2025.
a. What does this mean for companies?
From mid-2023, the FCA will introduce its anti-greenwashing rule that will apply to all firms. This will limit the use of ESG-related terminology, such as "green" and "sustainable", by firms to ensure alignment with their proposed sustainable strategies and objectives. A year later, specific rules will apply to firms' names and marketing material requiring "clear, fair and not misleading" actions to be taken in relation to names and marketing communications that imply a firm or investment product is ESG-focused.
In addition, from mid-2024, firms will have to assess and apply three sustainable investment labels to their products. These are:
- "Sustainable focus" – where at least 70% of a product's assets meet a "credible standard of environmental or social sustainability";
- "Sustainable improvers" – where investment in sustainable products aims to improve social or environmental sustainability over time; and
- "Sustainable impact" – where investment products invest in solutions with a positive and measurable real-world impact.
From 2024 – 2025, the proposed rules will require disclosures at various levels. Firms must make "consumer‑friendly" disclosures that explain the relevant sustainability characteristics of a product, whether or not the product has a sustainable investment label. More comprehensive disclosures are required at "product and entity level". For products that use a sustainable investment label, firms must disclose "ongoing sustainability‑related performance information". In addition, regardless of whether a firm uses, or a product has a sustainable investment label, pre-contractual disclosures must detail the specific sustainability features of a product, and a "sustainability entity report" must be produced to disclose on "sustainability-related risks and opportunities".
Finally, distributors will also be expected to make reference to the relevant sustainable investment label for applicable firms.
The FCA's infographic below demonstrates how these rules interact with each other.1
b. Next steps
The FCA aims for its rules to be finalised by mid-2023. Once introduced, new funds must meet the standards as a condition to being granted approval and existing funds will be given one year to comply. A Fund Authorisation Team will review and, if necessary, challenge new fund categorisations, but all firms remain responsible for ensuring a suitable label is selected in the first instance. While funds that have investment products, including certain fossil fuels, will not be excluded entirely from these labels, they must explain how these investment products are sustainable.
The FCA will apply its current supervisory and enforcement regime and may undertake intermittent assessments. It plans to deal with issues of non-compliance "as they arise", but provides examples of where it may take enforcement action, such as when a firm:
- ignores its disclosure requirements;
- misuses one of the above labels; and/or
- infringes the FCA's naming and marketing rules.
2. How does this compare to the US and the EU?
Regulators in the US and the EU have also stepped up efforts to curb greenwashing in the investment funds market, reflecting a global regulatory trend to promote transparency and integrity in ESG investing and to protect investors from mis-selling.
a. US: nominal and disclosure regulations
This year, the SEC proposed rule changes that promote transparency and reduce greenwashing in investment products.
i. Nominal regulations: On 25 May 2022, the SEC announced proposed changes to the "Names Rules" under Rule 35d-1 of the Investment Company Act of 1940 ("ICA"), which focuses on the importance of a fund's name as a marketing tool. Under the current rule, certain funds must apply the "80 per cent investment policy", which intends to ensure that 80% of fund investment activities remain consistent with the characteristics implied by the fund name. The new proposal intends to capture those funds utilizing names that imply the incorporation of ESG characteristics, for instance, funds with "green", "ethical", or "impact" in their name. In addition, funds will face more onerous recordkeeping obligations whether the 80% investment policy is followed or not and will limit the situations in which a fund can depart from the rule, among other expansions.
ii. Disclosure regulations: On the same day, the SEC proposed to expand fund and investment adviser disclosure obligations under the Investment Advisers Act of 1940 and the ICA in relation to the use of ESG factors. The changes will apply to prospectuses, annual reports, and adviser brochures. Moreover, ESG-Focused Funds (see below) will have an obligation to report on greenhouse gas emissions that relate to their portfolio. Under the proposal, funds will also be categorised as follows based on the level of their ESG-focus:
- "Integration Funds" – a fund that has a combination of ESG and non-ESG investments (must detail the method by which ESG practices are included in the investment process);
- "ESG-Focused Funds" – a fund whose main, or a significant portion of its investments, are ESG‑related (must make comprehensive disclosures); or
- "Impact Funds" – a fund that has a specific ESG impact focus (must measure progress).
Neither proposal has had a date of final publication confirmed, but in relation to the Names Rules' changes, the SEC proposes to give funds one year to comply following publication.
b. EU: categorisation rules
The Sustainable Finance Disclosure Regulation of 2019 ("SFDR") and Taxonomy Regulation form part of the EU's framework to regulate the sustainable investment sector. Together, they aim to encourage sustainable finance and tackle greenwashing practices.
The SFDR requires financial market participants and financial advisors to publish entity and product disclosures relating to sustainability "risks and impacts". Under SFDR, firms must classify an investment fund under one of three categories:
- Article 6: a financial product that is neither an Article 8 nor an Article 9 financial product (i.e., "neutral");
- Article 8: a financial product that promotes environmental and/or social characteristics (i.e., "light green"); or
- Article 9: a financial product that has a sustainable investment objective (i.e., "dark green").
Based on a fund's classification, certain disclosure obligations apply, and the level of disclosure required increases from "neutral" to "dark green".
Recently, on 18 November 2022, the European Securities and Markets Authority launched a public consultation on draft guidelines meant to govern investment funds' ability to market ESG-labelled products. The proposal would require funds to satisfy a "minimum proportion of investments" threshold before using ESG- and sustainability-related labels. The proposal contemplates the following minimum thresholds:
- Fund names using ESG-related words: at least 80% of investments should be used to meet environmental or social characteristics or sustainable investment objectives in accordance with SFDR Article 8 or Article 9 products, respectively; and
- Fund names using "sustainable" or a derivative thereof: of the minimum 80% of investments described above, at least 50% of such investments should be used to meet sustainable investment objectives in accordance with SFDR Article 9 products.
Final guidelines are expected before the end of 2023.
One key distinction between the UK and EU fund labelling regimes is the absence of a framework to identify green or sustainable activities. This is in contrast to the EU sustainability disclosure regime for which the EU Taxonomy serves as the keystone. Although the UK Sustainability Disclosure Requirements (see our previous client alert) contemplate the implementation of a UK Green Taxonomy, until such implementation, an investment fund's determination that the assets of a product with a sustainable focus meets a "credible standard of environmental and/or social sustainability" could be fairly subjective. While the FCA's proposed rules attempt to address such subjectivity by requiring any such determination to be "robust, independently assessed, evidence based and transparent", further guidance will be needed, particularly in terms of third-party assessment, to ensure that the FCA achieves its goal of tackling greenwashing.
Additionally, any divergence between the EU Taxonomy and future UK Green Taxonomy that results in varying standards sustainability may result in increased costs for investment funds due to multiple compliance hurdles when raising capital internationally. Moreover, any such divergence would likely impact consumers' ability to compare and contrast investment products. The UK's Green Technical Advisory Group recently published its advice to the government on the development of the UK Green Taxonomy, and further recommendations from the group are expected to be released later this year.
Companies should keep an eye out for the implementation of these proposed changes and should ensure that they are able to meet these obligations before the projected deadlines. In the interim, it is important for companies to comply with present greenwashing regimes, as regulatory enforcement and direct customer claims for misleading actions are potential risks for infringing companies. Whilst compliance might incur significant costs, non-compliance could incur reputational damage, which could lead to an even greater financial impact for companies.
The FCA's 2022 – 2023 business plan and wider 2022 – 2025 strategy demonstrate a dedication to building consumer trust towards ESG-linked investment products, reflecting the global trend towards commitments to sustainability by both businesses and investors. The FCA intends for ESG commitments to be entrenched throughout its policies and organisation to ensure effective enforcement action. To shape the changes of the forthcoming FCA proposals, businesses and investors can participate in the FCA's consultation.
Edie Essex Barrett and Michelle Luo, London trainee solicitors, contributed to the drafting of this alert.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
© Morrison & Foerster LLP. All rights reserved