FOR REVIEW by Wednesday: Draft Responses to EU Consultations on Draft ESG-Related Amendments to UCITS/MiFID II
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June 29, 2020 TO: ESG Task ForceEU ESG Disclosure Regulation Working Group
EU Sustainable Finance Strategy Working Group
ICI Global Regulated Funds Committee RE: FOR REVIEW by Wednesday: Draft Responses to EU Consultations on Draft ESG-Related Amendments to UCITS/MiFID II
Attached for your review are two (short) draft responses to the European Commission’s consultations on draft delegated acts (DAs) that would make several ESG-related amendments to the UCITS Directive[1] and Markets in Financial Instruments (MiFID) II frameworks.[2] Please provide any comments by COB Wednesday, 1 July. The Commission provided a very short timeframe for these consultations, and the deadline for submissions is Monday, 6 July. For your reference, the background section below provides a more detailed summary of the DAs and the provisions on which we are particularly focused. Please note that the MiFID II response is particularly key.
Our draft responses make the following points:
- MiFID II DAs – The MiFID II Draft DAs’ revised definition of ‘sustainability preferences’ significantly narrows the range of ESG products that can be distributed as meeting clients’ ‘sustainability preferences.’ This effectively gold-plates the sustainable finance Disclosure Regulation (SFDR)[3] Article 8 and creates a new ‘Article 8+’ category, contrary to the EU co-legislators’ agreed-on categories of Article 8 and Article 9 financial products in the SFDR. These two ‘gold-plating’ conditions are extremely concerning because they will significantly constrain the universe of available ESG products. Many existing Article 8 products will not be able to be distributed as meeting ‘sustainability preferences.’ We argue that narrowing the universe of available ESG products conflicts with the EU’s objectives.
- UCITS DAs – We express significant concerns about the provision that adds consideration of adverse impact to the UCITS due diligence requirements and urge the Commission to remove this requirement from the draft. We also question the amendments to the UCITS provisions on organisational requirements, senior management responsibilities, conflicts of interest, and risk management. Those provisions are not relevant for achieving the Commission’s aim of integrating sustainability risk into the investment process and should not be amended.
Background
On 8 June, the European Commission published long-awaited draft DAs that would amend the UCITS Directive, Alternative Investment Fund Managers Directive (AIFMD), and MiFID II frameworks.[4] As you may recall, we responded to an ESMA consultation in 2019 on these draft amendments,[5] and the Commission has been working on the amendments for quite some time. The amendments are intended to go hand-in-hand with the requirements of the SFDR and effectively integrate those disclosure requirements into the substantive provisions of the UCITS Directive, AIFMD, and MiFID II.
We would like to particularly draw your attention to the MiFID II amendments outlined below. These amendments contain a newly revised definition of “sustainability preferences” that would significantly narrow the universe of ESG funds that would be eligible for meeting clients’ “sustainability preferences,” both in the context of a suitability assessment and also when assessing a product’s target market.
Below is a short summary of the draft amendments that are most directly relevant for funds and fund managers:
MiFID II amendments integrating sustainability factors, risks, and preferences into certain organisational requirements and operating conditions for investment firms
Suitability. Requires investment firms to ask clients about their “sustainability preferences” as part of the suitability assessment process, and then take those preferences into account in selecting investments. Importantly, the definition of “sustainability preferences” has been narrowed from ESMA’s original technical advice to the Commission. This definition formerly cross-referenced ESG-related financial products under SFDR Articles 8 and 9.[6] The new definition includes only Article 8 products which either pursue sustainable investments or consider principal adverse sustainability impacts.
This appears to be problematic in that many existing ESG funds would fall into the Article 8 category but may not meet this new constraint, and those funds therefore would not be deemed to satisfy a client’s sustainability preferences.
Organisational requirements and risk management. Requires investment firms to take into account sustainability risks when complying with organisational requirements and to integrate sustainability risk into risk management policies.
MiFID II amendments to investment funds’ product governance requirements
Target market. Requires manufacturers and distributors to consider “sustainability preferences” when assessing a product’s target market before it is marketed or distributed to clients.
Importantly, the definition of “sustainability preferences” has been narrowed from ESMA’s technical advice to the Commission. This definition formerly cross-referenced ESG-related financial products under Disclosure Regulation Articles 8 and 9. The new definition includes only Article 8 products which either pursue sustainable investments or consider principal adverse sustainability impacts.
This appears to be problematic in that to construct a product that would be offered as an ESG fund, the target market’s “sustainability preferences” would need to be identified. However, “sustainability preferences” is defined so that it adds other conditions (i.e., pursue “sustainable investments” or consider principal adverse sustainability impacts) onto the existing Article 8 definition. Many existing ESG funds would fall into the Article 8 category but may not meet this new constraint.
UCITS Directive and AIFMD[7] amendments
Due diligence (ESG risks). Requires managers to take into account sustainability risks when complying with due diligence requirements.
Due diligence (adverse sustainability impact). Managers that disclose consideration of principal adverse sustainability impacts under SFDR Article 4 also must take those adverse impacts into account in their investment due diligence policies. This will add a substantive requirement to the due diligence provision. Asset managers that are required to disclose adverse impact due diligence policies under the SFDR would be required to take “adverse impact” into account when complying with the UCITS/AIFMD due diligence provisions.
Risk management. Adds sustainability risk to the list of risks (i.e., market, liquidity, and counterparty risks) in the risk management policy requirements.
Conflict of interests. Identification and management of conflicts of interest must include those that arise in connection to integration of sustainability risks.
General requirements on organisation and procedure. Managers must take into account sustainability risks when complying with these requirements.
Resources. Managers must retain the necessary resources and expertise for the effective integration of sustainability risks.
Control by senior management [UCITS amendments only]. Managers must ensure that senior management is responsible for the integration of sustainability risks.
The consultations are open for 4 weeks, with the deadline for response set to 6 July.
Unfortunately, it is our understanding that the Commission expects these consultations to be largely pro forma, given that the Commission has already negotiated the drafts with Member States. Following the end of the consultation period, the Commission can adopt the DAs, kicking off the scrutiny procedure at the end of which the Parliament and the Council can approve or reject each of the texts as a whole.
Linda M. French
Assistant Chief Counsel, ICI Global
Anna Driggs
Director and Associate Chief Counsel
ICI Global
endnotes
[1] See COMMISSION DELEGATED DIRECTIVE (EU) .../ of XXX amending Directive 2010/43/EU as regards the sustainability risks and sustainability factors to be taken into account for Undertakings for Collective Investment in Transferable Securities (UCITS), available at https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/11959-Integration-of-sustainability-risks-and-factors-for-undertakings-for-collective-investment-in-transferable-securities-.
[2] See COMMISSION DELEGATED REGULATION (EU) …/...of XXX amending Delegated Regulation (EU) 2017/565 as regards the integration of sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms, available at https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/12068-Strengthening-the-consideration-of-sustainability-risks-and-factors-for-financial-products-Regulation-EU-2017-565-. See also COMMISSION DELEGATED DIRECTIVE (EU) .../… of XXX amending Delegated Directive (EU) 2017/593 as regards the integration of sustainability factors and preferences into the product governance obligations, available at https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/12067-Strengthening-the-consideration-of-sustainability-risks-and-factors-for-financial-products-Directive-EU-2017-593-.
[3] See REGULATION (EU) 2019/2088 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 27 November 2019 on sustainability‐related disclosures in the financial services sector, available at https://eur-lex.europa.eu/eli/reg/2019/2088/oj.
[4] The Commission also published draft amendments to DAs under the Alternative Investment Fund Managers Directive (AIFMD), Insurance Distribution Directive (IDD), and the Solvency II Directive.
[5] See ESMA consultation paper on integrating sustainability risks and factors in the UCITS Directive and AIFMD (19 December 2018), available at https://www.esma.europa.eu/sites/default/files/library/esma34-45-569_consultation_paper_on_integrating_sustainability_risks_and_factors_in_the_ucits_directive_and_aifmd.pdf. Our response to the consultation is available at https://www.ici.org/my_ici/memorandum/memo31623. Our summary of ESMA’s final technical advice to the Commission is available at https://www.iciglobal.org/iciglobal/pubs/memos/memo31756.
[6] SFDR Article 8 products “promote environmental or social characteristics.” Article 9 products “have an objective of sustainable investments.”
[7] The draft amendments to DAs under AIFMD are available at https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/11960-Integration-of-sustainability-risks-and-factors-related-to-alternative-investment-fund-managers-.