Last week the Financial Conduct Authority (FCA) published a letter to the chairs of authorised fund managers (AFMs) setting out its expectations on the design, delivery and disclosure of environmental, social and governance (ESG) and sustainable investment funds (“Dear chair letter”). The “Dear chair letter” annexes a set of “guiding principles” intended by the FCA to help firms apply the FCA’s existing rules and, as such, there is no transition period before they can be said to take effect.
While the guiding principles are not rules in themselves, they do set out the FCA’s current expectations based on rules and guidance already in place and firms should expect the FCA to use these guiding principles for assessing whether ESG-related claims are clear and not misleading on an ongoing basis.
The approach taken by the FCA is not a surprise. In a speech delivered on 21 October 2020 by Richard Monks, Director of Strategy at the FCA (summarised in our update on regulatory sustainable finance developments earlier this year), it was made clear that the FCA was considering a guiding principles based approach to articulating its expectations on ESG product design and disclosure, and in the FCA’s business plan for 2021/22 published last week, achieving high-quality climate and sustainability-related disclosures to help consumers chose sustainable investments, promote trust and protect consumers from misleading marketing of ESG products was included as one of the FCA’s seven priorities across all markets.
The publication of the guiding principles represents an important step in setting the regulatory landscape for ESG/sustainable funds in the United Kingdom going forward, in particular given that the EU’s Sustainable Finance Disclosure Regulation (SFDR) has not been onshored in the United Kingdom following Brexit (although the FCA has made clear that the guiding principles are intended to be complementary to any existing obligations under SFDR that UK authorised firms may be complying with in relation to cross-border business in the European Union). It is also clear that there is more to come – ESG and sustainable investment funds are currently the fastest growing segment of the European funds market and in the same way that the guiding principles have been designed with compatibility with SFDR in mind, the FCA say that they have also been developed in a way that will be compatible with upcoming disclosure rules for responsible and sustainable investment products, including the plans set out in the Chancellor’s Mansion House speech for sustainability disclosure requirements and sustainable investment labels aimed at enabling consumers to compare the impacts and sustainability of their investments.
Who is within scope?
The letter is addressed to the chairs of AFMs and UCITS, NURS and QIS are all within scope. The principles are targeted at authorised funds that make specific ESG-related claims, including in relation to the name of the fund, investment objectives and policy or investment strategy, but not those funds that simply integrate ESG considerations into mainstream investment processes. Unauthorised funds are not within scope.
What are the guiding principles?
The letter to the chairs of AFMs and the guiding principles annexed to it is a helpful document. It is relatively short (nine pages), provides practical examples of the FCA’s expectations and is essential reading for AFMs of authorised funds pursuing a responsible or sustainable investment strategy. However, we have summarised below in very broad terms the guiding principles and key considerations, which comprise one overarching principle (consistency) and three supporting principles focussing on design, delivery and disclosure. Each principle is accompanied by a set of “key considerations” which add clarity.
Overarching principle: Consistency
A fund’s ESG/sustainability focus should be reflected consistently in its design, delivery and disclosure – including in its name, stated objectives, documented investment policy and strategy and in its holdings.
The design of responsible or sustainable investment funds and disclosure of key design elements in fund documentation – references to ESG (or related terms) in a fund’s name, financial promotions, or fund documentation should fairly reflect the materiality of ESG/sustainability considerations to the objectives and/or investment policy and strategy of the fund.
- Fund names must not be misleading. Where, for example, a fund uses a term like “ESG”, “green” or “sustainable” in its name, this could be misleading unless the fund has ESG/sustainability characteristics that are material to its objectives, investment policy and strategy.
- Irrespective of the name of a fund, where a fund claims to pursue ESG/sustainability characteristics, themes or outcomes, these should be appropriately reflected in the investment objectives and policy of the fund and set out in its prospectus.
- Where a fund claims to pursue ESG/sustainability characteristics, themes or outcomes, the information provided about investment strategy in its prospectus should reflect this – for example providing information going to the approach to stewardship, specific ESG characteristics or “real world” (non-financial) impacts pursued and screening criteria (positive and negative) applied to investments.
- Where stewardship forms part of a fund’s responsible or sustainable investment strategy, the AFM should develop an engagement policy that clarifies how stewardship contributes to meeting the fund’s intended ESG/sustainability characteristics, themes or outcomes.
The delivery of ESG investment funds and ongoing monitoring of holdings– the resources (including the skills, experience, technology, research, data and analytical tools) that a firm applies in pursuit of a fund’s stated ESG objectives should be appropriate and the way that its ESG investment strategy is implemented, and the profile of its holdings, should be consistent with disclosed objectives on an ongoing basis.
- Where a firm uses ESG/sustainability research, data and analytical tools, it should employ appropriate resources to do this, including considering due diligence on resources relied on (eg., third-party ESG ratings, data and research providers) in order to validate the ESG/sustainability claims made.
- Where a fund claims to pursue ESG/sustainability characteristics, themes or outcomes, the AFM should take into account whether a reasonable investor would consider the fund’s holdings to reflect those claims. By way of example, the FCA considers that where a fund claims to invest in companies contributing to ‘positive environmental change’ a consumer might expect fund disclosures to explain how the fund’s holdings contribute to matters of biodiversity and climate, and that where holdings appear contradictory to such claims, the AFM might consider explaining the apparent inconsistency.
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 - ESG/sustainability-related information should be easily available and clear, succinct and comprehensible, avoiding the use of jargon and technical terms when everyday words can be used instead. Periodic fund disclosures should include evaluation against ESG/sustainability characteristics, themes or outcomes as well as evidence of actions taken in pursuit of the fund’s stated aims.
- A firm should take appropriate steps to enable consumers to access relevant ESG/sustainability-related information to support their investment decisions and monitor outcomes.
- Information on a fund’s ESG/sustainability focus should be made available to consumers in regulatory documents and reflected in any marketing materials in a clear, fair and not misleading way.
- A firm should take appropriate steps to make information on how well a fund is meeting its stated ESG objectives available to consumers on an ongoing basis and that information should enable consumers to determine whether their expectations are being met, for example through providing relevant key performance indicators and reporting on non-financial outcomes in as measurable and quantifiable way as is feasible.
What impact are we likely to see going forward?
The “Dear chair letter” is a warning shot for AFMs of ESG & sustainable investment funds with the FCA making the point that it has seen a number of applications for authorisations of investment funds with an ESG or sustainability focus that have been poorly drafted, fallen below the FCA’s expectations and which contain claims that do not bear scrutiny. The FCA has said this situation must improve.
The guiding principles are being published both to reinforce the FCA’s expectations – pre and post authorisation – and also to support firms in the design, delivery and disclosure of responsible and sustainable investment funds.
AFMs of ESG & sustainable investment funds should take into account this “Dear chair letter” and the guiding principles in relation to new fund applications but also when assessing existing funds including in their assessment of value.
The FCA expects to see clear and accurate ongoing disclosures following authorisation where funds make ESG claims and to see funds deliver on their stated objectives and strategy. That will mean a focus on compliance with the guiding principles by the FCA in its supervisory interactions where ESG and sustainability claims are made and is also likely to mean an increasing focus on ESG and sustainability issues in the FCA’s enforcement activity.
In its 2021/22 business plan the FCA explained that work to address concerns about greenwashing will be a priority for the FCA going forward and also made clear an intention to be a more proactive and assertive regulator. AFMs of ESG & sustainable investment funds have been warned! ESG and sustainable funds represent an area of significant opportunity for firms, in particular given the growing demand for these funds from consumers, but also present risks to which those that do not take heed of the FCA’s guiding principles and its intensifying focus on the design, delivery and disclosure of ESG and sustainability focussed funds are likely to be most exposed.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, July 2021