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.
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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.
Read the full article here by Frances Schwartzkopff, Advisor Perspectives.
