ESG Update

Overview

Depositary banks (Verwahrstellen) for alternative investment funds (AIFs) and undertakings for collective investment in transferable securities (UCITS) are subject to various obligations arising under the Alternative Investment Fund Managers Directive (AIFMD) and the UCITS Directive and their delegated acts, as well as from national implementing legislation (in Germany, the German Capital Investment Code (Kapitalanlagegesetzbuch, KAGB). Based on this, Member State national supervisory authorities (NCAs) explain their administrative practice in publications and in turn receive recommendations or guidelines from the European Securities and Markets Authority (ESMA), the European Supervisory Authority (ESA) responsible for EU securities legislation. 

In accordance with EU and national requirements, depositaries are obliged to implement controls and carry out reviews of both investment limits and the compatibility of a fund management company’s instructions with investment rules (Anlagebedingungen), articles of association and statutory regulations. For an AIF, this obligation is based on Art. 21 (9) of Directive 2011/61/EU (AIFMD) in conjunction with Art. Art. 92 et seq. Delegated Regulation (EU) No. 231/2013; for UCITS based on Art. 22 (3) Directive 2009/65/EC (UCITS Directive) in conjunction with Art. 3 Delegated Regulation (EU) 2016/438. However, despite a corresponding recommendation by ESMA, there currently appears to be no uniform line among NCAs as to whether depositories need to monitor the investment thresholds that must be published under the Sustainable Finance Disclosure Regulation (SFDR).

Investment thresholds in pre-contractual information

The SFDR is supplemented by a delegated act (Delegated Regulation (EU) 2022/1288 of April 6, 2022) with binding templates in the annex, which have become applicable as of 1 January 2023. Under the SFDR pre-contractual disclosure requirements for financial products, the mandatory pre-contractual documents (usually a prospectus or information memorandum) must contain information on investment thresholds, such as:

• the minimum proportion of sustainable investments for investment funds in accordance with Art. 9 SFDR (template in Annex III);
• the minimum threshold of investments that meet the promoted social and/or environmental characteristics for investment funds under Art. 8 SFDR (template in Annex II); and
• the share of investments sustainable under the EU Taxonomy for investment funds under Art. 8 (template in Annex II) or 9 SFDR (template in Annex III).

ESMA recommendation

In May 2022, ESMA issued a non-binding supervisory briefing on sustainability risks and disclosures. In this briefing, ESMA addressed recommendations to the NCAs. These should take appropriate measures to ensure that UCITS management companies and alternative investment fund managers (AIFMs) provide the depositary with all relevant information and data to enable it to perform its depositary functions effectively. In particular, it indicated that depositaries should include ESG-related investment restrictions in their monitoring function.

CSSF in Luxembourg: Depositaries as obligated parties

The Luxembourg supervisory authority CSSF subsequently published in December 2022 a FAQ on the Disclosure Regulation which also included a question on investment thresholds under the SFDR.

The CSSF emphasizes that the minimum investment thresholds specified therein represent binding obligations of the investment strategy of an investment fund. In this context, the provisions of the pre-contractual documents (according to the CSSF: prospectus/issuing document) must be complied with on an ongoing basis by the investment fund, whereby the depositaries would have to independently monitor compliance with investment restrictions in accordance with the applicable regulations.

If an investment fund which aims at being categorized as falling within Art. 9 of SFDR specifies a minimum percentage of sustainable investments of 99% in such pre-contractual information, the consequence would be that the depositary would have to evaluate the underlying investments and reconcile them with this minimum percentage. In this context, it may become difficult to simply give a “yes” or “no” answer to the question whether an investment is sustainable; in many cases, a substantive review could therefore become necessary. Against this background, the question arises as to how far the scope of the control obligation extends and how regulatory uncertainties are to be dealt with. 

Control obligations would be a major challenge for depositaries primarily because there are currently still fundamental difficulties in determining product categories and investments. For example, the ESAs last addressed the issue in September 2022 with a Questionnaire to the European Commission. In particular, it is unclear how exactly sustainable investments are to be counted. An example of this is an investment in a company that contributes 20% of its economic activities to environmental or social goals and also complies with the other requirements for a sustainable investment. So far it is unclear whether 100% of the entire investment counts as a sustainable investment, or only the 20% that are actually invested into sustainable economic activities. So far, the Commission has not commented on these questions, and thus, the uncertainties in interpretation remain.

BaFin in Germany: Circular for depositaries

The German standards (as well as the AIFMD and the UCITS Directive themselves) do not refer to the prospectus or pre-contractual information with regard to the depositary's control obligations, but to the investment rules and/or statutory provisions which contain the binding investment restrictions. Therefore, the regulatory approach is different. BaFin last updated its circular for depositaries in 2020 which implements the requirements on the role of depositaries in the KAGB.

In the consultation version (Consultation 03/2020) a clarifying example on "sustainability funds" did not make it into the final version. According to BaFin's Guidelines on Fund Categories (Fondskategorien-Richtlinie), such funds must stipulate in their investment conditions that at least 51% of such fund’s net asset value must be invested in sustainable investments. Thus, it had been proposed that the control function of the depositary must also cover this threshold which is contained in the investment rules. The legal status of this consultation version was 2020, so that the general fund category guideline of BaFin was assumed. In the meantime, BaFin has based its administrative practice on the principles of its guideline for sustainable investment funds. As before, the term "sustainability" lacks tangibility in many aspects. Therefore, without a binding catalog of concrete criteria for permissible and, above all, impermissible investments, such a control function would be difficult to perform by the depositary given that a depositary is not expected nor even permitted to interfere with the material decision-making authority of the fund management company with regard to the investment strategy of the investment fund by replacing the fund manager’s decision with an own discretionary decision. Rather, the depository’s task is to monitor compliance with mandatory restrictions only. 

However, following ESMA’s recommendation, the CSSF’s submission and the entry into force of the binding templates contained in the regulatory technical standards to the SFDR, a development corresponding to Luxembourg’s supervisory practice could also gain further momentum in Germany. In particular, ESMA's supervisory briefing aims to ensure consistent supervisory practices so that other NCAs may follow suit. However, the question remains, how precise the question of how sustainable an investment is, can be put into unambiguous binding limits in a way to enable depositaries to exercise control tasks as foreseen by law. It must be borne in mind that it is not depositary’s task to generally monitor investment principles and thus, of the economic strategy a fund manager has in mind for a fund. Currently, the requirements regarding sustainability in investment funds’ strategies is still quite vague, given also lack of precise measurement rules, in particular after the acquisition process throughout the holding of an investment. 

Regarding the depth of the review, time and costs have to be borne in mind that could arise for a depositary if it were obliged to conduct an own full evaluation of the sustainability of an investee company. Accordingly, and in line with current practice, the depositary should be allowed to rely on the information provided by the investment management company instead of carrying out a completely independent review of the planned investment. In principle, the depositary should be able to limit itself to a review based on the information and expert opinions provided by the investment management company (as already explained in BaFin's Depositary Circular 05/2020 in connection with the ownership review) and only have to initiate further analyses and investigations in case of doubt.