ESMA guidelines on funds’ names using ESG or sustainability-related terms

Introduction

In May 2024, the European Securities and Markets Authority (the ESMA) published its eagerly anticipated final guidelines on funds’ names using environmental, social and governance (ESG) or sustainability-related terms. In August 2024, ESMA published the official translations of the guidelines which means that they will start to apply from 21 November 2024. Asset managers should therefore be taking urgent steps to ensure that they comply with them.

Background

Investor demand for investment funds that incorporate ESG factors have grown and will continue to grow in the future. In this context, the name of a fund is important as it is usually the first fund’s attribute that investors see with the potential to have a significant impact on their investment decisions. Financial services regulators are aware of this and have concerns regarding the risks of greenwashing from this point of view. 

On 31 May 2022, ESMA issued a supervisory briefing on sustainability risks and disclosures in the area of investment management (the Briefing) containing inter alia principles-based guidance on fund names with ESG and sustainability-related terms. The Briefing was issued under Article 29(2) of the Regulation establishing the ESMA¹ meaning that it was intended to promote common supervisory approaches and practices but it was not binding with Member State competent authorities (NCAs) not subjected to a comply or explain mechanism. 

Almost six months later ESMA followed up the Briefing with a consultation on draft guidelines on funds’ names using ESG or sustainability-related terms (the Consultation). The draft guidelines contained more specific guidance on the issue compared to the supervisory briefing. 

The Consultation closed on 23 February 2023 with ESMA expecting to issue the final guidelines relatively quickly thereafter by Q2 / Q3 2023. However, given the significant amount of feedback from the market the publication of the final guidelines was delayed and it was not until 14 May 2024 that they were published. The final guidelines (Guidelines) are issued under Article 16 of the Regulation establishing the ESMA meaning that unlike the Briefing NCAs are subject to a comply or explain mechanism. 

Quantitative thresholds

The Guidelines introduce quantitative thresholds (e.g., proportion of ESG related investments and/or sustainable investments) that will apply as a condition for funds using ESG and/or sustainability related terms in their names, as well as minimum safeguards (including the exclusion criteria defined in Commission Delegated Regulation (EU) 2020/1818 of July 17, 2020) depending on the type of terms used by a fund in its name.

Scope

The Guidelines apply to (i) management companies of undertakings for collective investment in transferable securities (UCITS) within the meaning of the UCITS Directive², including UCITS which have not designated such management company (i.e. internally managed UCITS), (ii) alternative investment fund managers (AIFMs) within the meaning of the Alternative Investment Fund Managers Directive  (the AIFMD), including internally managed alternative investment funds³ (AIFs) within the meaning of the AIFMD, as well as (iii) the managers of European Venture Capital Funds, European Social Entrepreneurship Funds, European Long-Term Investment Funds and Money Market Funds and (iv) NCAs. 

There remain some uncertainties around the exact scope of application of the final guidelines which will require further clarification from ESMA.

These include:

• The Guidelines suggest that they apply to funds that are closed to further subscription by investors, despite a majority of respondents to the Consultation being against it.
• The Guidelines do not expressly clarify if they apply to non-EU AIFMs and non-EU AIFs. Whilst non-EU AIFs managed by EU AIFMs are likely to be in scope provided that such non-EU AIFs are marketed in the EU, the situation is less clear for non-AIFMs marketing AIFs in the EU under Article 42 of the AIFMD (which requires compliance with Article 23 of the AIFMD, including Article 23(7) of the AIFMD under which the ESMA based the Guidelines). 

Also in terms of scope, it is worth noting that the Guidelines do not capture all the financial products captured by the Sustainable Finance Disclosure Regulation⁴ (SFDR), which has a much broader scope, leaving a strange gap between the two. 

Three categories

As for the content of the Guidelines, funds are bucketed into three categories, depending on the type of terms used in their name: 

• Funds using transition (i.e. “transition” and any terms derived from the base word “transition”, e.g. “transitioning”, “transitional” etc. and those terms deriving from “improve”, “progress”, “evolution”, “transformation”, “net-zero”, etc.), social (i.e. any words giving the investor any impression of the promotion of social characteristics, e.g., “social”, “equality”, etc.) and governance (i.e. any words giving the investor any impression of a focus on governance, e.g., “governance”, “controversies”, etc.) related terms (the Category 1). 
• Funds using environmental (i.e. any words giving the investor any impression of the promotion of environmental characteristics, e.g., “green”, “environmental”, “climate”, etc. These terms may also include “ESG” and “SRI⁵” abbreviations) or impact (i.e., “impact” or any terms derived from the base word “impact”, e.g., “impacting”, “impactful”, etc.) related terms (the Category 2).
• Funds using sustainability (i.e. “sustainability” and any terms only derived from the base word “sustainable”, e.g., “sustainably”, “sustainability”, etc.) related terms (the Category 3). 

Each of the above-mentioned categories share a common requirement: 80 per cent of the relevant fund’s investments should be used to meet the environmental or social characteristics or sustainable investment objectives (the Threshold) in accordance with the binding elements of the investment strategy disclosed in Annexes II and III of Commission Delegated Regulation (EU) 2022/1288, which supplements the SFDR (the SFDR Level 2).

In addition, if a fund belongs, or contemplates belonging to, (i) Category 1, it should apply Climate Transition Benchmark (CTB) exclusions⁶, and (ii) Category 2 and/or 3, it should apply the Paris-aligned Benchmark (PAB) exclusions⁷, noting that:

• Category 3 contains one additional requirement specific to it: funds falling in this category should also “invest meaningfully” in sustainable investments as defined in Article 2(17) of the SFDR.
• Funds from Category 1 using “transition” related terms in their names and funds from Category 2 using “impact” related terms in their names, shall ensure that their investments used to meet the Threshold “are on a clear and measurable path to social or environmental transition or are made with the objective to generate a positive and measurable social or environmental impact alongside a financial return”.
• The relevant requirements under each of the above-mentioned categories also apply to funds having designated an index as a reference benchmark. 

It is important to note that if a fund combines terms from Category 1 and Category 2 in its name, the requirements of each these categories apply cumulatively, except for those terms combined with any transition related terms (where only the requirements under Category 1 and 2 above apply). 

The Guidelines recommend that NCAs consider the above-mentioned rules throughout the life of a fund (with investors being able to verify this information through the periodic disclosures provided in accordance with the SFDR Level 2), and that a temporary deviation from the applicable thresholds/conditions, if the said deviation is not due to a deliberate choice of the asset manager, should be treated as a passive breach and corrected in the best interests of investors. Each NCA will have to define what they consider a passive breach in light of the foregoing.

The Guidelines also give examples of what NCAs should consider (subject to the relevant circumstances) as warranting further investigation and a supervisory dialogue with the relevant fund manager, such as:

• Discrepancies in the level of the quantitative threshold which are not passive breaches.
• A fund that does not demonstrate a sufficiently high level of investments to use transition, ESG, impact or sustainability related terms in its name.
• Where the NCA considers that using transition, ESG, impact or sustainability-related terms in the fund name would result in investors receiving unfair or unclear information or in a failure of the manager to act honestly or fairly thus misleading investors. 

Date of application

On 21 August 2024, ESMA published on its website the Guidelines in all EU official languages starting the clock as to when they will apply:

• NCAs must notify ESMA by 21 October 2024 whether they (i) comply, (ii) do not comply, but intend to comply, or (iii) do not comply and do not intend to comply with the Guidelines.
• The Guidelines apply from 21 November 2024.
• Managers of new funds are expected to comply with the Guidelines in respect of those funds from the date of application. Managers of funds existing before the date of application should comply with respect to those funds from 21 May 2025. 

Finally, it should be kept in mind that ESMA highlights in the  Guidelines that “it should be noted that these guidelines have been designed in light of the current legislative framework. ESMA will review the guidelines, if necessary, in case of any update of the relevant legislation”.

Next steps and how we can help

Whilst we expect Member States to comply with the Guidelines fund managers should keep an eye on the notifications that Member States make to ESMA by 21 October 2024. Where a Member State has communicated to ESMA that it will comply with the Guidelines or intends to comply with the Guidelines, fund managers should carefully note how such compliance will be locally expected.

If they have not already done so, fund managers should assess whether or not they fall within the scope of the Guidelines.

For those fund managers that are in scope, the next task is to identify those funds containing ESG or sustainability related terms in their names. One of the key points to note when doing this analysis is that it includes names that are not already provided as an example in the Guidelines but give investors the impression that they have environmental, transition, social and/or governance meanings. Firms will therefore need to think about this carefully. There may be instances where it will not be clear whether a term is or is not within scope and we can assist in these matters based on our experience working with NCAs.

Having identified those funds, fund managers then need to change the name of the fund to bring it outside the Guidelines (which may need investor consent) or review the fund’s investment strategy and legal documentation (including its SFDR disclosures) to ensure compliance with the Guidelines. We can assist with these steps too.