On 2 August 2021 – just in time for the entry into force of most of the amendments to the KAGB by the Fund Jurisdiction Act – a draft directive for sustainable investment funds was published for consultation by BaFin; BaFin had already published a first draft in April. The Directive contains requirements for public funds that have a reference to sustainability in their name or are marketed as sustainable. The goal is in particular to prevent so-called greenwashing.
1. What and who does the Directive regulate?
The Directive is product-related and regulates investment assets or funds designated as sustainable or marketed as sustainable (sustainable funds). As a result, requirements are set for the respective capital management company (KVG).
In the case of a fund that has a name component suggesting sustainability, there is no further examination; such a fund counts as sustainable within the meaning of the Directive without further ado. In the case of a fund marketed as sustainable, on the other hand, it must be examined whether sustainability is the main focus.
2. Core provisions
If a sustainable fund is deemed, both the sales documents (in this context BaFin refers to the sales prospectus) and the investment conditions must meet certain requirements so that sustainability can actually be ensured.
There are three ways of addressing this requirement: by appropriately designing (i) the investment limits, (ii) the investment strategy or (iii) by replicating a sustainable index.
a) Option 1: Sustainable assets – product-related
The fund must invest at least 75% (in the April draft, this was set at 90%) in sustainable assets – within the meaning of the European Sustainable Finance Disclosure Regulation (SFDR) and Taxonomy Regulation – whereby information must be included on which assets are considered sustainable. In principle, exclusion criteria (e.g. no acquisition of companies that generate electricity using fossil fuels, produce cluster munitions or use child labour) should be combined with positive specifications (e.g. acquisition of companies that generate at least xx percent of their turnover with renewable energies).
In the case of investments in target enterprises (incl. in issuers via financial instruments), these must a) make a significant contribution to at least one environmental objective (e.g. climate change mitigation, pollution prevention and control, protection and restoration of biodiversity and ecosystems) or social objective (e.g. combating inequalities, promotion of social cohesion or an investment for the benefit of economically or socially disadvantaged communities as defined in the SFDR or the Taxonomy Regulation), b) do not significantly harm any environmental or social objective (do no significant harm principle) and c) apply good governance.
The same applies to investments in tangible assets (e.g. real estate).
b) Option 2: Sustainable investment strategy – not product-related(?)
Sustainability aspects/factors must play a decisive role in the selection of assets for at least 75% of the fund or a sustainable investment strategy must be pursued with regards to the management of the entire fund (e.g. via a best-in-class strategy). The special role of sustainability aspects or the sustainable investment strategy must be described in more detail in the investment conditions. The do no significant harm principle and, if applicable, the governance requirement must also be complied with in this option.
It is questionable to what extent this option differs from option 1 (sustainable assets). In our opinion, the investment strategy can only have its own significance insofar as the target investment itself does not already make a significant contribution to the realization of an environmental or social objective. Conversely, however, this must mean that factors outside the target investment or product itself are also eligible for consideration. For example, in the case of an investment in real estate, it is conceivable that the real estate itself does not contribute to an environmental or social objective, but the tenant does (e.g. the real estate is rented to Greenpeace or Amnesty International).
c) Option 3: Replication of sustainable index
A sustainable index must be replicated. The do no significant harm principle must also be observed and issuers or target companies must have good governance. This can be ensured through exclusion criteria.
This expresses the fact that the index itself does not have to be sustainable in the sense of the SFDR/Taxonomy Regulation, as otherwise the do no significant harm principle would be complied with and good governance would be ensured for any issuers or target companies from the outset.
From a systematic point of view, i.e. in comparison to the other options, where a 75% minimum quota is prescribed in each case, at least 75% of the replicated index constituents should have to make a significant contribution to an environmental or social objective. This is logically the case, if an index is fully replicated and 75% of the index is sustainable within the meaning of the Directive.
In the end, it seems questionable to what extent this option can have its own scope, if the fund still has to analyze the individual titles.
More detailed explanations on the sustainability character of this index are required in the investment conditions. A mere reference to the sustainability determined by the index provider is not sufficient.
d) Negative examples
The Directive contains negative examples of when statements on sustainability are insufficient because they are not sufficiently meaningful. Overall, it is clearly expressed that generic statements such as that environmental, social, ethical and governance sustainability criteria are taken into account with regards to the investments are not sufficient. This seems appropriate, as the (potential) investor should know which environmental and/or social objectives are being pursued in concrete terms.
The negative examples mentioned can be divided into four categories:
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- The comments on sustainability are too general in nature. Examples:
- “More than 75 per cent of the value of the investment fund must be invested in […]. The selection […] shall be made according to environmental, ethical and governance sustainability criteria.”
- “More than 75 percent of the investment fund is composed of […] from issuers from […] selected according to sustainability criteria. Sustainability is understood as the pursuit of long-term economic success while simultaneously taking into account ecological, social and ethical principles or the principles of internationally and nationally recognized standards of good and responsible corporate governance.”
- Sustainability aspects are only taken into account instead of being (predominantly) decisive. Examples:
- “The fund takes ethical, social and environmental criteria into account when selecting issuers.”
- “The investment fund shall invest more than 75 per cent of its value in […] selected with due regard to sustainable aspects.”
- Sustainability aspects are only considered strategically in the future. Example:
- “The investment fund invests primarily in assets whose issuers operate sustainably. Sustainability is understood as a sustainable corporate policy that strategically incorporates economic, ecological and social aspects.”
- Only exclusion criteria without positive specifications are defined. Examples of exclusion criteria:
- no cluster bombs;
- no use of child labor;
- no power generation with fossil fuels.
- The comments on sustainability are too general in nature. Examples:
e) Reference value for the 75% minimum sustainability quotas, effects of de-investments
The draft does not explicitly comment on the reference value for the 75% minimum sustainability quotas, but in its negative examples it does in some cases refer to the “value” of the fund (see above). Pursuant to BaFin’s Fund Category Directive, which pursues a similar goal with regards to asset class funds (e.g. equity funds, bond funds), the fund’s NAV is relevant; however, in that context only an investment of over 50% in the respective asset class is required.
If the fund’s NAV is relevant, the resulting obligation to continuously monitor the fund’s NAV can significantly impair the use of the – explicitly granted – option to add non-sustainable investments, and BaFin in a way contradicts itself with regards to having lowered the minimum sustainability quota to 75% from previously 90%. Also, it is unclear how to deal with quota breaches, since the draft does not contain any provisions thereon.
Therefore, in our opinion, the (cost-adjusted) subscription capital of the fund should also be considered by BaFin as possible reference value for the minimum sustainability quota.
In any case, it should be set out that mere passive quota breaches and de-investments with regard to sustainable target investments should not constitute a violation that has to be cured (either through disposing non-sustainable investments and/or acquiring new sustainable investments), with potential negative effects for the investors. Only if and to the extent that re-investments are made should a new quota calculation be required.
Also, non-invested/non-allocated funds should not be considered for purposes of the quota calculation, at least temporarily after the preceding capital call.
3. Entry into force, grandfathering and outlook
The draft does not provide for an explicit date of entry into force or a transitional period, which means that the Directive should be immediately applicable upon publication of the final version. It could well be that the Directive will enter into force soon after the end of the consultation period.
The Directive will not apply to funds whose investment conditions were already approved at the time of publication of the consultation version (not the final version!). Thus, there will be grandfathering, but for which the relevant date (approval date) is already in the past; a mere application for approval before the draft was published or before the final directive is published does not grant grandfathering.
In any case, it will not be any easier for the funds or asset managers in the jungle of sustainability regulation, as not only the European regulation but also a national one will soon have to be adhered to.
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