Guidelines indicate when asset managers may legitimately use ESG or sustainability-related terms in their fund names.

By Nicola Higgs, Laura Ferrell, and Charlotte Collins

On 14 May 2024, ESMA published its final Guidelines on funds’ names using ESG- or sustainability-related terms. The Guidelines aim to address the risk of funds’ names misleading investors by ensuring that their names can be supported in a material way by evidence of sustainability characteristics or objectives that are reflected fairly and consistently in the fund’s investment objectives and policy.

ESMA originally consulted on the Guidelines in November 2022 (see this blog post), but finalisation has been delayed while reviews of the AIFMD and UCITS Directive were completed. Notably, ESMA received substantive feedback on the consultation and made several amendments to the Guidelines accordingly.

Key Elements of the Final Guidelines

The key recommendations are:

Funds using transition-, social- and governance-related termsAt least 80% of investments should be used to meet ESG or sustainable investment objectives
Must apply the EU Climate Transition Benchmark exclusions
Funds using environmental- or impact-related termsAt least 80% of investments should be used to meet ESG or sustainable investment objectives
Must apply the EU Paris-aligned Benchmark exclusions
Funds using sustainability-related termsAt least 80% of investments should be used to meet ESG or sustainable investment objectives
Must apply the EU Paris-aligned Benchmark exclusions
Must commit to invest meaningfully in sustainable investments

Aside from fund names using any transition-related terms, the thresholds will apply cumulatively (for example, a fund using social- and environmental-related terms will need to apply the requirements of the first two rows in the table above). Although ESMA notes that the majority of respondents did not agree with using the above thresholds, it also explains that many did not offer viable alternatives. In particular, while most respondents suggested that revisions to the Sustainable Finance Disclosure Regulation (SFDR) would be the best option, ESMA considers that the Guidelines are needed to urgently address greenwashing risk in the short term.

ESMA originally proposed an 80% investment threshold for ESG-related terms, with an additional requirement that 50% of investments within the 80% threshold would need to meet the sustainable investment test under the SFDR if a fund also used any sustainability-related terms in its name. ESMA subsequently dropped this additional threshold, following concerns that the definition of a sustainable investment under the SFDR is not sufficiently clear and that this threshold may not be attainable for many Article 8 funds. However, under the final Guidelines, funds using sustainability-related terms must commit to invest meaningfully in sustainable investments (in addition to the criteria applicable to environmental-related terms).

ESMA distinguishes social- and governance-related terms from environmental-related terms and specifies that the full list of EU Paris-aligned Benchmark exclusions will not apply to funds using social- and governance-related terms. Instead, the EU Climate Transition Benchmark exclusions will apply, which do not exclude investment in companies deriving part of their revenues from fossil fuels. ESMA does not consider it appropriate to prevent funds with a social or governance objective from investing in such companies. ESMA also clarifies that, for these purposes, ESG is considered an environmental term.

ESMA has introduced a new category of transition-related terms in the final Guidelines. This is broadly defined to include any terms derived from the word “transition”, as well as terms derived from “improve”, “progress”, “evolution”, “transformation”, “net zero”, and other similar terms. ESMA has introduced this category in order to promote strategies that will facilitate a transition towards a greener economy.

ESMA has also added language to clarify that funds using “transition”- or “impact”-related terms in their names should ensure that investments within the 80% threshold are on a clear and measurable path to social or environmental transition, or are made with the intention to generate positive, measurable, social, or environmental impact alongside a financial return, respectively. The aim of this provision is to create an additional qualifying link between the strategy of the fund and its name, ensuring a measurable dimension to the strategy itself.

Further, the final Guidelines confirm that index funds must meet the relevant thresholds before they can use in their names any of the ESG- and sustainability-related terms referred to in the Guidelines.

Next Steps

The Guidelines will now be translated into all EU languages and published on ESMA’s website; they will begin to apply three months after publication. However, as EU guidelines apply on a “comply or explain” basis, it will be up to individual Member States to decide whether, or to what extent, they choose to implement the Guidelines in their jurisdiction. New funds created on or after the application date will need to apply the Guidelines immediately, whereas existing funds will need to start applying the Guidelines six months after the application date.

ESMA notes that the majority of respondents agreed there would be merit in similar guidance for other financial products. For example, the Guidelines could be expanded to cover MiFID financial instruments, green bonds, or green loans. Consequently, ESMA will reflect on whether to widen the scope of the Guidelines in future.

US and UK Outlook

Regulators concerned about potential greenwashing risk have increasingly focused on fund naming conventions, and the EU is not the only jurisdiction to take action in this space.

In the US, changes have been made to the SEC’s Names Rule to broaden the scope of the 80% investment policy requirement for registered investment companies (see this Latham Client Alert). The Names Rule requires a registered investment company or business development company with a name that suggests it focuses on a particular type of investment or investments in a particular industry, country, or geographic region to invest at least 80% of its assets consistent with its name.

The amendments broaden the scope of the 80% investment policy requirement to apply to any registered fund name with terms that suggest the registered fund focuses on investments that have, or investments whose issuers have, particular characteristics or a thematic investment focus. This expanded requirement includes registered fund names that indicate the registered fund’s investment decisions incorporate one or more ESG factors. ESG terms that trigger the 80% requirement — if they describe ESG factors that may be considered when making an investment decision — include, for example, “ESG”, “sustainable”, “green”, “socially responsible”, “ethical”, “impact”, and “good governance”. The SEC also noted in the adopting release that if a fund subject to the Names Rule uses its 20% basket to invest in assets that are materially inconsistent with the investment focus or risk profile reflected by the fund’s name, the fund’s name would be materially deceptive or misleading under other provisions of the US securities laws. Further, the SEC stated that even funds that are not subject to the Names Rule are prohibited from using materially misleading or deceptive names, and such funds will continue to be subject to the anti-fraud provisions of the US securities laws regarding disclosures to investors.

The amendments to the Names Rule became effective on 11 December 2023. Fund groups with net assets of $1 billion or more have 24 months to comply with the amendments, and fund groups with net assets of less than $1 billion have 30 months to comply.

ESMA states that it specifically took into account the US 80% threshold when determining an appropriate threshold in the EU, signalling some level of international alignment.

In the UK, the FCA’s Sustainability Disclosure Requirements (SDR) and investment labelling regime will introduce product labels for funds meeting certain criteria, and new naming and marketing rules for funds that do not qualify for a label, but use sustainability-related terms (see this Latham Client Alert). The UK regime will apply to UK asset managers marketing UK funds to UK retail investors. The FCA is also currently consulting on extending the regime to UK portfolio managers and HM Treasury is considering applying the regime to overseas funds. As noted above, ESMA is also considering expanding its Guidelines to cover additional financial products. The UK regime has a retail focus, so the naming and marketing rules will only apply when facing retail clients, although firms serving professional clients may choose to use the labelling regime if they wish.

In order to use one of the investment labels (Sustainability Focus, Sustainability Improvers, Sustainability Impact, or Sustainability Mixed Goals), at least 70% of the product’s assets must be invested in accordance with its sustainability objective, and use of a label will require prior notification to the FCA.

Under the naming and marketing rules, if a product uses sustainability-related terms in its name (such as “green”, “climate”, and “social”), the product must have sustainability characteristics, and the product’s name must accurately reflect those characteristics. The sustainability characteristics of a product should be material to that product, meaning, for example, that at least 70% of its assets have sustainability characteristics. Further, the terms “sustainable”, “sustainability”, “impact”, and any variation of those terms must not be used (labelled products will also not be able to use the term “impact” unless they apply the Sustainability Impact label). The UK regime goes further than the EU or US regimes as it will also require products using sustainability-related terms to produce the same disclosures as those using an investment label.

The investment labelling regime will apply from 31 July 2024 for UK asset managers, and it is proposed that it will apply from 2 December 2024 for UK portfolio managers. The naming and marketing rules will apply from 2 December 2024.

Global businesses will need to take account of the varying scope and thresholds for the different regimes, and it may well be that the 80% threshold becomes the de facto approach in the UK, particularly as the FCA has made clear that it considers 70% to be an absolute minimum. Although naming rules are currently fairly limited in scope and focus mostly on the funds industry, financial services firms should be conscious of broader initiatives to tackle greenwashing and the general emphasis on ensuring that ESG- or sustainability-related financial products live up to expectations. Therefore, it may be prudent to consider applying the same approach to other financial products and to expect regulators to start to read principles from the existing guidance across to other products.