Sustainable Finance Insights Series - 6 | The European Commission publishes draft delegated acts on the integration of sustainability factors under MiFID II

On 8 June 2020, the European Commission published a set of draft delegated acts concerning the integration of sustainability factors under various legislative acts such as Directive 2009/65/EC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS), Directive 2011/61/EU on alternative investment fund managers and the Directive 2014/65/EU on markets in financial instruments (“MiFID”) – the following text will be limited to the integration of sustainability factors within the MiFID framework.

This initiative is part of the European Commission’s action plan on sustainable finance, seeking to ensure end investors have clear information on the social and environmental risks and opportunities pertaining to their investments and to clarify the duties of investment firms while providing their clients with advice on the social and environmental risks and opportunities in respect to their selected investments.

Both delegated acts listed below (open for feedback for four weeks from 8 June 2020 to 6 July 2020) are in alignment with the European Green Deal’s objectives and reinforce the Regulation 2019/2088 on sustainability-related disclosures in the financial services ( the “Disclosure Regulation”) and Regulation 2019/2089 on the EU Climate Transition Benchmarks and the EU Paris-aligned Benchmarks and sustainability-related disclosures for benchmarks, as well as the (not yet published) Regulation on the EU taxonomy for sustainable activities. We refer you to our BSP Newsflash series 1 and series 2 which address both Regulation 2019/2088 and Regulation 2019/2089.

1. Draft Commission Delegated Directive amending Delegated Directive (EU) 2017/593 as regards the integration of sustainability factors and preferences into the product governance obligations

Under the existing MiFID framework, it is required that investment firms which manufacture financial instruments for sale to clients ensure (i) that those financial instruments are designed to meet the needs of an identified target market of end clients within the relevant category of clients, (ii) that the strategy for distribution of the financial instruments is compatible with the identified target market, and (iii) that reasonable steps are taken to ensure that the financial instrument is distributed to the identified target market. However, the conditions to identify a target market under Commission Delegated Directive 2017/593 did not refer to the integration of sustainability preferences by investment firms manufacturing financial instruments and their distributors. This Draft Commission Delegated Directive clarifies that sustainability preferences should be taken into account in the product oversight and governance process.

This draft Delegated Directive will effectively amend Delegated Directive (EU) 2017/593 in the following ways:

• introduces a definition of “sustainability preferences”  which means a client’s or potential client’s choice as to whether either of the following financial instruments should be integrated into his or her investment strategy: (a) a financial instrument that has as its objective sustainable investments as defined in Article 2, point (17), of the Disclosure Regulation ; (b) a financial instrument that promotes environmental or social characteristics as referred to in Article 8 of the Disclosure Regulation and that either: (i) pursues, among others, sustainable investments as defined in Article 2, point (17), of that Regulation; or (ii) as of 30 December 2022, considers principal adverse impacts on sustainability factors, as referred to in Article 7(1), point (a), of the Disclosure Regulation (“Sustainability Preferences”);
• introduces a definition of “sustainability factors” which will have the same meaning as the definition in article 2(24) of the Disclosure Regulation: “environmental, social and employee matters, respect for human rights, anti‐corruption and anti‐bribery matters” (“Sustainability Factors”);
• adds a requirement for investment firms to also take into consideration Sustainability Preferences when determining whether a financial instrument is compatible with a type of client;
• adds a requirement for investment firms to also assess whether the financial instrument's Sustainability Factors are consistent with the target market when determining whether a financial instrument meets the identified needs, characteristics and objectives of the target market;
• adds a requirement for investment firms to also take into account Sustainability Preferences when reviewing a financial instrument on a regular basis and assessing any event that could materially affect the potential risk to the identified target market;
• adds a requirement for investment firms to also take into consideration Sustainability Preferences when implementing their product governance arrangements;
• adds a requirement for investment firms to also take into consideration Sustainability Preferences when reviewing the investment products they offer or recommend and the services they provide on a regular basis and taking into account any event that could materially affect the potential risk to the identified target market.

2. Draft Commission Delegated Regulation amending Delegated Regulation (EU) 2017/565 as regards the integration of sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms.

Under the existing MiFID framework, firms providing investment advice and portfolio management are required to perform a suitability assessment on their clients, including obtaining information on their investment objectives. However, the information about investment objectives generally relates to financial objectives, while non-financial objectives of the client, such as sustainability preferences, are usually not addressed. As a result, investment firms consistently do not give appropriate consideration to sustainability factors in the selection process.

This draft Delegated Regulation will effectively amend Delegated Regulation (EU) 2017/565 in the following ways:

• introduces the definitions of “Sustainability Preferences” and “Sustainability Factors” (as defined above);
• introduces a definition of “sustainability risks” which will have the same meaning as definition in article 2(22) of the Disclosure Regulation: “an environmental, social or governance event or condition that, which if it occurs, could cause an actual or a potential material negative impact on the value of the investment” (“Sustainability Risks”);
• adds a requirement for investment firms to also take into consideration Sustainability Risks when complying with their organisational requirements as set out in Article 21 of Delegated Regulation (EU) 2017/565;
• adds a requirement for investment firms to also take into consideration Sustainability Risks when establishing, implementing and maintaining risk management policies and procedures identifying the risks relating to the firm's activities, processes and systems, and, where appropriate, setting the level of risk tolerated by the firm;
• adds a requirement for investment firms to also take into consideration the client’s Sustainability Preferences for the purposes of identifying the types of conflict of interest that may arise in the course of providing investment and ancillary services or a combination thereof and whose existence may damage the interests of a client;
• adds a requirement for investment firms to also describe to the client any Sustainability Factors taken into consideration in the selection process used by the investment firm to recommend financial instruments;
• adds a requirement for investment firms to also flag to the client that the specific transaction to be recommended, or entered into in the course of providing a portfolio management service, meets the client’s Sustainability Preferences (if any);
• adds a requirement for investment firms to also request the Sustainability Preferences of a client when assessing such client’s investment objectives;
• adds a requirement for investment firms to also take into consideration Sustainability Factors within the course of implementing policies and procedures for ensuring adequate knowledge over their investment services offering and financial instruments selected in order to meet their clients profile;
• adds a requirement for investment firms, within the context of their investment advice offering, to also include in their reports to the relevant retail clients an explanation on how the recommendation provided is linked to such client’s Sustainability Preferences.