Would’ve, Could’ve, Should’ve: Preliminary Reflections on the EU’s New Corporate Sustainability Due Diligence Directive

 

Tara Van Ho, Senior Lecturer in Law, University of Essex

 

Photo credit: Infrogmation of New Orleans, via Wikimedia commons

 

The European Union’s Council and Parliament have agreed to a provisional text for a new directive that would require certain large corporations to undertake human rights and environmental due diligence.

 

I was reminiscing just the other day while having coffee all alone, and Lord, it took me away, back to a first-glance feeling during my first UN Forum. My hope was mixed with equal levels of scepticism about the likelihood that laws like this would be adopted let alone be effective. Over the past twelve years, the hopes and scepticism have been met in equal measure, but never more so than with this law.

 

While the final text is not yet public, a press release indicates the key expectations and components of the agreed text. MEP Axel Voss has posted the side-by-side comparator of the various drafts, including the new draft agreement. This draft confirms:

 

-          The directive will apply to large EU companies with a worldwide net turnover of €150million and 500+ employees;

-          It will eventually capture non-EU companies with €300 million net turnover generated in the EU and the Commission will publish a list of applicable non-EU companies the law;

-          Affected businesses will need to address actual and potential adverse human rights and environmental impacts in their “business chain of activities” which covers their own operations, their subsidiaries, and “the upstream business partners of the company and partially the downstream activities, such as distribution or recycling”;

-          The financial sector is (temporarily?) excluded pending a review and “a sufficient impact assessment;

-          There is a specific list of human rights and environmental protections that businesses will be expected to respect and address, and a list of obligations the breach of which will constitute “an adverse human rights impact”;

-          That list excludes from application certain ILO core conventions because not all EU member states have ratified them; 

-          Large companies will have an obligation of means to develop and implement an effective plan to mitigate their impact on climate change;

-          Those who are negatively affected (including civil society or trade unions) can bring claims for civil liability within a five-year period; and

-          At times, as a matter of last resort, businesses may need to end their business relationships where negative impacts cannot be prevented or ended.

 

This law represents progress for many in the world. If implemented in good faith, it could provide better access to remedies for victims who are negatively impacted by business operations. It should also lead to the adoption of better and greater preventative measures, avoiding the need for remediation in the first place.

 

It is the first mandatory human rights due diligence legislation to address climate change, not just environmental damage. It anticipates civil liability for businesses that breach their responsibilities. It suggests compliance with the law as a criterion for public procurement, placing the power of Member States’ purses beyond the law. The recognition that at times business relationships will need to be terminated to ensure compliance is significant and can help fill in gaps the negotiation has otherwise left unaddressed, like the issue of conflict-affected and high-risk areas (which I’ll return to later in the post).

 

I’d like to express my appreciation to the NGOs and Parliamentarians who have gotten us to this point: it is clear from the Council’s approach during negotiations that if you would’ve blinked then they would’ve looked away at the first chance. I particularly appreciate those who fought for the inclusion of international humanitarian law and specific language on conflict-affected and high-risk areas. This was needed and I was shocked by early rumours that the draft agreement excluded this issue. I’m happy those were wrong.

 

The long-awaited human rights requirements are intended to implement the 2011 United Nations Guiding Principles on Business and Human Rights (UNGPs). I remember it all too well how the EU celebrated the adoption of the UNGPs and how, together with the US and other capital-exporting states, promoted the UNGPs as the standard for businesses when addressing human rights. The EU long opposed proposals for an international treaty on business responsibility for human rights because they felt that it was unnecessary in light of the UNGPs’ existence and could distract states from implementing the UNGPs.

 

Only recently, and only because Parliament required it, the EU has joined the negotiations with all the enthusiasm of a 6-year-old child called to dinner when they’re playing with their dinosaurs (meaning: none). The new directive evidences strong disconnects from the EU’s demand that the UNGPs lead is pretty and what the EU advocates for in the binding treaty and what the directive now requires for reasons I set out below.

 

In this post, I provide a list of things the EU would’ve, could’ve, and should’ve done had the Council been as serious as Parliament about implementing the UNGPs. The would’ves apply to an ideal application of the UNGPs: applying to all businesses and with a more robust and comprehensive understanding of human rights. The could’ves represent those areas in need of greater development: consulting with rightsholders abroad; and clarifying that contractual clauses are not enough. Finally, the “should’ve” is applying the law to the financial and arms sectors, a bare minimum expectation under the UNGPs, the exclusion of which should embarrass Council members for decades to come (I would have said generations but that felt a tad bit dramatic).

 

Would’ve: Applied to all businesses

 

First, the UNGPs are explicit that the responsibility to respect human rights applies to all businesses at all times including small and medium-sized enterprises (SMEs). In the Geneva treaty negotiations the EU has always walked a very thin line, insisting that the treaty, like the UNGPs, should apply to all businesses, not just transnational corporations. The initial Parliamentary proposal for a directive would’ve (largely) continued this approach and complied with the UNGPs. Yet, it was clear from the Commission’s proposal and the Council’s response that we were never going to get a UNGP-compliant directive. The Directive will now only apply to large companies (and not in the financial sector, an issue I’ll return to). The press release does not indicate an intention to expand the scope of the Directive in the future.

 

Including SMEs is admittedly difficult. In the transnational context, large European companies have long forced SMEs in places like Bangladesh and Pakistan to absorb the cost of social auditing processes while insisting on contracts that limit the legal liability of European buyers and parents. This often leads to corrupt practices for certifications or in redirecting revenue for the certification away from protections or living wages for employees. That would defeat the purpose of the law.

 

EU SMEs, on the other hand, often already have a language of human rights, practices that facilitate due diligence, and networks that can support their efforts to develop in this area. A graduated expansion coupled with clauses aimed at protecting SMEs from the abusive practices we’ve seen elsewhere could’ve provided an important example of how SMEs can be included in mandatory human rights due diligence legislation. It also would’ve strengthened the EU’s position in the Geneva-based negotiations.

 

Instead, whenever the EU pushes for an expansion of the treaty, I hope states like Pakistan and Bangladesh point out the hypocrisy.

 

Would’ve: Taken a broader approach to human and labour rights

 

The UNGPs also call for businesses to account for all human rights. In Principle 12, it states that businesses should account for, “at a minimum,” the International Bill of Human Rights (the Universal Declaration of Human Rights, the International Covenant on Civil and Political Rights, and the International Covenant on Economic, Social and Cultural Rights) and the ILO Core Conventions. Where relevant, businesses need to rely on other standards as well.

 

The EU’s press release suggests that the directive will only invoke treaties that are universally ratified by EU member states. That would mean most of the major UN treaties are addressed but there are some disturbing omissions, including the International Convention on the Protection of All Migrant Workers and of their Families and the ILO Core Conventions. Those are rather significant omissions given issues of modern slavery in EU food supplies, and more broadly problems with the treatment of migrant workers throughout EU corporate supply chains.

 

The list also prioritises EU commitments over relevant obligations where the law has extraterritorial impacts. There should have been a recognition that at times the Inter-American and African systems on human rights can be applicable. This recognition is important as the Inter-American and African systems have produced stronger jurisprudence on various issues, including indigenous rights and community rights than Europe (significantly stronger in the Inter-American system) while the Inter-American system also produces more progressive jurisprudence on the definition and nature of reparations, and the direct responsibility of businesses. While the African system has more limited jurisprudence, its jurisprudence on land rights and community rights is similarly more advanced than the European system’s.

 

Sometimes, I miss who I used to be when I could naively believe the absence of reference to the other human rights systems was an oversight, but I fear this strengthens the case for the laws as a form of neo-coloniality by suggesting a hierarchy of rights and systems that centres European expectations in legislation that is supposed to reflect broader standards.

 

Could’ve: Undertaken Direct Consultations with Foreign Rightsholders

 

The failure to recognise the relevance of Inter-American and African jurisprudence reflects a broader procedural failure by the Commission to consult foreign rightsholders who will be affected the law. I cannot do greater justice to this criticism than Caroline Omari Lichuma has done already in her TWAIL critique of European human rights due diligence laws.

 

While my experience suggests that many victims groups and rightsholders want mandatory laws, what they want in those mandatory laws matters just as much as the desire for a law. They had a right not just to voice their support for (or criticism of) the law but to make substantive demands for the law itself. What would the additional demands of rightsholders look like? Well, sometimes you just don't know the answer ‘til someone's on their knees and asks you for a particular legislative proposal, but a very recent study suggests that consultation might have led to different approaches to remediation, particularly for climate-related harms.

 

I often find that memories feel like weapons. In this field, we have often seen European businesses and states undertake “new” initiatives they claim are for the benefit of others without actually talking to the “others.” For example, studies suggest “social auditing” and certification schemes do not deliver on the promises European companies and social initiatives claim. This is unsurprising. Writing in the U.S., the founding father of critical race theory, Derek Bell, has explained that many “anti-racist” developments really represent interest convergence of White and Black leaders. As such, the concessions are less radical or responsive than what racialised communities would seek themselves. These additional demands, however, are often dismissed or ignored. When Dr Lichuma provided an overview of her critique at the 2022 UN Forum on Business and Human Rights, one European delegate infamously responded that Europe’s position wasn’t a matter of imperialism but of “leadership.” Real leadership, however, would reflect the results of consultations with rights-holders not just the political interests and concessions of European leaders.

 

Could’ve: Clarified that Contractual Clauses are not Enough

 

Recital 34, para 43 in the table contains an extensive discussion of the kinds of measures companies can take to comply with their human rights responsibilities. One of those is the development of contractual clauses with business partners. I worry that I've seen this film before and I didn't like the ending.

 

I’ve now mentioned twice that social auditing is a sham. There will be exceptions to this rule and I can point people to a few of my favourite exceptions, but let me reiterate what existing research indicates: social auditing is generally ineffective and often detrimental for rights-holders, providing a veneer of respectability for disrespectful practices.

 

Increasingly, it is clear that this is equally true of index listings meant to advise institutional investors on their human rights risks. Last year, the US advisory company Morningstar adopted rules aimed at exempting Israel that so fundamentally misunderstand the UNGPs that it renders all its human rights reporting questionable (short story: Morningstar concluded Israel isn’t a conflict-affected area…). More recently, index provider MSCI accepted audits from Xinjiang, China, as evidence that the car company Volkswagen was seriously addressing the issue of Uyghur forced labour. No company can adequately address the issue of Uyghur forced labour when operating in Xinjiang and (again, I cannot emphasise this enough) it is irresponsible to rely on a social audit in this context. Because these indexes set their own rules, and have no professional board standards, I can’t actually accuse them of professional malfeasance but these responses are shockingly inept.

 

Human rights due diligence is not supposed to be the same as an audit, but often businesses looking for a quick and dirty misdirection will use social audits and contractual clauses as a substitution for due diligence. I fear that if contractual clauses are allowed, due diligence will start to look more and more like social auditing and indexing and less like the robust and circular mechanism of assessment, responsiveness, and reparations than it is supposed to be.  

 

The directive could and should clarify that while contractual clauses can be important they cannot transfer legal liability. 

 

Should’ve: Applied to the Financial and Arms Sectors

 

At Recital 18, para 27, and  Recital 19, para 28, we find an effective exemption from the law for the arms and financial sectors, respectively. In Recital 19, the CSDDD excludes “downstream business partners” from the scope of due diligence obligations. I knew this was true from the press release, but seeing the blatant language was surreal. I’m laughin', but the joke's not funny at all.

 

I’m going to set aside the arms sector for now (because I’m working on a lot regarding that sector right now), but the exemption for the financial sector is gross (gross being a legal term of art, just ask anyone…). The draft agreement says that “as regards regulated financial undertakings, only the upstream but not the downstream part of their chain of activities is covered by this Directive.” In other words: the bank is not responsible for breaches caused by its financing of another’s activities no matter how much the bank should have known how its financing would be used for human rights violations.

 

Out of every group you’re concerned with protecting, out of every business and industry, it is the banks you the Council thinks can’t do due diligence?

 

Really?

 

The banks that kept looted Nazi material from their rightful Jewish owners for decades?

 

The banks that repeatedly financed South Africa’s apartheid regime, saving it when it was on the brink of collapsing?

 

The banks accused of facilitating money laundering for drug lords and terrorists?

 

The ones who facilitate tax evasion? 

 

The banks that finance dam projects in indigenous lands with such disregard for human rights that many of their logos should just be “Hi, it’s me, I’m the problem. It’s me.”

 

The banks that know how to do extensive due diligence on operational impacts when it’s in their financial interests?

 

Those banks? That’s who needs protecting with this law?

 

You cannot be serious about human rights if you are not serious about tackling the responsibility of the financial sector. When it comes to the Council members who betrayed the rights-holders with this clause, I got a list of names and yours is in red, underlined, France and Austria. France was the first to indicate resistance to the application to the financial sector, but it is Austria’s recent pressure on Ukraine, in which it leveraged international assistance for the war on the removal of Austrian Raiffiesen Bank from the list of international sponsors of war, that is perhaps the worst development in this area. People need to know this, so they know where to put pressure moving forward.

 

It appears there will be an “impact assessment” to determine if the law should apply to this industry, but that will be too little and far too late.

 

It’s also wholly unnecessary.

 

There is nothing particularly special about banks or the financial industry that makes human rights due diligence hard. They just don’t want to pay for it to be done properly. That’s not surprising. No company wants to pay for it. Disney once complained about reporting requirements before we even had any human rights due diligence laws because they didn’t way to cut into CEO bonuses or shareholder profits. The desire to not spend money on human rights due diligence is not an adequate reason for allowing those complicit in the Nazi genocide or South African apartheid or Russia’s unlawful war of aggression in Ukraine to continue to evade human rights responsibilities. If anything, their focus on profits and finances over people is exactly why this law is needed.

 

Concluding note

 

So that’s it: my would’ves, could’ves, should’ve for the EU. At times, the CSDDD provides me with hope about the direction of travel for this field, but in other areas it represents a crisis of my faith.

 

 

 

PS, Taylor Swift’s birthday was on the same day as the final trilogue. As a fun Easter Egg hunt for my fellow Swifties, I’ve sprinkled her lyrics throughout this post (13 times, obviously). I’ll send a friendship bracelet to the first Swiftie who emails me a list of all the hidden gems. Please use the subject line “T-Swift Easter Egg Hunt” in your email. My email address can be found on my Essex profile.

The European Commission proposals on “Green” finance and the financial regulators’ initiatives on sustainability

Thomas Piticchio 

As green politics have gained greater public attention and support, investors who mandate financial intermediaries to take investment decisions on their behalf are calling for more sustainable products and greater transparency about how and where their money is invested. 

To accommodate investors’ request, financial intermediaries are offering financial products labelled as “green”.  These products are in the process of being regulated by the European Commission whose aim is to encourage capital flows towards sustainability and to provide investors with more clarity on what constitutes a sustainable investment.

In December 2018, the European Commission mandated a group of social, financial and academic experts to develop a strategy on sustainable finance which incorporates Environmental, Social and Governance (ESG) considerations into investment decisions and ensures that clients are accurately informed.

To implement the sustainable strategy, the European Commission adopted a package of proposed measures:

- Regulation on the establishment of a framework to facilitate sustainable investment (the “Taxonomy Regulation”)

- Regulation on disclosures relating to sustainable investments and sustainability risks and amending Directive (EU) 2016/2341 (the “Disclosure Regulation”)

- Regulation amending the benchmark regulation (the “Low Carbon Benchmark Regulation”)

This article analyses each proposed Regulation, explains the proposed requirements for a product to be labelled and branded as “green” and the regulators’ initiatives towards sustainability.

The Taxonomy Regulation

The Taxonomy Regulation establishes uniform criteria to determine whether an economic activity is environmentally sustainable and can, therefore, be labelled as green.  When offering green funds, financial intermediaries must indicate the extent to which the criteria for environmentally sustainable economic activities were used.  This is to avoid raising capital for “green” purposes without clear benefits to the environment.

The Taxonomy Regulation applies to the Union, Member States and financial market participants.  Manager of UCITS, AIFs, EuVECA and EuSEF, insurers and pension products providers fall within the definition of financial market participants and are referred to in this article as participants. 

Environmentally sustainable investment

To be considered as environmentally sustainable, an investment must fund one or more economic activities which:

- contribute substantially to one or more of the environmental objectives
- do not significantly harm any of these objectives
- comply with the minimum safeguards and the technical screening criteria

The environmental objectives set out in the Taxonomy Regulation are climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, waste prevention and recycling, pollution prevention and control and protection of healthy ecosystems.

The above activities must comply with the criteria set out in Article 12 of the Taxonomy Regulation which determines whether an economic activity harms any of the environmental objectives significantly.

Minimum safeguards

The economic activities must be carried out respecting the minimum social and governance safeguards, being the principles and rights set out in the International Labour Organisation’s declaration on Fundamental Rights and Principles at Work.

This is to ensure that financial intermediaries do not neglect social factors while promoting environmentally sustainable products.

Technical screening criteria

The economic activities must comply with the technical screening criteria set out in Article 14 of the Taxonomy Regulation:

- identify the most relevant potential contributions to the given environmental objective, over the short and long-term impacts 

- specify the minimum requirements to avoid significant harm to other objectives 

- be qualitative or quantitative, or both, and contain thresholds where possible

- build upon Union labelling and certification schemes, methodologies for assessing environmental footprint, and EU statistical classification systems, and take into account any relevant existing EU legislation

- be based on conclusive scientific evidence, high quality research and market experience

- consider the life-cycle of an economy activity 

- take into account the nature and the scale of the economic activity 

- consider the potential impact on liquidity in the market, the risk of certain assets becoming stranded as a result of losing value due to the transition to a more sustainable economy, as well as the risk of creating inconsistent incentives

- cover all relevant economic activities within a specific sector and ensure that those activities are treated equally if they contribute equally towards one or more environmental objectives, to avoid distorting competition in the market

- be set so as to facilitate the verification of compliance with those criteria whenever possible

If the investment funds one or more of the environmental objectives without causing significant harm to any of them and complies with the minimum safeguards and technical screening criteria, that investment can be labelled as green and EU compliant.

It must be noted that the Taxonomy Regulation considers E (environmental) factors only.  Social and governance related investments are expected to be regulated through separate legislative proposals.

The Disclosure Regulation

While the Taxonomy Regulation establishes the framework to define an environmentally sustainable activity, the Disclosure Regulation sets out how managers must disclose certain information to provide greater clarity and transparency to investors.

Websites

Participants are required to publish policies on the integration of sustainability risks in their investment decision-making process on their websites and keep these policies up to date. 

The website must have:

- a description of the sustainable investment target
- information on the methodologies used to assess, measure and monitor the impact of the sustainable investments, including its data sources, screening criteria for the underlying assets and the relevant sustainability
- an index or target as appropriate
- the information included in the periodical reports (discussed below) 

The methodology used for calculation of indexes and benchmarks must be made readily available for investors. 

Pre-contractual disclosures

The following descriptions must be included in pre-contractual disclosures:

- the procedures and conditions applied for integrating sustainability risks in investment decisions

- the extent to which sustainability risks are expected to have a relevant impact on the returns of the financial products made available

- how the participants’ remuneration policies are consistent with the integration of sustainability risks and are in line, where relevant, with the sustainable investment target of the financial product

Financial products with an index

If a financial product has as its target sustainable investments or investments with similar characteristics and an index is designated as a reference benchmark, the information to be disclosed must be accompanied by the following:

- information on how the designated index is aligned with that target

- an explanation as to why the weighting and constituents of the designated index aligned with that target differ from a broad market index

Financial products with no index

If a financial product has as its target sustainable investments or investments with similar characteristics and no index is designated as a reference benchmark, the information must include an explanation of how that target is reached.

Periodical reports

Periodic reports (i.e. annual and/or interim) must include:

- the overall sustainability-related impact of the financial product by means of relevant sustainability indicators

- if an index is designated as a reference benchmark, a comparison between the overall impact of the financial product with the designated index and a broad market index in terms of weighting, constituents and sustainability indicators

The Low Carbon Benchmark Regulation

The Low Carbon Benchmark Regulation establishes a new category of benchmarks comprising low-carbon and positive carbon impact benchmarks, which provides investors with better information on the carbon footprint of their investments. 

A low-carbon benchmark is defined as a benchmark for which the underlying assets are selected to have fewer carbon emissions than the assets that comprise a standard capital-weighted benchmark.

A positive carbon impact benchmark, by comparison, is defined as a benchmark for which the underlying assets are selected on the basis that their carbon emissions savings exceed the asset's carbon footprint.

Recently, there has been an increase in ESG benchmarks.  The users of those benchmarks do not always have the necessary information on the extent to which the methodology used to establish the benchmark considers ESG objectives.  The Low Carbon Benchmark Regulation requires disclosure of how the methodology takes into account the ESG factors for each benchmark or family of benchmarks to enable investors to make well-informed choices.

Technical report on the Taxonomy

The European Commission mandated a technical expert group (TEG)  to develop a unified classification system known as a Taxonomy.

In June 2019, the TEG published a report containing technical screening criteria for 67 activities that can make a substantial contribution to climate change mitigation across the sectors of agriculture, forestry, manufacturing, energy, transportation, water and waste, ICT and buildings. 

The report also contains methodologies and worked examples for evaluating substantial contribution to climate change adaptation, guidance and case studies.

The TEG’s mandate was extended until the end of the year to refine and further develop some incomplete aspects of the proposed technical screening as well as issuing further guidance on the implementation and use of the Taxonomy.

While the TEG is working on finalising the criteria, in order to avoid disproportionate costs for participants, a number of provisions were put in place to ensure that the Taxonomy will only be used once it is stable and mature.  Each activity fund managers would like to invest in must be analysed carefully to ensure that it satisfies the criteria set out in the Taxonomy.

The financial regulators’ initiatives towards sustainability

While some countries are regularly monitoring the EU’s proposed regulations on green finance, others have already enacted domestic legislation to safeguard investors in green products.  This will be analysed alongside third countries’ initiatives like China and Hong Kong that are significantly contributing towards a greener economy.

EU Member States

France

France is the most active country when it comes to sustainability.  Article 173-VI of the Law on Energy Transition for Green Growth (LTECV) requires asset management companies and institutional investors to provide information on the social and environmental consequences of their activities.  This includes disclosing impact on climate change, social factors, the circular economy, the fight against food waste, discrimination and promoting diversity.  However, the “comply or explain” principle applies to Article 173-VI giving flexibility to asset management companies and institutional investors to providing valid reasons for the non-compliance (Article 173-VI: Understanding the French regulation on investor climate reporting).

In July 2019, the Autorité des Marchés Financiers (AMF), the financial regulator in France, established the AMF’s Climate and Sustainable Finance Commission made up of experts mandated to ensure collective progress in understanding the challenges around sustainability. 

The AMF is reviewing KIIDs and prospectuses of French authorised funds to ensure that the information provided by asset management companies on their investment strategy and climate-related risks is clear, accurate and not misleading.  The AMF’s supervisory power was reinforced by the law on Business Growth and Transformation (the “PACTE Law”).

United Kingdom

The Financial Conduct Authority (FCA), the financial regulator in the United Kingdom, issued a Discussion Paper (18/8) on Climate Change and Green Finance last month saying it will challenge firms which provide misleading information on their “green” activities to investors.  The FCA will take appropriate action (e.g. issuing further policy and guidance) to prevent consumers from being misled and to align UK rules with EU regulations.  

The UK’s exit from the EU should, in theory, not compromise the UK's compliance with the EU legislative proposals.  The Taxonomy Regulation, the Disclosure Regulation and the Low Carbon Benchmark Regulation were all listed in the Financial Services (Implementation of Legislation) Bill 2017-2019 as pending EU legislation to be onshored.  It is likely that these regulations will be onshored into UK law under the legislation relating to the UK’s withdrawal from the EU and for the purposes and duration of any transitional or implementation period. 

Italy

The Commissione Nazionale per le Società e la Borsa (CONSOB), the financial regulator in Italy, recently established a Steering Committee to regularly monitor EU proposals, studies, researches and analysis on sustainable finance.

As to the domestic legislation, the Regulation establishing the provisions for implementation of Legislative Decree no. 58 of February 24, 1998, on intermediaries (Decree 58) requires intermediaries to provide accurate information (i.e. objectives and characteristics, general criteria for selection, policies in exercising voting rights, income generated) on products and services defined as “ethical” or “socially responsible”.  That information must be made available on the firm's website and disclosed yearly. 

Non-EU Member States

China

In December 2017, the China Securities Regulatory Commission (CSRC) issued standards for the content and format of the information provided in the semi-annual and annual reports produced by listed companies.  These standards include requirements for companies to report on relevant ESG matters. The requirements are mandatory for key polluters and apply on a comply-or-explain basis for all other listed companies.  CSRC is expected to introduce requirements for all listed companies and bond issuers to disclose environmental risks associated with their operations by 2020 and the requirement will become mandatory for all listed companies by then.

It is important to note that China’s guidelines for establishing a green financial system encourage securities regulators to increase penalties for listed enterprises and bond issuers that falsify environmental information (Sustainable Stock Exchanges Initiative).

Hong Kong

The Securities and Futures Commission of Hong Kong (SFC) issued a circular applicable to SFC-authorized funds incorporating ESG factors into their investment objective or strategy.

Under this circular, offering documents of SFC-authorized funds must contain information (i.e. description of key investment focus, relevant green or ESG criteria or principles…) necessary for investors to make an informed judgement of whether or not to invest in these products.  The manager of a green fund must regularly monitor and evaluate the underlying investments to ensure their fund meets the investment objective and requirements set out in the SFC’s circular.

The SFC is also in the process of launching a central datable of green funds on a dedicated webpage on its website.  Only SFC-authorized green funds complying with the requirements set out in the SFC’s circular will be listed.  The webpage is expected to be launched by the end of this year.

Conclusions

An analysis of the European Commission proposals is required for managers who are or will be offering financial products branded as green.  These products will have to comply with the criteria set out in the Taxonomy Regulation and participants disclose clear and accurate information so that investors can make well-informed decisions.  The Taxonomy Regulation will apply to climate change mitigation and adaptation activities from 1 July 2020 and appropriate measures must be taken by financial intermediaries if their funds invest in one or both of these economic activities. 

The European Commission will permit EU Member States to enact domestic legislation on green products.  This may help countries establishing national frameworks to facilitate sustainable investments, for example, issuing a special tax regime for green funds. 

However, the International Organization of Securities Commissions (IOSCO) has identified some discrepancies amongst domestic legislation on sustainable finance and this may undermine investors’ confidence.  The European Securities and Markets Authority (ESMA) stresses that coordination should be sought between countries and sustainability promoted and implemented by global regulators.  Similar and consistent measures across different jurisdictions would encourage financial intermediaries to market their green funds across the world enhancing capital flows towards sustainability.  

The Taxonomy could be a viable solution for establishing a unified and consistent classification system across several jurisdictions.  However, more actions must be taken to enhance investors’ confidence.  The SFC’s dedicated webpage listing ESG compliant funds should be considered by other regulators as this might have a positive impact on investing in green funds.

The CSRC’s initiative to making these requirements mandatory and to penalise financial intermediaries who provide misleading information could also be considered by EU regulators.  If the EU requirements become mandatory and the EU introduces penalties to financial intermediaries for non-compliance, investors would be properly safeguarded.  This would discourage financial intermediaries from offering funds labelled as green which do not have clear benefits to the environment.

Further reading:

European commission, Green Finance: Overview.  Available at https://ec.europa.eu/info/business-economy-euro/banking-and-finance/green-finance_es.

FCA, Discussion Paper (18/8) on Climate Change and Green Finance.

Barnard & Peers: chapter 23

Photo credit: euractiv.com

Accessing the EU’s Financial Services Market in the Event of a No-deal Brexit

Bartlomiej Kulpa, LLM (Twitter: @KulpaBart)

Introduction

Since Boris Johnson took the helm as British Prime Minister, a no-deal Brexit has become the most likely scenario. The UK-based financial services firms are waiting to hear if they will be able to serve clients in the EU 27, and if so, on what basis. Currently, the UK-based financial services firms rely on the so-called passporting rights. According to The Economist, 5,476 financial services firms based in Britain used 336,421 European passports to sell their products in the EU in 2016. By comparison, approximately 8,000 financial services firms based in the EEA used 23,535 European passports to sell their products in the UK. This proves that the removal of passporting rights as well as uncertainty over what will replace them amount to an existential threat.

The Concept of a European Passport             

A European passport is a right granted under the Single Financial Market Directives, such as MiFID II (The Markets in Financial Instruments Directive 2014/65/EU), to an EEA institution licenced in an EEA Member State. The European passport enables financial services firms to act on a cross-border basis within the EEA. If Britain leaves the EU without a Brexit deal, the UK-based financial services firms will lose the passporting rights and consequently full access to the single market. In other words, they will be treated as third country financial services firms.  

   

Articles 34 and 35 of MiFID II form the legal basis for the passporting rights. Article 34 provides for freedom to provide investment services and activities in another Member State if such investment services and activities are authorised by the competent authorities of a home Member State. As regards Article 35, that allows financial services firms to provide services in another Member State through the right of establishment of a branch provided that such services are authorised by the competent authorities of the home Member State. Pursuant to Articles 34 and 35, a financial services firm must notify the competent authorities of the home Member State of its intention to provide services in another Member State. In other words, the financial services firm must apply for a licence. Subsequently, the competent authorities of the home Member State inform the competent authorities of a host Member State of the financial services firm’s intention to serve clients in the latter.    

  

There is no doubt that the advantages of the concept of a European passport easily outweigh the disadvantages. Firstly, one licence enables financial services firms to obtain access to 31 countries which have a population of over 500 million consumers (this will be reduced after a Brexit). From a legal point of view, this means that a financial services firm that has been granted a European passport is not required to obtain a domestic licence in every Member State. Secondly, the concept of a European passport helps to keep business costs down. Thirdly, the concept of a European passport is free from political influence. Fourthly, the range of clients and investors is not limited in scope. In other words, the concept of a European passport does not only apply to professional investors but also to retail investors. Lastly, a home Member State regulator cannot revoke the European passport and the European passport is granted for a period of time with no fixed limit.

Further, it should be noted that the concept of a European passport does not have the qualities to be described as a single European passport. If it qualified as the single European passport, then financial services firms would be allowed to undertake cross-border activities throughout the EEA without taking any further actions. A good example of a single administrative act with EEA-wide effect is a European trademark granted by the European Union Intellectual Property Office (EUIPO).

The Equivalence Regimes       

The EU has operated the equivalence regimes (also known as the third country regime or TCR) in relation to financial services firms based outside of the single market under the relevant Single Financial Market Directives and Regulations, the USA being the prime example, for some years. In accordance with Articles 46-49 of MiFIR (The Markets in Financial Instruments Regulation (EU) No 600/2014), the equivalence regime is based on an equivalence decision made by the European Commission (EC) and the register of third country financial services firms kept by the European Securities and Markets Authority (ESMA). As regards the former, the EC’s equivalence decision states whether, firstly, the prudential and business conduct requirements that are legally binding in a third country have equivalent effect under EU law and whether, secondly, the legal and supervisory arrangements of the third country ensure that financial services firms authorised by the competent authorities of that third country comply with the legally binding prudential and business conduct requirements. Once the EC has made the equivalence decision in favour of a particular third country, financial services firms based in that third country need to register, within a transitional period of three years under Article 54 of MiFIR, with the ESMA. As a result, third country financial services firms are able to operate as a European hub. It should be noted that Member States shall not impose any additional requirements on such firms and shall not treat them more favourably than firms based in the EU.       

Moreover, it should be emphasised that the equivalence regime enables third country financial services firms to provide investment services and activities only to eligible counterparties and professional clients. This means that, unlike the concept of a European passport, the equivalence regime does not apply to retail clients. What is more, the EC can revoke an equivalence decision at any time if divergences between a regulatory framework of a third country and the regulatory framework of the EU appear.

One could argue that in the event of a no-deal Brexit the equivalence regime would be more attractive for smaller financial services firms. As practice proves, multinational financial services behemoths, which have used Britain as the gateway to the single market, have already relocated to the EU 27 or are in the process of setting up offices there as part of their Brexit strategy.

As far as the resolution of disputes is concerned, third country financial services firms shall, before providing any services or activities to the EU-based clients, offer to submit any disputes relating to the aforementioned services or activities to the jurisdiction of a court or arbitral tribunal in one of the Member States (Article 46(6) of MiFIR). In other words, such firms shall offer a forum in the EU where their right to conduct litigation could be exercised. If Britain were to access the single market via the equivalence regime in the event of a no-deal Brexit, then the English courts would not have any jurisdiction over disputes relating to such services or activities. In practice, this would result in London facing a struggle to retain its position as a global centre for securities litigation.         

Although the equivalence regime would allow the UK-based financial services firms to access, in the event of a no-deal Brexit, the single market, the equivalence regime suffers from a few drawbacks. Firstly, the equivalence regime is a unilateral mechanism. To put it simply, it only depends on the EU whether it recognises as equivalent the regulatory standards of a third country. Secondly, since an equivalence decision is made by a political body, namely the EC, various political factors can impact the equivalence assessment. Thirdly, the EC’s equivalence decision cannot be reviewed by a court.

        

The European Passport Light

The next issue that merits attention is the so-called ‘European passport light’ as set out in Article 47(3) of MiFIR. A third country financial services firm can rely on the European passport light if the following conditions have been met: (i) the EC has made an equivalence decision in favour of a particular third country; and (ii) the third country financial services firm has been granted the authorisation to establish a branch in one of the Member States pursuant to Article 39 of MiFID II. As a result, the third country financial services firm will be able to provide services and activities to eligible counterparties and professional clients in other Member States without the requirement to establish a new branch for each additional Member State. In the same way as the equivalence regime, the European passport light does not apply to retail clients. However, unlike the equivalence regime, the European passport light is not based on the requirement to register with the ESMA.         

  

The MiFID II Own Initiative Principle

Article 42 of MiFID II creates an exception to a Member State’s imposition of an authorisation requirement, which is enshrined in Article 39 of MiFID II, for a third country financial services firm where that firm provides investment services or activities at the exclusive initiative of a retail or professional client. The MiFID II Own Initiative Principle is coterminous with the reverse solicitation test. Compared to the equivalence regime, the MiFID II Own Initiative Principle applies to retail as well as professional clients. However, from a practical point of view, the MiFID II Own Initiative Principle does not seem to be useful for big financial services firms that intend to actively gain a market share. Furthermore, any marketing to EU-based clients triggers the EU rules for providing financial services and consequently the need for obtaining an EU licence.    

  

Conclusion

It seems that the equivalence regime is the only workable arrangement that could replace the concept of a European passport in the event of a no-deal Brexit. Unless the UK government creates ‘Singapore upon Thames’, the process of making a decision whether post-Brexit Britain’s regulatory regime is deemed to be equivalent should be relatively straightforward. However, one should remember that the equivalence regime does not apply to retail clients and the EC can revoke an equivalence decision at any time. Therefore, the equivalence regime would not fill the gaps created after the cessation of the application of a European passport to the UK-based financial services firms.

Further reading:

M Lehmann and D A Zetzsche, Brexit and the Consequences for Commercial and Financial Relations between the EU and the UK, 20 September 2016. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2841333;

H Nemeczek and S Pitz, The Impact of Brexit on Cross-Border Business of UK Credit Institutions and Investment Firms with German Clients, 1 February 2017. Available at: https://ssrn.com/abstract=2948944;

The Economist, London’s reign as the world’s capital of capital is at risk, 29 June 2019. Available at: https://www.economist.com/finance-and-economics/2019/06/29/londons-reign-as-the-worlds-capital-of-capital-is-at-risk.              

Barnard & Peers: chapter 14, chapter 27

Photo credit: via Wikicommons, photo taken by Andy F

The financial services industry and the European Central Bank: the UK has won a battle, but can it win the war?

 

Steve Peers

Until yesterday, two trends seemed consistent in the jurisprudence of the EU courts. First of all, the UK kept losing cases relating to the interests of its financial services industry: on short-selling (discussed here), the financial transactions tax (discussed here) and bankers’ bonuses (discussed here). Secondly, the UK kept losing cases concerning its opt-outs from EU law (for instance, on social security and the immigration opt out, see here).

However, yesterday’s judgment of the EU’s General Court on the UK’s challenge to the European Central Bank (ECB) policy on securities clearing systems bucks both trends. What are its implications for the UK's financial services industry, and for the UK's relationship with the EU?

The judgment

The UK challenged a ‘Policy Framework’ published by the ECB, which set out the role of the ‘Eurosystem’ (the ECB and the national central banks of Eurozone states) as regards payment, clearing and settlement systems. Sweden supported the UK, while Spain and France supported the ECB; the Commission stayed neutral. The UK objected to the Policy Framework provisions which stated that any central counterparties (CCPs) that held more than 5% of the credit exposure for one of the main euro-denominated product categories had to be legally incorporated and fully controlled from within the euro area. This would inevitably mean that a portion of the financial services industry which was traditionally located in the City of London would have to move to one or more Eurozone financial markets instead.

First of all, the judgment examined the admissibility of the action. The General Court rejected the ECB’s argument that its Policy Framework was not a reviewable act, ruling that despite its apparent soft law form it would perceived as a de facto binding policy and would be applied by Eurozone regulatory authorities in practice. Also, the Court ruled that the UK had standing to bring a legal action against acts of the ECB, despite its opt-out from the single currency.

Secondly, the Court ruled on the substance of the case. It was only necessary to rule on one of the UK’s five arguments against the validity of the Policy Framework: that the ECB lacked competence to adopt a measure on the location of CCPs. (The other arguments concerned Treaty free movement rules, competition law, non-discrimination on grounds of nationality and proportionality).

The ECB had claimed a power to regulate on the basis of Article 22 of its Statute, which takes the form of a Protocol attached to the Treaties, and states that the Bank ‘may make regulations, to ensure efficient and sound clearing and payment systems within the Union and with other countries’. Also, the Bank referred to Article 127(2) TFEU, which gave it the task ‘to promote the smooth operation of payment systems’, and the ECB’s general objective of maintaining price stability and supporting general economic policies, as set out in Article 127(1) TFEU.    

In the Court’s view, however, these powers only extended to the ability to regulate ‘payments’ in the narrow sense, ie the ‘cash leg’ of clearing operations, not the ‘securities leg’, since securities do not in themselves constitute payments. Article 22 of the ECB Statute could only apply to payment systems with a clearing stage, rather than all clearing systems, in the absence of any explicit reference to the clearing of securities. The Court also rejected the ECB’s argument that it had an implied power to regulate such issues, since such implied powers only existed ‘exceptionally’.

Finally, the Court concluded by sketching out (in effect) a ‘roadmap’ to change the current situation. Acknowledging that there are ‘very close links’ between payment systems and securities clearance systems, and that disturbances affecting securities clearance can affect payment systems, it stated that Article 129 TFEU could be used to amend the relevant provisions of the ECB Statute to extend the Bank’s powers in this field. So it suggested that the ECB could trigger that amendment process by requesting the EU legislature to amend the Statute.

Comments

The essential elements of the Court’s judgment (which could still be appealed to the Court of Justice) are convincing. From the perspective of accountability, the ECB should not be able to adopt ‘policy frameworks’ with quasi-mandatory language that will likely be applied in practice, as a means of evading the judicial review that would certainly apply if it adopted those rules (as its Statute specifies) in the form of regulations. Nor is it acceptable that the ECB could adopt measures with an impact on non-eurozone Member States and deny those countries standing to sue it, especially when the Treaties (as the Court pointed out) contain no limits on such standing.

As for the substance of the case, the Court is surely right, in the interests of accountability, to say that EU institutions’ implied powers have to be interpreted narrowly. There have been five major Treaty amendments in thirty years, and so there have been plenty of opportunities for Member States to decide what powers ought to be conferred upon EU institutions, and what powers should not. In the absence of an express conferral of power, the cases where the institutions have implied powers should be very exceptional indeed.

However, the Court takes an unusually narrow approach to the interpretation of an express power, namely the possibility for the ECB to regulate ‘clearing and payment systems’ as set out in its Statute. It is not self-evident that this provision can only apply to the ‘cash leg’ of clearing systems, especially in light of the links between payment and securities systems, and the impact of disturbances affecting securities clearance, which the Court expressly acknowledges.

This key aspect of the ruling can only be understood in light of the broader political context of this case. If the ECB had won, that result would have been widely regarded in the UK as a carte blanche for the ECB to split up the single market in financial services, as part of a broader ‘ganging up’ of Eurozone Member States against non-Eurozone Member States, in particular the UK. This would have been a rather hyperbolic reaction, since an ECB victory would not necessarily have had an impact beyond the specific issue of securities clearance, and the Eurozone Member States do not gang up as easily as is sometimes imagined: witness the current relationship between Greece and Germany, for starters. Nevertheless, it’s no wonder that the judges believed it would be wiser to hand this hot potato back to the politicians.

It’s striking, though, that the judges’ roadmap to give the ECB more powers is particularly easy to follow. The use of Article 129 TFEU to amend the ECB Statute only requires a proposal from the Commission or a recommendation of the ECB, followed by the ordinary legislative procedure, entailing joint power for the European Parliament and a qualified majority vote in Council. Although all Member States would have a vote, Eurozone States (if they do gang up together on this point) can now outvote non-Eurozone States.  The UK would have to seek alliances, rather than threaten vetoes, to block such a move. The referendum requirement in the UK’s European Union Act 2011 wouldn’t apply (see s. 10(1)(b) of the Act; the requirement for parliamentary approval there is meaningless, since the UK could be outvoted). Indeed, the UK would need the backing of some Eurozone States, as well as all non-Eurozone States, to block such a Treaty amendment. This would entail, for instance, securing the support of countries like Poland, at the same time as the UK (whichever of the two largest parties forms the biggest part of government after the next election) seeks to cut back the rights of Polish workers.

Failing that, the UK could bring a legal challenge to the Treaty amendment, or the ECB measure implementing it, invoking again its arguments concerning the internal market, competition law, discrimination and proportionality, which were not addressed in the General Court’s judgment. There’s a strong case to be made that the valid objective of regulating securities clearance effectively could be ensured by collaboration between the ECB and the Bank of England, rather than forcing some part of the financial services industry to move from the UK to the Eurozone, but the UK could not count on the EU courts accepting it.  

What are the broader implications of this judgment for the UK’s role in the EU? First of all, it weakens the pro-Brexit argument that ‘we should leave the EU because the Eurozone Member States are ganging up on us’. For now, the UK has won this battle, and it’s only a hypothetical possibility that it will lose the war later on. Secondly, it weakens the argument that ‘the City of London would be perfectly fine after Brexit’. If that were true, then why were Eurosceptics poised to make an unholy fuss if the UK had lost this case? Indeed, if the UK were not in the EU, it would not have had the privileged standing to sue the ECB, and the government (or British securities firms) would have had to go through national courts in the Eurozone to challenge this policy instead. Moreover, it might be harder to invoke the other arguments which the UK made in this case (and would have to make in future), depending on what legal arrangements governed the EU/UK relationship after Brexit.

 

Barnard & Peers: chapter 19