Integrating ESG matters into suitability: EU and Swiss legislative concepts and implications for product governance and organisation

ABSTRACT

This paper reviews approaches to include ESG matters into different levels of statutory provisions and technical norms. The discussion includes a comparison of how the European Union (EU) and Switzerland approach this task. In the EU, the ‘Green Deal’ represents a strong foundation for integrating ESG into financial markets laws since it represents an official strategy that aims to reorient capital flows towards sustainable investments to achieve sustainable and inclusive growth. We argue that such a strategic objective broadens the legal basis linked to investor protection to permit introducing more comprehensive rules that touch on all aspects of providing financial services, including product governance and organisational requirements.

KEYWORDS:

• Suitability
• product governance
• investment funds

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 OECD, ‘ESG Investing and Climate Transition: Market Practices, Issues and Policy Considerations, OECD Paris 2021’ (OECD Report 2021, https://www.oecd.org/finance/ESG-investing-and-climatetransition-Market-practices-issues-and-policy-considerations.pdf accessed 11 March 2023), 3, 11–13.

2 ibid., 3-4, 8.

3 Bundesrat, ‘Finanzmarktpolitik für einen wettbewerbsfähigen Finanzplatz Schweiz’ (October 2017) (Bundesrat, Finanzmarktpolitik), 17.

4 OECD Report 2021 (n 1) 3.

5 ibid., 7 with reference to Bloomberg, ESG assets may hit USD 53 trillion by 2025, a third of global AUM (https://www.esgplaybook.com/ accessed 11 March 2023).

6 ibid.

7 CFA Institute (https://www.cfainstitute.org/en/research/esg-investing, accessed 11 March 2023).

8 CFA Institute, ‘Sustainable, Responsible, and Impact Investing and Islamic Finance: Similarities and Differences’ (2019) 5.

9 For the history of this fund see https://www.amundi.com/usinvestors/Local-Content/Product-Pages/Pioneer-Fund/Pioneer-Fund (accessed 11 March 2023).

10 See https://www.investopedia.com/terms/d/domini_400.asp and https://www.msci.com/www/research-report/domini-social-index-performance/014639791 (accessed 11 March 2023).

11 UBS (Lux) Equity Fund-Eco Performance.

12 Such ‘thematic funds’ invested in specific areas such as water or agriculture but also in such varied sectors such as internet security or the needs of an ageing society.

13 See below section B.I.

14 See ESMA Annual Statistical Report 2020 and the related news item https://www.esma.europa.eu/press-news/esma-news/esg-funds-provided-better-returns-investors-in-2020 (accessed 11 March 2023).

15 OECD Report 2021 (n 1) 16.

16 ibid., 19.

17 For an illustrative example, see JP Casey and K Lannoo, The MiFID Revolution (New York 2009) 56 (JP Morgan).

18 Cf. FINRA Rule 2111: ‘A customer’s investment profile includes, but is not limited, to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation’.

19 WF Sharpe, ‘Capital Asset Prices: “A Theory of Market Equilibrium under Conditions of Risk”’ (1964) 19 Journal of Finance 425–42.

20 J Klement, ‘Investor Risk Profiling: An Overview’ in Risk Profiling and Tolerance: Insights for the Private Wealth Manager (CFA Institute Research Foundation 2018), 8.

A Barnea, H Cronqvist and S Siegel, ‘Nature or Nurture, What Determines Investor Behavior?’ (2010) 98–3 Journal of Financial Economics 585–604.

22 Klement (n 20) 9.

23 See for example the CFA Institute, ‘Code of Ethics and Standards of Professional Conduct’ (https://www.cfainstitute.org/en/ethics-standards, accessed 11 March 2023).

24 ESMA, ‘Guidelines on certain aspects of the MiFID II suitability requirements’ (23 September 2022) (ESMA Guidelines 2022), 4.

25 See section C.I.

26 See Freshfields Bruckhaus Deringer, ‘A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment’ (2005) (Freshfields Report, https://www.unepfi.org/fileadmin/documents/freshfields_legal_resp_20051123.pdf, accessed 10 March 2023). The full wording of the question reads as follows: ‘Is the integration of environmental, social and governance issues into investment policy (including asset allocation, portfolio construction and stock-picking or bond-picking) voluntarily permitted, legally required or hampered by law and regulation; primarily as regards public and private pension funds, secondarily as regards insurance company reserves and mutual funds?’, 6.

27 See UNEP FI, ‘Fiduciary Duty in the 21st Century, Final Report’ (2021) (UNEP FI Report, https://www.unepfi.org/fileadmin/documents/fiduciary_duty_21st_century.pdf, accessed 10 March 2023).

28 Freshfields Report (n 26) 19.

29 ibid. 19; cf. CFA Institute, ‘Investment Governance for Fiduciaries’ (2019), for a general introduction and overview for practitioners.

30 See generally Box 2 in UNEP FI Report, 12 on the traditional notion of fiduciary duties.

31 Cf. L Mehmetaj and K Brunner, ‘ESG and Fiduciary Duties of Investment Managers’ [2021] GesKR 441–56, 444.

32 See Art. 51b(2) 2 BVG, ‘treuhänderische Sorgfaltspflicht’.

33 Freshfields Report (n 26) 7.

34 Mehmetaj and Brunner (n 31) 441 with reference to UNEP FI Report, 12.

35 See J Klement, 'Best Does Not Mean Optimal', CFA Institute Enterprising Investor blog, 9 January 2029, highlights that investment professionals tend to construct the ‘optimal’ portfolio for their clients, rather than the ‘best’. However, the scope of Art. 24-25 MiFID II seems slightly broader, including aspects like costs, conflicts of interests/inducements next to appropriateness and suitability, cf. L Enriques and M Gargantini, 'The Overarching Duty to act in the Best Interest of the Client in MiFID 2' in D Busch and G Ferrarini (eds), Regulation of the EU Financial Markets MiFID 2 & MiFIR (OUP 2017), n. 4.04.

36 Freshfields Report (n 26) 13.

37 UNEP FI Report (n 27) 9.

38 ibid.

39 ibid., 12.

40 Cf. Mehmetaj and Brunner (n 31) 445 investigating the conditions for evolving legal interpretations in Swiss law, requiring ‘some sort of formalization by public authorities, either in regulation or in a binding court ruling’.

41 UNEP FI Report (n 27) 12.

42 ibid. 22.

43 ibid. 23.

44 EU Commission, ‘Action Plan: Financing Sustainable Growth’ COM(2018) 97 final, 1.

45 Reference by the Commission to Art. 3(3) of the Treaty on the European Union (TEU) and the role of environmental and social issues in international cooperation (Art. 21 TEU).

46 Com. Del 2021/1270 Preamble 2.

47 COM(2018) 97 final, 2.

48 Regulation (EU) 2020/852 of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088.

49 Regulation (EU) 2019/2088 of 27 November 2019 on sustainability-related disclosures in the financial services sector.

50 ESMA, ‘Final Report of 23 September 2022, Guidelines on certain aspects of the MiFID II suitability requirements’, ESMA35-43-3172 (ESMA Guidelines 2022), 4.

51 Directive 2014/65/EU of 15 May 2014 on markets in financial instruments.

52 Commission Delegated Directive (EU) 2017/565 of 25 April 2016 supplementing Directive 2014/65/EU as regards organizational requirements and operating conditions for investment firms and defined terms for the purpose of the Directive.

53 ESMA Guidelines 2022(n 50) 6.

54 COM(2018) 97 final, 6.

55 See section C.I.1.

56 COM(2018) 97 final, 8.

57 ESMA, ‘Final Report of 28 May 2018, Guidelines on certain aspects of the MiFID II suitability requirements’, ESMA35-43-869; also consultation paper of 13 July 2017, ESMA35-43-748 (ESMA Guidelines 2018).

58 On the topic of robo-advice see Rolf H. Weber and Rainer Baisch, ‘Regulierung von Robo-Advice’ (2016) AJP 1065–1078.

59 ESMA Guidelines 2018 (n 58), 18 (mn. 17).

60 ibid. 6 (mn. 8).

61 COM(2018) 97 final, 12.

62 ibid. 7.

63 ibid. 8.

64 See Art. 288 of the Treaty on the Functioning of the EU (TFEU).

65 Art. 289(3) TFEU. According to Art. 289(1) TFEU, the ordinary legislative procedure shall consist in the joint adoption by the European Parliament and the Council of a regulation, directive or decision on a proposal from the Commission. The ordinary legislative procedure is complemented by special procedures according to Art. 289(2) TFEU to be used in specific cases provided for in the Treaties.

66 C Blumann and L Dubois, Droit institutionnel de l’Union Européenne (LexisNexis 2010), 542.

67 Art. 290(1) TFEU; for Swiss law cf. Art. 164(2) BV.

68 Art. 291(2) TFEU.

69 e.g. the ESMA Guidelines 2012/2018/2022 discussed in this paper.

70 Art. 16(1) of Regulation 1095/2010 of 24 November 2010 establishing a European Supervisory Authority (European Securities and Markets Authority).

71 Recitial 26 to Regulation 1095/2010.

72 Art. 10 and 15 of Regulation 1095/2010, respectively. These technical standards must be distinguished from European Standards (EN) developed by the European standard setting bodies CEN, CENELEC and ETSI; see e.g. EN ISO 14001 for environmental management systems. EN are technical specifications defining requirements for products, production processes, services or test-methods. These specifications are voluntary and are developed by industry and market actors following some basic principles such as consensus, openness, transparency and non-discrimination. They are used to ensure interoperability and safety, reduce costs and facilitate companies’ integration in the value chain and trade.

73 Art. 10 and 15(1) of Regulation 1095/2010, respectively. EMSA proposed and published numerous technical standards, e.g. in 2021 the draft regulatory technical standards with regard to the content and presentation of sustainability disclosures pursuant to Art. 8(4), 9(6) and 11(5) of Regulation (EU) 2019/2088.

74 Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (‘MiFID II’).

75 See Art. 25(8).

76 Commission Delegated Regulation (EU) 2017/565 of 25 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive.

77 Commission Delegated Regulation (EU) 2021/1253 of 21 April 2021 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.

78 Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) (‘UCITS V’).

79 Based on the regulatory procedure with scrutiny according to Art. 8 of Commission Decision 2001/528/EC. This procedure is a specimen of the EU’s comitology procedures. Note that this decision has since been replaced by Regulation (EU) No. 182/2011; see A Hardacre and M Kaeding, Delegated & Implementing Acts, The New Comitology (European Institute of Public Administration 2011).

80 Commission Directive 2010/43/EU of 1 July 2010 implementing Directive 2009/65/EC of the European Parliament and of the Council as regards organisational requirements, conflicts of interest, conduct of business, risk management and content of the agreement between a depositary and a management company.

81 Commission Directive (EU) 2021/1270 of 21 April 2021 amending Directive 2010/43/EU as regards the sustainability risks and sustainability factors to be taken into account for Undertakings for Collective Investment in Transferable Securities (UCITS).

82 Directive 2011/61/EC of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers.

83 Based on the regulatory procedure with scrutiny according to Art. 8 of Commission Decision 2001/528/EC. This procedure is a specimen of the EU’s comitology procedures. On comitology, see CF Bergstroem, Comitology, Delegation of Powers in the European Union and the Committee System (OUP 2005); T Christiansen, JM Oettel and B Vaccari (eds), 21st Century Comitology, Implementing Committees in the Enlarged European Union (European Institute of Public Administration 2009); F Bergold amd DH Wendt, Technische Durchführungsstandards im Finanzmarktrecht – Fortschrittliche Rechtsetzung oder Demokratiedefizit? (2019) 1 EuR 89.

84 Commission Delegated Regulation (EU) No 231/2013 of 19 December 2012 supplementing Directive 2011/61/EU of the European Parliament and of the Council with regard to exemptions, general operating conditions, depositaries, leverage, transparency and supervision.

85 Commission Delegated Regulation (EU) 2021/1255 of 21 April 2021 of 21 April 2021 amending Delegated Regulation (EU) No 231/2013 as regards the sustainability risks and sustainability factors to be taken into account by Alternative Investment Fund Managers.

86 Which for some time have been a topic intensively discussed between the Commission and the Parliament; see e.g. D Gueguen, Comitology, Hijacking European Power (European Training Institute 2011); A Hardacre and M Damen, 'The European Parliament and Comitology, PRAC in Practice' (2019) 1 EIPASCOPE 13-18.

87 On client suitability in general see Casey and Lannoo (n 17) 45.

88 See Art. 25(8) MiFID II.

89 See n 52.

90 Art. 54(2)(a) MiFID II Delegated Regulation as amended. The amendment of the original text is underlined.

91 One could question whether sustainability preferences are really on the same level as investment objectives and risk tolerance, which may both be appropriately assessed using quantitative models.

92 Art. 54(5) MiFID II Delegated Regulation as amended.

93 Art. 54(9) MiFID II Delegated Regulation as amended.

94 Art. 54(10) MiFID II Delegated Regulation, old version.

95 But not the portfolio managers.

96 No such report need be issued to professional clients, who are expected to understand the advice received on their own.

97 Art. 54(12) MiFID II Delegated Regulation as amended.

98 Cf. for banks Art. 1(1) SBVg Richtlinien zur Vermögensverwaltung (2017): „Zu diesem Zweck erstellt sie ein Risikoprofil, das die Risikobereitschaft und Risikofähigkeit des Kunden festhält“; for advisors see CFA Code of Ethics and Standards of Professional Conduct, Section III.C. ‘Suitability’.

99 ESMA Guidelines 2022 (n 24) 6.

100 Based on Art. 25 (9) and (19) MiFID II.

101 ESMA Guidelines 2022 (n 24), 6.

102 ibid. 7.

103 The term appears 106 times throughout Annex IV.

104 See points (a) to (c) of Art. 2(7) MiFID II Delegated Regulation.

105 ESMA Guidelines 2022 (n 24) 42.

106 ibid. 45–46.

107 ibid. 54.

108 The term only appears in Recital 71 of MiFID II.

109 Art. 24(2) subparagraph 2 MiFID II.

110 Art. 9(3)(b) MiFID II.

111 Recital 15 of Delegated Directive (EU) 2017/593.

112 Commission Delegated Directive (EU) 2017/593 of 7 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to safeguarding of financial instruments and funds belonging to clients, product governance obligations and the rules applicable to the provision or reception of fees, commissions or any monetary or non-monetary benefits.

113 Commission Delegated Directive (EU) 2021/1269 of 21 April 2021 amending Delegated Directive (EU) 2017/593 as regards the integration of sustainability factors into the product governance obligations.

114 Recital 5 of Delegated Directive (EU) 2021/1269.

115 See Art. 16(3) MiFID II: ‘The product approval process shall specify an identified target market of end clients within the relevant category of clients for each financial instrument and shall ensure that all relevant risks to such identified target market are assessed and that the intended distribution strategy is consistent with the identified target market’.

116 Art. 9(9) Delegated Directive (EU) 2017/593 as amended.

117 Recital 6 of Delegated Directive 2021/1269.

118 See section D.

119 Similar requirements hold for AiFM but we will not discuss these in this paper.

120 See Recital 10 to UCITS V.

121 See Regulation (EU) 2016/679 (General Data Protection Regulation).

122 Art. 4(1)(a) UCITS Implementing Directive.

123 Art. 4(1) UCITS Implementing Directive, as amended.

124 Art. 5(1) UCITS Implementing Directive.

125 Art. 5(1) UCITS Implementing Directive, as amended.

126 Art. 5a UCITS Implementing Directive, as amended.

127 Art. 23 UCITS Implementing Directive.

128 Art. 23 UCITS Implementing Directive, as amended.

129 Art. 38(1) UCITS Implementing Directive.

130 Art. 38(1) UCITS Implementing Directive, as amended.

131 Art. 9(2)(g) UCITS Implementing Directive, as amended.

132 The three ESAs are the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA).

133 ESMA, Progress Report on Greenwashing (31 May 2023); final report to be published in May 2024.

134 ibid. 6.

135 ibid. 7.

136 Cf. e.g. O Kruse and J Winter, 'Produkt- und Beratungsanforderungen nachhaltiger Geldanlagen – Im Spannungsfeld zwischen Anlegerschutz und Praktikabilität' [2020] ZBB 178–89, who warned against too bureaucratic an approach and more recently S Steuer, 'Grüne Transparenz und nachhaltige Verwirrung – Die produktbezogenen Informationsvorschriften der SFDR' [2022] ZBB 31–46 who criticises an overly complicated regulation and lack of consistency, especially with respect to the SFDR.

137 See https://www.admin.ch/gov/en/start/documentation/media-releases.msg-id-84106.html (accessed 18 March 2023).

138 The new requirements of the CO on non-financial company reporting are a remnant of a proposal to introduce more stringent liability provisions for companies in the human rights context. This proposal was closely rejected in a public vote on 29 November 2020.

139 See also the Ordinance on Due Diligence and Transparency in relation to Minerals and Metals from Conflict-Affected Areas and Child Labour (DDTrO) of 3 December 2021.

140 See https://www.six-group.com/en/products-services/the-swiss-stock-exchange/market-data/shares/sustainability-reporting.html (accessed 18 March 2023).

141 Defined in Art. 1(1) FINMASA as the group of laws comprised of the Mortgage Bond Act of 25 June 1930; the Federal Act on Contracts of Insurance of 2 April 1908; the Collective Investment Schemes Act of 23 June 2006; the Banking Act of 8 November 1934; the Financial Institutions Act of 15 June 2018; the Anti-Money Laundering Act of 10 October 1997; the Insurance Supervision Act of 17 December 2004; the Financial Market Infrastructure Act of 19 June 2015; the Financial Services Act of 15 June 2018.

142 See FINMA Circulars 2016/1-2 on public disclosure for banks and insurers.

143 See FINMA Guidance 03/2022 on implementation of climate-related risk disclosures by category 1–2 institutions of 29 November 2022.

144 Art. 4 FINMASA.

145 FINMA Guidance 01/2023 of 24 January 2023 on developments with regard to the management of climate risks.

146 FINMA Guidance 01/2023, 3.

147 See above, section B.I.

148 For example Art. 29(3) FinMIA on post-trade transparency; see also FINMA Guidance 01/2023, 4 where FINMA refers to standards by BCBS and IAIS.

149 Bundesrat, ‘Nachhaltigkeit im Finanzsektor Schweiz, Eine Auslegeordnung und Positionierung mit Fokus auf Umweltaspekte’ (24 June 2020), 9.

150 SK FIDLEG-Winkler, Art. 1 N 1.

151 EFD, ‘Bericht des Eidgenössischen Finanzdepartements über die Vernehmlassungsergebnisse zum Finanzdienstleistungsgesetz (FIDLEG) und zum Finanzinstitutsgesetz (FINIG)’ (13 March 2015), 13.

152 Bundesrat, Finanzmarktpolitik, 17.

153 Bundesrat, Nachhaltigkeit 8.

154 Bundesrat, Finanzmarktpolitik, 19.

155 See section B.IV.

156 Art. 10–14 FinSA.

157 Bundesrat, Finanzmarktpolitik, 39.

158 Art. 25(8) MiFID II.

159 Cf. Art. 182(2) Const.

160 BSK FINMAG/BEHG-Daeniker/Waller, Art. 4 N 3-4, jetzt BSK FINMAG/FinfraG-Daeniker/Waller, Art. 27 FinfraG N 9 et seq.; CFA Institute, ‘Self-Regulation in Today’s Securities Markets, Outdated System or Work in Progress?’ (2013); W Wolfgang, ‘Selbstregulierung – Aufsichtsrecht – Strafrecht: (Ziel-) Konflikte und Interdependenzen’ in JB Ackermann and W Wolfgang (eds.), Finanzmarktrecht ausser Kontrolle? Selbstregulierung – Aufsichtsrecht – Strafrecht (Schulthess 2009); P Zysset, Selbstregulierung im Finanzmarktrecht (Schulthess 2017).

161 For example, for specifying the details of due diligence duties for the prevention of anti-money laundering or in the period before the enactment of the FinSA with respect to the rules of conduct applicable to manufacturers and distributors of investment funds.

162 BSK FINMAG7FinfraG-Winzeler, Art. 7 FINMAG N 87.

163 The Swiss Bankers Association SBA has published in June 2020 a ‘Position Paper on Sustainable Finance and a Guideline for the Integration of ESG Considerations into the Advisory Process for Private Clients’, the latter of which contains explicit information on the relevant methods and strategies.

164 AMAS, ‘Self-regulation on transparency and disclosure for sustainability-related collective assets’ (2022).

165 CFA Institute, ‘Global ESG Disclosure Standards for Investment Products’ (June 2022).

166 See section C.I.5.

167 Art. 12 CISO.

168 Art. 10 CISO.

169 Art. 12a CISO.

170 Art 38 et seq. CISO-FINMA. Clearly, using VaR as a risk measure for more complex types of investments can be seen as market standard reflecting professional diligence.

171 Art. 12a CISO requires that ‘all material risks’ are taken into account; Art. 80 CISO sets some minimal standards for dealing in OTC derivatives; Art. 39(3) CISO-FINMA requires that the VaR model covers the risks related to changes in interest rates, share prices, and commodities.

172 CFA Institute, ‘Positions on Environmental, Social, and Governance Integration’ (January 2021).

173 CFA Institute, ‘Consultation paper on the development of the CFA Institute ESG Disclosure Standards for investment products’ (August 2020).

174 An ESG-related need is defined as a benefit related to ESG matters that an investor must obtain (needs) or would like to obtain (wants); ESG matters are defined as affairs, situations, or topics related to the environment, society, or governance (ESG), Consultation Paper, 3.

175 An ESG-related feature is defined as a component or capability, intentionally incorporated into the design of an investment product to provide a benefit for the investor that relies on ESG-related factors, Consultation Paper, 3. or addresses investors’ ESG-related needs.

176 Consultation Paper, 24.

177 ibid., 25.

178 For suitability, see Art. 70 MiFID II, in German law transposed in § 120 WpHG; in Switzerland the enforcement landscape is different with criminal sanctions limited to individuals working for non-supervised entities only; for details see Y Mauchle, 'Durchsetzung der FIDLEG-Normen' [2021] GesKR 202–24.

179 Cf. Bergold and Wendt (n 83) 86–110, who on the one hand question the legitimacy of provisions under delegating powers but on the other hand recognise that technical standards represent a coherent attempt at modernising financial market regulations.