Navigating the EU's rules on sustainable financial investments

Failing to grasp the full implications of the EU’s Sustainable Finance Disclosure Regulation (“SFDR”) is no longer an option for investors and asset managers in today’s rapidly evolving financial and legal landscape.  With intensified regulatory scrutiny, reputational and litigation risks on the rise, and sustainability credentials becoming a critical factor in investment decisions, understanding the SFDR is essential to maintaining compliance, competitiveness and investor trust. This article unpacks the complexities of the SFDR – its classifications, obligations, risks and the far-reaching impact on fund marketing and sustainability disclosures – offering vital insights to navigate Europe’s sustainable investment landscape.

As greenwashing concerns have mounted in recent years, the SFDR of 2021 promised to bring much-needed transparency to sustainable investing by standardising how ESG-related risks are disclosed by asset managers in fund materials. The SFDR has veered into the spotlight again after the European Commission launched its consultation on simplifying the regulation, which is about to end on 30 May 2025, as well as increased criticism and tougher regulatory stances since 2024 - more of that later. It is an opportune time to reflect on what the SFDR had set out to do and share what we believe are regulatory and litigation risks for asset managers.

What is the SFDR

A core pillar of the European “Green Deal”, the SFDR came into effect in March 2021 and creates a framework with the aim of increasing transparency in the financial sector in relation to sustainability. By requiring financial market participants and financial advisers to disclose how they integrate sustainability risks into their investment decision-making processes, the SFDR seeks to help investors to distinguish between financial products based on their environmental, social and governance (“ESG”) characteristics, reducing the risk of greenwashing and promoting responsible investing. 

Although the UK has left the EU, the majority of collective investment funds are EU domiciled (Luxembourg or Ireland) and therefore this remains of major importance to UK-based managers, advisers and investors.

The SFDR requires asset managers and investment advisers to provide firm-level disclosures relating to key ESG risks and opportunities. It also seeks to assist investors in making informed choices by requiring increasing levels of disclosures, depending on the degree to which sustainability is a consideration. The regulation establishes three distinct product classifications:

• "Article 6” products which do not promote any sustainability characteristics
• “Article 8” products which promote environmental or social characteristics and
• “Article 9” products with sustainable investment objectives.

By making sustainability-related disclosures consistent, the SFDR aims to make it easier for investors to compare investment options in terms of the degree to which ESG factors are a consideration within the investment decision-making process.

Who does it affect?

The SFDR has significant implications for a range of financial market participants.  Asset managers and financial institutions offering investment products must classify their funds as Article 6, Article 8 or Article 9. These classifications influence how funds are marketed and the extent to which they must disclose “sustainability risks” and “principal adverse impacts”:

• Sustainability risks are defined as ESG events or conditions, such as climate change, which could cause an actual or a potential material negative impact on the value of an investment.
• Principal adverse impacts are defined as any negative effects that investment decisions or advice could have on sustainability factors. These could include investments in companies with high carbon emissions or poor practices in water, waste or land management.

For investors, both institutional and retail, the SFDR serves as a tool in assessing the sustainability credentials of investment products. As demand for ESG-compliant investments grows, a standardised approach to evaluating funds, helps investors make informed decisions that align with their values and financial goals.

Companies seeking investment from SFDR-compliant funds must also consider how they present their sustainability practices. By ensuring they provide reliable ESG data, businesses can enhance their attractiveness to investors. However, failing to meet ESG expectations or providing misleading information can pose reputational and financial risks.

Interplay with other regulatory regimes

With the SFDR a core pillar of a wider EU action plan, it interacts with several other EU sustainability regulations. The EU Taxonomy Regulation (“TR”), which came into effect in January 2022, plays a complementary role by introducing standard environmental criteria within the EU, affecting Article 8 and Article 9 classified financial products:

• For Article 8 products, asset managers and investment advisers need to state if they have any investments in sustainable investments and whether these investments are in activities aligned with the TR.
• For Article 9 products, which have sustainable investment as an objective, asset managers and investment advisers need to disclose whether their sustainable investments are in activities aligned with the TR.

Further, the Corporate Sustainability Reporting Directive, which came into effect in December 2022, expands sustainability disclosure requirements for companies, ensuring greater data availability to support SFDR compliance.  In addition, the Corporate Sustainability Due Diligence Directive, which came into effect in July 2024, focuses on responsible business conduct, further reinforcing sustainability objectives within corporate and investment strategies.

Similar regulatory efforts have emerged beyond the EU too.  In the UK, the Sustainability Disclosure Requirements (“SDR”) share some of SFDR’s objectives but differ in classification criteria and reporting obligations and do not apply to as large a constituency as the SFDR (earlier this year, a proposed extension to portfolio management was delayed).

Finally, the voluntary B Corp certification serves as a complementary initiative alongside the SFDR, SDR and other regulatory frameworks by encouraging businesses to meet high sustainability standards.  Many asset managers have sought B Corp certification, which has recently been overhauled by replacing a points scoring system with minimum standards across seven key areas, from climate action to human rights, which will be implemented from next year.

How is the SFDR enforced?

The SFDR does not contain an EU-wide penalty regime and enforcement of the SFDR is carried out by national regulators across EU member states (“National Competent Authorities” or “NCAs”).  Financial institutions must ensure compliance with the SFDR’s disclosure requirements or risk facing penalties, reputational damage and potential legal consequences (as discussed below).

NCAs have recently signalled that they will be taking a tougher stance in relation to non-compliance with the SFDR. In late 2024, Aviva Investors became the first asset manager to be fined for breaching the SFDR. Luxembourg´s Financial Supervisory Authority found that Aviva Investors misrepresented its ESG credentials, sending ripples through the market.

Other NCAs have made it clear that market participants have had sufficient time to familiarise themselves with the obligations under SFDR and that they no longer intend only to monitor compliance but also to intensify enforcement actions in relation to non-compliant actors.  For example:

• In May 2024, the Dutch Authority for the Financial Markets said that it will start to apply a much greater level of scrutiny
• In December 2024, France’s Financial Markets Authority said that it will apply and enforce the European Securities and Markets Authority’s (“ESMA”) guidelines on fund naming rules
• Germany’s Federal Financial Supervisory Authority announced the same in January 2025 and
• Austria’s financial regulator has highlighted that its focus in 2025 will be on combating greenwashing, conducting targeted supervisory activities as part of its off-site analyses and on-site audits to verify disclosures and compliance.[1]

These examples underscore the increasing scrutiny that regulators are placing on sustainability-related claims.

As oversight intensifies, fund managers and financial institutions must continue to ensure their disclosures accurately reflect their sustainability practices to avoid regulatory breaches.

Risks and concerns

While the SFDR aims to enhance transparency and accountability, it has also faced criticism, including that it actually increases the risk of greenwashing, which the SFDR was introduced to reduce.  As currently drafted, the SFDR’s requirements are vague and it lacks standardised definitions (including the definition of “sustainable investments”). These shortcomings, combined with the burden of compliance and limited enforcement mechanisms, could allow funds or companies to exaggerate their ESG credentials to attract investors.

In its report in February 2023, ESMA says that “in the absence of an EU-wide labelling regime for ESG funds, some managers have also used Articles 8 and 9 as proxy labels for communication purposes.”[2]  This echoed the view of the FCA in its October 2022 consultation paper on the SDR which pointed to “growing concerns that firms may be making exaggerated, misleading or unsubstantiated sustainability-related claims about their products; claims that don’t stand up to closer scrutiny (so-called ‘greenwashing’).”

In July 2024, ESMA – whose views influence developments in this space – published its vision for how the SFDR ought to evolve in light of these concerns.  Its proposals, which, taken together, would represent a major overhaul of the regulatory regime, include (among other things):

• Consumer and industry testing should be used to ensure that policy solutions are appropriate for retail investors as well as the feasibility and workability of those solutions;
• The EU Taxonomy classification system should become the sole, common reference point for the assessment of sustainability and the SFDR definition of “sustainable investments” should be phased out;
• A product categorisation system that includes strong categories for sustainable and transition investments should be established; and
• The way in which investors are asked to express their sustainability preferences with the future product categorisation should be streamlined.

In the meantime, however, given the evolving nature of ESG criteria and the lack of standardisation in data collection, inconsistencies in sustainability reporting remain a challenge and investors will be looking to fund managers to continue to ensure their ESG due diligence and disclosure processes align with their sustainability commitments and regulatory expectations.

Whether the content of fund investments matches ESG disclosures is an issue being closely examined in both the active and passive fund management sectors. For example, in March 2024, Reclaim Finance accused five of the biggest asset managers in the US and Europe of ”greenwashing” their passive funds. It claimed that 70% of the 430 supposedly “sustainable” passive funds that it analysed were exposed to companies with fossil fuel expansion plans.

As stated above, the European Commission launched its own consultation, running to 30 May 2025, in advance of a review of SFDR at the end of 2025 with the aim to address the “burdens” of ESG reporting and simplify sustainability reporting. 

Potential for legal action

The SFDR introduces potential legal risks, particularly for funds and financial institutions.  If a fund markets itself as ESG-compliant but fails to meet the disclosed sustainability criteria, or where investors believe they were misled into investing in a product that did not adhere to SFDR requirements, investors may have grounds to pursue legal action on the basis of misrepresentation or breaches of consumer protection laws. For misrepresentation, investors would need to show that they invested, or carried on investing, in reliance on the fund categorisation and that the asset manager knew or should have known that the categorisation was incorrect.  The proper venue for such claims will depend on contractual terms and, in the case of misrepresentation, where the representations were made and received.

These kinds of claims would be particularly suitable for group action and attractive to funders.  Therefore, consumer-focused legal actions are likely to emerge, particularly if regulators determine that misleading ESG claims have become a widespread issue – and there may be exposures for other market players, such as pension trustees and financial advisers too.

Comment

Looking ahead, investors, funds and companies should prepare for increased scrutiny, even as regulators refine the framework to address the SFDR’s shortcomings. For all the efforts at simplification, the drive for sustainable finance will not lose momentum, providing risks (as well as opportunities) and maintaining transparency, and credibility will remain essential. More ESG litigation is likely to be on the horizon.

Footnotes