EU: Building governance expectations in sustainable finance under SFDR 2.0

The SFDR has been in force since March 2021. It introduced a number of disclosure requirements for sustainable finance products and their issuing entities which had the effect of strengthening governance and transparency in the market. Focus on the “E” of ESG has been a focus for the last few years. Governance (also known as the “G” in ESG) has long been an important part of corporate law and remains the backbone for the implementation of the “E” and “S” in ESG but now governance is becoming a headline topic of its own.

The current position under SFDR

Under Articles 8 and 9 of the SFDR, funds need to ensure that their investee companies follow good governance practices with respect to sound management structures, employee relations, remuneration of staff and tax compliance (these are the four SFDR governance pillars).

The SFDR does not set out any minimum requirements that determine concepts such as ‘good governance’ and managers must carry out their own assessment for each investment. The pre-contractual disclosure templates require managers to disclose details of their policy to assess good governance practices of the investee companies. The periodic disclosure templates do not have a specific question that requires managers to report on governance issues. However, there is a regulatory expectation that annual reviews of investee companies are performed in order to ensure that they continue to be eligible investments under Articles 8 and 9 and that includes an assessment regarding their continued good governance.

The European Supervisory Authorities (the “ESAs”) have indicated that the good governance assessment must cover all four SFDR pillars and that each pillar must meet a minimum “acceptable” standard. It is not sufficient to average or net weaknesses across pillars. As summarised in the ESAs Q&A: “where an investee does not meet at least “good” in each governance area, the good governance test would fail.”

Recent regulatory guidance and enforcement actions

We have previously written about ESMA and EU competent authority enforcement action (here and here). Competent authorities have found shortcomings in certain asset managers’ compliance with the SFDR, including in relation to good governance requirements. For example, the Danish Financial Supervisory Authority assessed that a manager did not have sufficient methods and processes to ensure that the investee companies comply with good governance practices because the manager did not have clear criteria to determine when an investment cannot stay in products disclosing under Article 8 of the SFDR as a result of a breach of good governance practice. In the absence of clear and relevant criteria and processes, the FSA found that there was a risk that the product included companies with material breaches of good governance practices, in particular with regard to solid governance structures, employee relations, remuneration of staff or tax compliance.

In June 2025, ESMA’s final report highlighted good and bad practice relating to the good governance test. It found that for some Article 8 SFDR funds there were no processes in place to ensure that good governance practices were followed for investee companies. In particular, managers did not have criteria for how long a company could remain in the portfolio if it showed an improvement, while still being in violation of good governance principles. Additionally, they did not have criteria for determining when a breach was sufficiently severe to lead to the exclusion from the product.

• Examples of good governance included a manager which performed a screening for good governance practices, with clear criteria and principles to assess whether a company should be excluded or remain in the portfolio when a controversy was identified, both at the time of the investment, and on an ongoing basis.
• Examples of non-compliance with SFDR governance requirements included managers who had insufficient processes in place for Article 8 SFDR funds to ensure that good governance practices were followed in the companies invested in. Although there was some level of screening for these practices, there were no defined timeframes or materiality thresholds for how long engagement with a non-compliant company could continue before it would be excluded from the investment universe. Article 8 SFDR requires that, independently of whether the fund is investing in sustainable investment or not, investments are made in companies that follow good governance practices.

SFDR 2.0

It will not have escaped your awareness that the SFDR is under review. The details are not yet agreed, with the Parliament, Commission and Council taking slightly different negotiating stances but it seems that the key changes will be to: (i) remove entity-level disclosure obligations; (ii) take financial advisers out of scope; (iii) significantly reduce the product-level disclosure obligations; and (iv) implement a new SFDR categorisation system, which would be more closely aligned with existing market practice and the existing legislative framework. (See our briefings here and here for more detail on the proposed amendments.)

It is not clear what the final details will be but some enhanced governance requirements have been added to SFDR 2.0, including:

• The Commission has introduced categories for Sustainable funds which will have two main criteria: (i) exclusions – products cannot invest in investments which are incompatible with that category and (ii) positive contribution – at least 70% of the portfolio must follow the ESG strategy linked to the claims made by the product. Only products complying with the category criteria will be allowed to make ESG claims in their names and marketing documents, with the exception of non-categorised products under Article 9a of the SFDR that would be able to make such claims in marketing communications but not their names, subject to meeting certain conditions. This means that it will be clearer for investors what is and is not included in a labelled fund.
• The Parliament draft requires a description of the sustainability-related engagement strategy pursued, including how that strategy has been implemented in alignment with the sustainability-related objectives of the financial product, or a clear and reasoned explanation of why it does not pursue such a strategy – adding a layer of governance to protect against greenwashing. The draft also requires disclosure of mandatory principal adverse impact (“PAI”) indicators and any further material PAI indicators.

Effectively it looks like there is a move away from principles to a more prescriptive approach to governance, for example requiring prescriptive exclusions of investments which breach investment policies and which do not comply with the new exclusions and positive contribution requirements.

What should Financial Market Participants do now?

Regulatory expectations have increased over the last year particularly in relation to how managers apply and comply with the requirement that investee companies follow good governance processes. As such, managers must be able to explain:

• their policy for assessing good governance;
• data sources used;
• escalation/remediation process;
• treatment of failed assessments – rationale for over-riding if applicable; and
• consistency of disclosures in pre-contractual and periodic reports.

Bearing the above in mind, now is a good time for managers to revisit their internal frameworks, taking a fresh look at the policies and procedures linked to entities and funds to (i) respond to the guidance which has already been given by the regulators and (ii) get ready to implement the changes under SFDR 2.0.

Our global Sustainable Finance & Investment group brings together a multidisciplinary global team that provides clients with best-in-market support. We are following developments relating to ESG regulation, so please get in touch if you would like to discuss.

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This note is intended to be a general guide to the latest ESG developments. It does not constitute legal advice.

Authored by Emily Julier, Rita Hunter and Julia Cripps.