EU Sustainable Finance: Complex Rules and Compliance Problems’ Review of Banking and Financial Law

My article looks into the problem of rule complexity in the context of EU sustainable finance based on the intuition that complex rules make noncompliance more likely because they create greater compliance burdens. Academics have investigated the association between complex rules and noncompliance. Lehman, Cooil and Ramanujam (hereafter Lehman et al) found that increases in rule complexity are associated with higher probabilities of noncompliance. Spence found that the complexity of environmental regulations in the United States has made compliance more difficult to achieve. Mendoza, Dekker and Wielhouwer recognized that although complexity ‘can make regulations more precise and encompassing, it can also lead to reduced compliance’. Drawing from prior literature, my article shows that EU sustainable finance rules contain features of complex rules, such as  density, granularity, technicality, cross-referencing, difficult determinations, and functional dependence, and argues that such complexity is likely to pose serious compliance problems to regulatees.

After identifying rule complexity in specific rules, notably the definition of sustainability preferences and rules on product suitability evaluation under the Markets in Financial Instruments Directive (MiFID II), the article turns to examine complexity in the wider context of multiple sustainable finance reforms. The association between complexity in sustainable finance rules and noncompliance is analysed in the second part of this article. Complex rules can influence noncompliance through different channels, including economic motivations (compliance with complex rules is more costly to accomplish),[1] normative motivations (compliance with complex rules is perceived to be unfair),[2] and organisational motivations (complex rules are more difficult to implement).[3] Although both economic and normative motivations for noncompliance are acknowledged in this article, the focus is on organisational burdens. More particularly, it is argued that complexity in sustainable finance rules promotes noncompliance by amplifying the organisational problems faced by regulated entities in their effort to meet such rules, including problems of cognition, business operational disfunctions, and system problems.[4] These problems are discussed at length in the context of the Sustainable Finance Disclosure Regulation (SFDR). This setting for analysis reflects a current concern shown by financial market participants in their efforts to make progress towards implementing the SFDR.

From the vantage point of cognition, evidence has shown multiple problems of interpretation relating to the SFDR. The ESAs, for example, have repeatedly requested that the European Union clarify the meaning and scope of provisions in the SFDR, such as the meaning of the term ‘promotes’ in article 8 SFDR, the scope of disclosure obligations, and the interpretation of ‘sustainable investment’ in article 2(17) SFDR. Morningstar, a well-established investment research company, recently found that market actors have generated multiple interpretations of the SFDR and the EU Taxonomy Regulation creating uncertainty as to the appropriate way to calculate sustainability in financial products and undermining product comparability.[5] Recent interpretations of the SFDR made by the Commission have caused a wave of re-classification of investment funds whereby article 9 SFDR funds are being shifted to article 8 SFDR funds. As reported by the Financial Times, confusion has been the result of poor guidance by European officials on how to define sustainability. Legal uncertainty has followed because the actual purpose pursued by the SFDR has remained unclear (information disclosure versus product labelling tool), as has the applicable law to classify sustainable investment products, with the SFDR and MiFID II providing two very distinct approaches to categorization.

Rule complexity has also demanded more time and staff to meet the SFDR and other sustainable finance rules, making compliance more difficult. The swiftly accretion of rules in the form of Directives, Regulations, Delegated Regulations, Regulatory Technical Standards, Technical Screening Criteria, technical guidelines, among other rules, has required extensive information acquisition and cognitive effort to identify and comprehend the applicable rules. Facing mounting compliance burdens, noncompliance risk is likely to increase in resource-constrained organizations. Moreover, compliance with EU sustainable finance rules, which are abundant and fluid, requires particularly dynamic and flexible compliance routines. Such routines are difficult to achieve where regulated entities are characterized by organizational inertia (or lack of dynamism for evolution and change).[6] Complex sustainable finance rules may also augment information flow problems within the company, disrupting compliance routines, especially when such routines involve the processing and transmission of granular and highly technical data (such as preparing the reporting on Principal Adverse Impact indicators), which requires substantial system capacity and expertise.[7] The effort and informational burdens involved in these routines can be substantial.[8]

Critically, system problems associated with the SFDR pose serious constraints to compliance. Following Lehman et al, compliance routines can be negatively affected by problems of functional dependence among rules that operate within a system of rules. Such functional dependence is undoubtedly present in the SFDR to the extent that compliance by financial market participants and advisors with the SFDR’s disclosure obligations (such as accurate reporting on the sustainability properties of a financial product and on the taxonomy alignment of a financial product) depends on the quality of sustainability reporting by corporate issuers. It is submitted that the quality of corporate sustainability reporting under the NFRD, and more recently the CSRD, has been mediocre, failing to provide sufficient, accurate and high-quality corporate data, a problem widely accepted by commentators and scholars. As reported by the Financial Times, ‘[i]nvestors [such as investment funds or asset managers] have said they cannot yet fully meet these [SFDR’s] disclosure requirements because some important information—for example, data on companies’ hazardous waste production, the proximity of their assets to biodiversity hotspots, or even the proportion of assets aligned with the EU’s green taxonomy—is not yet consistently published by the companies they invest in.’ Rule complexity taking the form of functional dependence has a strong potential to severely disrupt the compliance routines that asset managers and other financial actors operate, increasing the likelihood of rule noncompliance.

This article concludes by acknowledging the challenges that complex sustainable finance rules pose to regulators and calling for the evaluation of alternative regulatory enforcement strategies. As a distinctive feature of this challenge, noncompliance behaviour in a setting of complex rules need not stem from wrongful actions. Instead, breaches can very often result from organizational problems that law-abiding firms acting in good faith struggle to overcome.[9] These firms find themselves in a situation of noncompliance for reasons that include mistakes, confusion, misinterpretation, mismanagement, or dependence.[10] In this light, scholars have noted that the excessive recourse to coercive tools to enforce complex rules can engender perceptions of unfairness and undermine legitimacy in the regulatory system.[11] Future investigation in this field can shed light on the strategies and tools available to NCAs to manage problems of compliance with complex sustainable finance rules. Several options can be explored including enforcement strategies that rely on the sequential use of collaboration and coercion.

Félix Mezzanotte is an Assistant Professor at Trinity College Dublin.

[1] V Lehmann Nielsen and C Parker, ‘Mixed Motives: Economic, Social, and Normative Motivations in Business Compliance’ (2012) 34(4) Law & Policy 428, 430-435; T F Malloy, ‘Regulation, Compliance and the Firm’ (2003) 76(3) Temp L Rev 451, 453-454 and 461-473 (discussing compliance burdens in companies from the perspective of organizational theory).

[2] Nielsen and Parker (n 1) 432; Malloy (n 1) 464-65; Mendoza et al 724 and 739; Spence section III.

[3] Malloy (n 1) 456-461; Spence 731-36; Mendoza et al 721 (citing various sources); Lehman et al 1441-1443.

[4] Sources utilised to identify and examine problems impacting noncompliance include Lehman et al, Malloy (n 1) 453-454 and 461-473; J B Ruhl and James Salzman, ‘Mozart and the Red Queen: The Problem of Regulatory Accretion in the Administrative State’ 91 GEO LJ 757 (2003).

[5] Morningstar ‘SFDR Article 8 and Article 9 Funds: Q2 2022 in Review’, 28 July 2022, 2.

[6] Malloy (n 1) 502. Changes to the text or interpretation of sustainable finance rules are likely in future and routines for compliance are expected to follow suit. See, for example, Eurosif, ‘EU Sustainable Finance & SFDR: making the framework fit for purpose. Eurosif Policy Recommendations for Article 8 & 9 product labels.’ June 2022 (stating the urgent need to modify the current text of the SFDR). On the notion of ‘fluidity’, see Spence 933-34; Mendoza et al 722.

[7] In relation to PAI metrics, see SFDR DR 2022/1288.

[8] Ruhl and Salzman (n 4) (effort burdens refer to the additional time and resources, such as personnel, training, processes, and administration, that a firm must allocate to comply with laws and regulations. Information burdens is related to the information search and gathering tasks that a firm needs to engage in order to identify and comply with the legal and regulatory requirements).

[9] Malloy (n 1) 456-461; Spence 731-36; Mendoza et al 721 (citing various sources); Lehman et al 1441-1443.

[10] ibid.

[11] Spence (n 2) section IV; Malloy (n 1) 471, footnote 80; Dietrich H Earnhart and Robert L Glicksman, ‘Coercive vs. Cooperative Enforcement: Effect of Enforcement Approach on Environmental Management’ International review of Law and Economics 42 (2015) 135-146, 136 (citing several sources).