(Bloomberg) -- Europe’s top ESG fund class may be close to reaching a tipping point.

Known as Article 9, the designation may be stripped from hundreds of funds in the coming months, industry estimates show. There are now signs that investment clients are starting to retreat, as fresh data points to a marked slowdown in flows. And on Thursday, a report indicated that some Article 9 funds hold assets that may violate UN and OECD standards on everything from bribery to environmental damage.

Many fund managers “are trying their best and have spent millions on legal fees to ensure they take the right approach,” but “outcomes won’t be coherent across the industry” and that “creates systemic risks,” said Hugo Gallagher, senior policy adviser at the European Sustainable Investment Forum, whose members represent about $20 trillion in assets under management.

It’s a development that exposes gaps in an ESG regulatory framework once hailed as the world’s most ambitious. Since the Sustainable Finance Disclosures Regulation was enforced in March 2021, the EU has had to provide several clarifications. These include telling the industry that all Article 9 funds must be entirely sustainable, with some allowances for hedging and liquidity. 

A study by Clarity AI found that close to 20% of the 750 Article 9 funds it analyzed have more than 10% exposure to companies “that have violations” of United Nations Global Compact principles or the OECD Guidelines for multinational enterprises. Its research also shows that 40% of the funds studied have more than a 5% exposure to such violations.

“The classification of funds according to the SFDR guidelines is increasingly used by fund providers as a shorthand for communicating that a product is sustainable,” Clarity AI said in the report, which was compiled by a team led by Patricia Pina, the firm’s head of product research and innovation. 

“However, our analysis shows that some of the Article 9 funds currently in the market might be falling short of complying with the do-no-significant-harm criteria as defined by the regulation,” the authors wrote.

Alexander Stafford, chairman of the UK parliamentary group on ESG, said the Clarity AI report highlights “flaws in the EU's ESG instruments and regulatory framework,'' and added that the UK government now “has its work cut out” to avoid falling into similar traps as it designs its own ESG investing rules.

The report followed a study last week by Morningstar which found that less than 5% of funds meet the EU’s requirements of holding only sustainable assets. Morningstar also noted that some asset managers are taking a “surprisingly” lax approach toward Article 9, with 43% of funds analyzed targeting a sustainable-asset threshold of less than 50%.

Now, “asset managers wishing to avoid greenwashing accusations seem to be downgrading,” said Lara Cuvelier, a campaigner at environmental nonprofit Reclaim Finance. “National regulators will have to take up the issue and define red lines for what should not be in a ‘sustainable’ fund. Minimum standards are needed.”

Article 9 funds attracted considerable client inflows in the first nine months of this year, while a less stringent SFDR category known as Article 8 lost money. In the third quarter, Article 9 products drew almost $13 billion, compared with close to $30 billion of outflows from Article 8, Morningstar estimates. Investments in Article 9 funds slowed last month with clients allocating just $1 billion to the top SFDR category, according to an analysis by Bloomberg,  

For now, Article 9 is “still attracting money,” said Hortense Bioy, Morningstar’s global director of sustainability research. But “some managers are reporting lower client appetite because of both reclassification and greenwashing concerns.”

At the same time, the EU’s ESG rulebook has been criticized for feeding confusion. The requirement that Article 9 funds be filled exclusively with sustainable assets, which was only clarified long after SFDR was enforced, means many firms with between 80% and 90% sustainable assets may also find themselves on the wrong side of regulations. That raises “questions about the feasibility of the new regulatory guidance,” Morningstar said.

Due to the uncertainty that now exists around SFDR, Goldman Sachs Group Inc.’s NN Investment Partners said earlier this year it would downgrade some of its Article 9 funds, with 10 of those set to be reclassified this quarter following regulatory approval. Axa Investment Management plans to cut 24 Article 9 funds, after downgrading 21 funds in recent months. 

Robeco Institutional Asset Management BV has said it will take similar steps. Pacific Investment Management Co., Van Lanschot Kempen NV and Neuberger Berman Group LLC are among firms to have already stripped the Article 9 tag from several funds.

“We expect to see more reclassifications in the market,” said Malene Christensen, a sustainable investment specialist at Robeco.

Meanwhile, asset managers are waiting for the EU Commission to explain what it means by a “sustainable investment,” among other basic ESG concepts. The EU Commission said last month it has received such “queries” and “will reply in due time.” 

The confusion surrounding SFDR fund designations has led EU regulators to publicly criticize the bloc’s ESG investing framework. Verena Ross, the chair of the European Securities and Markets Authority, last month referred to the existing rule-set as a “real challenge,” and noted that it’s “extremely difficult” for market participants to navigate. The UK’s Financial Conduct Authority has explicitly said its ESG investing framework will avoid making the same mistakes around fund categories.

Some lawyers are advising asset managers not to take any steps until the EU has addressed the holes in SFDR. 

Anna Maleva-Otto, a partner at Schulte, Roth & Zabel LLP who represents mostly UK and US-based alternative investment managers, said “such a reclassification is likely to be a material issue from an investor relations standpoint, so such a decision would need to be made very carefully.”

--With assistance from Leonid Bershidsky.

(Adds comment from UK lawmaker)

©2022 Bloomberg L.P.