(Bloomberg) -- An obscure rule covering environmental, social and governance investing in Europe has prompted hedge-fund managers in the U.S. and U.K. to turn to their lawyers.

At issue is whether they need to comply with one of the most complicated corners of Europe’s Sustainable Finance Disclosure Regulation. The sub-section in question -- the so-called Principal Adverse Impact rule -- requires investment firms to state whether their actions might in any way harm the environment. U.S. and U.K. hedge funds had thought the rule applied only to products marketed in Europe. But it now seems they must state PAI risks for their entire firm, even those parts that don’t target European clients.

“It’s a very difficult issue,” according to Lucian Firth, an attorney at the London-based law offices of Simmons & Simmons LLP who advises investment managers all over the world. PAI “is one of the most difficult and onerous parts of SFDR.”

Firth has spent much of the year helping international hedge funds and private equity firms comply with Europe’s sustainable finance rulebook, which was enforced in March. He says confusion around the Principal Adverse Impact clause -- the biggest item on a list of compliance areas that has non-EU managers scratching their heads -- has the potential to upend business models across the industry. 

Caymen Funds

In anticipation of the requirement, some major hedge funds outside Europe are now looking into restructuring their operations to create separate legal entities that would protect the bulk of their business from the regulation, according to Firth. 

“They want to keep marketing their Cayman hedge funds in Europe, but they don’t want to be forced into doing Principal Adverse Impact disclosures across the whole of their business because that is just too burdensome and they won’t do it,” he said.

Mikhaelle Schiappacasse, a lawyer at Dechert LLP’s London office, says the current guidance from Europe around PAI is unclear. Both she and Firth point to a Q&A document on the website of the European Commission as the origin of the confusion: 

“Where an AIFM (alternative investment fund manager) from a third country enters the market of a given Member State by means of a National Private Placement Regime, that AIFM must ensure compliance with Regulation 2019/2088, including the financial product related provisions.” Until this statement by the commission, fund managers outside the EU had assumed compliance only stretched as far as products marketed to EU clients. Now, they’re not so sure.

A European Commission spokesperson who handles SFDR questions hasn’t responded to a request for comment.

European regulators, meanwhile, say there’s little doubt that fund managers outside the bloc are expected to live up to the PAI clause under SFDR, not just for individual investment products marketed to EU clients, but for their entire business.

According to Dan Nacu-Manole, a spokesman for the European Securities and Markets Authority, alternative asset managers based outside the EU are “required to file entity level SFDR disclosures.”

And fund industry representatives also suggest it’s risky to interpret the commission’s guidance in any other way. 

“For me, it’s clear that the requirement applies to both entity and product related requirements,” said Marc-Andre Bechet, deputy director general of the Association of the Luxembourg Fund Industry, which represents Europe’s largest hub for fund managers. “Some people might not be happy about having to comply,” but “it’s not like you pick and choose.”

Dangerous Bet

For now, however, lawyers aren’t advising their hedge-fund clients to draw that conclusion.

“We think it would be dangerous” to do so, “without thinking through the implications,” Schiappacasse said. 

Firth said he hopes the European Commission will provide further clarification. Until that happens, firms should sit tight and not make any major adjustments to how they operate, he said.

“My large clients are concerned about this,” Firth said. “They don’t want to be doing PAI for all of their U.S. business and so they are watching this space very carefully.”

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