The Alternative Investment Fund Managers Directive (“AIFMD”) establishes a common set of EU-wide rules on any European alternative investment fund manager (“AIFM”) which manages one or more alternative investment funds (“AlFs”). The aim of the AIFMD is to introduce a harmonised regulatory framework across the EU for EU-established AIFMs and to regulate the marketing of AlFs within the EU.
The European Commission has now adopted the long-awaited AIFMD Regulation (the “Regulation”), providing detailed implementing rules for the AIFMD. The Commission was due to publish the implementing measures in July 2012, but publication was delayed due to discussions concerning a number of key provisions, such as those relating to delegation and the depositary regime.
The implementing measures take the form of a regulation, meaning that it will be directly applicable in all EU Member States from July 2013. The Regulation elaborates on the provisions contained in the AIFMD, and provides further detail on the requirements regarding the conditions and procedure for the determination and authorisation of AIFMs, including the capital requirements applicable to AIFMs; operating conditions for AIFMs; conditions for delegation; rules on depositaries; reporting requirements and leverage calculation; and rules for co-operation arrangements.
The Regulation is now subject to a three-month scrutiny period in which each of the European Parliament and Council has the right to object to the entire Regulation (no longer having the ability to propose amendments). It is unlikely that either body will exercise its right to object, so assuming that no such objection is made, the Regulation will apply from 22 July 2013.
Some of the key implications of the Regulation includes:
- Calculation of assets under management
- Own funds and professional indemnity requirements
- Delegation and letterbox entities
- Depositary duties and liabilities
- Transparency and leverage
- Co-operation agreements
Calculation of assets under management
The calculation of an AIFM’s assets under management (“AUM”) is essential for working out whether the light registration regime available under Article 3 of the Level 1 Directive applies, rather than the full regime (for example, where the AIFM has assets under management of €100 million or less). The AIFM must aggregate the value of the assets of the AIF that it manages. The AIFM does count assets in respect of which it has delegated management, but does not count assets that it is managing as a delegate of another manager. The AIFM also does not count assets held in managed accounts rather than for AIFs, nor does it double-count an interest in an AIF held by an AIF, where both AIFs have the same manager.
The AIFM is required to value the AIF’s derivative positions by converting the derivative position into its equivalent position in the underlying assets of the derivative. For example, an AIF’s contract for differences position would be treated as follows
number of shares/bonds to which the contract relates X market value of the underlying reference instrument.
The AIFM will be required to monitor the AUM on an ongoing basis and should the AUM exceed thresholds for more than 3 months, the AIFM must submit an application for full authorisation to its competent authority within 30 days.
Own funds and professional indemnity requirements
AIFMs will be required to cover their professional liability risks though the use of additional own funds or professional indemnity insurance and can no longer choose to use a combination of the two as was originally proposed by ESMA. Where applicable, the amount of additional own funds for covering liability risks are to be equal to at least 0.01 per cent of the value of the AIFM’s AUM. Any professional indemnity insurance must be sufficient to cover aggregated annual claims equal to at least 0.9 per cent of the AIFM’s AUM. In addition, insurance for an individual claim needs to be equal to at least 0.7 per cent of the value of the portfolios of AIFs managed by the AIFM.
The delegation restrictions aim to ensure that the AIFM’s obligations to the AIF and its investors are not altered as a result of that delegation. Article 20 of the Level 1 Directive imposes the conditions to be met before an AIFM can delegate its functions.
The Regulation’s contractual requirements are similar to those imposed under the Markets in Financial Instruments Directive (“MiFID”) in respect of outsourcing. The delegation must be governed by a detailed written agreement in which the AIFM must set out:
- its rights to instruct the delegate and its rights to terminate the delegation;
- rights to obtain information and to inspect books, records and premises; and
- details of sub-delegation by the delegate, which can only occur with the consent of the AIFM, delegating the AIFMs. Consent must be in writing and general consents in advance will not be sufficient, which may have implications for the use of common provisions allowing a delegate to sub-delegate to affiliates without consent.
The Directive requires that an AIFM provide its regulator with details of the “objective reasons for delegation”. The regulator will consider issues such as whether the delegation results in saving costs, whether the delegate has specific expertise, and whether the delegate has access to “global trading capabilities”.
Letter box entities
The conditions concerning the letter box provisions of the Regulations have been the subject of much debate, causing delays in publication of the Regulation. The AIFMD contains detailed provisions in relation to the delegation of functions by the AIFM, providing that that an AIFM cannot delegate its functions to the extent that it becomes a “letter-box entity”. The Regulation sets out four criteria for determining whether an AIFM ought to be deemed a letter-box entity:
- the AIFM does not retain the necessary expertise and resources to supervise the delegated tasks effectively and manage the risks associated with the delegation;
- the AIFM does not have the power to exercise certain senior management functions;
- the AIFM has lost its contractual rights to inquire, inspect, have access or give instructions to its delegates; or
- the AIFM has delegated the performance of investment management functions to an extent that exceeds by a “substantial margin” the investment management functions performed by the AIFM itself.
While the first three requirements are manageable, the fourth provision is still unclear about what functions will need to be retained and how much, before the delegation “exceeds a substantial margin” which will result in the AIFM falling foul of the Regulation. The effect of these provisions will be that structures under which the delegating manager does not perform any of the investment management for the AIF, or where it performs less than is delegated as a proportion of the whole investment management function, will be particularly exposed under AIFMD. AIFMs will need to structure management and delegation arrangements in such a way that there is no doubt who the AIFM is, to ensure that regulators do not determine that a delegate is the AIF’s AIFM, rather than the AIFM which has been expressly appointed as AIFM by the AIF.
The Regulations do, however, confirm that the Commission will review the letter box entity provisions in 2015 to assess how they work in practice.
Depositary duties and liabilities
It was thought that the scope of depositary liability was one of the two main reasons for the delayed publication of the Regulation, although the liability provisions remain largely the same as those contained in previous leaked versions of the Regulation. Depositary duties are extensive and as well as introducing an almost, strict liability regime for the safeguarding of assets, the duties cover a much wider range of obligations than custody alone.
All assets which are capable of being physically delivered to the depositary and also those that are not where they are transferable securities that can be registered or held in an account directly or indirectly in the name of the depositary, must be held in a custody account.
Custody of collateralised assets can be achieved in 3 ways:
- The collateral taker is appointed custodian over the collateralised assets;
- The depositary appoints a sub-custodian that acts for the collateral taker; or
- The collateralised assets remain with the depositary and are kept in favour of the collateral taker.
A full title transfer of the collateralised assets is not deemed to be held in custody and is therefore not subject to the above requirements.
Depositaries will be required to:
- safeguard assets by correctly registering them and retaining records and segregated accounts;
- monitor cash flows by implementing effective policies and procedures to carry out daily reconciliations (where applicable), identifying significant cash flows and monitoring any discrepancies;
- assist with investor subscriptions/redemptions;
- verify ownership of an AIF’s assets and ensure they cannot be transferred or used without the depositary being informed;
- ensure transactions comply with national law and the AIF’s own policies; and
- ensure there are consistent policies and procedures in place.
Monitoring cash flows
The requirement on a depositary to monitor cash flows places an obligation on a depositary to:
- ensure the AIFs cash is booked in accounts with appropriate entities;
- create procedures which identify significant close of business cash flows;
- create cost effective procedures for reconciling cash flow movements and to perform daily reconciliations;
- review the adequacy of these procedures at least annually; and
- check its cash position records against the AIFM’s for consistency, with the AIFM providing the depositary with instructions and information relating to any cash account it opens with a third party.
An AIFM is also obliged to ensure that a depositary is provided with all the information necessary to perform these functions.
Financial instruments held in custody
Financial instruments required to be held in custody are wide and include any transferable securities, money market instruments or units in collective investment undertakings, which are capable of being registered or held in the name of the depositary. Derivatives and assets directly registered in the name of the AIF with the issuer itself are excluded. Real estate interests will also not be financial instruments for these purposes.
A depositary is only liable for the loss of assets held in custody (or in the custody of a delegate). Where assets are not capable of being held in custody, then the depositary will escape liability.
The loss of a financial instrument held in custody is deemed to have taken place in three situations:
- where the ownership right is not valid as it has either ceased or never existed;
- where the financial instrument exists but the AIF has definitively lost its ownership right; or
- where the AIF has the ownership right but cannot dispose of it on a permanent basis.
The Level 2 Measures permit a contractual discharge of depositary liability, however, this discharge may not be used to circumvent the provisions of AIFMD and there must be an ‘objective reason’ to avail of the discharge. The depositary needs to demonstrate that it had no other option but to delegate its custody duties to a third party. In particular, this shall be the case if the law of the third country requires that certain financial instruments are held in custody by a local entity and local entities that satisfy the delegation criteria of the AIFMD do not exist or the AIFM insists on maintaining an investment in a particular jurisdiction despite warnings by the depositary as to the increased risk this presents
Where a depositary is taken to have “lost” a financial instrument in its custody (or in the custody of the depositary’s delegate), the depositary will be liable to return an equivalent financial instrument – except where:
- the loss is caused by an event that is outside the depositary’s, or a third party who held custody of the assets, control;
- the depositary could not have reasonably prevented the event from occurring, despite taking all “precautions incumbent on a diligent depositary;” and
- despite rigorous and comprehensive due diligence the depositary could not have prevented the loss.
Transparency and disclosure
The AIFMD imposes obligations on an AIFM to disclose certain information to regulators and investors. This includes detailed annual reports containing financial statements, a review of the AIF’s activities and details of remuneration of the AIFM.
With respect to remuneration, the Regulations say that the AIFM will need to be clear in the annual report when disclosing the remuneration of the AIFM, “whether the figure given for “total remuneration” relates to either the entire staff of the AIFM or only those staff involved in the relevant AIF’s activities.” Breakdowns of remuneration attributable to each AIF should also be provided where possible.
An AIFM must also periodically provide its national regulator with information regarding matters such as the primary markets and instruments in which it trades, the principal exposures of each AIF, and details of the liquidity of each AIF’s assets. The Regulations also provide a template form in the Annex to be used by AIFMs when making the required disclosures to any EU regulator. This will be of use to non-EU managers in particular, who otherwise may have encountered numerous different filings with different EU regulators.
The Level 1 Directive requires an AIFM to set the maximum leverage that it can deploy at the level of the AIF. It requires this level and subsequent performance against this level, to be disclosed at the outset and then periodically to relevant authorities and investors. The leverage provisions do not apply to leverage applied by companies held by an AIF. The relevant authorities have powers to control leverage. AIFs that employ leverage on a substantial basis, i.e., where exposure exceeds three times the AIF’s net asset value (based on the commitment calculation), will trigger additional reporting requirements to the AIFM’s local competent authorities
There has been much debate over which methods AIFMs would have to use to calculate leverage. The Regulation provides that an AIFM must calculate leverage using the gross method and the commitment method and gives the Commission power to review this combination in 2015 where an advanced method might also be considered. Essentially, the gross method gives the overall exposure and the commitment method gives insight into the hedging and netting techniques used by an AIFM.
The Directive imposes a requirement for co-operation agreements to be in place between EU and Non-EU regulators in certain circumstances. Funds will not be able to be marketed in the EU without co-operation agreements in place by July 2013, which will be of particular significance for non-EU managers and managers of non-EU funds.
Welcome news for smaller, EU-based AIFMs is that they will be entitled to “register” with national regulators in the EU, rather than having to submit to full authorisation. This “registration-only” regime avoids most of the burden of the Directive and will be available to AIFMs that have:
- AUM of no more than €100 million; or
- AUM of no more than €500 million, but only where its funds are unleveraged and investors are not permitted to redeem their investments for at least five years.
The Regulations contain guidance on how to calculate AUM for this purpose – and what to do in the case of a temporary breach of the limits.
While the Regulations provide useful detail in many areas, its provisions relating to letter-box entities, in particular, departing from ESMA’s advice is still a great cause for industry concern. Other key important issues arising from the Directive are addressed in the Regulations and many questions still remain unanswered; such as: what an AIFM is, in particular structures; clarification of what is and is not an AIFM; whether an AIFM delegates all portfolio management or not and this uncertainty is not welcome when we are only six months away from implementation.
On top of the Directive, and the Regulations, the funds industry also needs to keep up to speed with the consultation papers circulating in relation to the Directive, such as the FSA’s second consultation paper, which is due for release in February.
It seems unlikely at this stage that the implementation date will be extended from the effective date of 22 July 2013, (although there is an optional grace period of one year to comply for existing AIFMs authorised before 22 July 2013) which means managers whether domiciled inside or outside of the EU will need to consider now to what extent fund documentation will need to be revised before 22 July, 2013 and they would be well-advised to do that over the coming weeks and months. In summary, AIFMs should consider liaising with their lawyers with respect to the following:
- tracking the FSA’s response and issue of application forms with a view to completing and submitting the forms when they become available;
- deciding who will conduct risk management and portfolio management, and how;
- review and negotiation of administration and prime/clearing brokerage agreements to meet depositary rules;
- updating offering memoranda and all marketing documentation;
- putting in place internal and compliance procedures; and
- putting in place reporting procedures.
If you would like more information on the AIFMD or advice on how it will impact your business, please contact:
+44 (0)20 7597 6812
+44 (0)20 7597 6156