Ireland: Update on Alternative Investment Fund Managers (AIFM) Directive

EXECUTIVE SUMMARY

On 11 November 2010 the European Parliament finally approved the Directive on Alternative Investment Fund Managers. The Directive has changed significantly since the European Commission's original proposal of April 2009, not least in the "third country" provisions dealing with the application of the Directive to non-EU alternative investment fund managers (AIFM) and alternative investment funds (AIF).

Key points to note are:

• EU Member States have until 2013 to implement the Directive into their local law;
• from 2013
• • EU AIFM authorized under the Directive will be able to sell EU AIF on passported basis across the EU to institutional and sophisticated investors. National private placement regimes will be discontinued;
  • non-EU AIFM and non-EU AIF may market/be marketed under Member States' national private placement regimes to institutional and sophisticated investors subject to compliance with national law and certain provisions of the Directive (including provisions relating to co-operation arrangements between Member States and non-EU countries);
• from 2015
• • the European Securities and Markets Authority (ESMA) may approve the introduction of a passport regime for non-EU AIFM/non-EU AIF. This will effectively require a non-EU AIFM to be regulated under, and comply with, the entire Directive as if it were an EU AIFM;
  • the national private placement regimes may exist in parallel with this passport regime until at least 2018, at which point ESMA may approve the termination of national private placement regimes;
• AIFM authorized under the Directive will be subject to an extensive set of obligations, including those relating to:
• • minimum capital requirements;
  • delegation arrangements;
  • disclosure to investors;
  • reporting to Member State regulators;
  • remuneration;
  • the location and standard of liability of depositaries;
  • valuation of AIFs;
• additional obligations for AIFM of:
• • funds engaged in substantial leverage;
  • private equity AIF (including provisions on "asset stripping");
• numerous provisions of the Directive to be elaborated on by more detailed "level 2" rules to be developed by ESMA over the course of 2011.

This bulletin summarises the material provisions of the Directive, with a focus on its impact on promoters and managers of alternative investment funds.

TIMING

The Directive is expected to come into effect in March/ April 2011 and Member States will have until early 2013 to transpose the Directive into national law. The extended timetable for the introduction of the "third country" passports is discussed below under 'EU passport, private placement and "third country" rules'.

In the meantime, a significant amount of "level 2" implementing measures (Level 2 Rules) and "level 3" technical standards and guidelines will be issued to flesh out the detail of the Directive. ESMA will lead the drafting of the Level 2 Rules and is working towards a deadline of September 2011 to produce its advice to the Comission on the Level 2 Rules. In December, ESMA issued a "call for evidence" on these rules. The deadline for replies to this consultation paper was 14 January 2011 and the replies submitted may be found on the ESMA website at: http://www.esma.europa.eu/index.php?page=responses&id=176.

At EU level, the work on the Level 2 Rules has been split into four areas:

• general provisions of the Directive, the authorization of, and operating conditions for, alternative investment fund managers;
• depositary requirements;
• transparency requirements and leverage; and
• supervision of AIFM, including "third country" AIFM.

The Commission intends to adopt the Level 2 Rules by early 2012, allowing Member States one year to implement any rules which take the form of EU directives. To achieve this deadline, ESMA is requested to provide its advice on the Level 2 Rules by September 2011. Given the range and complexity of issues involved, this is an ambitious timetable. The Commission has acknowledged this by noting that there may be scope for prioritizing some areas over others (e.g., those which will take the form of an EU regulation and therefore do not require further implementation into the local law of a Member State or those which relate to the "third country" passport which is not expected to take effect until 2015).

SCOPE

AIF and AIFM within scope

The Directive's scope is broad: it applies to managers (AIFM) of alternative investment funds (AIF). An AIF is defined as "any collective investment undertaking ...which raises capital from a number of investors, with a view to investing it in accordance with a defined investment policy for the benefit of those investors" and which does not require an authorisation under the UCITS Directive. Therefore, AIF comprise all non-UCITS funds, not just hedge funds commonly considered to be "alternative" funds. Whether or not a particular AIFM is within the scope of the Directive depends on its location and that of the AIF it manages, as well as the countries into which the AIF are marketed.

The Directive applies to:

• all EU AIFM, which manage one or more EU or non-EU AIF;
• all non-EU AIFM, which manage one or more EU AIF; and
• all non-EU AIFM, which market one or more EU or non-EU AIF in the EU.

AIF and AIFM outside of scope

The Directive does not apply to the following:

• holding companies;
• institutions for occupational retirement provision (IORP) covered by EU Directive 2003/41/EC;
• supranational institutions (e.g., the World Bank, the IMF, the ECB etc.);
• central banks;
• governments and institutions which manage funds supporting social security and pension systems;
• employee participation schemes or employee saving schemes;
• securitisation special purpose entities; and
• AIFM insofar as they manage one or more AIF whose only investors are the AIFM or its affiliates, provided that none of those investors itself is an AIF (e.g., true "family offices").

"Registration only" regime for smaller AIFM

The Directive also contains de minimis exemptions based on the level of assets under management. It does not require the authorization of AIFM who, together with any affiliates, manage:

• AIF with total assets, including those acquired through the use of leverage, of less than €100 million; or
• AIF with total assets of less than €500 million, provided that the AIF are unleveraged and are subject to redemption lock-up periods of at least five years.

Such AIFM cannot benefit from the passporting rights under the Directive unless they opt-in to the Directive. Therefore, this exemption may be of limited interest to managers with cross-border businesses. It is also important to note that those managers that do not opt-in are still required by the Directive to:

• be subject to registration with a national regulator;
• notify that regulator of the AIF they manage and the investment strategies employed;
• provide that regulator with periodic information on the main instruments they hold and the principal exposures and concentrations of the AIF; and
• notify the regulator if they breach the de minimis thresholds.

For those managers who, to date, have been entirely unregulated, these additional registration and reporting requirements are significant.

Possibility of AIF being internally managed and not appointing an external AIFM

The AIFM itself can be either an external manager of the AIF or, where the legal form of the AIF permits internal management and the AIF chooses not to appoint an external AIFM, the AIF itself. Ireland already has a regulated hedge fund product, the qualifying investor fund (QIF), many of which are structured as self-managed investment companies. This has particular significance when one considers that an authorized AIFM may delegate the portfolio or risk management function to entities which themselves are not required to be authorized AIFM (see below under "Delegation"). Accordingly, if an internally managed AIF were authorized as an AIFM and were permitted to delegate this function to a US-regulated manager, that manager would not have to be authorized as an AIFM under the Directive. Therefore, the QIF may offer some interesting structures, subject to further clarification in Level 2 Rules as to what level of delegation by internally-managed AIF is permissible. In particular, clear guidance is needed as to when an AIF would be considered to have delegated its functions to the extent that it becomes a "letter-box entity". There is a precedent for self-managed funds in Ireland in the form of UCITS established as self-managed investment companies.

WHAT DOES THE DIRECTIVE MEAN FOR MANAGERS OF AIF?

EU passport, private placement and "third country" rules

The EU passport, private placement and "third country" provisions of the Directive are complex. A summary of those provisions is set out below. A more detailed overview, including details of the cooperation arrangements applicable to non-EU AIFM and non-EU AIF, is contained in the appendix to this bulletin.

EU AIFM of EU and non-EU AIF (e.g., a UK, French or German manager of Irish- and Cayman-domiciled funds)

Passport for EU AIF; national private placement regimes discontinued

From 2013, EU AIFM will be required to be authorized under, and comply in full with, the Directive. The Directive will enable EU AIFM to market EU AIF on a passported basis to "professional investors" (broadly speaking, institutional and sophisticated investors) across the EU. The definition of "marketing" captures both public offerings and private placements, but does not encompass "reverse solicitations" (i.e., where the investment in the AIF is unsolicited and is at the initiative of the investor). From 2013 onwards, national private placement regimes will no longer be available.

National private placement regimes continue for non-EU AIF; possibility of passport

National private placement regimes will continue to apply to the marketing by EU AIFM of non-EU AIF to professional investors in the EU from 2013 until at least 2018. Subject to ESMA approval, a passport regime may apply from 2015 onwards (which will operate in parallel to the national private placement regimes for at least three years). Irrespective of whether the non-EU AIF are being marketed on a passported or private placement basis, the EU AIFM will have to be authorized under the Directive. The AIFM will have to comply in full with the Directive, although more limited depositary requirements apply if the non-EU AIF are being marketed by way of private placement. From 2018, ESMA may approve the termination of the national private placement regimes.

EU AIFM must be authorised even if no marketing within the EU

Even if the EU AIFM does not market the EU or non-EU AIF within the EU, it will nevertheless be required to be authorized under the Directive from 2013. This will entail full compliance with the Directive, except that the depositary and annual report provisions of the Directive will not apply in respect of non-EU AIF.

Non-EU AIFM of EU and non-EU AIF (e.g., a US, Hong Kong or Swiss manager of Irish - and Cayman-domiciled funds)

National private placement regimes continue for EU and non- EU AIF subject to conditions

Non-EU AIFM may continue to market EU and non-EU AIF on a private placement basis to professional investors in the EU from 2013 until at least 2018, at which point ESMA may approve the termination of national private placement regimes. However, non-EU AIFM will have to comply with the provisions of the Directive relating to, among other things, annual reports, disclosures to investors and reporting to Member State regulators (and, where relevant, the rules applicable to private equity AIFM; See below under "What does the Directive mean for AIFM managing private equity AIF?").

Importantly, the Directive explicitly states that Member States are free to impose stricter requirements under their own national private placement regimes. Some commentators have predicted that certain Member States will rely on this statement to impose a de facto prohibition on private placements.

Also, if ESMA approves the introduction of a passport regime for non-EU AIFMs from 2015, the Directive appears to suggest that non-EU AIFM which manage (as distinct from market) EU AIF will have to comply with substantially all of the Directive.

Possibility of passport

The Directive provides that ESMA may approve the introduction of a passport regime for non-EU AIFM from 2015. If this happens, a non-EU AIFM may market EU and non-EU AIF on a passported basis to professional investors across the EU. It may only do so if it is authorized by its "Member State of Reference" (Reference Member State) and complies with substantially all of the Directive.

Does this mean business as usual?

For EU AIFM the Directive clearly represents a major change in the regulatory regime.

For non-EU AIFM, the Directive appears to mean, at first glance, "business as usual" until at least 2018 provided that the AIFM can comply with the national private placement regimes and a limited number of the Directive's provisions. However, this is not the case. The much-heralded compromise on the Directive in November 2010 parked some difficult issues and masked a considerable degree of uncertainty on the timing and impact of the "third country" rules. A number of these are considered below. For a non-EU AIFM to be able to continue to offer EU AIF or non-EU AIF on a private placement basis:

• there must be appropriate co-operation arrangements between the relevant Member State and non-EU regulators; and
• the relevant non-EU jurisdictions must be designated as Financial Action Task Force (FATF) compliant countries.

The Commission is tasked with adopting Level 2 Rules to provide for a "common framework" to facilitate the establishment of the co-operation arrangements. Separately, ESMA is to "develop guidelines to determine the conditions of application" of those Level 2 Rules. It is not clear how these rules and guidelines will interact. Furthermore, the Directive gives the European Parliament and Council a broad veto over the Level 2 Rules. If either institution exercises that veto, arguably there is no scope under the Directive for the national private placement regime within a particular Member State to apply if the co-operation arrangements with the relevant non-EU jurisdiction(s) – those of the non-EU AIFM and any non- EU AIF - are not in place. Just how controversial these issues are is demonstrated by the statement published by the Commission which accompanied the compromise text of the Directive in November 2011. This stated that the Commission had "serious doubts" as to whether the restrictions on its role when adopting Level 2 Rules were in line with the EU treaties.

Furthermore, the introduction of a passport regime for non-EU AIFM and non-EU AIF in 2015 is subject to ESMA approval. Either the European Parliament or Council may object to the Level 2 Rules introducing the passport regime. It appears that, notwithstanding this objection, the Commission may re-issue the Level 2 Rules "at a later stage which seems appropriate to it" although it is not clear whether the Parliament or Council can raise a further objection to those rules. Either way, the prospect of a seamless transition to a passport regime for non-EU AIFM and non-EU AIF in 2015 is not assured.

Even if the passport regime is introduced, there are a number of potential pitfalls:

• the Directive envisages that the non-EU AIFM must be authorized and supervised by the regulator in the AIFM's Reference Member State. The criteria for determining the Reference Member State are not clear and could result in there being a number of possible Reference Member States. Where a regulator in another Member State disagrees with the determination by the AIFM of its Reference Member State or the authorization of the AIFM by that Reference Member State, that other regulator may refer the matter to ESMA which may exercise its dispute resolution powers under Regulation (EU) No. 1095/2010 (the ESMA Regulation). The obvious risk for non-EU AIFM is that this mechanism effectively allows other Member States to delay or obstruct its authorisation;
• similarly, where a regulator in another Member State disagrees with the assessment made by the Reference Member State on the co-operation arrangements between the relevant Member State(s) and non-EU jurisdictions, that other regulator may refer the matter to ESMA which may exercise its dispute resolution powers under the ESMA Regulation;
• if a non-EU AIFM is authorized under the Directive, it must comply with all provisions of the Directive subject to the exception that if compliance with a provision of the Directive is incompatible with compliance with the law to which the non-EU AIFM and/or the non-EU AIF is subject, the AIFM is not required to comply with that provision of the Directive if it can demonstrate that (i) it is impossible to combine compliance with the provision of the Directive and compliance with the mandatory third country law; and (ii) the law of the third country provides for an "equivalent rule having the same regulatory purpose and offering the same level of protection to the investors of the relevant AIF". On the face of it, this could be a helpful means by which non-EU AIFM could avoid those provisions of the Directive which might involve obligations additional to those to which it is subject to in its home jurisdiction. However, it is thought that this exception will be of limited application in practice. The Directive envisages technical standards being developed by ESMA for adoption by the Commission on equivalency. It is thought unlikely that these technical standards will give breadth to this exception. Where a regulator in another Member State disagrees with the assessment made by the Reference Member State on equivalency that other regulator may refer the matter to ESMA which may exercise its dispute resolution powers under the ESMA Regulation. It is difficult at this stage to predict with any certainty the extent to which Member States might seek to intervene in this fashion.

Application for authorisation

All AIFM required to be authorized under the Directive will have to obtain authorisation from its home Member State regulator (or the Reference Member State regulator in the case of a non-EU AIFM). A maximum three-month authorisation process is envisaged, although this may be extended for a further period of three months where considered necessary by the regulator.

Applicants will be required to provide the following information:

• details of the management and substantial shareholders of the AIFM;
• a programme of activity setting out the organisational structure of the AIFM and how it intends to comply with the Directive;
• details of the AIFM's remuneration policies;
• details of any proposed delegation arrangements; and
• details of the AIF it intends to manage, including their investment strategies; use of leverage; risk profiles; location; the fund rules or instruments of incorporation; details of the depositary and the investor disclosure document required by the Directive.

Before granting an authorisation under the Directive, the regulatory authority must be satisfied that certain conditions are met, including:

• the AIFM can meet the minimum capital requirements:
• • where the AIFM is an internally managed AIF, €300,000;
  • where the AIFM is an external manager to AIF, the higher of (i) €125,000 plus 0.02% of assets under management exceeding €250 million, up to a maximum of €10 million and (ii) the capital required to be held under the European Capital Adequacy Directive;
• the management of the AIFM is of sufficiently good repute and has sufficient experience in relation to the types of AIF managed; and
• the shareholders of the AIFM are suitable.

Ongoing obligations

General principles and other requirements

Authorised AIFM must comply on an ongoing basis with certain high level principles set out in the Directive. For example, an AIFM must act honestly, with due skill, care and diligence and fairly in conducting its activities. The AIFM is also required to "act in the best interests of the AIF or the investors of the AIF it manages and the integrity of the markets". It may not always be possible to reconcile the interests of the AIF, all of its investors and the "integrity of the market" and it is to be hoped that the Level 2 Rules will assist the AIFM in addressing any such conflicts.

Conflicts, liquidity and risk management

AIFM are required to have appropriate conflicts and liquidity management policies and a risk management function which is separate from the portfolio management function.

Delegation

An AIFM which intends to delegate to a third party one or more of its functions shall notify its home Member State regulator before the delegation arrangements become effective. Where the delegation concerns portfolio management or risk management, the delegate must be regulated for the purpose of asset management (apparently in any jurisdiction) and subject to supervision, and cooperation between the home Member State and the country of the delegate must be ensured. Where this condition cannot be satisfied, delegation may only be given on the condition of prior approval by the home Member State of the AIFM. This is an improvement on the original draft of the Directive, which required that the delegate be another AIFM authorised under the Directive. It is welcome because many AIFM delegate the portfolio management function to non-EU sub-investment managers.

The AIFM's liability towards the AIF and its investors shall not be affected by the fact that the AIFM has delegated functions to a third party, or by any further sub-delegation. Furthermore, the Directive prohibits an AIFM from delegating its functions to the extent that, in essence, it can no longer be considered to be the manager of the AIF or to the extent that it becomes a "letter-box entity". Level 2 Rules will provide further guidance on this. There are similar requirements applicable to UCITS management companies and self-managed investment companies. In that context, corporate governance procedures, frequent board reporting and supervision of delegates which are formalized in a "business plan" are one of the means by which the management company/self-managed investment company demonstrates that it is not a letter-box entity. (See the discussion above under "Possibility of AIF being internally managed and not appointing an external AIFM".)

Annual report

An AIFM must make available an annual report and audited financial statements for each of the EU AIF it manages and for each of the AIF it markets in the EU. The annual report must contain a profit and loss account and balance sheet. It must also include:- (i) the total amount of remuneration for the financial year, split into fixed and variable remuneration paid by the AIFM to its staff members, and number of beneficiaries, and, where relevant, carried interests paid by the AIF; and (ii) the aggregate amount of remuneration broken down by senior management and members of staff of the AIFM whose actions have a material impact on the risk profile of the AIF. It appears that the annual reports do not have to break down the remuneration by specific amounts paid to named individuals. The annual report shall be provided to investors on request and made available to the regulator(s) in the home Member State of the AIFM, and, where applicable, the home Member State of the AIF.

Prospectus disclosure

AIFM must make available to AIF investors the following information before they invest in the AIF:

• a description of the investment strategy and objectives of the AIF, the types of assets which the AIF may invest in, the level and sources of leverage used and associated risks;
• a description of the procedures by which the AIF may change its investment strategy or investment policy, or both;
• a description of the main legal implications of the contractual relationship entered into for the purpose of investment, including information on jurisdiction, applicable law and on the existence, or not, of any legal instruments providing for the recognition and enforcement of judgments on the territory where the AIF is established;
• the identity of the AIFM, the AIF's depositary, auditor and any other service providers and a description of their duties and the investors' rights;
• a description of any delegated management function by the AIFM and of any safekeeping function delegated by the depositary, the identification of the delegate and any conflicts of interest that may arise from such delegations;
• a description of the AIF's valuation procedure and of the pricing methodology for valuing assets;
• a description of the AIF's liquidity risk management, including the redemption rights both in normal and exceptional circumstances, and existing redemption arrangements with investors;
• a description of all fees, charges and expenses and of the maximum amounts thereof which are directly or indirectly borne by investors;
• how the AIFM ensures a fair treatment of investors and, whenever an investor obtains a preferential treatment or the right to obtain preferential treatment, a description of that preferential treatment, the type of investors (as opposed to name(s)) who obtain such preferential treatment as well as, where relevant, their legal or economic links with the AIF or AIFM;
• the latest annual report;
• where available, the historical performance of the AIF; and
• the identity of the prime broker and a description of any material arrangement of the AIF with its prime brokers and the way the conflicts of interests in relation thereof are managed and, as the case may be, the provision in the contract with the depositary on the possibility of transfer and reuse of AIF assets, and about any transfer of liability to the prime broker that may exist.

While the disclosure requirements appear to be extensive, they would not in practice exceed those applicable to an Irish regulated hedge fund structure.

Periodic disclosure of information to investors

AIFM must periodically disclose to investors:

• the percentage of the AIF's assets which are subject to special arrangements arising from their illiquid nature (e.g. side-pockets, redemption gates etc);
• any new arrangements for managing the liquidity of the AIF; and
• the current risk profile of the AIF and the risk management systems employed by the AIFM to manage these risks.

AIFM managing leveraged AIF must disclose on a regular basis:

• any changes to the maximum level of leverage which the AIFM may employ on behalf of the AIF as well as any right of the re-use of collateral or any guarantee granted under the leveraging arrangement; and
• the total amount of leverage employed by that AIF.

AIFM must also disclose any material changes to any information previously provided to investors.

Reporting to regulators

Separate from its obligations of disclosure to investors, an AIFM must report regularly to its home Member State regulator on the principal markets and instruments in which it trades on behalf of the AIF it manages, the main instruments in which it is trading, markets of which it is a member or where it actively trades, and on the principal exposures and most important concentrations of each of the AIF it manages.

An AIFM shall provide the following to its home Member State regulator:

• the percentage of the AIF's assets which are subject to special arrangements arising from their illiquid nature;
• any new arrangements for managing the liquidity of the AIF;
• the actual risk profile of the AIF and the risk management tools employed by the AIFM to manage the market risk, liquidity risk, counterparty risk and other risk including operational risk;
• the main categories of assets in which the AIF invested; and
• the results of the stress tests performed to comply with the Directive.

AIFM managing one or more AIF employing leverage on a "substantial basis" shall make available arrangements to its home Member State regulator:

• information about the overall level of leverage employed by each AIF it manages;
• a break-down between leverage arising from borrowing of cash or securities and leverage embedded in financial derivatives; and
• the extent to which their assets have been re-used/ re-hypothecated under leveraging.

Level 2 Rules will define what is meant by the use of leverage on a "substantial basis".

It will be interesting to see how regulators approach the potentially huge volume of data provided by AIFM in compliance with these new reporting obligations.

Preferential treatment

No investor in an AIF may "obtain a preferential treatment, unless this is disclosed in the relevant AIF's rules or instruments of incorporation". Therefore, any fee discounts, rebates or other side-letter arrangements with favoured investors will have to be disclosed.

Remuneration policies

AIFM must have remuneration policies which are consistent with sound and effective risk management and do not encourage risk-taking which is inconsistent with the risk profiles, fund rules or instruments of incorporation of the AIF. The AIFM must determine its remuneration policies and practices in accordance with principles set out in Annex II to the Directive, which are based largely on the Financial Stability Board/G2O standards. While these policies focus on the remuneration paid to key staff within the AIFM, they apply to the remuneration of any type paid by the AIFM and to any amount paid directly by the AIF itself (including "carried interest") to the benefit of those staff. Therefore, certain arrangements whereby performance fees are payable by an AIF to the AIFM, based upon which staff of the AIFM receive performance-related remuneration, would be subject to these principles.

The more noteworthy principles contained in the Directive include the following:

• performance-related remuneration must be based on a "multi-year framework appropriate to the life-cycle of the AIF" in order to ensure that the assessment process is based on longer term performance;
• subject to the legal structure, constitutive documents and rules of the AIF, a "substantial portion" which is at least 50% of any bonuses shall consist of units of the AIF or instruments related to those units. The minimum of 50% does not apply where the management of AIF accounts only for less than 50% of the total portfolio managed by the AIFM;
• such units or instruments must be subject to an appropriate retention policy to align the interests of the AIFM with the AIF and the AIF's investors;
• at least 40% of bonuses must be deferred over a period which is appropriate in view of the life cycle, redemption policy and risk profile of the AIF.

This period should be at least three to five years unless the life cycle of the AIF concerned is shorter. In the case of variable bonuses "of a particularly high amount", at least 60% of the amount must be deferred. Certain details of the remuneration of an AIFM's staff must be included in the annual report that the AIFM prepares for AIFs - see above under "Annual Report".

WHAT DOES THE DIRECTIVE MEAN FOR MANAGERS OF LEVERAGED AIF?

The Directive does not impose any fixed limits on leverage. However, an AIFM must demonstrate that the leverage limits for each AIF it manages are reasonable and that it complies at all times with the leverage limits set by it. When it is deemed necessary in order to ensure the stability and integrity of the financial system, the home Member State regulator of the AIFM may impose limits to the level of leverage that an AIFM may employ or other restrictions on the management of the AIF with respect to the AIF under its management to limit the extent to which the use of leverage contributes to the build-up of systemic risk in the financial system or risks of disorderly markets.

There is also a provision enabling ESMA where it determines that an AIFM or group of AIFM pose a substantial risk to the stability and integrity of the financial system to issue advice to Member State regulators specifying the remedial measures to be taken (including limits to the level of leverage employed). If a Member State regulator acts contrary to the ESMA advice, ESMA may "name and shame" that Member State.

WHAT DOES THE DIRECTIVE MEAN FOR MANAGERS OF PRIVATE EQUITY AIF?

The Directive also imposes requirements on AIFM managing AIF which acquire "control" of an unlisted company (i.e., more than 50% of the voting rights of the company). This is particularly relevant to private equity funds. These provisions do not apply where the unlisted companies are small and medium enterprises (SMEs) or SPVs established to purchase, hold or administer real estate.

When an AIF acquires, disposes or holds shares of an unlisted company, the AIFM must notify its home Member State regulator of the proportion of voting rights held by the AIF any time when that proportion reaches, exceeds or falls below the thresholds of 10%, 20%, 30%, 50% and 75%.

When an AIF acquires, individually or jointly, control over an unlisted company, the AIFM managing such AIF shall notify:

• the unlisted company;
• the shareholders of which the identities and addresses are available to the AIFM or can be made available by the unlisted company or through a register to which the AIFM has or can get access; and
• its home Member State regulator.

This notification must include information on, among other things, the conditions under which control has been reached, including information about the identity of the different shareholders involved, any natural person or legal entity entitled to exercise voting rights on their behalf and, if applicable, the chain of undertakings through which voting rights are effectively held.

The AIFM must also make available the following information¹:

• the policy for preventing and managing conflicts of interests (including information about the specific safeguards established to ensure that any agreement between the AIFM and/or the AIF and the company shall be at arms length); and
• the policy for external and internal communication relating to the company in particular as regards employees.

In addition, in the case of unlisted companies, the AIFM shall make available to the unlisted company and its shareholders the AIFM's intentions with regard to the future business of the unlisted company and the likely repercussions on employment, including any material change in the conditions of employment.

The AIFM must also request, and use its best efforts to ensure, that the board of the target company informs the employee representatives, if any, or the employees themselves of the acquisition of control and the other information set out above.

The AIFM must also provide the competent authorities of its home Member State and the investors of the AIF with information on the financing of the acquisition.

The Directive also contains what are described as "asset stripping" provisions which apply to both listed and unlisted target companies. For a period of 24 months following the acquisition of control, the AIFM is prohibited from facilitating, supporting, instructing or voting in favour of, and is required to use its best efforts to prevent, the following:

1. any distribution to shareholders made when on the closing date of the last financial year the net assets as set out in the company's annual accounts are, or following such a distribution would become, lower than the amount of the subscribed capital plus those reserves which may be not distributed "under the law or statutes";
2. any distribution to shareholders the amount of which would exceed the amount of the profits at the end of the last financial year plus any profits brought forward and sums drawn from reserves available for this purpose, less any losses brought forward and sums placed to reserve "in accordance with the law or the statutes";
3. the acquisitions by the company of its own shares, including shares previously acquired by the company and held by it, and shares acquired by a person acting in his own name but on the company's behalf, that would have the effect of reducing the net assets below the amount mentioned in paragraph (a) above.

The provisions on capital reductions do not apply to a reduction in the subscribed capital whose purpose it is to offset losses incurred or to include sums of money in a non-distributable reserve provided that, following this operation, the amount of such reserve is not more than 10 % of the reduced subscribed capital. The restriction at paragraph (c) above shall be subject to certain exceptions specified in the Second EU Company Law Directive.

WHAT DOES THE DIRECTIVE MEAN FOR SERVICE PROVIDERS INVOLVED IN THE VALUATION OF AIF?

AIFM must ensure that appropriate and consistent procedures are established so that a proper and independent valuation of the assets of the AIF can be performed in accordance with the Directive and the applicable national and AIF rules.

The AIFM shall ensure that the "valuation function" is either performed by:

• an external valuer, being a legal or natural person independent from the AIF, the AIFM and from any other persons with close links to the AIF or the AIFM. The Directive does not elaborate on what constitutes the "valuation function" but does distinguish between the "valuation of assets" and "the calculation of the net asset value per share or unit of the AIF". Therefore, it would be helpful if the Level 2 Rules clarified whether the entity carrying out the valuation function (either the AIFM or an external valuer) is considered to be different from the entity carrying out the "calculation function" (i.e., the calculation of the AIF's NAV based upon the valuation of the assets of the AIF) or whether it is the same entity which carries out both of these functions. This has particular relevance where a fund administrator carries out solely the function of "calculation agent" (i.e., calculating the AIF's NAV on the basis of asset valuations provided by recognised industry pricing specialists);
  
  or
• the AIFM itself, provided that the valuation task is functionally independent from the portfolio management and the remuneration policy and other measures ensure that conflicts of interest are mitigated and that undue influence upon the employees is prevented. When the valuation function is not performed by an independent external valuer, the competent authorities of the home Member State of the AIFM may require the AIFM to have its valuation procedures and/or valuations verified by an external valuer or, where appropriate, an auditor.

When an external valuer is performing the valuation function:

• the external valuer is subject to mandatory professional registration recognized by law or to legal or regulatory provisions or rules of professional conduct; and
• the external valuer can furnish "sufficient professional guarantees" to be able to effectively perform the relevant valuation function.

In many EU jurisdictions, including Ireland, fund administrators are required to be authorised and regulated. On that basis, it is assumed that they will satisfy the first limb. However, the Directive does not define what constitutes a "professional guarantee" or clarify to whom the guarantee must be provided. Clarification of this in Level 2 Rules would be very welcome, bearing in mind that if such guarantees necessitate disproportionate cost for a potential external valuer without any additional benefit to investors, this may make the role of external valuer prohibitively expensive.

The Directive states that the appointed external valuer may not delegate the valuation function to a third party. Fund administrators have identified this as being potentially problematic and do not believe that this should prevent the external valuer from using the valuation services provided by recognised industry pricing specialists with the necessary expertise to value particular assets. To prohibit arrangements of this nature, it is argued, would put investors in an AIF in the position of relying wholly on one entity to value all assets in the AIF, even where that entity may not have the competency to carry out that valuation (this is of particular relevance where there are difficult-to-value or exotic assets). They submit that to rely on entities with particular expertise in the valuation of particular asset-types should not be viewed as a delegation of the valuation function; instead it is the AIFM / external valuer exercising the necessary diligence to ensure that the assets of an AIF are properly valued.

The Directive states that the AIFM is responsible for the proper valuation of AIF assets, the calculation of the net asset value and the publication of that net asset value and that, in no case, shall the AIFM's liability towards the AIF and its investors be affected by the fact that the AIFM has appointed an external valuer. However, notwithstanding the above and irrespective of any contractual arrangements providing otherwise, the external valuer shall be liable to the AIFM for any losses suffered by the AIFM as a result of the external valuer's negligence or intentional failure to perform its tasks.

WHAT DOES THE DIRECTIVE MEAN FOR CUSTODIANS OR "DEPOSITARIES" OF AIF?

Entities eligible to act as depositaries

Each AIF must have a single "depositary" which may not be the AIFM and must be one of the following:

• an EU credit institution (i.e. a bank);
• a MiFID investment firm authorized to provide custodial services and which meet certain capital requirements;
• other authorized entities which are eligible to be UCITS depositaries.

For EU AIF, the depositary must be established in the home Member State of the AIF.

For non-EU AIF only, the depositary must be established in the third country where the AIF is established or the relevant AIFM's home Member State or Reference Member State and may be a non-EU bank or custodian provided that:

• such entity is subject to prudential regulation and supervision of the same effect (including as to capital requirements) as EU law and which is "effectively enforced";
• co-operation and exchange of information arrangements must be in place between the regulator of the depositary and the regulators in the Member States in which the AIF are being marketed, and insofar different, the home Member State of the AIFM;
• agreements on the exchange of tax information must be in place between the country of establishment of the depositary and the Member States in which the AIF are being marketed, and insofar different, the home Member State of the AIFM;
• the country of establishment of the depositary is not designated by FATF as a non-cooperative country; and
• the depositary shall by contract be subject to the same standard of liability to the AIF or to the investors of the AIF as that provided for in the Directive (see below).

A prime broker acting as counterparty to an AIF is not permitted to act as depositary unless it has adequately separated the prime broker and depositary function and the associated conflicts of interest are properly identified, managed, monitored and disclosed to the investors of the AIF.

Depositary "safekeeping" functions

Under the Directive, the functions of the depositary are to:

• ensure that the AIF's cash flows are properly monitored and that all subscription payments have been received and that all cash of the AIF has been booked into a cash account opened in the name of the AIF or in the name of the AIFM acting on behalf of the AIF or in the name of the depositary acting on behalf of the AIF;
• safekeep the assets of the AIFM as follows:
• • for "financial instruments that can be held in custody" – the types of assets within the scope of this definition will be detailed in Level 2 Rules - the depositary shall hold in custody in a segregated account opened in the depositary's books in the name of the AIF or the AIFM acting on behalf of the AIF and all financial instruments that can be physically delivered to the depositary;
  • for all other assets:
  • • the depositary shall "verify the ownership" of the AIF of such assets based upon evidence provided by the AIF or the AIFM and, where available, external evidence; and
    • the depositary shall maintain an up-to-date record of such assets.

Depositary "supervisory" functions

In addition the these safe-keeping functions, the depositary shall:

• ensure that subscriptions and redemptions of shares are carried out in accordance with national law and the AIF's rules or constitutive documents;
• ensure that the value of the shares of the AIF is calculated in accordance with national law and the AIF's constitutive documents and the valuation procedures set out in the Directive;
• carry out the instructions of the AIFM, unless they conflict with national law or the AIF's rules or constitutive documents;
• ensure that in transactions involving the AIF's assets any consideration is remitted to the AIF within the usual time limits; and
• ensure that an AIF's income is applied in accordance with the applicable national law and the AIF rules.

Delegation

The depositary may not delegate any of the functions described in the Directive other than the safekeeping functions. In delegating the safekeeping function, the depositary must exercise all due skill, care and diligence in the selection, appointment, periodic review and ongoing monitoring of the delegate. The depositary must ensure that where the delegate safekeeps financial instruments which can be held in custody (see above under "Depositary "safekeeping" functions") that the delegate is regulated (including being subject to minimum capital requirements) and supervised in the jurisdiction concerned and is subject to external periodic audit to ensure that the financial instruments are in its possession.

However, where the law of a third country requires that certain financial instruments are held in custody by a local entity and there are no local entities that satisfy the delegation requirements laid down in the Directive the depositary can delegate its functions to such local entity notwithstanding that the requirements have not be fulfilled, if and to the extent (i) required by the law of the third country; and (ii) only as long as there are no local entities that satisfy the delegation requirements; and (iii) the investors of the relevant AIF have been duly informed of this delegation required due to legal constraints in the law of the third country and the circumstances justifying the delegation prior to their investment; and (iv) the AIF or the AIFM on behalf of the AIF instructed the depositary to delegate the custody of such financial instruments to such local entity.

The Directive clarifies that the provision of services by securities settlement systems shall not be considered a delegation of custody functions.

Liability

The depository's liability to the AIF (or to AIF investors) is near-strict. The depositary shall be liable to the AIF, or, as the case may be, to the investors of the AIF, for the loss by the depositary, or as the case may be, a third party to whom the custody has been delegated, of financial instruments held in custody. In such case, the depositary shall return a financial instrument of the identical type or the corresponding amount to the AIF without undue delay. The depositary can avoid liability if it can prove that the loss has arisen "as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary". In addition, the depositary shall be liable to the AIF, or, as the case may be, to the investors of the AIF, for all other losses suffered by them as a result of the depositary's "negligent or intentional failure to properly perform its obligations" pursuant to the Directive.

The depositary's liability shall not be affected by any delegation. However, in case of a loss of financial instruments held in custody by a delegate, the depositary can discharge itself of its liability where:

• the contract between the depositary and the third party explicitly transfers the liability of the depositary to that third party and makes it possible for the AIF/AIFM to claim against the third party in respect of the loss or for the depositary to make such a claim on their behalf; and
• the contract between the AIF/AIFM and the depositary expressly permits such a discharge of liability.

Investors must be informed of such arrangements before they invest in an AIF.

CONCLUSION

Following the compromise reached on the Directive in November 2010 and the commencement of work on the Level 2 Rules to implement the Directive, managers and service providers to alternative investment funds (both EU- and non-EU domiciled) are faced with a number of challenges. Those with distribution channels within the EU should conduct an immediate assessment of the potential impact of the Directive on their business. The assumption that the delayed-implementation of the "third country" rules means that the Directive means "business as usual" for managers marketing funds within the EU on a private placement basis is not correct. Ireland, as a domicile for the regulated hedge fund product (QIF) may offer some interesting opportunities for managers whose existing structures will not function under the Directive. The recent introduction of re-domiciliation legislation in Ireland should assist with those thinking of moving their product range to a regulated jurisdiction for the purposes of the Directive (on Redomiciliation, see our bulletin of September 2010 at: www.arthurcox.com/whats-new/publications/irelands_ response_to_demand_from_investors_to_move_onshore_ september2010.html).

We will issue further updates on this area as information on the detail of the Level 2 Rules becomes available.

APPENDIX - PASSPORT/PRIVATE PLACEMENT RULES

GLOSSARY

"Appropriate Cooperation Arrangements" – arrangements between regulators to ensure an efficient exchange of information to allow Member State regulators to carry out their duties under the Directive. In certain cases, these arrangements are described in the Directive as being for the purpose of "systemic risk oversight".

"FATF Non-Cooperative Country" – a country listed as a Non-Cooperative Country and Territory by the Financial Action Task Force on anti-money laundering and terrorist financing.

"Legal Representative" – each non-EU AIFM authorized under the Directive is required to have a "legal representative" established in its Reference Member State who shall be the contact point of the AIFM in the EU. Any official correspondence between the AIFM and regulatory authorities, ESMA or EU investors must take place through this representative. The legal representative must be "sufficiently equipped" to perform the compliance function relating to the management and marketing activities performed by the AIFM under the Directive. It will be interesting to see whether existing or new service providers in the market will seek to develop expertise as a non-EU AIFM's legal representative. Unlike the entities carrying out the external valuer and depositary functions, the Directive does not contain any provisions on the extent of the liability of the legal representative.

"Marketing" – any direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM of shares in an AIF it manages to or with investors domiciled in the European Union.

"Professional Investor" – any investor which is considered to be a professional client or may be treated as a professional client on request within the meaning of the MiFID Directive (Directive 2004/39/EC). The following are considered to be professional clients:- regulated financial institutions (e.g., banks, investment firms, insurance companies, investment funds, pensions funds, other institutional investors); large undertakings (meeting two of the following size requirements: balance sheet of EUR 20 m, net turnover of EUR 40 m and own funds of EUR 2 m); governments, central banks, international and supranational institutions such as the World Bank, the IMF, the ECB and the EIB.

"Reference Member State" – the Member State which authorizes non-EU AIFM under the Directive. The Reference Member State is determined by reference to a number of criteria including: (i) the Member State(s) in which any relevant EU AIF are located; (ii) the Member State(s) into which the AIF is/are to be marketed; and (iii) the nebulous concept of the Member State where the AIFM intends to "develop effective marketing".

"Tax Information Exchange Agreement" – an agreement which fully complies with the standards laid down in Article 26 of the OECD Model Tax Convention and ensures an effective exchange of information in tax matters, including, if any, multilateral tax agreements

Footnote

1. The requirements set out in this paragraph also apply where the target company is listed.

This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.