On 16 November 2011 the European Securities and Markets Authority (ESMA) issued its technical advice to the European Commission on possible implementing measures in respect of the Alternative Investment Fund Managers Directive (the Directive).1 ESMA had issued consultation papers in July and August on this technical advice.

Despite over 150 submissions in response to the consultation, the final advice issued by ESMA does not differ significantly from the original draft. This bulletin focuses on the material elements of the advice, with an emphasis on its impact on managers and other service providers to alternative investment funds.

Executive Summary

Key points of the ESMA advice:

  • Uncertainty remains about the "third country rules" and treatment of non-EU managers and non-EU funds.
  • Irish-domiciled funds may offer a solution. An Irish qualifying investor fund (QIF) may be authorised as an "internally-managed AIF" under the Directive. A non-EU manager itself does not need to be authorised as an AIFM and could act as a delegate of the AIF.
  • Challenges in respect of the scope of duties and level of liability for depositaries and valuers of AIF.
  • The European Commission is expected to issue final rules in mid-2012, giving EU member states a year to transpose the rules into local law.

What does the advice mean for Investment Managers?

Persistent uncertainty about "third country" rules

The Directive provides that the AIFM 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 (an internally-managed AIF). It is thought that the internally-managed AIF may offer some useful structuring opportunities for non-EU managers wishing to manage / market AIF in the EU and looking at Ireland as a funds domicile. The additional compliance burden imposed by the Directive for an EU manager already regulated (e.g., under MiFID) should not be prohibitive. However, it is felt that the real challenge will be for non-EU managers to operate within the EU following the coming into effect of the Directive in 2013.

Passport not immediately available to non-EU managers

Non-EU managers will not be permitted to use the passport procedure under the Directive until 2015 at the earliest. Even then, the non-EU managers must be authorized by a "Member State of reference" (MSR). Unfortunately, ESMA's advice does not help greatly with the question of what the MSR will be in circumstances where there are several possible MSRs. The advice states that the MSR should be identified taking into account the member state in which the AIFM intends to develop effective marketing for most of its AIFs. In determining this, the following criteria should be considered: (i) the Member State where the distributors (and the AIFM in the case of self-distribution) are going to promote most of the units; (ii) the Member State where most of the targeted investors have their domicile; (iii) the Member State in whose official language the offering and promotional documents are translated; and (iv) the Member State where advertisements are most visible and frequent. These criteria could lead to a number of different conclusions and may lead to the MSR changing from year to year, or more frequently. Suggestions by respondents to the consultation paper that the test should be based on the Member State in which the marketing strategy, including the approval, review and oversight of marketing materials is developed were unfortunately ignored. Even if clarity is reached on the MSR question, assuming that the non-EU manager does seek authorisation from the relevant MSR, the Directive requires that the manager complies with substantially all of the Directive as if it were an EU AIFM. Managers who are themselves subject to onerous regulatory regimes in their home countries may well question whether the benefit of the passport under the Directive is outweighed by the associated compliance burden and costs.

Private placement route is not straightforward

Prior to 2015 and up until 2018 at least, non-EU managers may choose to rely on offering AIF by way of private placement instead of by passport. One of the pre-conditions to being able to place AIF privately under the Directive is that there be co-operation arrangements in place between the relevant Member State and the regulator of the non-EU manager. ESMA advises that the co-operation arrangement with the third country competent authority should be in writing and provide for:

  • exchange of information for supervisory purposes;
  • exchange of information for enforcement purposes;
  • the ability to obtain all information necessary for the performance of the duties provided for in the Directive;
  • the ability to carry out an on-site inspection where required for the exercise of the EU regulator's obligations under the Directive. The on-site inspection should be performed directly by the EU regulator or by the non-EU regulator with the assistance of the EU regulator.

In addition, ESMA advises that the non-EU regulator should assist the EU regulators where it is necessary to enforce EU legislation and national implementing legislation breached by the entity established in the non-EU jurisdiction.

There is no certainty at this stage as to how the negotiation of the co-operation arrangements will take place although the advice suggests that they could take the form of memoranda of understanding based on IOSCO principles and may be centrally negotiated by ESMA. It remains to be seen how willing non-EU regulators will be to sign up to these arrangements given how intrusive they could be. It is also worth noting that each Member State will have the final say in what the private placement rules are in its jurisdiction; the Directive expressly states that Member States are free to impose stricter private placement rules than those in the Directive.

Is the Irish qualifying investor fund (QIF) the solution for non-EU managers?

For those non-EU AIFM who wish to avail of the passport from 2013 or simply avoid some of the uncertainty associated with the private placement route, the Irish qualifying investor fund (QIF) could be the solution. QIFs are regulated by the Central Bank of Ireland (Central Bank) and are open to subscriptions from "qualifying investors" (i.e., professional clients under MiFID and other sophisticated investors) who invest a minimum of €100,000. They may be established as investment companies, unit trusts, common contractual funds or investment limited partnerships. Unit trusts, common contractual funds and, in some cases, investment companies have separate management companies. The Directive requires that each AIF have a designated AIFM. In the case of the Irish QIF, this could be the investment company (an internally-managed AIF) or the management company to the investment company, unit trust or CCF (an external AIFM).

How would the delegation of portfolio/risk management from the QIF to the non-EU manager comply with the Directive?

Under the Directive, the responsibility for portfolio management and/or risk management of the QIF could, in turn, be delegated to the non-EU manager. The key point is that the non-EU manager would not itself have to be subject to the requirement to be authorised as an AIFM under the Directive as the authorization would be applied for by the investment company or management company. This structure of having the regulated entity based in Ireland meeting the requirements of the relevant directive, while out-sourcing the investment management function to non-EU entities, is the established model in Ireland for UCITS funds. Indeed, ESMA's advice expressly states that it considered the UCITS approach as a basis for the reason that many AIFM are already authorised as management companies and because a consistent approach with the UCITS Directive avoids the application of different delegation requirements for an AIFM when it manages UCITS on the one hand, and AIF on the other hand.

In the case of non-EU entities, ESMA's draft advice required that the authorization or registration be based on local criteria which are "equivalent to those established under EU legislation". Helpfully, ESMA has accepted the critical feedback on this received during the consultation process and the requirement for equivalence has been removed. Accordingly a non-EU manager will be deemed to meet the requirements of the Directive when it is authorised or registered for the purpose of asset management based on local criteria and is effectively supervised by an independent competent authority. It is important to note however that there must be appropriate co-operation arrangements in place between the Central Bank (as regulator of the QIF or management company) and the regulator of the non-EU manager. See the earlier discussion on this above. The following diagram illustrates the structure using a QIF.

In line with MiFID, the AIFM must comply with certain principles when delegating tasks to third parties. In particular, the principle of senior management's sole responsibility should not be affected due to the delegation nor should the obligations of the AIFM towards its investors under the Directive be altered. The senior management remains fully responsible for the delegated tasks. The Directive requires that the AIFM evaluate whether the delegate has sufficient resources to perform the delegated tasks, and whether the persons who effectively conduct the business of the delegate are sufficiently experienced and of sufficiently good repute. The advice provides guidance in determining whether the delegate meets these criteria. In determining whether a delegate meets the requirement of being of sufficiently good repute, this criterion will be deemed satisfied where the delegate is regulated in respect of its professional services within the EU. Therefore, the onus will be on the board of directors of the QIF or management company to conduct appropriate due diligence of the delegate and ensure that there is adequate oversight of the investment management of the QIF by the delegate.

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". ESMA has identified two circumstances under which an AIFM would become a letter-box entity. Firstly, where the AIFM is no longer able to supervise effectively the delegated tasks and to manage the risks associated with the delegation. This might be the case where the AIFM only retains few resources to supervise the delegated tasks in proportion to the extent to which it has delegated tasks and these resources are not sufficient for an effective supervision of the delegated tasks. Secondly, where the AIFM no longer has the power (i) to take decisions in key areas which fall under the responsibility of the senior management; or (ii) to perform senior management functions. Senior management functions include, for example:

  • responsibility for ensuring that valuation procedures are established;
  • responsibility for ensuring that the AIFM has a permanent and effective compliance function;
  • ensuring and verifying on a periodic basis that the general investment policy, the investment strategies and the risk limits of each managed AIF are properly and effectively implemented;
  • receiving on a frequent basis, and at least annually, written reports on matters of compliance, internal audit and risk management indicating in particular whether appropriate remedial measures have been taken in the event of any deficiencies.

To readers who are familiar with the supervisory and reporting structures adopted by UCITS self-managed investment companies and management companies, these requirements will sound very familiar. It is therefore likely that the type of oversight and reporting procedures outlined in UCITS business plans and risk management policies will need to be adopted by QIF investment companies or management companies to demonstrate that they carry out the substantive requirements of the Directive and have appropriate delegation arrangements in place. These will have to be tailored, as appropriate, to take account of the different investment strategies and investor profile of AIF.

General operating conditions

The overall approach taken by ESMA to the advice on general operating conditions applicable to AIFM has been to align the requirements as much as possible with the existing provisions in the UCITS Directive and MiFID, while recognising that the UCITS Directive covers retail-oriented funds.

One of the aspects of the draft advice which received the most advice from respondents was the section dealing with the own funds requirements. As in the case of the UCITS Directive, the Directive provides for a minimum capital requirement which may be increased if AUM exceed a specified threshold. However, the Directive also requires that AIFM have additional own funds and/or professional indemnity insurance to cover risks arising from professional negligence. The additional own funds requirement for liability risk is equal to 0.01% of the value of the portfolios of AIF managed by the AIFM. The regulator of the AIFM may authorize the AIFM to lower the percentage to 0.008%, provided that the AIFM can demonstrate – based on its historical loss data and a minimum historical observation period of three years – that liability risk is adequately captured. Conversely, the regulator may raise the additional own funds requirements if they are not sufficient to capture liability risk arising from professional negligence. As an alternative to the additional own funds requirement, the AIFM may take out professional indemnity insurance or combine such insurance with a reduced own funds requirement. The proposed procedures for the calculation of the own funds / insurance requirement are complex and leave managers in the position of being unclear as to what amounts will need to be maintained / covered by insurance.

In addition, ESMA's advice covers areas such as:

  • conflicts of interest;
  • risk management - a risk management policy and permanent risk management function need to be in place;
  • liquidity management - AIFMs should implement systems and procedures to ensure the liquidity profiles of AIFs comply with their underlying obligations (including the redemption facilities offered to investors);
  • investment in securitization positions - the objective of these provisions is to ensure cross-sectoral consistency and remove misalignment between the interests of firms that repackage loans into tradable securities and originators.

Thresholds to determine whether a manager is within the scope of the Directive.

The Directive contains de minimis exemptions for managers (AIFM) based on the level of assets under management (AUM) in alternative investment funds (AIF). It does not require the authorization of AIFM who, together with any affiliates, manage:-

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

ESMA advises that the AUM figures should be calculated as follows:-

  • the calculation should be performed at least annually;
  • the AUM figure should be based on the latest valuation of the AIF and should include assets acquired through leverage;
  • derivative positions should be converted into their equivalent position in the underlying assets using the "commitment approach" applied in the calculation of global exposure of UCITS;
  • it is not required to double-count AUM in cases where (i) an AIF managed by an AIFM invests in another AIF managed by the same AIFM; or (ii) one sub-fund of an AIF invests in another sub-fund of the same AIF;
  • where the AUM occasionally exceed the threshold, the AIFM must consider whether this situation is likely to be of a temporary nature. If not, it should seek authorisation under AIFMD. In any event, the AIFM should notify the national regulator without delay stating whether the situation is expected to be temporary (including supporting material to justify this view). ESMA does not consider situations lasting for more than three months to be temporary.

What does the advice mean for Valuers?

Under the Directive the AIFM is responsible for the proper valuation of assets but may delegate to an "external valuer" who is liable in turn to the AIFM. The Directive provides that an external valuer cannot limit its liability to the AIFM in relation to its negligence or intentional failure to perform its duties. In their response to ESMA's consultation paper, fund administrators pointed out that in most cases they were simply calculation agents responsible for calculating the NAV of AIF based on prices obtained from other sources and that they should not be viewed as external valuers.

ESMA's advice provided for some clarification in this area:-

  • a third party which carries out the calculation of the net asset value for an AIF is not considered to be an external valuer, so long as this entity does not provide valuations for individual assets, including those requiring subjective judgement, but incorporates values which are obtained from the AIFM, pricing sources or the external valuer(s) into the calculation process;
  • price providers (e.g. Bloomberg, IDC) are not considered to be external valuers; and
  • due to the diversity of assets in which an AIF may invest, it may be difficult for an AIFM/AIF to find a valuer capable of properly valuing all portfolio assets. Hence, an AIFM may have several external valuers for any one AIF in order to ensure a proper valuation of all assets.

What does the advice mean for Depositaries?

Under the Directive the depositary has two primary functions: to safekeep the AIF's assets and to oversee its compliance with the AIF's rules and instruments of incorporation and with applicable law and regulation. The Directive further assigns the depositary with a requirement to ensure the AIF's cash flows are properly monitored.

Safekeeping

The duty to safekeep consists either of custody or of record keeping, depending on the type of asset. ESMA's advice addresses the types of financial instrument which should be included in the scope of the depositary's custody functions and the conditions upon which the depositary can fulfil its obligation to safekeep the assets. The "other assets" subject to the recordkeeping obligation are then defined as all assets not covered by custody. The significance of this distinction is that in the case of the "loss" of financial instruments held in custody, the depositary is under a duty to return financial instruments of the identical type or corresponding amount without undue delay. See below under "Depositary liability".

According to ESMA's advice financial instruments belonging to the AIF should be included in the scope of the depositary's custody function when they meet all three of the criteria below:

  • they are transferable securities, money market instruments or units of collective investment undertakings;
  • they have not been provided as collateral under the terms of a title transfer financial collateral arrangement or under a security financial collateral arrangement as defined in Directive 2002/47/EC (the Financial Collateral Directive) by which the control or possession of the financial instruments has been transferred from the AIF or the depositary to the collateral taker or a person acting on its behalf. (As collateral is defined by reference to the EU Financial Collateral Directive, there is a concern that potentially certain collateral arrangements which fall outside the scope of the definition in that Directive could be excluded. It is further unclear what the implications of such exclusions are and its impact, if any of the relationship between the prime broker and the depositary); and
  • they are registered or held in an account directly or indirectly in the name of the depositary.

Financial instruments that are directly registered with the issuer itself or its agent (e.g. a registrar or a transfer agent) in the name of the AIF should not be held in custody unless they can be physically delivered to the depositary or the instrument is registered or held in an account directly or indirectly in the name of the depositary. In the case of funds of hedge funds, for instance, typically units in the underlying fund are registered in the name of the depositary or its nominee on behalf of the fund and it appears that such units will now be considered to be assets held "in custody".

All financial instruments that do not comply with the above definition should be considered as "other assets" and be subject to record keeping duties. According to ESMA "other assets" would include: physical assets that do not qualify as financial instruments or cannot be physically delivered to the depositary, derivatives, cash deposits and investments in privately held companies and interests in partnerships. In respect of those assets, the depositary is required to verify the right of ownership of the AIF to those assets and maintain a record of those assets. ESMA suggests that in order to fulfil these obligations the depositary should have timely access to information and the AIFM has an obligation to ensure this happens. The depositary must register in its record in the name of the AIF, assets and their notional amounts which it believes the AIF holds and it must be in a position to provide at any time a comprehensive and up to date inventory of the AIF's assets either by ensuring that procedures exist to ensure the depositary is informed of all transactions involving the assets or by obtaining documentary evidence of each transaction.

Oversight function

The Directive contains the same provisions regarding the depositary's oversight functions as those set out in the UCITS Directive. However, in light of the differences in interpretation of the five oversight duties of a depositary across Member States, ESMA's advice aims to clarify each task.

Cash monitoring

ESMA's advice considers the depositary's cash monitoring function as a general requirement to have a full overview of all cash movements of the AIF (i.e., not just subscriptions) which should be read alongside its oversight duties. The advice acknowledges that an AIF may have cash accounts at various entities outside the depositary; as such, the aim is to have a strong requirement on the AIFM to ensure the depositary has access to all information related to each cash account opened at a third party.

Regarding the tasks which would be expected of a depositary when implementing its cash monitoring obligations, the advice would require the depositary to ensure there are procedures in place to monitor appropriately the AIF's cash flows and that they are effectively implemented and periodically reviewed. In particular, the depositary would be required to look into the reconciliation procedure and monitor that remedial action is taken without undue delay whenever a discrepancy is identified.

Under its cash monitoring function, the depositary is also required to ensure that payments made by investors upon subscription have been received by the AIF. ESMA's advice is that the depositary is not expected to interfere with the distribution channels of the AIF, but simply to verify the information at the level of the AIF's register.

Due diligence duties

The Directive provides significant detail as to the conditions to be met for the depositary to be able to delegate any of its safekeeping functions. ESMA was asked to provide further guidance in relation to the specific tasks the depositary would be expected to carry out in order to comply with its due diligence duties and, if possible, to provide a template of evaluation, selection, review and monitoring criteria to be considered. The advice focuses on what the depositary is expected to do when delegating custody tasks given the potentially significant implications for the AIF and its investors.

Segregation

The third party to which the depositary wishes to delegate custody tasks must segregate the assets belonging to the depositary's clients from its own assets and from the assets of other depositaries and their clients, for whom it may be acting as delegate, in such a way that they can at all times be clearly identified as belonging to clients of a particular depositary. ESMA's advice on what the specific requirements should be to make sure the sub-custodian effectively meets that obligation is based on the MiFID implementing Directive (2006/73/EC), adapted to reflect that sub-custodians may, as the Directive acknowledges, use "omnibus accounts".

Depositary liability

The depositary's liability regime is one of the key areas of controversy surrounding the Directive. ESMA's advice provides definitions of what would constitute: (i) the loss of a financial instrument; (ii) an external event beyond the reasonable control of a depositary, the consequences of which would have been unavoidable despite reasonable efforts; and (iii) the objective reason which could enable a depositary to discharge its responsibility by transferring it to a sub-custodian.

The ESMA advice provides that the loss of the financial instrument must be permanent in nature and the assessment of the loss must follow a documented process.

In the case of the insolvency of a sub-custodian, financial instruments should be considered lost as soon as one of the conditions proposed by ESMA is met with certainty as opposed to at the end of the insolvency proceedings which was proposed in the original ESMA consultation paper.

The question of what constitutes "an external event beyond the reasonable control of a depositary, the consequences of which would have been unavoidable despite reasonable efforts" is possibly the most important one for depositaries. This determines whether a depositary is liable for the loss of a financial instrument held in custody by itself or a sub-custodian. According to ESMA's advice, the depositary will not be liable for the loss of financial instruments held in custody by itself or by a sub- custodian if it can demonstrate that all the following conditions are met:

  1. the event which led to the loss is not a result of an act or omission of the depositary or one of its sub-custodians to meet its obligations;
  2. the event which led to the loss was beyond its reasonable control i.e. it could not have prevented its occurrence by reasonable efforts; and
  3. despite rigorous and comprehensive due diligence, it could not have prevented the loss.

One of the most noteworthy aspects of this test is that a depositary would have to show that the loss is not a result of an act or omission of the depositary or one of its sub-custodians. Therefore, irrespective of whether or not a sub-custodian is an affiliate of the depositary, the loss of a financial instrument through the act or omission of a sub-custodian will be deemed to be an event that is "internal" to the depositary. While the contractual arrangements between the depositary and its sub-custodian may contain indemnity and other provisions which seek to protect the depositary from the default of its sub-custodian, this may provide little comfort where an AIF demands from the depositary the return "without undue delay" of financial instruments that were lost at the level of the sub-custodian. Other provisions in the Directive allow the depositary to contract the discharge of its liability but these provisions are available in limited circumstances and might not always be available to depositaries. ESMA's advice provides little guidance as to how a "contractual discharge" would operate in practice.

According to ESMA, subject to the requirements of paragraphs (i) and (ii) above being fulfilled, the depositary or the sub-custodian could be regarded as having made reasonable efforts to avoid a loss of a financial instrument held in custody if it can prove that it has taken all of the following actions:

  • it has ensured that it has the structures and expertise that are adequate and proportionate to the nature and complexity of the assets of the AIF to identify in a timely manner and monitor on an ongoing basis any external event it could reasonably identify which it considers may result in a loss of a financial instrument held in custody;
  • it has reviewed on an ongoing basis whether any of the events it has identified under point (a) present a significant risk of loss of a financial instrument held in custody; and
  • where it has identified actual or potential external events which it believes present a significant risk of loss of a financial instrument held in custody, it has taken appropriate actions, if any, to prevent or mitigate the loss of financial instruments held in custody.

Conclusion

The European Commission will now work on the Level 2 rules on the basis of ESMA's advice. It is expected that the final form of rules will be issued by the Commission in mid-2012, giving Member States a year to transpose the rules into national law. It is likely that the Commission will seek to achieve maximum harmonisation of the rules effective in Member States by means of regulations, as opposed to Directives which leave Member States a measure of flexibility as to how to implement the rules. It is also important to note that the Commission is not bound to follow ESMA's advice. We will issue further updates on this area as information on the shape of the Level 2 rules becomes available.

Footnotes

1 Readers might also like to refer to our previous bulletin on the Directive itself http://www.arthurcox.com/whats-new/publications/update_on_alternative_investment_fund_managers_%28aifm%29_directive_february2011.html

2 Similar structures can be used with an Irish management company as the external AIFM (e.g. unit trusts or common contractual funds).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.