The European Securities and Markets Authority ("ESMA") issued its final report to the European Commission regarding the implementation of the Alternative Investment Fund Managers Directive ("AIFMD") on 16 November 2011. This article gives the background to this latest development regarding the AIFMD as well as an overview of the contents of the report itself.
Introduction and Background
The European Commission (the "Commission") first published a proposal for a directive regulating alternative investment fund managers ("AIFMs") at a European level in April 2009. Following numerous counter-proposals and amendments, a draft directive was ultimately agreed in October 2010. This directive was prepared as a principlebased framework document under the Lamfalussy procedure and accordingly, following its implementation, much of the fine detail remained to be determined, as "Level 2" measures. As a result the Commission requested the Committee of European Securities Regulators ("CESR"), which has now been replaced by ESMA, for advice on finalising the relevant details and ultimate implementation of the directive. CESR in turn requested stakeholders to make submissions on the open issues (the deadline for submissions being 14 January 2010). ESMA then produced two draft advisory reports as consultation papers.
The first, issued in July 2011, addressed the first three sections of the Commission's request for input, which included general operating conditions to be applicable and exemptions from the scope of the AIFMD.
The second, issued in August 2011, addressed relations with third countries (including regarding supervisory co-operation, marketing of non-EU Alternative Investment Funds ("AIFs"), delegation to service providers outside the EU and the appointment of non-EU service providers including depositaries.
Responses to these consultation papers were invited until mid-September and open hearings were held by ESMA in Paris at which further submissions could be made and questions posed. Following all of this consultation the Final Report of ESMA issued on November 16 and is available here (the "Final Report").
Overview of the Final Report
The Final Report comprises an executive summary, background information and then the body of the report, which is itself divided into four parts under the following headings (which address the specific format of the original request for guidance from the Commission): (i) General provisions, authorisation and operating conditions; (ii) Depositary; (iii) Transparency and Leverage; and (iv) Supervision. It is further supported by five Annexes containing supplementary information.
Part I: General provisions, Authorisation and Operating Conditions
The general approach of ESMA in drafting this report has been to seek to make the applicable conditions for alternative investment funds ("AIFs") and AIFMs as compatible as possible with those currently applicable to UCITS and under the Markets in Financial Instruments Directive ("MiFID"). This is particularly the case in relation to general operating conditions, conflicts of interest, risk management and liquidity management. However, recognising that the AIFs in question will not be retail products and may not be open-ended, slightly different criteria may be appropriate in some areas. In this regard, the Final Report deals with general operating conditions and the scope of the AIFMD, including potential exemptions, and the organisational requirements for AIFMs, as well as a series of other sub-headings detailed below. The potential for obtaining an exemption from the scope of the AIFMD, as provided for in Article 3 of that directive, is a key issue. Accordingly this is explored in detail and in this regard the Final Report addresses the identification of AIFs under management by a particular AIFM and the calculation of the value of assets under management, the specific content of the obligation to register with national competent authorities (as well as suitable mechanisms for gathering information) and an opt-in procedure for small or borderline managers who wish to come within the AIFMD's scope.
Initial Capital and Own Funds
The Final Report sets out a methodology for calculating the capital requirements of AIFMs based on assets under management and contains guidelines regarding the possible combination of professional indemnity insurance with additional capital in some circumstances subject to specific conditions.
Conflicts of Interest
ESMA's advice addresses the steps an AIFM should take to identify, prevent, manage, monitor and disclose conflicts of interest.
Risk Management
The provisions in the Final Report on risk management can be divided into three strands: (i) techniques for measuring and managing specific types of risk; (ii) the establishment of a risk management policy by AIFMs; and (iii) the establishment of a permanent risk management function.
Liquidity Management
The existing provisions applicable to UCITS were taken as the starting point for developing advice on this area and ESMA's advice focuses on the systems and procedures used by AIFMs and the content and frequency of stress tests to be performed by them.
Valuation
The Final Report recognises that a range of different valuation standards currently exist and indeed may be required for specific AIFs, based on the law applicable to them due to their domicile. Accordingly, general principles are recommended for the valuation of individual assets and the calculation of NAV. However, a general principle to be observed is that financial instruments should be valued each time a NAV is produced for an AIF.
Delegation
The general principle established is that delegation is to be permitted where its purpose is to ensure the more efficient conduct of business. A list of recommended criteria to be used to assess whether this is the case is included. The issue of the delegation of portfolio management to third countries is specifically addressed and this is of particular interest in the Irish context where the standard model is for self-managed investment companies to delegate portfolio management activities to investment managers based in other jurisdictions, including the U.S. It is recommended that delegation to third country entities will be permitted subject to certain conditions, including the existence of a written agreement between the home authorities of the AIFM (or ESMA- which raises the potential for accords at a European level between ESMA on behalf of the EU and other countries, such as the U.S.) and the authorities of the delegated entity. It can be noted that delegation to the extent that the AIFM is rendered a letterbox entity will not be permitted and the circumstances where this would be deemed to occur are stated to include situations where the AIFM is unable to supervise the delegated activities effectively or where it no longer has the power to take decisions in key areas.
Part II: Depository Requirements
The appointment of a third party depository is a key requirement of the AIFMD. The Final Report includes recommendations in relation to the appointment of a depository (the issuance of a standard form contract to ensure consistency was considered but ultimately rejected), the general criteria for assessing the effective prudential regulation and supervision of third countries, the duties of the depository and the applicable liability. ESMA's advice regarding the recognition of third country regimes recommends considering such factors as the applicable capital requirements, the regulatory environment therein and the sanctions applicable under local law for breaches of these applicable rules. The role of the depository can be divided into two primary functions- safekeeping AIF assets and monitoring compliance with applicable rules. The oversight function under the AIFMD will be similar to that currently required for UCITS but in order to avoid divergence of interpretation across the EU and consequent regulatory arbitrage, the specific tasks inherent in this role are clarified. These include details on cash monitoring, safekeeping and the due diligence to be carried out when any roles are delegated to third parties. The extent of the liability of the depository is a central issue for the AIFMD and as one of the ongoing criticisms of the UCITS directives has been the lack of clarity around this question (which is proposed to be addressed in a future UCITS V directive), this is dealt with in detail. The aim has been to strike a balance between investor protection and placing an undue burden on the depository, which would inevitably lead to a sharp reduction in the range of suppliers willing to service this market. Accordingly the Final Report addresses: (i) what would constitute the loss of a financial instrument; (ii) an external event beyond the reasonable control of the depository; and (iii) the circumstances under which responsibilities could be deemed discharged and deemed to be successfully transferred to a subcustodian.
Part III: Transparency and Leverage
Three broad elements are covered under the heading of transparency, being: the annual reporting requirements of AIFMs in respect of AIFs marketed in the EU (which will include contents and format of balance sheets and income and expenditure accounts); periodic and regular disclosures that AIFMs must make to investors (including risk profiles of related AIFs and risk management systems) and the information that AIFMs must make available or report to regulatory authorities (which will include details of principal markets and instruments used, sources of leverage and exposure concentrations).
The Final Report addresses (i) the methodologies to be adopted for the calculation of leverage under the AIFMD (generally two mandatory methods are to be used- the "gross" and "commitment" methods, with a third potential method being optional and usable in addition on notification to the regulatory authorities); (ii) methods of increasing leverage, such as through the use of derivatives; and (iii) principles specifying circumstances where local regulatory authorities will be able to impose limits on leverage (including the relevant factors to be taken into account in this regard).
Part IV: Supervision
The Commission had requested advice on the creation of a framework to facilitate the establishment of co-operation arrangements with supervisory authorities in third countries in order to provide for systemic risk oversight. It recommends that cooperation arrangements with regulatory authorities in third countries should be in writing and provide for the exchange of information for supervisory and enforcement purposes, the right to obtain all information necessary to fulfill their respective duties and the right to request an onsite inspection to be performed or to perform it directly. A key concern is the avoidance of an unlevel playing field whereby AIFs in third countries would be treated unduly favorably. The provisions in relation to the potential for a passport for third countries will be prepared at a later date, closer to 2015 when the passport for such funds may become operable.
Additional Information
A cost-benefit analysis of ESMA's advice is included in Annex II. Pro-forma examples for AIFM reporting to the relevant authorities are included in Annex V to facilitate the adoption of unified European standards in this regard. Also included in the Annexes to the Final Report are the feedback received to the earlier consultation papers and the advice of the securities and markets stakeholder group.
Next Steps
The Commission is expected to issue the final Level 2 measures by June 2012 and the AIFMD will take effect in July 2013. ESMA will continue to work on the other subordinate measures anticipated by the AIFMD including guidelines and regulatory and technical standards. ESMA will also identify key areas where it considers it appropriate to develop guidelines to facilitate a harmonised implementation of the new framework. The extent to which ESMA's advice will be adopted remains to be seen.
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.
