The outcome of the financial crisis shed light on the lack of adequate measures surrounding the regulation and supervision of hedge funds, exposing a number of vulnerabilities within the Fund industry. After much debate and controversy, the European Commission decided to act upon this and regulate this industry with tighter regulation and more vigilant measures of supervision.
On 30th April 2009, the European Commission published the draft Directive on Alternative Investment Fund Managers (the “AIFM Directive”) . On 1st July 2011 the Directive was published in the Official Journal of the EU. The Directive entered into force on 21st July 2011. Member States are granted two years to transpose this Directive into national law. Member States are required to implement the provisions of the Directive by 22nd July 2013, at which point various elements of the new framework will be phased in over a staggered timetable.
The AIFMD represents the first phase of the legislative process which will effectively proceed until the deadline for the implementation in 2013. The AIFMD “Level 1” framework directive is due to be supplemented by a series of more detailed “Level 2” measures which shall be determined by the European Commission on the basis of the technical advice provided to it by the European Markets and Securities Authority ( “ESMA”) and ultimately by the “Level 3” guidance also issued by ESMA.
The AIFMD regulates the managers of alternative investment funds (“AIFs”) and subjects them to compulsory regulation in the EU. This Directive is an important departure from the UCITS Directive in that it regulates the workings of the fund manager and not the fund per se. The AIFMD regulates alternative investment fund managers (“AIFMs”) which engage in EU-related management or marketing activities. The Directive also captures non-EU managers which market or manage a fund which is based in the EU.
The Directive thus applies to;
- EU AIFMs which manage one or more AIFs irrespective of whether such AIFs are established in the EU or not;
- Non-EU AIFMs which manage one or more EU AIFs; and
- Non-EU AIFMs which market one or more AIFs in the EU irrespective of whether such AIFs are EU AIFs or non-EU AIFs.
An AIFM is defined in the Directive as being any legal person whose regular business is managing one or more AIF, with an AIF being defined as a ‘non-UCITS collective investment undertaking of any legal form which raises capital from a number of investors with a view of investing it in accordance with a defined investment policy for the benefit of those investors’. The Directive also lists certain entities which are exempt from its provisions, such exemptions include; supranational institutions, central banks, holding companies, employee participation or employee savings schemes, securitization special purpose entities.
AIFMs which manage AIFs with a cumulative value of less than €100 million, or €500 million if the AIF is unleveraged, and subject to a minimum five-year lock up period, are automatically subject to a light-touch regime which would consist only in the mandatory registration and reporting requirements. These exempt entities are still given the option to voluntarily ¬opt-in to the full workings of the Directive regime thus being able to benefit from the passporting system.
Additionally the Directive also exempts AIFMs which manage one or more AIF whose only investors are the AIFM, or the parent undertakings or the subsidiaries of the AIFM or other subsidiaries of those parents’ undertakings, provided that none of those investors are itself an AIF.
Member States shall ensure that for each AIF managed within the scope of the Directive, a single AIFM shall be appointed. The appointed AIFM shall either be;
- An external manager which is the legal person appointed by the AIF or on behalf of the AIF and which is responsible for the managing of the AIF, or;
- Where the legal form of the AIF permits, an internal manager who will be responsible for the management of the AIF.
The AIFM, being either an EU-AIFM or a non-EU AIFM, and which falls within the scope of the Directive, are required to obtain authorization from the competent authority of their home Member State . Upon requesting an application for authorization, the AIFM must provide the Member State with certain information which relates to the AIFM, such as information on the structure, constitution, investment strategy and remuneration policy. This authorization is required in order for the AIFM to be able to carry out management and marketing activities.
Non-EU AIFMs which wish to market their AIFs in a Member State may do so under the local private placement regime. By opting to market under this regime they will not be required to request authorization. They will, however, still need to comply with certain Directive requirements.
The competent authorities of the home Member State of the AIFM shall only grant authorization once specific requirements have been met by the AIFM.
The competent authorities of the home Member State of the AIFM are also reserved the right to withdraw the authorization issued where situations of misconduct materialize.
Initial capital and own funds
AIFMs shall be subject to capital requirements which start at €125,000 for an external AIFM, and €300,000 for internally managed funds. AIFMs which manage an AIF exceeding €250 million must provide an additional amount of own funds which correspond to 0.02% of the excess amount, which shall be subject to an overall capping of €10 million for initial capital and own funds.
Member States may allow an AIFM to provide up to 50% of the additional amount of own funds in the form of a guarantee from a bank or insurance undertaking. Subsequently, AIFMs are required to have additional own funds or a professional indemnity insurance policy to cover any potential liability risks.
Organisational and conduct-of-business principles
AIFMs are required at all times to act honestly and apply due skill, care and diligence, acting in the best interests of the investors and avoiding any conflict of interest which may arise. AIFMs are required to separate the functions of risk management from operating units, which include portfolio management. Managers must implement risk management systems and comply with specific due diligence standards when investing on behalf of the AIF. The AIFM must also conduct a liquidity management and monitoring system to ensure that the liquidity profile of the AIF matches its redemption policy.
AIFMs must ensure that a proper and independent valuation of the assets of the AIF can be performed. Valuation may be carried out by the AIFM or by an external valuer, provided it is carried out independently from the AIF and from the portfolio management function. A depositary which is appointed for the AIF may act as its external valuer if it can separate its depositary functions from those of the valuation functions.
The valuation provisions set forth in the AIFMD defer from the valuation principles which are laid down by the law of the jurisdiction in which the AIF is registered and to those which are contained in the AIF rules or instruments of incorporation. Additional obligations such as; applicable valuation procedures and frequency of valuation for open-ended funds are laid down by the European Commission as additional implementing measures following formal adoption of the Directive.
Disclosure and reporting standards
For each AIF that an AIFM manages and markets in the EU, it must prepare an annual report which must be provided to the competent authorities and to the investors on request. The annual report must be prepared by an EU auditor and shall contain information on the AIFs balance sheet or statement of assets and liabilities. The AIFM must also provide investors, for each AIF that it manages and markets in the EU, with minimum pre-investment information from the AIFs investment strategy and objectives to its liquidity risk management and leverage levels.
Besides the reporting standards which are required under the Directive, the AIFM is required to set a maximum level of leverage which the AIFM may employ on behalf of each AIF it manages. The AIFM must limit the extent of its right to reuse any collateral or guarantee that may be granted under a leveraging arrangement. The AIFM must be capable of demonstrating that the leverage limits set are reasonable and that it complies with them at all times.
The authorities of the home Member State of the AIFM may set limits to the leverage amounts that an AIFM may employ, or impose other restrictions on the management of the AIF if this is deemed necessary to prevent the build-up of systemic risk in the financial system.
An AIFM may delegate one of its functions to a third party; it must however notify its home Member State authority before the delegation arrangements are affected. The AIFM must be able to provide objective reasons for the delegation. The delegate must dispose of sufficient resources and be managed by a person of sufficient repute and experience in order to be able to perform the tasks under the Directive. Delegation must be supervised in order for the AIFM to act in the best interests of the investors. The AIFM must select the delegate with due care and must retain the ability to monitor its activities. The AIFM remains strictly liable for all the functions if has delegated or the functions the delegate has sub-delegated.
The AIFM is required to appoint a depositary for each AIF that they manage. This has stirred up quite a controversy in Malta since we are lacking in the area of depositaries. MFSA has been making arrangements to advertise Malta as best they can to attract more depositaries to establish in Malta, however due to the small size of the industry in Malta, this is proving to be a daunting task.
An EU AIF must appoint a depositary which must have its registered office or a branch in the Member State where the AIF is authorized or registered. The appointed depositary must be either a; credit institution, a MiFID investment firm or any institution which has been determined by a Member State as being an eligible depositary under the UCITS Directive.
The depositary’s duties are laid down in a written contract form which is entered into between the depositary and the AIFM, or, as the case may be, by the self-managed AIF. The contract must, inter alia, regulate the flow of information necessary for the depositary to perform its tasks under the Directive. The minimum content of what should be included in the written contract will be further analysed with the ‘Level 2’ measures.
The obligations of the depositary are primarily three. These are;
- To ensure proper monitoring of AIFs cash flows and ensure that all payments made by or on behalf of investors upon the subscription of units or shares of an AIF have been received;
- To perform proper safekeeping of financial instruments and assets of the AIF;
- To carry out a number of monitoring and oversight tasks and to oversee its compliance with the AIF rules and instruments of incorporation and with applicable law and regulation.
Delegation of duties by the depositary
The depositary may delegate its functions of safekeeping to a third party subject to the following conditions;
- The tasks are not delegated with the intention of avoiding the requirements of the Directive;
- The depositary can demonstrate that there is an objective reasons for the delegation;
- The depositary has exercised all due skill, care and diligence in the selection and appointment of the third party;
- The third party must have the structures and expertise which are adequate and proportionate to the nature and complexity of the assets of the AIF;
- The third party must be subject to effective prudential regulation;
- Segregation of assets from the assets of the third party and the assets of the depositary’s clients must be effected in such a manner for them to be clearly identifiable at any given time.
The depositary will be liable to the AIF and to its investors for any loss of financial instrument which is held under its custody. The depositary may avoid liability if it can prove that such loss has arisen as a result of an external event which was beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary.
The depositary shall be held liable for any loss to the AIF or to its investors which arise out of its negligence or intentional failure to comply with the provisions of the Directive.
In respect of liability arising out of delegated activities, the depositary is strictly liable for losses caused by delegates or sub-delegates. The Depositary may nonetheless avoid liability for loss of financial instrument held by the sub-delegate if a contract is entered into between the depositary and the AIF, or the AIFM acting on behalf of the AIF, which stipulates the discharge of liability on the basis of an objective reason. The Depositary may also avoid liability for loss of financial instruments held by a third country sub-custodian which is not subject to effective prudential regulation and supervision or to external auditing if equivalent contractual agreements are in place.
Remuneration of AIFM and categories of staff including; senior management, risk-takers, control functions and employees, whose professional activities have a material impact on the risk profile of the AIF shall be subject to risk-adjustment principles. The remuneration principles are designed to achieve alignment with the CRD3 rules on remuneration principles which apply to; banks, building societies and investment firms. The AIFM must also comply with the proportionality principle and hold that at least 50% of variable remuneration awarded to relevant staff must consist of shares of the AIF.
The right of passporting
The Directive provides that ESMA may approve the introduction of a passport regime for non-EU AIFM as from 2015. Once this is in place, a non-EU AIFM may market EU and non-EU AIFs on a passport basis to professional investors across the EU. Once ESMA approves the introduction of a passport regime for non-EU AIFMs from 2015, the Directive appears to suggest that non-EU AIFMs which manage an EU AIF will have to comply with substantially all of the Directive.
The right to passport under the Directive revolves around the principle that an EU AIFM is able to manage an EU AIF throughout the European Union, either on a cross-border basis or through the establishment of a branch. The EU AIFM will also be entitled to market the AIF to professional investors in other Member States.
Marketing to retail investors
The Directive does not provide for the managing and marketing of the AIF to retail customers, however, the directive allows for the Member States to provide that AIFMs may market to retail investors in their territory any such units or shares of the AIF. In such cases, Member States may impose stricter requirements on the AIFM or the AIF than those requirements which are applicable to the AIFs marketed to professional investors.
What is meant by ‘marketing’?
The definition of marketing captures both public offerings and private placements but does not encompass ‘reverse solicitations’, which relates to an investment of the AIF being unsolicited and which is at the initiative of the investor.
An EU AIFM which does not market the EU or non-EU AIF within the EU, will nevertheless be required to be authorized under the Directive as from 2013. This will entail full compliance with the Directive, excluding provisions relating to the depositary and annual report provisions of the Directive; these will not apply in respect of non-EU AIFs.
National private placement regimes
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 up until 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 passport or private placement basis, the EU AIFM will still have to comply in full with the provisions of the Directive, although more limited depositary requirements will apply if the non-EU AIF are being marketed by way of private placement. As from 2018, ESMA may approve the termination of the national private placement regimes.
The Directive explicitly states that Member States are free to impose stricter requirements under their own national private placement regimes.
Following the compromise reached on the Directive in November 2010 and the commencement of work on the Level 2 rules and EMSA technical advice in November 2011, managers and service providers to alternative investment funds, both EU and non-EU domiciled are faced with a number of challenges and should conduct an immediate assessment on the potential impact which the Directive shall have on their business structures. The Level 2 measures will give a further insight on the content of the implementing measures to be adopted for the AIFMD.
The AIFMD aims to regulate AIFMs in a manner which has never been done before, shaping investor protection and behavior and placing greater demands on fund operation.
Journals and articles
- ‘AIFM Directive – A new beginning’ RegZone Article by CMS Cameron McKenna.
- ‘Update on Alternative Investment Fund Managers Directive’ by Arthur Cox, February 2011.
- Directive 2011/61/EU on Alternative Investment Fund Managers