AIFMD: final measures give managers clearer direction

The European Commission is now considering a final report governing the operation of the Alternative Investment Fund Managers Directive (AIFMD). The European Securities and Markets Authority (ESMA) published advice last month as the last step in the consultation process.

The proposed rules are based upon and follow two previous consultation papers issued in July and August 2011. Now as a next step and albeit not binding on the Commission, the ESMA advice will more than likely constitute the backbone of the future  implementing measures, which are due to be issued in June 2012.

The AIFMD will fundamentally change the alternatives fund space when it comes into force in 2013. Our White Paper published in June 2011 analysed the possible impact of the AIFMD on managers and the real estate and private equity sectors. We also published a survey in conjunction with KPMG, which found that managers may decide to co-domicile their funds as a result of the directive.

ESMA’s 500-page document covers four broad areas:

1. General provisions for managers, authorisation and operating conditions
The first part of the advice clarifies the asset thresholds that determine whether or not the manager of an alternative investment fund (AIF) is subject to the AIFMD. It also details how managers should cover risks arising from professional negligence through the holding of additional own funds and/or professional indemnity insurance.

ESMA notes that many of the rules in this section, such as on conflicts of interest, record-keeping and organisational requirements, are based on the equivalent provisions of the Mifid and UCITS frameworks.

2. Governance of AIF depositaries
The key issues include the criteria for assessing whether the prudential regulation and supervision applicable to a depositary established in a third country has the same effect as the provisions of the AIFMD.

ESMA has identified a number of criteria, such as the independence of the relevant authority, the requirements on eligibility of entities wishing to act as depositary and the existence of sanctions in the case of violations.

Another crucial point is the liability of depositaries, the first element of which relates to when a financial instrument held in custody should be considered as ‘lost’. This assessment is crucial in determining whether a depositary must subsequently return an asset. ESMA’s advice proposes conditions to be fulfilled in order for an asset to be considered “lost”.  

It is interesting to note that under this regulation the default of a sub-custodian does not automatically trigger a loss event and a restitution liability, as this will now rightly happen at the end of the administration process and after a due assessment on what caused the eventual losses.

Another important concept that ESMA’s advice aims to clarify relates to which events would constitute external events beyond the reasonable control of the depositary. Finally, the advice clarifies the objective reasons that would allow a depositary to contractually discharge its liability.

3. Transparency requirements and leverage
One of the key objectives of the AIFMD is to help prevent the build-up of systemic risk. To help achieve this aim, ESMA’s advice clarifies the definition of leverage, how it should be calculated and in what circumstances a competent authority should be able to impose limits on the leverage a particular AIFM may employ.

ESMA considers it appropriate to prescribe two different calculation methodologies for the leverage (commitment and gross methods) as well as a further option (the advanced method) that can be used by managers on request and subject to certain criteria. The AIFMD also aims to increase transparency of AIFs and their managers.

In this context, ESMA’s advice specifies the form and content of information to be reported to competent authorities and investors, as well as of the information to be included in the annual report.

4. Third countries
With a view to ensuring the smooth functioning of the new requirements with respect to third countries, the AIFMD puts in place an extensive framework regarding supervisory co-operation and exchange of information.

ESMA’s advice envisages that the arrangements between EU and non-EU authorities should take the form of written agreements allowing for exchange of information for both supervisory and enforcement purposes.

The huge amount of work input on both sides during the extensive consultation period raised high expectations among the industry in the hope that the more factual and technical debate organised by ESMA would lead to recommendations that take into account the business realities of this important and complex activity, in line with their claim of striving to strike the right balance between ensuring high level of investor protection on the one side without putting the whole burden of responsibility on industry players on the other hand.

Impact on depositaries
While good progress could be achieved on a number of operational measures, expectations have not been met on some core concerns where the proposal still goes beyond what can reasonably be accepted and might result in being counterproductive for the end investors. 

For example, despite all the factual arguments brought forward over the last months and more importantly, having diligently fulfilled all their duties under the proposed regulations, depositaries may end up being liable for errors and fraud by staff of third-party sub-custodian banks, as well as for losses that result if a fund manager does not diligently act on the depository’s duly communicated risk warnings.

We remain very concerned there is no realistic prospect of utilising the “transfer of liability” provision in practice because of possible legal confusion. For example, there is the question of how an AIF might assert rights directly against the third party under all legal regimes. As a result, it does not seem possible to implement a “one-size-fits-all” theory of liability on legal systems throughout the world, which may not recognise such a new concept with little or isolated legal precedent.

Furthermore, a proposal providing for potential “transfer” of liability to sub-custodians would detract from the depositary’s fundamental role. This is to select a sub-custodian which is the best provider in the interest of the AIF and its investors, and not to focus on whether the depositary can find a sub-custodian which will accept the “transfer” of liability.

Sub-custodians should be selected on the basis of reputation, financial strength, commitment, technical capacity, responsiveness and other factors bearing on quality and safety. It would be highly counterproductive to incorporate criteria that force the depositary to focus on prospects for liability transfer. 

Jean-Michel Loehr
Chief Industry & Government Relations

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