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Alternative Investments Update: ESMA Consultation on AIFMD and New Prime Brokers’ Guidance Note
The month of July saw a number of significant developments for the alternative investment funds industry, starting on 1 July 2011 with the publication of the Alternative Investment Fund Managers Directive (“AIFMD”) in the Official Journal of the European Union. The AIFMD enters into force on 21 July 2011, and is due to be transposed into domestic law by all member states by 22 July 2013. In the intervening two years, a number of implementing measures are required and on 13 July 2011, the European Securities and Markets Authority (“ESMA”) published a consultation paper setting out its proposals for detailed rules underlying the AIFMD. In a separate development, the Central Bank has continued to ensure that Ireland is in the best position to secure the smooth transposition of the AIFMD into Irish law by issuing a finalised guidance note on the appointment of prime brokers, which replaces prior draft guidance.
ESMA’S CONSULTATION ON AIFMD IMPLEMENTING MEASURES
ESMA’s consultation is in response to a request for assistance which the European Commission sent to ESMA’s predecessor, CESR, in December 2010. ESMA must deliver its final advice to the Commission by 16 November 2011.
On 27 May 2011, the Council of the European Union formally adopted the text of the AIFMD. The AIFMD seeks to regulate the activities of alternative investment fund managers (“AIFM”) at European level. To date, such activities have been regulated by a combination of national laws operating individually within European countries and the general provisions of EU law, supplemented in some areas by industry standards. The AIFMD imposes harmonised conditions and requirements on the structure and operation of AIFM, in return for which authorised AIFM will, for the first time, be permitted to avail of a passport to market alternative investment funds (“AIF”) to professional investors across the EU and to manage AIF domiciled in member states other than the AIFM’s home member state. The basic regulatory quid pro quo is that, unless authorised under the new regime, an AIFM qualifying under the parameters set out in the AIFMD will not be permitted to manage or market relevant AIF.
A number of difficult issues arose in the course of the debates over the draft AIFMD, particularly in relation to how these provisions might apply to non-EU AIFM or non-EU AIF, and how the provisions on delegation, valuation, remuneration, leverage rules and requirements around the depositary function would operate. Whilst compromise was achieved in relation to each of these matters at framework directive level, the legacy of the difficulties involved in reaching agreement is reflected by the fact that the primary legislative act makes provision for a very extensive set of implementing measures which must now be devised and enacted.
Implementation of the AIFMD
The publication by ESMA of its consultation paper on 13 July 2011 represents a significant development in the implementation process. The Commission’s mandate to ESMA for technical advice is broken into four sections:
- Part 1 covers general provisions, authorisations and operation conditions.
- Part 2 relates to implementing measures regarding the depositary.
- Part 3 covers transparency requirements and leverage.
- Part 4 concerns implementing measures on supervision of AIFM, including non-EU AIFM.
The consultation paper sets out ESMA’s draft advice on most of the elements covered under the first three parts of the Commission’s request. It does not address the issues surrounding non-EU AIFM and non-EU AIF, which have proved to be the most controversial. ESMA explains the reason Part 4 was not addressed in full in this consultation paper is that certain of the implementing measures foreseen under Part 4 of the request are less urgent as they relate to the passport for third country entities, which would not be operational until at least two years following the transposition deadline for the AIFMD. However, the cooperation arrangements between the competent authorities of member states and third countries referred to in a number of the articles of the directive have to be in place as from the first day the national laws transposing the AIFMD take effect in 2013. ESMA has been working on developing draft proposals for these implementing measures, which will be contained in a separate consultation to be published later this summer.
Overview of Proposals
Part 1 General Provisions, Authorisations and Operating Conditions
The advice in this section incorporates the feedback received in relation to the discussion paper on the scope of the AIFMD published by ESMA on 15 April 2011.
A partial exemption from the requirements of the AIFMD applies for AIFM managing AIFs with assets under management which in total do not exceed €100 million (including assets acquired through leverage), or €500 million where the AIFs are not leveraged and investors have no redemption rights for the first five years. The draft advice seeks to clarify certain issues regarding the thresholds and methods of calculation that determine whether a manager is subject to the AIFMD. The draft advice provides that the total value of the assets under management should be calculated at least annually using the latest available net asset value calculation, which must be produced within 12 months of the threshold calculation date. The AIFM should assess situations where the value of total assets exceeds the threshold, and if it considers that the situation is not likely to be of a temporary nature (ie it is likely to continue for a period in excess of three months), seek authorisation under the AIFMD. The AIFM should notify the competent authority without delay where the total value of assets under management exceeds the threshold.
In relation to valuation, ESMA sets out draft advice on criteria for the proper valuation of assets by identifying general principles that should guide managers in developing and implementing policies and procedures for a proper and independent valuation of assets of the AIF. The intention is that these general principles can be adapted to the types of assets in which an AIF can invest. There was some uncertainty and ambiguity surrounding the use of the term “valuation function” in Article 19 of the directive, but the draft advice seems to make a distinction between the valuation of assets and the calculation of net asset value, which has been welcomed by industry.
In relation to delegation, ESMA had been requested to provide advice on the criteria for objective reasons justifying a delegation. The consultation paper puts forward two alternative proposals in this regard: the first takes a flexible approach according to which a delegation can be justified where the manager can demonstrate that the delegation is done for the purposes of the more efficient conduct of the management of the fund; the second option sets out an indicative, non-exhaustive list of criteria to be used when making the assessment.
General Operating Conditions
The overall approach taken to the draft advice on general operating conditions 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.
Part 2 Governance of AIF’s Depositaries
This section addresses the appointment of depositaries, the depositary’s duties, and the depositary liability regime. ESMA sets out its proposals on the content of the contract evidencing the appointment of the depositary, taking the UCITS Directive as a starting point. There has been a considerable amount of debate on the issue of depositary liability, as the original proposal for the directive imposed strict liability on the depositary. This was modified in later drafts to provide that the depositary is liable for the loss of financial instruments in its custody unless it can prove that the loss was due to an external event beyond the reasonable control of the depositary. The draft advice seeks to clarify the circumstances in which a financial instrument held in custody should be considered to be “lost”. The proposals identify three conditions, at least one of which would have be to fulfilled in order for an asset to be considered lost:
(a) a stated right of ownership is uncovered to be unfounded because it either ceases to exist or never existed;
(b) the AIF has been permanently deprived of its right of ownership over the financial instruments; or
(c) the AIF is permanently unable to directly or indirectly dispose of the financial instruments.
ESMA also seeks to clarify which events would constitute external events beyond the reasonable control of the depositary, and considers the options for the objective reasons that would allow a depositary to contractually discharge its liability, such as legal constraints that give the depositary no choice but to delegate its custody duties to a third party.
Part 3 Transparency Requirements and Leverage
One of the key objectives of the AIFMD is to increase transparency of alternative investment funds and managers. In this context, ESMA’s advice specifies the form and content of information to be reported to competent authorities and to investors. The advice also addresses the content and format of the annual report to be prepared for each fund. In this regard, ESMA’s approach has been to recognise the existence of national and international accounting standards already in place and to develop a compatible framework.
The AIFMD also aims to help prevent the build-up of systemic risk. With this aim in mind, ESMA’s proposals cover several issues related to leverage such as, 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 manager may employ. Taking into account the wide range of funds covered by the AIFMD and the diverse nature of the assets in which such funds invest, the ESMA proposals prescribe two different calculation methodologies for the leverage (commitment and gross methods) as well as a further option that can be used by managers on request and subject to certain criteria.
ESMA has given market participants and other interested parties until 13 September 2011 to feedback on the detailed material within its draft proposals. As mentioned above, ESMA’s deadline for delivery of its advice and recommendations to the Commission is 16 November 2011.
The consultation offers industry an important channel for contribution and engagement. Practical and meaningful contributions will be critical as a means of influencing the detail and workability of the extensive secondary measures required under the AIFMD.
The partners in the Asset Management and Investment Funds Group will be making a submission in response to ESMA’s consultation, as will the Irish Funds Industry Association. We would welcome input from our clients in this regard.
NEW GUIDANCE NOTE ON PRIME BROKERS
Ireland is well placed in the lead up to the implementation of the AIFMD. The Irish regulatory regime already incorporates many of the provisions set out in the legislation, such as the depositary requirement and that funds are administered and valued by entities already authorised and supervised by the Central Bank of Ireland. The Central Bank has continued to improve and enhance existing procedures to ensure that Ireland is AIFMD-ready by finalising a new guidance note entitled Professional collective investment schemes: Appointment of prime brokers and related issues” (“GN 2/11”) which applies to professional investor funds (“PIF”) and qualifying investor funds (“QIF”) and replaces prior draft guidance.
The finalised guidance note follows extensive engagement with industry in which the Central Bank has been responsive to industry submissions relating to the demands of the alternative investments sector. Despite the fact that the guidance was in draft form until 1 July 2011, the Central Bank was prepared to approve prime brokerage arrangements and financing arrangements with other counterparties on the basis of the proposed rules.
GN 2/11 contains some amendments to the draft guidance which, although minor in nature, represent welcome developments for the industry. The guidance note clarifies that, in the case of a PIF, cash delivered by the PIF to the prime broker, which is not protected by client money rules or other similar arrangements to protect the fund against the insolvency of the prime broker, is to be taken into account in calculating the 140 per cent limit of indebtedness of the PIF to the prime broker (the 140 per cent limit applies only to PIFs; there is no limit in the case of a QIF). GN 2/11 also extends the circumstances in which the prime broker may return cash in lieu of the same or equivalent assets to the fund to include a circumstance in which the prime broker has an “inability to return assets”. The prime broker’s obligation to indemnify the fund in respect of any costs and losses incurred as a result of such an election is expressed to be subject to the prime broker’s right of set-off upon the default of the fund. Finally, the minimum credit rating requirement of a prime broker, or its parent company, has been amended from A1/P1 to A-1 or equivalent.
The Central Bank has indicated that it does not intend to consider any substantial amendments to the guidance note while the appointment of prime brokers remains under consideration in the context of the AIFMD. The Central Bank’s willingness to take account of the demands of the alternative investments industry, and the continued productive engagement between industry and the Central Bank, indicate a commitment to build on Ireland’s reputation as a centre for prudently regulated alternative investments, and to ensure a smooth transposition of the AIFMD into Irish law.