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2 news & views european fiduciary services first edition 2012 AIFMD special Inside this issue: Overview of AIFMD Level 1 text Prime brokers and related issues Third country regulation of custodians Key impacts for asset managers Depositaries duties on safekeeping and oversight Custodians: due diligence, segregation obligations and liability Article 19: Independent valuation of AIF assets Calculation of leverage; transparency requirements; and co-operation agreements for supervision Impact of the AIFMD on Sweden

3 Contributors Ireland Robert Hennessy Head of Fiduciary Services, Ireland Citibank International plc E: T: Jersey Alastair Drummond Counsel, Corporate and Commercial Appleby, Jersey E: alastair.drummond@applebyglobal.com T: +44(0) Luxembourg Hermann Beythan Partner Linklaters LLP, Luxembourg E: hermann.beythan@linklaters.com T: Sweden Dan Hanqvist Specialist Counsel Vinge, Stockholm E: dan.hanqvist@vinge.se T: United Kingdom Amanda J. Hale Head of UK Fiduciary Technical Citibank International plc E: amanda.jayne.hale@citi.com T: +44 (0) Selina Staines Fiduciary Technical Analyst, UK Citibank International plc E: selina.ann.staines@citi.com T: +44(0) Ronald Paterson Partner Eversheds LLP E: ronaldpaterson@eversheds.com T: +44 (0) Alwine Jones EU and International Regulation Investment Management Association E: ajones@investmentuk.org T: +44 (0) Peter McGowan Partner, Private Investment Funds, Hedge Funds and Financial Services Group Proskauer Rose LLP E: pmcgowan@proskauer.com T: +44 (0) Kimberly Everitt Associate, Private Investment Funds Group Proskauer Rose LLP E: keveritt@proskauer.com T: +44 (0) James Greig Partner PwC Financial Services Regulatory Practice E: james.greig@uk.pwc.com T: +44 (0) Peter Wilson Senior Associate PwC Financial Services Regulatory Practice E: peter.wilson@uk.pwc.com T: +44 (0) European Fiduciary Services News and Views First Edition 2012 AIFMD Special

4 Contents Introduction By David Morrison 2 Overview of AIFMD Level 1 text The consolidated AIFMD text after ECOFIN 4 Prime brokers and related issues Financial Instruments to be held in custody, reporting obligations of prime brokers and the Central Bank of Ireland Guidance Note 2/11 14 Third country regulation of custodians ESMA s final advice to the Commission on implementing the AIFMD third country regulation of custodians and cash-flow monitoring 18 Key impacts for asset managers The impact on asset managers of the AIFMD 21 Depositaries duties on safekeeping and oversight ESMA Technical Advice on the AIFMD implementing measures with respect to depositary safekeeping and oversight duties 25 Custodians: due diligence, segregation obligations and liability Advantage affiliated networks? 29 Article 19: Independent valuation of AIF assets The issues and impacts of Article 19 of the AIFM Directive: External Valuers and Valuation Requirements 34 Leverage, transparency requirements and co-operation agreements Leverage, transparency and supervision under ESMA s technical advice to the EC on AIFMD implementing measures 38 Impact of the AIFMD on Sweden Implementing the AIFMD in Sweden 42 Glossary 46 European Fiduciary Services News and Views First Edition 2012 AIFMD Special 1

5 Introduction David Morrison Director and Head of Fiduciary Services, EMEA Welcome to the first 2012 edition of European Fiduciary Services News and Views, a special edition dedicated to the Alternative Investment Fund Managers Directive (AIFMD). The European Commission s proposal for a Directive on Alternative Investment Fund Managers was published in April 2009 (referred to as Level 1). The draft Directive caused much concern within the industry and, after a period of intensive negotiations, a political compromise was reached on the draft in October In December 2010, a request was sent to CESR (now ESMA) for technical advice on the detailed implementing measures that should form part of the AIFMD framework. Upon receipt of the request, CESR published a call for evidence. As a result of the feedback received and additional discussions with external stakeholders ESMA developed two consultation papers, which were issued in July 2011 and August Open-hearings were held on the two consultations by ESMA in Paris in September 2011 and the final text of the AIFMD, which will take effect in July 2013, was published in the Official Journal on 1 July On 16 November 2011, ESMA published technical advice to the Commission on possible implementing measures of the AIFMD (Level 2). The first article in this special edition provides an overview of some of the very detailed provisions of the Level 1 text, which sets the scene for the remaining articles which focus on the most recent final advice from ESMA provided to the European Commission in November The next article focuses on three areas of particular relevance to depositaries: the definition of instruments to be held in custody; reporting obligations for prime brokers; and the Central Bank of Ireland Guidance Note 2/11, which deals with the appointment of prime brokers and related issues. Alastair Drummond, Appleby, then provides an overview of the third country regulation of custodians under the Directive and their duty to monitor fund cash flows. Alastair highlights a number of issues with the advice as drafted which need further clarification. Next, Alwine Jones, IMA, discusses the scope of the Directive and details the key impacts on asset managers according to their fund types and existing management status. Key areas include leverage, transparency and depositaries. Hermann Beythan, Linklaters, then outlines depositaries duties on safekeeping, explaining the distinction between Custody Assets and Other Assets and ESMA s proposals on oversight duties. A joint piece written by Peter McGowan and Kimberley Everitt, Proskauer Rose, discusses the custodians due diligence and segregation obligations in relation to sub-custodians as set out in ESMA s final advice and the liability regime for custodians, exploring in particular what constitutes loss when referring to instruments held in custody. James Greig and Peter Wilson, PWC, then focus on Article 19 of the AIFMD, which imposes obligations on AIFMs to introduce procedures for the independent valuation of AIF assets. The article sets out the core legal requirements and discusses the 2 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

6 industry response to the Level 1 text and comments on ESMA s final advice. The calculation of leverage using the gross, commitment or advanced approach is covered in the next article, written by Ronald Paterson, Eversheds. Transparency requirements and cooperation agreements for supervision are also detailed. And, finally, Dan Hanqvist, Vinge, examines the impact of the Directive on Sweden s approach to financial regulation, which has, until now, been viewed as more liberal than some of its EU counterparts. Dan explains the action the Swedish government has taken to ensure the timely implementation of the Directive. ESMA s final advice remains nonbinding at this stage. The next step is for the European Commission to digest the advice and to use it as a basis to introduce Level 2 measures, which are expected to be published in their final form in June In the UK, the FSA recently published Discussion Paper 12/1, which sets out their provisional thinking on their approach to implementing the Directive. The closing date for responses is 23 March We will provide further information in our monthly Bitesized publication once we have had the opportunity to digest the FSA s proposals. Interestingly, on 26 October 2011, the US SEC adopted Form PF for use by SEC-registered investment advisers when providing the new Financial Stability Oversight Council, created under the much talked about Dodd- Frank Act. This contains information required to help the US regulator monitor systemic risk. ESMA s technical advice also contains a pro-forma template for AIFMs to use when reporting to competent authorities in complying with Article 24 of the Directive. It appears that both the SEC and ESMA have taken into account not just each other s systemic risk reporting initiatives but those of the various regulators around the world. Both institutions have mentioned the desirability of globally harmonised reporting requirements. From what we have seen over the past twelve months, it is clear that future regulation will not only be driven purely by European bodies, we will also see a greater degree of international influence. We hope you enjoy this special edition of European Fiduciary Services News and Views and we very much welcome your comments and suggestions on anything of interest to you in these engaging articles. The AIFMD is particularly important as it has been heralded as the standard for European regulation. Therefore, we may well find many of the policies adopted under the Directive creeping in to other directives currently under review, such as the review of MiFID known as MiFID II and UCITS V. European Fiduciary Services News and Views First Edition 2012 AIFMD Special 3

7 United Kingdom The consolidated AIFMD text after ECOFIN After many draft proposals and much industry consternation over a period of nearly 19 months, the final text of the Alternative Investment Fund Managers Directive (the AIFMD or the Directive) 1 was adopted on its first reading in the European Parliament plenary session on 11 November It was expected to have a huge impact on nearly all participants in the investment management industry, whether regulated or not, and on their existing business models. Much debate has surrounded the scope of the Directive, and more questions have been raised than answered since its adoption. The Directive is long, complex and onerous, and a number of questions still remain over its workability. Here we provide an overview of some of the very detailed provisions in the Level 1 text and highlight key aspects of each Article. This sets the scene for the remaining articles in this special edition of European Fiduciary Services News and Views, which will focus on the more recent European Securities and Markets Authority (ESMA) Level 2 consultation (July 2011) 2 and ESMA s Final Advice to the European Commission (November 2011). 3 General provisions scope (Articles 2 5) The Directive explains that the requirements will apply to: EU Alternative Investment Fund Managers (AIFMs); Non-EU AIFMs who manage an EU AIF, where the AIF is authorised or has its registered office/head office in the EU; and Non-EU AIFMs, which market AIFs in the EU. It also explains that an AIF is any collective investment undertaking, which: 1) raises capital from a number of investors and invests it in accordance with a defined investment policy for the benefit of those investors; and 2) is not a UCITS. It can be open-ended or closed-ended, constituted under contract, trust or statute. It is also irrelevant whether the fund is listed. Each AIF must have a single AIFM that can be external (e.g. private equity fund, hedge fund, real-estate fund) or internal (e.g. possibly investment trust or other corporate entity). If the AIFM is internal, then the AIF itself will be treated as the AIFM. The Directive also explains that an AIFM is any legal person whose regular business is managing one or more AIF; it covers portfolio management and risk management. AIFMs can also undertake administration, marketing and other activities related to the assets of an AIF. An EU AIFM is an AIFM with its registered office in a Member State. Parts of Articles 2 and 3 of the Directive also provide a list of entities to which the requirements do not apply. Authorisation of AIFMs (Articles 6-11) Article 6 covers the conditions for taking up activities as an AIFM. No AIFM can manage an AIF unless authorised under the Directive. AIFMs must comply with the conditions for authorisation and provide the information required under the Directive at all times. Article 7 provides details on the requirements for application for authorisation. An AIFM must apply to the competent authority of its home Member State and supply information on: 1) persons effectively conducting the business; 2) identities of qualifying shareholders or members; 3) the organisational structure of the AIFM and how it intends to comply with its obligations under the Directive; 4) its remuneration policy; and 5) information on arrangements made for the delegation and sub-delegation of functions to third parties. Article 8 covers conditions for granting authorisation under the Directive. An AIFM must comply with the Directive and have sufficient initial capital and own funds (AIFMs that are internally managed shall have initial capital of at least EUR300,000; and where an AIFM is appointed as an external manager of one or more AIF, the AIFM shall have initial capital of at least EUR125,000). Further details are contained within Article 9. The AIFM must also be able to demonstrate that persons who conduct the business: are of sufficient good repute and sufficiently experienced in relevant investment strategies and can demonstrate that shareholders or members with qualifying holdings are suitable. Its head office and registered office must be in the same Member State. Operating conditions for the AIFM General principles (Article 12) An AIFM must: 1. Act honestly, with due care and diligence and fairly in conducting its activities. 2. Act in the best interests of the AIF or its investors and the integrity of the market. 3. Have and employ effectively the resources and procedures that are necessary for the proper performance of its business activities. 4. Take all reasonable steps to avoid conflicts of interest. Where it cannot 4 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

8 United Kingdom be avoided, the AIFM must identify, prevent, manage and monitor and, where applicable, disclose any such conflicts. 5. Comply with all regulatory requirements applicable to the conduct of its business to promote the best interests of the AIF or the investors in it and the integrity of the market. 6. And treat all AIF investors fairly. In addition to the above list, no investor may obtain preferential treatment unless disclosed in the AIF s constitutional documents. Remuneration (Article 13) The AIFM is required to have a remuneration policy and practice applicable to categories of staff. This should include senior management, risk takers, control functions and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers whose professional activities have a material impact on the risk profiles of the AIF they manage. Full details on the remuneration policies are set out in Annex II of the Directive. investors before undertaking business on their behalf and develop appropriate policies and procedures. Conflicts of interest (Article 14) AIFMs must take all reasonable steps to identify conflicts of interest that might arise between the AIFM and other funds that it manages or its (the AIFM s) clients. To achieve this, the Directive says: The AIFM should separate within its own operating environment tasks and responsibilities that might be regarded as incompatible with each other or might potentially generate systemic conflicts of interest. Any other material conflicts of interest should be disclosed to AIF investors. Where organisational arrangements made by the AIFM are not sufficient to ensure with reasonable confidence that risks of damage to investors interests will be prevented, the AIFM must clearly disclose the general nature or sources of conflicts of interest to European Fiduciary Services News and Views The AIFM should separate within its own operating environment tasks and responsibilities that might be regarded as incompatible with each other or might potentially generate systemic conflicts of interest. Where an AIFM uses a prime broker, terms must be set out in a written contract. In particular, it should detail any possibility that the transfer and First Edition 2012 AIFMD Special 5

9 United Kingdom re-use of AIF assets will be provided for in that contract and comply with the AIFs rules. The contract will also provide that the depositary be informed of the contract. AIFMs must exercise due skill, care and diligence in the selection and appointment of prime brokers with whom a contract is to be concluded. Risk management (Article 15) The requirements under Articles 15 and 16 of the Directive largely follow existing requirements under the UCITS Directive. 4 AIFMs must functionally and hierarchically separate the risk management functions from the operating units (including portfolio management). AIFMs must implement a risk management system that looks at all risks which are relevant to each AIF s investment strategy and to which each AIF is or can be exposed. AIFMs are required to review their risk management systems with appropriate frequency (but no less than once per year) and these should be adapted whenever necessary. The AIFM must set a maximum level of leverage that the AIFM can employ on behalf of each AIF it manages and set the extent of the right of the re-use of collateral or guarantee that would be granted under the leveraging arrangement. In so doing, the AIFM should take account of: the type of AIF; its strategy; its sources of leverage; any other interlinkage or relevant relationships with other financial services institutions that could cause systemic risk; the need to limit exposure to any one counterparty; the extent to which leverage is collateralised; the assets liability ratio; and the scale, nature and extent of the AIFM s activity in the markets concerned. Liquidity management (Article 16) If an AIFM operates an AIF that is not un-leveraged (i.e. leveraged) and it is closed-ended, the AIF must employ an appropriate liquidity management system and monitor liquidity risk. The AIFM must conduct stress testing and ensure that the liquidity profile and redemption policy are consistent. General principles (Article 18) AIFMs are required to have the following in place: Sound administrative and accounting procedures. Control mechanisms (including rules for personal transactions by its employees or for the holding or management of investments in order to invest on its own account). At the very least, it should be possible to reconstruct each transaction involving the AIF to its origin, including the parties to it, its nature, the time and place at which it was effected, and the assets of the AIF managed by the AIFM. Valuation (Article 19) AIFMs should ensure: The proper and independent valuation of the AIF s assets at least once a year. That, if the AIF is closed-ended, such valuations and calculations are carried out in the case of an increase or decrease of the capital by the relevant AIF. An AIFM can undertake the valuation itself, but only if the valuation function is functionally independent from portfolio management and conflicts of interest are mitigated. If an external valuer is appointed, it must have mandatory professional registration or provide sufficient professional guarantees of performance. It must also apply due skill, care and diligence. In addition, the AIFM remains liable to the AIF and its investors, but the Directive says that the external valuer will be liable to the AIFM for negligence/intentional failures. The appointment of an external valuer must be notified to the AIFM s home state regulator and comply with general rules on delegation. The valuation rules must be set out in the laws of the AIF s home state. Delegation of AIFM functions (Article 20) If an AIFM wants to delegate its functions, it must tell its regulator. There must be an objective reason for delegating. The delegate must be 6 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

10 United Kingdom selected with due care and be of good repute and sufficiently experienced and resourced so due diligence is required. Portfolio management and risk management can only be delegated to a firm authorised to undertake asset management. The AIFM may not delegate so many functions so as to become a mere letter-box entity. Sub-delegation is permissible, but Directive requirements apply at that level too. The AIFM remains liable to the AIF and investors. Portfolio management and risk management can only be delegated to a firm authorised to undertake asset management. The AIFM may not delegate so many functions so as to become a mere letter-box entity. Sub-delegation is permissible, but Directive requirements apply at that level too. The AIFM remains liable to the AIF and investors. Depositary (Article 21) For each AIF it manages, the AIFM must ensure that a single depositary is appointed in accordance with specified provisions contained within the Level 1 text of the Directive. The appointment of the depositary must be evidenced by a contract in writing and shall, among other things, detail regulation of the flow of information deemed necessary to allow the depositary to perform its functions for the AIF. A depositary can be any of the following: an EU credit institution; EU investment firm or firm that meets the requirements to be a depositary of a UCITS under Directive 2009/65/EC (the UCITS Directive). The depositary may be an entity that carries out depositary functions as part of its professional or business activities and is subject to mandatory professional registration. For an EU AIF, the depositary must be established in the home state of the AIF; for a non-eu AIF, the depositary can be a non-eu entity, provided it is similar to an EU credit institution and is subject to EU equivalent prudential regulation and supervision. An AIFM is not allowed to act as a depositary. A prime broker acting as counterparty to an AIF is not allowed to act as depositary for that same AIF unless it has functionally and hierarchically separated the performance of its depositary functions from its tasks as prime broker. Also, potential conflicts of interest must be properly identified, managed, monitored and disclosed to the investors of the AIF. Depositary responsiblities Proper monitoring of the AIF s cash flows: particularly to ensure that investors money and cash belonging to the AIF or, as the case may be, to the AIFM acting on behalf of the AIF are booked correctly on accounts 5 opened in the name of: 1) the AIF; 2) the AIFM acting on behalf of the AIF; or 3) the depositary acting on behalf of the AIF. In cases where the cash accounts are opened in the name of the depositary acting on behalf of the AIF, no cash of the credit institution or the depositary should be included in the same account. The safe-keeping of the assets of the AIF, which should include: the holding in custody of financial instruments that can be registered in a financial instruments account opened in the depositary s books and all financial instruments that can be physically delivered by the depositary; and verification of ownership of all other assets by the AIF or the AIFM on behalf of the AIF. In addition to the above, the depositary shall also ensure: that the sale, issue, re-purchase, redemption and cancellation of shares are carried out in accordance with applicable national law; that the value of shares or units is calculated in accordance with European Fiduciary Services News and Views First Edition 2012 AIFMD Special 7

11 United Kingdom applicable national law and the AIF rules or instrument of incorporation and procedures laid down in Article 19; that the instructions of the AIFM are carried out (unless they conflict with applicable national law, AIF rules of instrument of incorporation); and that, in transactions involving the AIF s assets, any consideration is remitted to the AIF within usual timeframes. The delegation of safe-keeping of assets: the safe-keeping of assets could be delegated to a third party (which itself, in turn, could delegate this function) as is currently the case in terms of both global and sub-custodian networks. However, both delegation and sub-delegation should be objectively justified and subject to strict requirements in relation to the suitability of the third-party entrusted with this function. It should also not conflict with the depositary s responsibility to act honestly, fairly, professionally, independently and in the interest of the AIF or, as the case may be, the investors of the AIF. The strict limitations and requirements contained within the Directive s consolidated text as they relate to the delegation of tasks by the depositary only apply to the monitoring of cash flows, the safe-keeping of assets and oversight functions. They do not cover such administrative or technical functions performed by the depositary. Also, delegation does not cover entrusting assets to the operator of securities settlement systems, such as CREST, for example. The use of prime brokers (PBs): the Directive takes into account the fact that many AIFs, in particular hedge funds, currently use PBs. The Directive ensures that AIFs can continue to use the function of one or more PBs, but this is only if certain criteria are met: The PB has functionally and hierarchically separated the performance of its depositary functions from its tasks as prime broker. Potential conflicts of interest must also be properly identified, managed and disclosed to the investors of the AIF. In addition, no PB should be appointed as a depositary, because in the EU Commission s view, as PBs act as counterparties to AIFs, they cannot act in the best interest of an AIF at the same time, as is required by a depositary. Depositary liability The Directive states that a depositary should be liable for the losses suffered by the AIFM, the AIF and the investors, but there is a distinction between the loss of financial instruments held in custody and any other losses. Other losses: the depositary should be liable in cases of intent or negligence. Assets held in custody are lost: the depositary should be liable, unless it can prove that the loss is the result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary. As an example, a depositary could not invoke certain internal situations such as a fraudulent act by an employee to discharge itself from its liability. The depositary has delegated custody tasks and financial instruments held in custody by a third party are lost: the depositary should be liable. However, there are circumstances in which this liability can be discharged or transferred to the third party. These are as follows: There is a written contract between the depositary and the AIF or, as the case may be, the AIFM acting on behalf of the AIF, where such a discharge is objectively justified. And based on a contract between the depositary and the third party, if the depositary can prove that it has duly performed its due diligence duties and that the specific requirements relating to that delegation to the third party are met. In allowing for a contractual transfer of liability to the third party, the Directive intends to make the third party directly liable to the AIF or, as the case may be, the investors of the AIF for the loss of financial assets held in custody. The Directive states that a depositary should be liable for the losses suffered by the AIFM, the AIF and the investors, but there is a distinction between the loss of financial instruments held in custody and any other losses. Where the law of a third country requires that certain financial instruments are held in custody by a local entity (sub-custodian, agent, etc.) and there are no local entities that satisfy the depositary delegation requirements, the depositary can discharge itself of its liability providing that the following provisions are met: The fund rules or articles of association of the AIF concerned expressly allow for such a discharge of liability. The investors have been duly informed of the discharge and the circumstances justifying the discharge prior to their investment. 8 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

12 United Kingdom The AIF or the AIFM, on behalf of the AIF, instructed the depositary to delegate the custody of such financial instruments to a local entity. There is a written contract between the depositary and the AIF or, as the case may be, the AIFM acting on behalf of the AIF, which expressly allows such a discharge of liability. And there is a written contract between the depositary and the third party which explicitly transfers the liability of the depositary to that third party and makes it possible for the AIF or, as the case may be, the AIFM acting on behalf of the AIF to make a claim against the third party in respect of the loss of financial instruments or for the depositary to make such a claim on their behalf. Transparency requirements Annual report (Article 22) An AIFM must, for each EU AIF it manages, and for each AIF it markets in the EU, make available an annual report for each financial year no later than six months following the end of the financial year. 6 However, Member States do have the right to impose a shorter time period. The annual report must contain at least the following: a balance sheet or statement of assets and liabilities; an income and expenditure account for each financial year; a report on activities of the financial year; any material changes in the information listed in Article 23 (disclosure to investors) during the financial year covered by the report; total amount of remuneration for the financial year, split into fixed and variable remuneration paid by the AIFM to its staff members, numbers of beneficiaries and, where relevant, carried interest paid by the AIF; and an aggregate amount of remuneration, broken down by senior management and members of staff of the AIFM whose actions have a material impact on the risk profile of the AIF. Annual report accounting information must be prepared in accordance with the accounting standards of the home Member State of the AIF or, as the case may be, in accordance with the accounting standards of the third country where the AIF has its registered office. Accounting information provided in the annual report must be audited by one or more persons empowered by law to audit accounts. 7 The auditor s report (including any qualifications) must be reproduced in the full annual report. Disclosure to investors (Article 23) a) The AIFM must, for each of the EU AIFs it manages and for each of the AIFs it markets in the EU, make available to AIF investors (as set out in the AIF s fund rules or articles of association): a description of the investment strategy and objectives of the AIF; information on where any master AIF is established; where underlying funds are established, if the AIF is a fund of funds; the type of assets the AIF may invest in; the techniques the AIF may employ along with associated risks; applicable investment restrictions; the circumstances in which the AIF may use leverage (including the types and sources of that leverage with associated risks); restrictions to the use of leverage and of any collateral and asset re-use arrangements (re-hypothecation); and information on the maximum level of leverage that the AIFM may employ on behalf of the AIF. b) A description of procedures for the AIF to change its investment objectives or policy or both. c) A description of the main legal implications of the contractual relationship entered into for the purpose of investment (including information on jurisdiction, applicable law and on the existence, or not, of any legal instruments that provide for the recognition and enforcement of judgements on the territory where the AIF is established). d) The identity of the AIFM, AIF s depositary, auditor and any other service providers with a description of their duties and investor s rights. e) How the AIFM complies with requirements in Article 9 (7) potential professional liability risks and the requirement to have additional own funds to cover liability arising from professional negligence or holding a professional indemnity insurance against such. f) A description of any delegated management function, delegated depositary functions, identification of the delegate and any conflicts of interest that may arise. g) A description of the AIF s valuation procedure and of the pricing methodology for valuing assets, including methods used for hard to value assets as per Article 19 (valuation). h) A description of the AIF s liquidity risk management, including redemption rights (both in normal and exceptional circumstances), and existing redemption arrangements with investors. i) A description of all fees, charges and expenses, including maximum amounts that are directly or indirectly borne by investors. j) How the AIFM ensures fair treatment of investors where an investor obtains preferential treatment or the right to obtain preferential treatment, a description of that preferential treatment and, where relevant, their legal or economic links with the AIF or AIFM. k) The latest annual report. l) The procedure and conditions of issue and sale of units or shares. 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13 United Kingdom m) The latest net asset value of the AIF or the latest market price of the unit or share of the AIF as per Article 19 (valuation). n) Where available, the historical performance of the AIF. o) The identity of the prime broker and a description of any material arrangement of the AIF with its prime brokers and the way the conflicts of interests are managed; and, if applicable, the provision in the contract with the depositary on the possibility of transfer and the re-use of AIF assets and any transfer of liability to the prime broker that may exist. p) How and when the information required in Articles will be disclosed. Reporting obligations to competent authorities (Article 24) There are also extensive reporting requirements for the AIFM to competent authorities covering instruments traded and on which markets, exposures and concentrations of each AIF it manages, as well as other types of risks arising from illiquid assets, risk profiles and associated risk management processes/tools etc. AIFMs managing leveraged AIFs Use of information by competent authorities (Article 25) Member States must ensure that competent authorities of the home Member State of the AIFM use the information gathered under Article 24 (above) for the purpose of identifying the extent to which the use of leverage contributes to the build up of systemic risk. Obligations for AIFMs managing AIFs that acquire control of nonlisted companies and issuers Scope (Article 26) This article brings into scope an AIFM managing one or more AIF, which either individually or jointly (on the basis of an agreement aimed at acquiring control) acquires control of a non-listed company in accordance with paragraph 5 (that is more than 50% of the voting rights of the company). Also caught are AIFMs cooperating with one or more other AIFMs on the basis of an agreement, to which AIFs managed by these AIFMs jointly, acquire control of a non-listed company in accordance with paragraph 5. Outside of scope are small and medium enterprises 8 and special purpose vehicles with the purpose of purchasing, holding or administrating real estate. Notification of the acquisition of major holdings and control of non-listed companies (Article 27) Member States require that when an AIF acquires, disposes or holds shares of a non-listed company, the AIFM managing the AIF should notify its home Member State s competent authority of the proportion of voting rights of the non-listed company held by the AIF any time that the proportion of those voting rights reaches, exceeds or falls below the thresholds of 10%, 20%, 30%, 50% and 75%. Member States also require that when an AIF acquires, individually or jointly, control over a non-listed company, the AIFM managing such an AIF will notify: 1) the non-listed company; 2) shareholders of the company for which the identities and addresses are available to the AIFM or can be made available by the nonlisted company or through a register to which the AIFM has or can get access to; and 3) the competent authorities of the home Member State of the AIFM of the acquisition of control by the AIF. The notification required above must contain additional information, including: a) the resulting situation in terms of voting rights; b) the conditions under which control has been reached, including information about the identity of the different shareholders involved, any natural person or legal entity entitled to exercise voting rights on their behalf and, if applicable, the chain of undertakings through which voting rights are effectively held; and c) the date on which control was reached. In its notification to the non-listed company, the AIFM must request the board of directors of the company to inform the representatives of employees or, where there are no such representatives, the employees themselves, without undue delay of the acquisition of control by the AIF managed by the AIFM. 10 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

14 United Kingdom These notifications should be made as soon as possible, but no later than ten working days (the first of which being the day on which the AIF has reached, exceeded or fallen below the relevant threshold or, as the case may be, acquired control over the non-listed company). There are also extensive reporting requirements for the AIFM to competent authorities covering instruments traded and on which markets, exposures and concentrations of each AIF it manages, as well as other types of risks arising from illiquid assets, risk profiles and associated risk management processes/tools etc. Disclosure in case of acquisition of control (Article 28) Member States require that, when an AIF acquires (individually or jointly) control of a non-listed company or an issuer, the AIFM managing such an AIF will make information available on: The identity of the AIFM, which, either individually or in agreement with the other AIFM, manage(s) the AIF and has control of that AIF. The policy for preventing and managing conflicts of interest (in particular between the AIFM, the AIF and the company) including information about the specific safeguards established to ensure any agreement between the AIFM and/or the AIF and the company shall be at arm s length. The policy for external and internal communication relating to the company (in particular with regards to its employees). This information should be made available to the following: 1) the company concerned; 2) the shareholders of the company of which the identities and addresses are available to the AIFM or can be made available by the company or register to which the AIFM has or can get access to; and 3) the competent authorities of the home Member State of the AIFM. Member States also require that when an AIF acquires, individually or jointly, control of a non-listed company, the AIFM managing such an AIF shall ensure that the AIF, or the AIFM acting on behalf of the AIF, makes available its intentions about the future business of the non-listed company and the likely repercussions on employment, including any material change in the conditions of employment to 1) the non-listed company and 2) shareholders of the non-listed company. When an AIF reaches a position to exercise control of a non-listed company, the AIFM managing the AIF will provide the competent authorities of its home Member State and the investors of the AIF with information on the financing of the acquisition. Specific provisions regarding the annual report of AIF exercising control of non-listed companies (Article 29) When an AIF acquires individually or jointly control of the non-listed company the AIFM must: Either request and use its best efforts to make sure that the annual report of the non-listed company (as drawn up in accordance with paragraph two of Article 29) 9 is made available by the board of the company to all representatives of employees, or where there are no such representatives, to the employees themselves in accordance with the time period specified under the applicable national law. Or for each such AIF, include in the annual report (as required under Article 22) the information relating to the relevant non-listed company. Asset Stripping (Article 30) Member States require that when an AIF individually or jointly acquires European Fiduciary Services News and Views First Edition 2012 AIFMD Special 11

15 United Kingdom control of a non-listed company or an issuer, the AIFM managing such an AIF (before the end of a period expiring 24 months following the acquisition of control of the company by the AIF): Must not be allowed to facilitate, support or instruct any distribution, capital reduction, share redemption and/or acquisition of own shares by the company as described in paragraph 2 below. 10 Must, if the AIFM is able to vote on behalf of the AIF at the governing bodies of the company, not vote in favour of a distribution, capital reduction, share redemption and/ or acquisition of own shares by the company as described in paragraph 2 (footnote 9). And must use its best efforts to prevent distributions, capital reductions, share redemptions and/or the acquisition of own shares by the company as described in paragraph 2 (footnote 9). The rights of EU AIFMs to market and manage EU AIFs in the EU (Articles 31 33) Managing and marketing an EU AIF to professional investors is permitted if the AIFM is authorised under the AIFMD and the relevant competent authority has given its permission. An EU AIFM will benefit from an EU marketing passport for an EU AIF to professional investors provided that certain conditions are met. The passport will become available on the implementation date (scheduled 2013). An EU AIFM will benefit from an EU management services passport provided certain conditions are met. The management services can either be provided on a cross-border basis or from a branch entity. Member States may allow marketing of EU AIFs and non-eu AIFs to retail investors by EU AIFMs. However, Member States will be granted the power to impose greater restrictions on the EU AIFM. Specific rules in relation to third countries (Articles 34 40) An EU AIFM can manage a non-eu AIF if the EU-based AIFM is authorised under the Directive and the relevant competent authority has given its approval. EU AIFMs must comply with all provisions in the draft Directive except for the depositary and the annual reporting requirements. Furthermore, there must be cooperation agreements in place. An EU AIFM can market a non-eu AIF to professional investors, via the pan EU marketing passport, two years after transposition of the Directive (i.e. 2015). The EU-based AIFM must comply with all of the provisions of the Directive and have cooperation agreements in place. The non-eu AIF must not be established in a jurisdiction that is designated as non-cooperative by the Financial Action Task Force (FATF) and tax information exchange arrangements must be in place. A non-eu AIFM may take the benefit of a pan-eu passport for their marketing and management activities two years after transposition of the Directive. An EU AIFM may be able to continue to market non-eu AIFs to professional investors under Member States private placement regimes. The EU AIFM must comply with all the provisions of the Directive except the depositary requirements, and there must be Event timeline for full implementation Date Entry of the AIFMD into force 21 July 2011 ESMA to provide advice to European Commission November 2011 FSA to issue a discussion paper on UK implementation Draft legislation due to be published Trialogues to commence Final text to be published FSA Consultation FSA Policy Statement End of January 2012 (subject to change) January 2012 (subject to change) March 2012 (subject to change) June 2012 (subject to change) During Q (estimated) Towards the end of 2012 (estimated) Deadline for transposition into national law of the AIFMD 22 July European Fiduciary Services News and Views First Edition 2012 AIFMD Special

16 United Kingdom cooperation agreements in place. The non-eu AIF must not be established in a jurisdiction that is designated as non-cooperative by FAFT. Member States may impose stricter marketing requirements on the EU AIFM. A non-eu AIFM may take the benefit of a pan-eu passport for their marketing and management activities two years after transposition of the Directive. Non-EU AIFMs will be required to be authorised by the relevant EU competent authority (i.e. Home State Supervisor, and detailed rules apply). The non-eu AIFM will be required to comply with all the provisions of the Directive and certain other provisions depending on whether the AIF is EU or non-eu, including cooperation arrangements and tax informationsharing agreements. The non-eu AIF must not be established in a jurisdiction that is designated as non-cooperative by FATF. The non-eu AIFM must establish a legal representative in the relevant Member State to act as a contact with the regulator. ESMA will conduct a peer review of the competent authority s authorisation and supervision of non-eu AIFMs. Non-EU AIFMs can market EU AIFs to professional investors in the EU under Member States private placement regimes (as they can currently). However, from 2013, the non-eu AIFM must comply with the transparency requirements and have cooperation agreements in place. The non-eu AIF, or the non-eu AIFM, must not be established in a country designated as a non-cooperative by FATF. Member States may also impose greater requirements on the non-eu AIFM. 11 Marketing to retail investors The marketing of AIFs by AIFMs to retail investors (Article 41) Member States may allow AIFMs to market shares or units of AIFs they manage to retail investors on their territory, but they may impose stricter requirements. Member States who permit this activity will be required to inform the Commission and ESMA of the types of AIFs that AIFMs may market to retail investors in their territory and any additional requirements that have been imposed. The remaining timeline for full implementation of the Directive by Member States is detailed in the table opposite. 1 Proposal for a Directive of the European Parliament and of the Council on Alternative Investment Fund Managers and amending directives 2003/41/EC and 2009/65/EC, April ESMA s draft technical advice to the European Commission on possible implementing measures of the Alternative Investment Fund Managers Directive, July ESMA s technical advice to the European Commission on possible implementing measures of the Alternative Investment Fund Managers Directive, November Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities, July When ensuring money is booked in cash accounts, the depositary should take into account the principles regarding organisational requirements and operating conditions for investment firms and defined terms, as laid out in the Markets in Financial Instruments Directive known as MiFID (Directive 2004/39/EC) and also article 16 of the MiFID Implementing Directive (2006/73/EC). 6 Where the AIF is required to make public an annual financial report in accordance with Directive 2004/109/ EC, only such additional information in points (a) to (f) of the list above needs to be provided to investors on request, either separately or as an additional part of the annual financial report. In the latter case, the annual financial report must be made public no later than four months following the end of the financial year. 7 In accordance with Directive 2006/43/EC on statutory audits of annual accounts and consolidated accounts. 8 Within the meaning of article 2(1) of the annex of Commission Recommendation 2003/361/EC, concerning the definition of micro-, small- and medium-sized enterprises. 9 Report to give an indication of a) any important events that have occurred since the end of the financial year, b) company s likely future development and c) information concerning acquisitions of own shares. 10 Paragraph 2 states a) any distribution to shareholders made when, on the closing date of the last financial year, the net assets as set out in the company s annual accounts are, or following such a distribution would become, lower than the amount of the subscribed capital plus those reserves that may not be distributed under the law of statutes, in the understanding that where the uncalled part of the subscribed capital is not included in the assets in the balance sheet, this amount will not be deducted from the amount of subscribed capital; b) any distribution to a shareholder the amount of which would exceed the amount of profits at the end of the last financial year plus any profits brought forward and sums drawn from reserves available for this purpose, less any losses brought forward and sums placed to reserve in accordance with law or statutes; and c) to the extent that acquisitions of own shares are permitted by the company, including shares previously acquired by the company and held by it, and shares acquired by a person acting in his own name but on the company s behalf, that would have the effect of reducing the net assets below the amount mentioned in paragraph a). 11 The private placement regime is optional for Member States. In addition, the private placement regime may be potentially phased out in 2018, subject to ESMA s opinion on the functioning of the pan-eu Passport. European Fiduciary Services News and Views First Edition 2012 AIFMD Special 13

17 Ireland Financial Instruments to be held in custody, reporting obligations of prime brokers and the Central Bank of Ireland Guidance Note 2/11 As noted elsewhere in this publication, the European Securities and Markets Authority (ESMA) published its final advice 1 on the detailed rules underlying the Alternative Investment Fund Managers Directive (AIFMD) on 16 November ESMA s advice runs to over 500 pages and is a very comprehensive document. This article will focus on three areas, which are of particular relevance to depositaries: the definition of financial instruments to be held in custody; reporting obligations for prime brokers; and the Central Bank of Ireland Guidance Note 2/11, 2 which deals with the appointment of prime brokers and related issues. The definition of financial instruments to be held in custody ESMA s advice seeks to set out a clear definition of the financial assets that are to be held in custody, and to differentiate those other assets that will be subject to a recordkeeping requirement. This is a critical definition as it will clearly have a consequent impact on the potential liability of the depositary. In principle, the depositary shall be liable for the loss of financial instruments that it has itself held in custody, or a third party to whom custody has been delegated. The same standard of liability will not automatically apply for assets that are not held in custody. The other assets that are subject to the recordkeeping requirement are defined as all assets not held in custody. ESMA explains that the suggested definition of financial instruments subject to custody duties is designed to capture all financial instruments that the depositary is in a position to control and, if necessary, retrieve. The following are the financial instruments to be held in custody: 1. Transferable securities (including those that embed derivatives). (The rationale behind the inclusion of those transferable securities that embed derivatives is not very clear at this stage.) 14 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

18 Ireland 2. Money market instruments. 3. Units of collective investment undertakings (as listed in Annex I, Section C of Directive 2004/39/EC 3 ). The financial instruments must also meet the following criteria: They must not have been provided as collateral under the terms of a title transfer collateral arrangement or under a security financial collateral arrangement by which control or possession of the financial instrument has been transferred from the Alternative Investment Fund (AIF) or the depositary to a collateral taker. The financial instruments must be registered or held in an account directly or indirectly in the name of the depositary. It is intended that this definition will provide a clear framework for the scope of custody with very little room for interpretation. Under the new AIFMD liability regime, the depositary may be obliged to return a financial instrument of an identical type or the corresponding amount. This obligation is to be linked to all assets held in custody for which only the depositary can instruct a transfer including where it is the registered owner in the issuer s register, which may be the case for target funds. Taking into account the definition set out above ESMA s advice also sets out details of financial instruments that would fall into the other assets category. Other assets would include, but not be limited to, the following: Physical assets that do not qualify as financial instruments or cannot be physically delivered to the depositary. Financial contracts e.g. derivatives. All financial instruments, including units and shares of collective investment schemes, issued in a nominee name or registered directly in the name of the AIF, provided they cannot be physically delivered to the depositary or they are not registered or held in an account in the name of the depositary. Cash deposits. Investments in privately held companies and interests in partnerships. Financial instruments provided by an AIF under a financial collateral arrangement where there is a title transfer, or under a security financial collateral arrangement by which control over/possession is transferred away from the AIF or the depositary are excluded from the scope of the depositary s custody duties. ESMA clarifies that financial instruments provided by an AIF under a financial collateral arrangement where there is a title transfer, or under a security financial collateral arrangement by which control over/ possession is transferred away from the AIF or the depositary are excluded from the scope of the depositary s custody duties. It is clear from the definitions that it is only collateral arrangements that are included in the Financial Collateral Directive 4 that are dealt with. ESMA further clarifies that where consent has been given for re-hypothecation of financial instruments, such instruments remain in custody when the right of re-use has not been excercised. With regard to the receipt of collateral by the depositary for the benefit of the AIF, such financial instruments should be regarded as having been entrusted to the depostary for safekeeping. Reporting obligations of prime brokers The main duties imposed on the depositary that relate to other assets concern ownership verification and record-keeping. The depositary must be provided with the information it needs to discharge its obligations. ESMA recognises this and confirms that the Alternative Investment Fund Manager (AIFM) must ensure that, on an ongoing basis, the depositary is provided with all the relevant information it needs to comply with its obligations. With this in mind, ESMA has included the following specific reporting obligations for prime brokers. 1. Where the AIFM has appointed a prime broker, it must ensure that the prime broker makes available to the depositary of the AIF a statement in a durable medium: a) Showing the value at the close of each business day of the items in 3 below. b) And detailing any other matters that the prime broker considers necessary to ensure that the depositary of the AIF has up-to-date and accurate information about the value of assets of which the safekeeping has been delegated. European Fiduciary Services News and Views First Edition 2012 AIFMD Special 15

19 2. The statement must be made available to the depositary of the AIF not later than the close of the next business day to which it relates. 3. The statement must include: a) The total value of assets held by the prime broker for the AIF. b) The value of each of the following: i) Cash loans made to the AIF and accrued interest. ii) Securities to be redelivered by the AIF under open short positions entered into on behalf of the AIF. iii) Current settlement amount to be paid by the AIF under any futures contracts. iv) Short-sale cash proceeds held by the prime broker in respect of short positions entered into on behalf of the AIF. v) Cash margin held by the prime broker in respect of open futures contracts entered into on behalf of the AIF. vi) Mark-to-market close-out exposure of any OTC transaction entered into on behalf of the AIF. vii) Total secured obligations of the AIF against the prime broker viii) And all other assets relating to the AIF. c) Total collateral held by the prime broker in respect of secured transactions entered into under a prime brokerage agreement, including where the prime broker has exercised a right of use in respect of the AIF s assets. d) A list of all the institutions at which the prime broker holds or may hold cash of the AIF. All of these requirements are new and seem to reflect requirements that were recently imposed by the FSA in the UK with respect to reporting by prime brokers to the regulatory authorities. There was support in the consultation process for the introduction of similar requirements at an EU level. There is an obligation on the depositary to ensure it has timely access to all of the relevant information it needs to perform its ownership verification and recordkeeping duties, pursuant to Article 21 (8)(b) of the AIFMD. The introduction of these new requirements on prime brokers is therefore a welcome development. Central Bank of Ireland Guidance Note 2/11 In this Guidance Note, published in December 2011, the Central Bank of Ireland (Central Bank) refers to the general requirement that the assets of a collective investment scheme must be entrusted to a trustee for safekeeping. If the trustee in turn appoints a third party, that third party must be appointed as a sub-custodian. The purpose of the Guidance Note is to set out the circumstances under which a professional collective investment scheme (PIF) or a Qualifying Investor Fund (QIF) may enter into arrangements with a prime broker pursuant to which the assets may be transferred out of the control of the trustee. a) Both a PIF and a QIF may deliver assets to a prime broker on terms that permit the prime broker to pledge, lend, rehypothecate or otherwise use the assets for its own purposes if certain conditions are met as follows: i) For a PIF, the amount of assets available to the prime broker (PB) must not exceed 140% of the level of the PIF s indebtedness to the PB. In the case of a QIF, there is no limit, but the extent to which assets are available to the PB must be fully disclosed in the prospectus. ii) There must be an agreed procedure for the positions to be marked to market daily. iii) The prime broker must agree to return the same or equivalent assets to the collective investment scheme. iv) There must be a legally enforceable right of set-off. b) In any situation where the prime broker will hold assets of a PIF or QIF, other than in accordance with the conditions as set out above, the prime broker must be appointed as a sub-custodian by the trustee. As prime brokers may not be familar with the standard form of subcustodian agreement, there will often be a lenghty negotiation required to finalise these arrangements. c) The prime broker must be regulated and authorised to provide prime broker services by a recognised regulatory authority, and it, or its parent, must have shareholders funds in excess of EUR200 million. In addition, the prime broker or its parent company must have a minimum credit rating of A-1 or equivalent. The Guidance Note also includes provisions for a PIF or QIF to enter into collateral arrangements with OTC counterparties whereby assets of the collective investment scheme are passed outside of the control of the trustee, and it imposes a minimum credit rating requirement of A-2 or equivalent on such counterparties. Where a prime broker is appointed by a PIF or a QIF the Guidance Note introduces specific compliance 16 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

20 obligations on the trustee on the basis that the trustee is best placed to monitor compliance on an ongoing basis. At a minimum, the trustee is required to confirm that it will: a) Receive daily reports from the prime broker on assets held by the prime broker and valuations for those positions. b) Reconcile those positions with its own records, on a nominal basis. c) On each valuation point, reconcile assets on a valuation basis and where the period between valuation points exceed two weeks, the valuations received from the prime broker should be independently verified. d) Any discrepencies arising from the reconciliation should be escalated if they cannot be satisfactorily resolved. e) Request confirmation from the prime broker that it holds assets only in accordance with the Guidance Note and the provisions of the sub-custody agreement. There must be full disclosure of the prime broker relationships in the prospectus and the agreement with the prime broker must be submitted to the Central Bank. While there may not be a formal regulatory review of the agreement, there must be a confirmation provided to the Central Bank that the various conditions set out above are included in the agreement and nothing in the agreement conflicts with the Guidance Note. The new reporting obligations imposed on prime brokers under the AIFMD, as described above, will certainly assist trustee s in meeting their obligations under the Guidance Note. It is also anticipated that there may be further changes to the Guidance Note as the AIFMD implementing measures (Level 2 measures) are finalised. Conclusion This latest advice from ESMA was delivered to the European Commission by the prescribed deadline of 16 November It is anticipated that the European Commission will publish its own proposals on implementing measures before mid-2012, and Member States will be required to transpose the AIFMD by 22 July Given the liability that will be imposed on depositaries for the loss of financial instruments held in custody, it is extremely important to clarify which assets are held in custody and which ones fall into the category of other assets. Although further clarification is required in certain areas, the guidance is to be welcomed. The new reporting obligations on prime brokers will also assist the depositaries in meeting their obligations as they relate to other assets and will also create consistent requirements across the EU in this area. These obligations will also help Irish trustees to meet their compliance obligations under the Central Bank Guidance Note. Although there are a significant number of additional steps to be completed before the AIFMD is fully implemented, the publication of ESMA a final advice is an important stage in the process. 1 ESMA s technical advice to the European Commission on possible implementing measures of the Alternative Investment Fund Managers Directive, November Guidance Note 2/11 Professional collective investment schemes: Appointment of prime brokers and related issues. 3 Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/ EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC. 4 Directive 2002/47/EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements. European Fiduciary Services News and Views First Edition 2012 AIFMD Special 17

21 Jersey ESMA s final advice to the Commission on implementing the AIFMD third country regulation of custodians and cash-flow monitoring On 16 November 2011, the European Markets and Securities Authority (ESMA) published its final advice (the Advice) to the European Commission (the Commission) on implementing the Alternative Investment Fund Managers Directive 1 (the Directive). What follows is a necessarily brief overview of aspects of the Advice relating to the third country regulation of custodians and their duty to monitor fund cash flows. 1. The criteria for assessing the regulation and the supervision of third country custodians The re-emergence of the concept of regulatory equivalence, which occurred during the consultation exercise that preceded the publication of the Advice, was a key concern for custodians based in third counties. This was all the more troubling given that the Commission had been persuaded to drop the concept of equivalence during the course of the Level 1 negotiations. The concern was that equivalence would mean that third country regulatory regimes would have to replicate or mirror the EU s regulatory regime in all relevant respects. On balance, therefore, it is a positive development that equivalence was not reinstated during the course of the Level 2 consultation exercise and that ESMA has recommended that the criteria for assessing the regulation and supervision of third country custodians should be determined on a same-effect basis. Specifically, the Advice (at Box 76) specifies that: Third country regulatory frameworks should set out eligibility criteria for entities to act as custodians that have the same effect as those set out for credit institutions or investment firms by EU regulations. Third country capital requirements for custodians should have the same effect as those applicable in the EU. Operating conditions imposed on custodians by third country regulators should have the same effect as those imposed on EUbased custodians. And regulatory requirements in relation to the performance of the specific duties of a third country custodian should have the same effect as those provided for in the Directive and in its implementing directives. However, while the concept of same effect is undoubtedly preferable to equivalence, it is still potentially problematic in that it is open to subjective, and hence political, interpretation. For instance, does a third country s regulation have the same effect if it secures the same outcome as the corresponding EU regulation? Or do we also have to consider the manner in which third country regulation is implemented? If we do (and there are certainly those that want us to), we end up effectively back at equivalence with all the scope for subjectivity that that entails. What happens, for instance, if a given third country s regulatory regime specifies that a custodian requires a lesser level of regulatory capital than EU regulation requires of an equivalent EU custodian? In such a case, the third country regulator might well argue that its lower capital requirement achieved the same effect but did so more at a lower cost. One suspects that the Commission might take a different view. A further issue centres on the concern that, despite including same-effect language, the rules set out at Box 76 are sufficiently detailed and onerous to require, in practical terms, Jersey to have an equivalent regulatory regime. There are three other criteria for assessing the regulation of third country custodians set out in the Advice: The depositary should be supervised by an independent and competent authority with adequate resources to fulfil its tasks. At face value, this would appear to be a standard met by the Jersey Financial Services Commission (the JFSC). Explanatory notes to the Advice state that whether or not a third country regulator is considered independent or not will be judged by whether it is 18 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

22 Jersey fully compliant with Part II of the IOSCO Objectives and Core Principles for Securities Regulation 2, the Basel Committee Core Principles 3 and their respective methodologies. On its last IMF assessment, the JFSC was assessed as being broadly compliant with the IOSCO standard. It was not fully compliant because, in certain, limited instances, ministers of the Jersey government could intervene in the JFSC s decision-making process. In light of this, some amendments are required to Jersey s regulatory system but they should not be substantial. That said, there is again a subjective element to whether or not the JFSC is fully compliant. These are generic objectives and principles and whether or not the JFSC lives up to them will be judged by the Commission. The third country regulatory framework must provide for sufficiently dissuasive sanctions in the case of breach by a custodian of the Directive or its implementing provisions. ESMA provides no guidance on what level of dissuasion would be considered sufficient, but it is our view that the range of sanctions available to the JFSC represents, on any reasonable basis, an adequate deterrent. The custodian must be liable to the underlying investors, either directly or indirectly, through the fund, depending on the legal nature of the relationship between the custodian, the fund manager and the investors. It is already a regulatory requirement in Jersey for an open-ended fund to have a Jersey-based custodian. If the fund is a company or limited partnership, the custodian will be appointed directly by the company or on behalf of investors by the General Partner (GP). If the fund is a unit trust, the trustee will act as custodian and there will be a direct legal relationship between investors and the trustee pursuant to the trust deed. It is possible that, under the Directive, the GP of a limited partnership may be the fund manager of the fund. Save in the context of trusts, Jersey law has not widely accepted a concept of third party rights (although there is evidence in historic case law of the enforcement of rights conferred on third parties outside the privity of contract). It may be that statutory development of third party or investor rights against depositaries in Jersey may be required. Such a change is not unprecedented. England has the Contracts (Rights of Third Parties) Act 1999, which, in summary, allows third parties to enforce terms of contracts that benefit them in some way or which the contract allows them to enforce. It is unlikely that Jersey would introduce an equivalent law of wholesale application. More likely, specific amendments would be inserted into the Collective Investment Funds (Jersey) Law 1998, permitting investors to sue custodians directly. 2. Depositary functions cash monitoring general information requirements The Directive requires that a custodian must ensure that the fund s cash flows are properly monitored and that all subscription moneys are received and then booked to accounts opened in the name of, or on behalf of, the fund. The accounts must be held at a central bank or an authorised credit institution or a bank authorised in a third country or a similar entity in a third country provided it is subject to regulation of the same effect as EU regulation. The Advice adds further detail to this general obligation imposed by the Directive. It provides (at Box 77) that, where an account is opened by or on behalf of a fund at a third party, the fund manager must ensure that, when a custodian is appointed and on an ongoing basis thereafter, the custodian is provided with all the information it needs to comply with its obligations under the Directive and in particular that: The custodian is informed upon its appointment of all accounts opened by or on behalf of the fund. The custodian is kept informed of all new accounts opened by or on behalf of the fund. Third party entities at which accounts are opened should provide information directly to the custodian. European Fiduciary Services News and Views First Edition 2012 AIFMD Special 19

23 Jersey And that the form and frequency of cash-flow monitoring must be set out in the contract appointing the custodian or a service level agreement or other similar document. 3. The proper monitoring of all fund s cash flows The Advice also sets out (at Box 78) minimum requirements for proper monitoring of the fund s cash flows. A custodian must at least: Ensure the fund s cash is credited to one or more accounts at a central bank or an authorised credit institution or a bank authorised in a third country or, where necessary, at an appropriate third country bank or credit institution. Ensure there are proper procedures in place to reconcile all cash flows and that these reconciliations are performed with appropriate frequency. Ensure appropriate procedures are in place to identify on a timely basis significant cash flows and in particular those which appear anomalous. Review periodically the adequacy of those procedures including a full review of the reconciliation process at least once a year and ensuring that any accounts opened by, or in the name of, the fund itself are included in the reconciliation process. Monitor on an ongoing basis the actions taken to rectify any discrepancies identified by the reconciliation procedures and promptly alert the fund manager and/or the fund itself if an anomaly has not been rectified. And check that its own records of cash positions are consistent with those of the fund manager. 4. Conclusion The detailed obligations in relation to cash monitoring set out in the Advice (and explained above) will now be turned into implementing measures by the Commission, a task it is expected to complete by mid Once the relevant regulations and/or directives have come into force, either directly (in the case of regulations) or by EU Member States legislating (in the case of directives), they will govern the manner in which EU-based custodians must operate. Crucially for Jersey, however, the EU cash monitoring requirements will then become the benchmark by which Jerseybased custodians will be judged by ESMA if they are custodians of funds which want access to EU-based investors. The question will then be: does Jersey regulation in relation to cash monitoring by custodians have the same effect as EU regulation? The answer, in our opinion, is broadly yes, but to reach this conclusion one must believe that the same effect means achieving the same outcome. The reality is that Jersey does not achieve the same outcome by detailed provisions of the sort set out in the Advice. The nearest Jersey comes to this approach is the trustee/custodian section of the JFSC s Guide to Open-Ended Unclassified Collective Investment Funds Offered to the General Public, which does not expressly refer to cash monitoring. The fact is that Jersey and EU regulators both seek to achieve the same effect but do so in different ways: Jersey regulation operates at a more general level; the EU seeks to micro-legislate. To the extent that there is a difference of opinion as to the effect of these approaches, we expect that the Jersey regime will have to be modified to accommodate the needs determined by ESMA. Alastair Drummond Counsel, Corporate and Commercial Appleby, Jersey Please note that the above is only intended to provide a very general overview of the matters to which it relates. It is not intended as legal advice and should not be relied on as such. 1 ESMA s technical advice to the European Commission on possible implementing measures of the AIFMD, November International Organisation of Securities Commissions Objectives and Principles of Securities Regulation, June Basel Committee Core Principles for Effective Banking Supervision European Fiduciary Services News and Views First Edition 2012 AIFMD Special

24 United Kingdom The impact on asset managers of the AIFMD November 2011 saw the publication of ESMA s final advice on Level 2 measures under the AIFMD (Directive) 1. We are now waiting to see the Commission s draft legislation, which should be published mid Given that the Directive needs to be implemented by July 2013 (and all AIFMs have to apply for authorisation by July 2014), managers will have a tight timetable to put the necessary systems and procedures in place after the measures are agreed with the European Council and Parliament in June next year. We have also yet to see ESMA s Guidelines and technical standards on a number of issues, which will flesh out the legislative requirements. These will include measures on remuneration, leverage, third countries and scope. Meanwhile, the FSA intends to publish a discussion paper on Level 1 implementation in January So, what will the impact be on asset managers? Scope Although commonly referred to as the hedge fund directive, in reality the Directive captures a wide range of different types of vehicle. We estimate that IMA members operate (or are the appointed investment managers of) around 2000 UK domiciled AIFs; and this does not take account of the substantial number of offshore funds being managed or advised from the UK. According to IMA research, UK-domiciled AIFs include non-ucits retail funds (NURS) (over 400), authorised openended institutional funds, listed closedended investment companies (around 400), and registered charity funds and unauthorised institutional investment vehicles (around 800 of which are constituted as other unit trusts, most of which are available to pension funds and charities only). They deploy a wide range of investment strategies and invest across asset classes and regions. They may have no, moderate or higher leverage. In terms of the original intent of the Directive to regulate hedge (or higher-leveraged) funds and private equity vehicles few UK-domiciled AIFs fit this description. Indeed, under any recognised definition of systemic risk, on which subsequent debate has been focused, few UK-domiciled AIFs pose such risk and neither do many non-eu AIFs. Proportionality Given that the Directive captures a much wider range of non-ucits investment vehicles than the original intent, it has been a key concern for managers and professional investors that the detail of the Level 2 measures should recognise and cater for this diversity in the AIF population. The Commission s request to ESMA for advice, issued in December 2010, 2 recognised that ESMA should respect the principle of proportionality, saying Solutions proposed should be simple, and avoid creating excessive administrative or procedural burdens either on AIFMs or on the national competent authorities responsible for their supervision. European Fiduciary Services News and Views First Edition 2012 AIFMD Special 21

25 United Kingdom Managers concerns have been addressed on a number of issues, and the final advice sets out a more pragmatic approach in a number of areas that are outlined in the consultation papers. For example, ESMA s consultation paper published in August 2011, which dealt with delegation to non-eu asset managers, was widely regarded as being unworkable since it effectively only permitted such delegation if the non-eu manager was subject to equivalent regulation. And this appeared to require equivalence down to a detailed level. Although regulatory frameworks have, in general, been developed with common objectives in mind, regulatory means to achieving those objectives can be quite different in practice. So in practical terms, this meant that EU managers would be unable to delegate to non-eu entities, even in highly regulated jurisdictions such as the US. ESMA has taken this point on board, and the final advice sets out a much more pragmatic approach in this area. Nevertheless, there are a number of problem areas that still remain (see below). Given that the Commission has constitutionally limited room to manoeuvre to depart from ESMA s advice (and has indicated publically that it would adopt 90% of the final advice), it is clearly important that careful thought be given to what issues should be prioritised. Key impacts on managers The impacts very much depend on the fund types and the existing status of the manager. For regulated firms subject to UCITS 3 and/or MiFID, 4 a number of the requirements are very similar to those existing requirements, and so minimal system changes will be required to accommodate them. This is particularly true in terms of general operating conditions, where the requirements on conflicts management, general principles, organisational requirements and risk management are very similar to those that currently exist under MiFID and the UCITS Directive. And, in practice, it is likely that firms managing a range of different types of collective investment schemes (CISs) will already have appropriate procedures across the piece to meet these requirements. On the other hand, more specialist managers such as real-estate managers might not have been subject to such detailed operational requirements in these areas. So they will have to carry out a more extensive gap analysis to identify where changes might be necessary. And there are areas where, even for UCITS and MiFID authorised firms, considerable changes will be necessary. For instance, the transparency requirements bring in extensive reporting, particularly to regulators. And, as the proposals stand, detailed quarterly reports will need to be submitted to regulators for the vast majority of funds. This includes information that will not necessarily lend itself to being aggregated easily so there could be a significant amount of manual information gathering each quarter. Third country funds One of the most contentious areas throughout the consultation process was how non-eu funds being sold into Europe should be treated, and this became very politicised during the Parliamentary debates, with the Rapporteur in ECON, Jean Paul Gauzes, arguing strongly that such funds would need to be brought within the full regime immediately. Eventually, a compromise was reached at Level 1, whereby such funds could continue to be marketed into the EU under existing national private placement regimes until 2018 (subject to their meeting the transparency requirements, and other conditions such as cooperation agreements being in place). In 2015, there will be a review of the regime, which may result in non-eu AIFMs needing to be authorised and meeting the full requirements of the Directive. Even for UCITS and MiFID authorised firms, considerable changes will be necessary. For instance, the transparency requirements bring in extensive reporting, particularly to regulators. And, as the proposals stand, detailed quarterly reports will need to be submitted to regulators for the vast majority of funds. Although managers of third country funds have some breathing space before they need to be fully authorised, the transparency requirements themselves are problematic for them. For one thing, they differ in many respects from local reporting requirements. For instance, the pro forma for regulatory reporting under the AIFMD is not the same as the form PF 5 recently introduced in the US for private funds so it is entirely possible that managers might have to complete lengthy and different reports in different jurisdictions for the same funds. In addition, ESMA s pro forma might require non-eu managers to undertake calculations of, for example, leverage, on a different basis than required locally which could well cause confusion from an investor s viewpoint. 22 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

26 United Kingdom Which entity is the manager? Under the Directive, there is some flexibility as to which entity is the AIFM and thus requiring authorisation under the Directive: so, where a fund is set up offshore with an offshore manager and the investment and risk management is delegated to a UK entity, firms will need to decide whether it is the offshore or onshore entity that should apply for authorisation. The Directive also allows for the possibility of self-managed AIFs for entities such as investment trusts. Key areas of impact As noted above, this will largely depend upon the fund type, with some funds in MiFID/UCITS authorised groups facing less extensive change than others. But some aspects of the requirements (as they stand) will require changes for all managers. It is not possible to go into detail about all such areas here but they include: Leverage The method to calculate leverage is broadly similar to that proposed within the consultation. AIFMs must calculate leverage as a ratio of exposure to NAV. The exposure is calculated in accordance with a gross and commitment method and, after notification to their regulator, an advanced method. The commitment method is similar to the CESR Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS. 6 The gross method is similar to the commitment method but removes the ability for AIFMs to take into account netting or hedging arrangements, which may reduce exposure. A particular concern that IMA and others expressed when responding to the consultation paper was the requirement to disclose gross leverage to investors. Despite significant opposition to this, the final advice has not changed in this respect. Although duration netting is permitted for the commitment approach, it is still likely that both of these methods will provide confusing information to investors, as they do not adequately take into account the impact of hedging and netting arrangements that reduce overall exposure. Transparency ESMA requires detailed reporting to competent authorities for the fund s investment profile, risk, liquidity and leverage. ESMA has set out in Annex V of the document a template for the information that the AIFM will need to submit for each AIF. In the earlier consultation, quarterly reporting was required for all AIFMs, and ESMA has revised its approach to the frequency of regulatory reporting according to the scale of the AIFM. Now smaller funds and unleveraged private equity funds can report less frequently, but all funds above EUR500 million still have to report on a quarterly basis. Moreover, where an AIFM manages over EUR1.5 billion AIFs in aggregate, quarterly reporting is required for all AIFs they manage irrespective of the size, type and strategy of the individual funds. Derivatives have to be included at the absolute value of the equivalent underlying position. So many AIFs will be caught, even if their NAVs are below these thresholds. We remain concerned that the thresholds are still too low. Realistically particularly since the aggregate FUM need to be looked at for all AIFs managed by one AIFM the vast majority of funds will be caught within the quarterly reporting requirements. Depositaries ESMA has provided detailed advice on matters relating to the appointment of the depositary and the depositary s duties. In particular, ESMA has set out detailed due diligence requirements and segregation obligations, which we commend and support. We believe that these measures, if adopted by the Fund manager s view 1 The AIFMD was the first European directive to come out of the regulatory storm designed to address the issues encountered in the financial crisis of Unfortunately, as it was the first piece of legislation to emerge, the asset management industry was not ready to interact with legislators in a manner that would result in a directive that would meet the required regulatory outcomes without significant consequences. As an industry, we should expect increased regulation as a result of the financial crisis it is expected by our clients, the public at large and our politicians which will result in a new regulatory environment for the future. We need to work as individual firms and as an industry to help legislators understand our business and the impact of legislation so that future directives meet the required regulatory outcomes with manageable consequences for clients and our businesses. The AIFMD does have a significant impact on many funds and products that did not cause any of the issues of the financial crisis. The Directive will apply to funds directed at institutional investors only, such as unregulated collective investment schemes, which are used for more alternative asset types such as private equity and property, and funds used by retail investors such as investment trusts and non-ucits regulated schemes. The impact on these funds will be different, and each will present particular problems to AIFMs and clients. European Fiduciary Services News and Views First Edition 2012 AIFMD Special 23

27 United Kingdom Fund manager s view 2 The conundrum of the AIFM is in the balance of risk and cost. It is clear that the AIFMD is a politically driven response to the travails of 2008, and it does clearly seek to mitigate real risk. Fund investors suffered actual loss as a result of issues that the Directive seeks to address. That said, the difficulty lies in picking out the right path between mitigating risk, control and loss. It remains the case that AIFMs will have both real and opportunity cost in implementation. Depositaries will be required to be appointed and undertake robust oversight, liability will be accepted but not absorbed, and each will come at a cost. That liability cost for more esoteric markets may be such that the risk-reward trade-off of participation means investment ceases to be practicable. For hedge-type strategies, which are typically dependent on a prime broker (PB) relationship, the depositary obligation will give a loss of amenity with assets historically held by the PB now required to be held by the depositary. PBs will seek to protect revenues and additional cost is inevitable. The consequence for investors will be increased costs. Commission, will enhance the clientasset protection regime. We remain concerned that ESMA s advice on matters pertaining to the liability regime appears not to have been calibrated in a proportionate manner so as to provide investors with a viable client-asset protection regime. We are particularly concerned about the requirement that the depositary assume responsibility for non-affiliated sub-custodians in its sub-custody network (for fraud, negligence and, in certain cases, insolvency). Next steps To what extent the Commission will depart from ESMA s advice remains to be seen. Realistically, however, it can only do so if there are compelling reasons and cost-benefit arguments to support a different approach. It has already indicated that it would be adopting around 90% of the advice as it stands. It is important to remember that there are a number of other initiatives in train at the moment with reviews of MiFID, the UCITS Directive and the IORP Directive 7 underway, it is likely that policies adopted under AIFMD could well find their way into these other directives as well. Alwine Jones EU and International Regulation Investment Management Association 1 ESMA s technical advice to the European Commission on possible implementing measures of the Alternative Investment Fund Managers Directive, November European Commission provisional request for a technical advice on the Directive for AIFM Level 2 measures, 2 December Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities, July Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC. 5 Form PF refers to t he Securities and Exchange Commission reporting form for investment advisers to private funds and certain commodity pool operators and commodity trading advisors 6 ESMA Final report - Guidelines to competent authorities and UCITS management companies on risk measurement and the calculation of global exposure for certain types of structured UCITS, 14 April Directive 2003/41/EC of the European Parliament and of the Council of 3 June 2003 on the activities and supervision of institutions for occupational retirement provision. 24 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

28 Luxembourg ESMA Technical Advice 1 on the AIFMD implementing measures with respect to depositary safekeeping and oversight duties The duties of the depositary relate to all of the assets of the AIF for which the depositary has been appointed. However, depending on the vast array of assets in which an AIF can possibly invest, such as transferable securities listed on an official stock exchange, real estate, private equity, etcetera, the relevant duties of the depositary can change. From an investor-protection point of view, the depositary should have as much control as possible over the AIF s assets, but adaptations have to be made in accordance with the nature of the assets in which the relevant AIF invests. Consequently, a distinction is made between financial instruments that can be held in custody ( Custody Assets ) and other assets ( Other Assets ). Ultimately, what counts is that there is adequate comfort that the AIF has ownership of its assets. For Custody Assets this is achieved when the depositary records such assets in segregated accounts opened for the AIF, be it for the AIF itself (if a corporate structure) or (in the case of a contractual structure) accounts opened by the AIFM acting for the AIF. Of course, Other Assets cannot be registered in such accounts. Here the depositary has a duty to ascertain that the AIF is the legal owner of the assets by way of having access to relevant information and keeping a record of the non-custody assets of the AIF, including ensuring that changes of ownership of the recorded assets do not occur without the depositary having been informed. It is therefore of great importance to properly allocate the AIF s assets in accordance with the distinction between Custody Assets and Other Assets. This has consequences not only on the nature of the depositary s duties but also on the type of liability of the depositary. Only Custody Assets fall into the strict liability of restitution, whereas for Other Assets negligencebased liability applies. An obvious question to ask in this context, with respect to Custody Assets and Other Assets, is how the situation is treated where the AIF does not invest directly but, for tax or other reasons, chooses to have intermediated structures, controlled by the AIF, between the assets and the AIF itself. One may be tempted to stop at AIF level and to only see the interest in the intermediated structures as the assets relevant to the duties of the depositary, i.e. to not look through such intermediated structures. This would, however, be short-sighted in terms of investor protection. Indeed intermediated structures are only a means to efficiently access what are commercially the AIF s investments, but such structures are not the investments themselves. ESMA shares this view and has now made it clear beyond doubt that a look-through applies to assets held by structures controlled by the AIF (either directly or by way of the AIFM acting for the AIF), i.e. in relation to the duties of the depositary such assets are treated as if they were the AIF s direct own assets. European Fiduciary Services News and Views First Edition 2012 AIFMD Special 25

29 Luxembourg In addition to safe-keeping the AIF s assets (which, as outlined, can take the form of custody or of ownership verification for Other Assets), the depositary has oversight duties. These duties are modelled on the UCITS provisions for contractual investment funds, even though under the AIFMD 2 they also apply without distinction to contractual- and corporate-type AIFs. This means that the depositary is required to ascertain: that subscriptions and redemptions of shares or units are carried out correctly; that the NAV calculation conforms to the AIF s constitutive documents and applicable law; that the AIF complies with its constitutive documents and applicable law, most notably with regard to investment restrictions; that the settlement of transactions is timely; and that the income of the AIF is applied in conformity with the AIF s constitutive documents and applicable law. This gives the depositary an additional nanny role. The main issue with this is that, while a certain oversight may be beneficial for reasons of investor protection, the depositary is not to take the place of the AIFM or other relevant service provider such as the AIF administrator. Therefore, there is a risk that the boundaries may become blurred, and/or there may be inefficiencies due to the depositary duplicating some of the tasks performed by others. Therefore, as requested by the industry, ESMA has provided that such controls be ex-post and not ex-ante and establish that proper procedures are in place as opposed to allowing for an inefficient repetition of tasks. For safekeeping and oversight duties, there is, however, an important issue that remains largely unresolved. Reference is made to what concrete and specific remedial actions the depositary is to take when shortcomings are detected and what the consequences of such remedial actions are to be in terms of depositary liability. ESMA favours a regime in which the depositary is to first bring shortcomings to the attention of the AIF or the AIFM and then to ultimately terminate the depositary agreement (while remaining liable until the new depositary has taken over). This does not appear to be realistic and/or efficient. Experience shows that the replacement of a depositary is not an easy or quick matter. It cannot be that the depositary is held hostage to the AIF. We would favour a reduced depositary liability for duly notified shortcomings. The duty of safe-keeping Custody Assets As already mentioned, the depositary must ensure that Custody Assets are properly recorded in segregated accounts in its books. While this principle has remained unchanged between ESMA s consultation paper 3 and ESMA s final advice 4, it is noteworthy that further details have been added in the final advice, notably that the accuracy of such accounts must be ascertained and that periodic reconciliation is required between the depositary accounts and records and the accounts and records of third parties who hold Custody Assets. This does not appear to be a source of major concern for the industry as this corresponds with good practice. The provision that the depositary must exercise due care to ensure a high level of protection has remained unchanged from the original consultation and does not seem to be controversial. The same applies to the principle that the depositary must assess and monitor custody risks throughout the custody chain and inform the AIFM of any material risks that have been identified. The question here is what happens if the depositary has identified such risks and informed the AIFM. There is a new requirement to provide for adequate organisational arrangements to minimise the risk of a loss of the financial instruments or of the rights attached to them, notably as a result of misuse, fraud, poor administration, inadequate recording or more generally negligence. With regard to the strict liability regime for loss, depositaries should indeed give serious consideration to this. The look-through approach has now been specifically laid down. While for Luxembourg depositaries this is not new, depositaries in other jurisdictions will have to adapt to this. The use of sub-custodians will not absolve the depositary from the above duties. Therefore it appears fair to say that ESMA has not fundamentally changed the position it had previously taken. Other Assets Here it is important to note that ESMA does not recommend the mirroring of all transactions, as suggested in Option 2 of their consultation paper. The requirement is that the depositary has continuous and timely access to the information it needs to perform ownership verification and to comply with its record keeping obligations. Such ownership verification is to be based on certificates or other documentary evidence every time there is a sale or purchase of assets or a corporate action resulting in the issue of additional assets, but at least once a year. 26 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

30 Luxembourg The depositary must maintain records for those assets where it is satisfied with the ownership rights, including the respective notional amounts. The records must be such that they permit to establish at any time a comprehensive and up-to-date inventory of the Other Assets of the relevant AIF. While this does not seem to be controversial, the question arises as to what the depositary should do if it is not satisfied with the ownership rights. One may take the view that ESMA s advice indicates that such assets are not to be entered into the record kept by the depositary but that the depositary then has to escalate the issue by notifying the AIFM and, if the problem persists, the competent regulator. This seems sensible, but again the question arises as to what the next step should be and what the consequences would be of such notification. In addition, procedures must be in place to ensure that the assets held on record by the depositary cannot change ownership or be assigned or delivered without the depositary having first been informed. As already mentioned, a look-through approach should be applied in cases where the assets are held by structures controlled by the AIF. The AIFM must have procedures in place to verify that the assets are appropriately registered in the name of the AIF and to check consistency between the records of the AIFM and the records of the depositary. The depositary must ensure that such procedures are in place and implemented by the AIFM. The above correspond to the positions ESMA had already taken in its original consultation. ESMA has added a new box specifically dealing with reporting obligations for prime brokers. The AIFM must ensure that the prime broker makes a statement available to the depositary on each business day. The AIFM must have procedures in place to verify that the assets are appropriately registered in the name of the AIF and to check consistency between the records of the AIFM and the records of the depositary. The statement should be quite detailed and must contain the total value of the assets held by the prime broker for the AIF and the value of cash loans and accrued interest: of securities to be redelivered by the prime broker under open short positions; of the current settlement amount to be paid to the AIF under futures contracts; of various cash positions; of mark-to-market close-out exposure of OTC transactions; and of total secured obligations of the AIF and the total collateral held by the prime broker as well as a list of all the institutions at which the prime broker holds or may hold cash of the AIF. One may conclude that ESMA has maintained the positions previously taken, with the addition of the new prime broker reporting regime and the clarification of the look-through approach. Duty of oversight General principles ESMA recognises that a one-size-fits-all approach is not appropriate. To the contrary, the depositary must assess the risks associated with the nature, scale and complexity of the AIF to set up adequate procedures that are to be reviewed and updated regularly. The role of the depositary is not to repeat what has been done by the AIFM or its delegates but to perform ex-post controls of the processes and procedures set up by the AIFM or its delegates. The depositary must ascertain that such procedures are appropriate, that they are implemented and that they are frequently reviewed. The AIFM must ensure that the depositary is continuously provided with the information it needs and that the depositary is able to perform on-site visits at the AIFM s or third-party service providers premises and/or to review reports and statements in this respect of recognised external certifications by independent auditors or other experts. The latter was a specific request by the industry that has now been accepted by ESMA. Should the depositary detect irregularities, these must be brought to the attention of the AIFM and, upon request, to the competent regulators, including an escalation procedure. Subscriptions and redemptions The depositary must ensure that adequate procedures are in place to reconcile subscription and redemption orders as well as the number of shares or units issued or redeemed with the subscription monies received and redemption payments made. Moreover, the depositary must regularly ascertain that the procedures for the issue and redemption of shares or units conform to the AIF s constitutive European Fiduciary Services News and Views First Edition 2012 AIFMD Special 27

31 Luxembourg documents and applicable law and such procedures are effectively implemented. Finally, the depositary must regularly check the consistency between the AIF s register of shares or units and the AIF s accounts in relation to the total number of outstanding shares or units. NAV calculation While the depositary does not have to perform a recalculation of the NAV, it must nevertheless verify, on a continual basis, that the NAV calculation procedures are appropriate, consistent and in compliance with the requirements of Article 19 of the AIFMD and the AIF s constitutive documents. It must also verify that such procedures are effectively implemented and periodically reviewed. Where applicable, the depositary must further check that the appointment of the external valuer conforms to Article 19 of the AIFMD. The procedure to be set up by the depositary for such verifications as well as the verifications themselves must be consistent with the nature, scale and complexity of the AIF and the frequency of the NAV calculations. Where the depositary considers that a NAV calculation does not conform to the applicable laws and rules, it must notify the AIF and the AIFM and ensure timely remedial action is taken in the best interest of investors. The latter may not be without problems and may be a source of potential liability of the depositary. AIFM instructions This duty must not be underestimated. The provision that the depositary must set up and implement appropriate procedures to verify that instructions received by the depositary are in compliance with the AIF s constitutive documents and applicable law, notably in relation to investment restrictions and leverage limits, may not always be an easy task. Irregularities that have been detected are to be the object of a predefined escalation procedure. Timely settlement of transactions While the need for the depositary to set up procedures to detect situations where the consideration is not remitted within the usual time limits, and the obligation to notify the AIFM does not seem to be controversial, one may wonder about the obligation of the depositary to request where possible restitution of the financial instruments from the counterparty in case the situation has not been remedied. Indeed the latter may not always be reasonably possible or possible at all, and the settlement risk must not become a depositary s risk. The decisive point may be to define when such restitution is possible and when it is not possible. This issue must be kept on the radar. Income distribution An important modification from the consultation is that in ESMA s advice reference is made to verification of net income distribution once such a distribution has been calculated. This means it is and remains up to the AIFM to determine such a distribution. Though ex-post, the depositary must ensure that the distribution is in conformity with the AIF s constitutive documents and applicable law and verify that payments of dividends and (where applicable) carried interest is effectively made in accordance with what has been declared by the AIFM. In addition, where the AIF auditors have expressed reserves on the annual financial statements of the AIF, the depositary must take appropriate measures. To put the depositary in a position to comply with this, a specific obligation of the AIF to provide the depositary with information on reserves by the auditors, has been added. This corresponds to a demand by the industry and appears reasonable. Conclusion Overall, ESMA s advice seems to be in line with what could be expected in light of the consultation. However, the advice is not binding on the EU Commission and changes are still possible. That said, it is not anticipated that the Level 2 measures will materially deviate from ESMA s advice. It remains to be seen what ESMA s technical guidelines and the Level 3 measures will bring. As always, the devil is in the detail. Hermann Beythan Partner Linklaters LLP, Luxembourg 1 ESMA s technical advice to the European Commission on possible implementing measures of the Alternative Investment Fund Managers Directive, November Proposal for a Directive of the European Parliament and of the Council on Alternative Investment Fund Managers and amending directives 2003/41/EC and 2009/65/EC, April ESMA s draft technical advice to the European Commission on possible implementing measures of the Alternative Investment Fund Managers Directive, July ESMA s technical advice to the European Commission on possible implementing measures of the Alternative Investment Fund Managers Directive, November European Fiduciary Services News and Views First Edition 2012 AIFMD Special

32 United Kingdom Advantage affiliated networks? One of the stated aims of the European Commission and Parliament in proposing the Alternative Investment Fund Managers Directive (AIFMD) 1 was to deal with the risks presented to investors in AIFs in the event of a custodian s default. This aim manifested itself in two main proposals. First, to define the functions of a custodian and secondly, to establish when a custodian should be liable to an AIF. While the first proposal is forward looking, in defining the duties that a custodian must perform in order, hopefully, to avoid losses to AIFs, the second proposal is in effect retrospective, in seeking to apportion responsibility where an AIF has, in fact, suffered a loss. Custodian functions Key areas in which ESMA s technical advice 2 seeks to give greater definition to the custodian s responsibilities are in relation to the custodian s due diligence and segregation obligations in relation to sub-custodians. Due diligence The AIFMD requires the custodian to conduct due diligence and monitoring of a sub-custodian to which it has delegated safe-keeping functions on an ongoing basis. 3 In keeping with its emphasis on meaningful action by custodians to help avoid loss, ESMA expressly declined to issue a list of due diligence tasks to perform in its advice, citing the danger that such guidance could constitute a boxticking approach to due diligence. Rather, ESMA took the view that it would be preferable to delineate a set of principles for due diligence and ongoing monitoring of sub-custodians based on what it deemed to be best market practice. 4 While ESMA s due diligence requirements largely reflect current good practice among custodians (including, for example, obligations to assess the sub-custodian s jurisdictional and regulatory risks, practices and procedures, financial strength and reputation, and operational and technological capabilities), ESMA s advice prescribing de minimis monitoring of sub-custodians goes further than the prevailing industry norm. ESMA requires the custodian to perform at least the following in its ongoing monitoring of the sub-custodian: 5 (a) monitor the sub-custodian s compliance with the AIFMD and the custodian s standards, and the performance of the sub-custodian; (b) ensure that the sub-custodian exercises reasonable care, prudence and diligence in the performance of its custody tasks and effectively European Fiduciary Services News and Views First Edition 2012 AIFMD Special 29

33 United Kingdom segregates financial instruments; and (c) review custody risks based on the delegation and notify the AIF or AIFM of any changes. ESMA clarifies in its advice that a custodian s ongoing monitoring should mainly consist of verifying that the sub-custodian is correctly performing all of its tasks and complying with its obligations specified in the contract. 6 This clarification likely qualifies the custodian s ongoing monitoring requirements in (b) to ensure that the sub-custodian is exercising reasonable care, prudence and diligence and effectively segregating assets rather than guaranteeing the performance of the sub-custodian, which the word ensure first suggests. Nevertheless, the framing of the obligations in (b) as absolute obligations is consistent with the proposals in ESMA s technical advice providing for the liability of custodians for events deemed internal, including events arising from actions relating to the subcustodian s performance and segregation obligations (see below). It is likely that this tension between what is achievable as a preventative measure and the apportionment of the responsibility should that measure be ineffective will be the subject of further debate before Level 2 regulation is finalised. Segregation ESMA s advice also requires custodians to ensure that sub-custodians effectively segregate assets by obliging the custodian to verify that the subcustodian has put in place compliant arrangements. 7 According to current practice, the custodian would typically cover off these requirements in its subcustody or service level agreement. Based largely on the Undertakings for Collective Investment in Transferable Securities (UCITS) regime requirements, 8 ESMA s advice broadly reflects the current practice of the market. However, a few of the requirements appear to go beyond what is industry standard. For example, ESMA requires a custodian to ensure that a sub-custodian keep special accounts for AIFs enabling the custodian to distinguish assets held for AIFs not only from its own and its clients assets and the custodian s own and its clients assets, but also from those assets held for any other clients. 9 Furthermore, ESMA suggests that a sub-custodian may be required to take additional measures, such as additional investor disclosures, the use of buffers, the prohibition of temporary deficits or the prohibition of client balance offsets, to provide adequate protection where local insolvency law does not recognise segregation as sufficient to protect the assets in insolvency. 10 Liability framework The onerous liability regime for custodians that is foreshadowed in AIFMD is given further definition in the ESMA technical advice regarding the definition of loss, external events beyond the custodian s control and the objective reasons for the custodian to discharge a contract. What is a loss? The AIFMD provides that a custodian is liable to the AIF or to the investors of the AIF, for the loss by the custodian or sub-custodian to whom the custody of financial instruments held in custody has been delegated. In the case of such a loss, the AIFMD provides for a form of strict liability and requires that the custodian return a financial instrument of identical type, or the corresponding amount, to the AIF or the AIFM acting on behalf of the AIF without undue delay. However, the custodian will not be liable if it can prove that the loss arose as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary. 11 ESMA s technical advice proposes that financial instruments held in custody should be considered as lost if at least one of the following conditions is met: 12 (a) a stated right of ownership of the AIF is uncovered to be unfounded because it either ceases to exist or never existed (e.g. disappearance due to accounting error or nonexistence due to fraud); (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. These conditions are intended to cover losses due to fraudulent conduct or deprivation of ownership or disposition rights on a permanent rather than temporary basis. Because of the importance of the notion of permanence, in relation to the insolvency of a subcustodian, the financial instruments will not be deemed as lost until it is apparent that they will not be recovered. Further, ESMA is cautious in its approach to the insolvency of sub-custodians with respect to loss and suggests that it would not be appropriate to deem the financial instruments as lost from commencement of the proceedings, not only because of the inability at such an early stage to determine whether the assets have effectively been lost, but importantly because deeming a loss would trigger the custodian s liability, potentially increasing systemic risk to a significant degree. 13 This cautious approach is to be welcomed. 30 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

34 United Kingdom If a loss of financial instruments is determined, the custodian will not be liable if it can prove that the loss arose as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary. External vs internal As stated above, even if a loss of financial instruments is determined, the custodian will not be liable if it can prove that the loss arose as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary. 14 Under ESMA s advice, three conditions must be met for the custodian (or the sub-custodian, where the custodian has contractually transferred its liability) not to be held liable for the loss: 15 (a) the event which led to the loss must be external (i.e. it is not a result of an act or omission of the custodian or one of its sub-custodians to meet its obligations); (b) the event was beyond the custodian s reasonable control (i.e. it could not have prevented its occurrence by reasonable efforts); and (c) the consequences could not have been avoided with reasonable efforts (i.e. the custodian could not have prevented the loss despite rigorous and comprehensive due diligence). The basic approach taken by ESMA is that an event is external if it did not occur as a result from the acts and omissions of the depositary or its subcustodian. ESMA also dismisses various types of events and classifies them as follows. Beyond the custodian s reasonable control Once an event is determined to be external, it must be established whether the event was beyond the custodian s reasonable control, i.e. if there was nothing the custodian could reasonably have done to prevent its occurrence. This will include events deemed acts of state or God, including nationalisation. 17 ESMA s view of external and internal events 16 Event Type Result for custodian* 1 Accounting error of sub-custodian. Internal Liable 2 Fraud of custodian or sub-custodian Internal Liable 3 Insolvency of sub-custodian: loss following failure to segregate. Internal Liable 4 Insolvency of sub-custodian: loss due to disruption of sub-custodian s activities in relation to its default. Internal Liable 5 Insolvency of sub-custodian: loss because sub-custodian s jurisdiction does not recognise effects of segregation even though there has been appropriate segregation. External Not liable ** 6 Market closure. External Not liable 7 Operational failure of sub-custodian. Internal Liable 8 Settlement system failure. External Not liable * Presupposes a loss has occurred. ** Not liable assumes other thresholds of the liability framework are met (see below). European Fiduciary Services News and Views First Edition 2012 AIFMD Special 31

35 United Kingdom Finally, the custodian must demonstrate that the loss could not have been avoided despite reasonable efforts. ESMA s advice sets out three actions that, if taken by the custodian, will have the effect of the custodian being regarded as having made reasonable efforts: 18 (a) it has ensured that it has appropriate means to identify and monitor external events it could reasonably identify which could lead to a loss; (b) it has assessed on an ongoing basis whether any events identified in (a) present a significant risk of loss; and (c) where it has identified such events in (b), it has taken appropriate action, if any, to prevent or mitigate the loss. While (c) is likely to be covered by disaster recovery, business continuity and other risk management policies currently maintained by custodians, (a) and (b) are likely to require a bolstering of the risk monitoring processes of custodians. Moreover, under ESMA s advice, the custodian has a duty to consider seeking a transfer of its liability to a sub-custodian or termination of its contract with the AIFM where the AIFM has ignored repeated warnings from the custodian as to an unsatisfactory level of protection for the AIF s assets. 19 Whilst investment risk identification and monitoring will continue to be the preserve of the AIFM, the custodian, on an assessment of the risks associated with a particular sub-custody market, may decide to withdraw from providing sub-custody services in that market. Objective reasons to contract a discharge The AIFMD provides that the custodian s liability to the AIF and the investors of the AIF is not affected by delegation of its safe-keeping functions to a sub-custodian. However, under the AIFMD, the custodian can discharge its liability in the event of a loss of financial instruments held by a subcustodian if certain conditions are met, including delegation in compliance with the AIFMD s requirements, a written contract between the custodian and the sub-custodian transferring liability and a written contract between the custodian and the AIFM discharging liability and establishing the objective reason for the discharge. 20 ESMA s technical advice proposes that, to establish the objective reason for the discharge, the custodian must demonstrate either that it had to appoint a specific sub-custodian as a result of an applicable legal requirement or that the delegation of its custody functions to the subcustodian is in the best interests of the AIF (for example, where the sub-custodian has particular relevant expertise) and the AIF would not be disadvantaged. 21 In practice, it should not be problematic for custodians to demonstrate that it is in the best interests of the AIF to appoint a specialist sub-custodian in the relevant country. However, it remains to be seen: whether sub-custodians will be prepared to accept a transfer of liability; what the form that the transfer of liability may take; and whether AIFMs will agree to transfer in the first instance. Conclusion Given the long-established practices of the market on liability standards, on which custodians have built risk models, legal documentation, systems and processes, and, of course, fee structures, it is likely that the above proposals may have a significant impact on all these areas. The current liability standard of the market is that a custodian excludes liability to an AIF except to the extent of its negligence, fraud or wilful default, or that of its affiliates. In addition, the market standard tends towards custodians accepting responsibility for losses arising from affiliated sub-custodians, but excluding responsibility, in varying degrees, for those caused by non-affiliates. Against this background, it becomes apparent that ESMA s approach may benefit the custodian whose network is made up predominantly or wholly of affiliates or branches, since it will be able to better assess and manage the custodial risks within a group structure and marry the new AIFMD liability regime to its existing approach to liability caused by affiliated subcustodians. For example, as referred One can see that a custodian with a network made up predominantly of affiliated companies may more easily accommodate ESMA s pronouncement that it regards fraud within a custodian s network as an internal event. 32 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

36 United Kingdom to above, custodians will typically exclude liability for the fraud of non-affiliates. One can see that a custodian with a network made up predominantly of affiliated companies may more easily accommodate ESMA s pronouncement that it regards fraud within a custodian s network as an internal event rather than were its sub-custodians to be predominantly non-affiliates. Peter McGowan Partner, Private Investment Funds, Hedge Funds and Financial Services Group Proskauer Rose LLP Kimberly Everitt Associate, Private Investment Funds Group Proskauer Rose LLP 1 Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers. 2 Final Report: ESMA s technical advice to the European Commission on possible implementing measures of the Alternative Investment Fund Managers Directive (ESMA/2011/379) (Final Report). 3 Article 21(11) of the AIFMD. 4 See paragraph 4 of the explanatory text to Box 89 of the Final Report. 5 Box 89 of the Final Report. 6 See paragraph 6 of the explanatory text to Box 89 of the Final Report. 7 Box 90 of the Final Report. 8 See the requirements in article 16 of the UCITS IV Organisation Directive (Commission Directive 2010/43/EU of 1 July 2010 implementing Directive 2009/65/EC of the European Parliament and of the Council as regards organisational requirements, conflicts of interest, conduct of business, risk management and content of the agreement between a depositary and a management company). 9 Box 90 of the Final Report. 10 See paragraphs 4 and 5 of the explanatory text to Box 90 of the Final Report. 11 Article 21(12) of the AIFMD. 12 Box 91 of the Final Report. 13 See paragraph 17 of the explanatory text to Box 91 of the Final Report. 14 Article 21(12) of the AIFMD. 15 Box 92 of the Final Report. 16 See paragraphs of the explanatory text to Box 92 of the Final Report. 17 See paragraphs 29 and 30 of the explanatory text to Box 92 of the Final Report. This article is designed only to give general information on the developments actually covered. It is not intended to be a comprehensive summary of recent developments in the law, treat exhaustively the subjects covered, provide legal advice or render a legal opinion. 18 Box 92 of the Final Report. 19 See paragraph 35 of the explanatory text to Box 92 of the Final Report. 20 Article 21(13) of the AIFMD. 21 Box 93 of the Final Report. European Fiduciary Services News and Views First Edition 2012 AIFMD Special 33

37 United Kingdom The issues and impacts of Article 19 of the AIFM Directive: External Valuers and Valuation Requirements This article focuses on the key issues and impacts on the alternatives industry of Article 19 of the AIFMD 1, which imposes obligations on AIFMs to introduce procedures for the independent valuation of alternative investment fund (AIF) assets. The Alternative Investment Fund Managers Directive (AIFMD or the Directive) entered into force on 21 July 2011 and must be implemented by EU Member States by 22 July The Directive aims to create a comprehensive and effective regulatory and supervisory framework for managers of alternative investment funds (AIFMs) at European level. In the European Commission s (EC s) view, the Directive will provide robust and harmonised regulatory standards for all AIFMs within scope. For investors and regulators, it will enhance the transparency of the activities of AIFMs and the funds they manage. AIFMs and self-managed funds will become subject to new valuation obligations and requirements under Article 19 of the Directive. Article 19 should be read in conjunction with the recent final advice on possible AIFMD implementing measures (also known as the Level 2 measures) issued by ESMA to the Commission on 16 November 2011, 2 which contains suggested implementing measures on valuation under the AIFMD. It should be noted that ESMA s final advice is just that advice. The Commission, under the new Post- Lisbon processes for the production of European regulation, is now empowered to accept or reject advice in those areas where it has particularly strong views. Notwithstanding this risk, which is real in areas such as depositary liability, the definitions of assets held under strict liability and the so called third countries regime, in many areas the Level 2 measures give a clear picture of what the AIFMD regulatory framework will mean for the alternatives industry, and substantial portions of the final advice are likely to pass through without material change, giving the industry a pretty clear picture of the standards with which it will have to comply. Valuation under the AIFMD The basic requirements for valuation processes are derived from the UCITS framework and, at least at a superficial level, contain no substantial surprises and appear reasonable. Again, at least superficially, they do not appear to be overtly in conflict with current best industry practice. The core legal requirements set out in Article 19 are as follows. An AIFM is required to have in place proper and independent procedures for the valuation of the assets of each of the AIFs that it manages. An AIFM must also ensure that the net asset value (NAV) per share or unit issued by the AIF is calculated in accordance with methodologies and processes as defined by the fund documentation and national law. The NAV must be disclosed to investors at least annually, and otherwise at times consistent with the timing of subscriptions and redemptions. The Directive provides that the valuation function may be performed by either the AIFM or a professional (regulated) third-party valuer. Member States can require an AIFM that carries out its own valuations to have them, or its valuation procedures, verified by an external valuer or, where appropriate, an auditor. Third-party valuers will be required 34 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

38 United Kingdom to provide professional guarantees in written form, designed to provide evidence of their qualification and capability to perform the valuation with respect to the assets they have been appointed to value. Valuations must be performed impartially and with all due skill, care and diligence. Most importantly, third-party valuers have unlimited and uncapped liability to the AIFM for any errors in their valuation. The basic requirements for valuation processes are derived from the UCITS framework and, at least at a superficial level, contain no substantial surprises and appear reasonable. Details of the valuation procedures for an AIF (including pricing methodology and methods for valuing hard-to-value assets) must be made available to investors before they invest, and this information must be updated to reflect any material changes. This information should also be provided to an AIFM s regulator when the AIFM applies for authorisation. Valuations must be disclosed to investors in the manner required by the AIF rules. The industry s response to Level 1 The industry greeted the initial drafts of the Level 1 text with concern. The requirements had been for all valuations to be conducted by an independent valuator and had also taken little account of the numerous valuation codes not encapsulated in national law, e.g. the various codes issued by the Royal Institution of Chartered Surveyors (RICS) for the valuation of real estate. Furthermore, there were (and remain) significant concerns about liability and also, materially, about who, in the supply chain, might actually be regarded as an independent valuer. For example, are administrators who are price aggregators accepting data feeds from the markets they watch on behalf of managers to be treated as valuers? The Level 1 text was unclear. The Level 2 consultation stage When the Commission issued its request to CESR 3 (now ESMA), it did not directly recognise many of these issues. ESMA s brief was to advise the Commission on criteria for the proper valuation of assets and the calculation of the NAV. ESMA was also requested to advise what type of specific professional guarantees an external valuer should be required to provide. ESMA was also requested to advise on the frequency of valuation carried out by open-ended funds. Not unsurprisingly, industry commentators took the opportunity to raise a number of issues and areas of concern about the possible adverse implications of Article 19. Valuations must be performed impartially and with all due skill, care and diligence. Most importantly, third-party valuers have unlimited and uncapped liability to the AIFM for any errors in their valuation. The potential liability of external valuers In terms of concerns over liability, while it was generally conceded that a negligent external valuer should be liable for reasonably foreseeable losses, which would be consistent with current law, the Directive s prescription for liability lacks both proportionality and certainty. While AIFMs are ultimately responsible for the proper valuation of AIF assets to the AIF and its investors, the external valuer shall be liable to the AIFM for any losses suffered by the AIFM as a result of the external valuer s negligence or intentional failure to perform its task. This raises two immediate concerns: firstly, potential exposure to unlimited liability over an unlimited timeframe ( any losses suffered ), without any reference to obvious and legitimate distinctions between direct and consequential loss; and secondly, no guidance about European Fiduciary Services News and Views First Edition 2012 AIFMD Special 35

39 United Kingdom exactly what would constitute a valuer s intentional failure to perform. Commentators also noted that the threat of potential uncapped liability could make it difficult for external valuation firms to obtain insurance cover and/or materially increase insurance premiums. This could lead to valuation firms leaving the market, compromising both the availability and the capabilities of the firms that remain. There remain uncertainties in the context of valuation. ESMA s final advice has not addressed the governance role and responsibilities of AIFs and their governing bodies in valuation. Also, for many managers, there will be conflicts to manage and operational issues with how administrators, prime brokers and depositaries will work together. Proving functional independence Another area of concern was the requirement that if the valuation function is performed by the AIFM itself, it must be functionally independent from the portfolio management function. This may be particularly difficult for a small manager, where all functions sit closely under one roof, and where the principal will often be hands-on in all areas. How this issue will be resolved will be interesting will the formation of a valuation committee suffice where the portfolio manager has no more than a right of challenge? Article 19(4) stipulates some organisational requirements to ensure functional independence of the process for the valuation of assets. For example, an AIFM must put in place measures to mitigate conflicts arising from its remuneration policy and to prevent undue influence on staff. However, commentators have expressed concern that there is insufficient clarification in the draft Level 2 implementing measures as to what the AIFM must do to prove functional independence. The delegation of the NAV calculation for an AIF We also mentioned issues with the role of administrators. The Directive provides for the delegation of certain AIFM functions to third parties. Many AIFMs perform the valuation function themselves, but delegate parts of the task to third-party fund administrators (e.g. the NAV calculation for an AIF but off the back of formulae or values provided by other third parties or the AIFM itself). In the explanatory text of ESMA s final advice, it states that a fund administrator performing the NAV calculation would not be considered to be an external valuer, as defined by the Directive, as long as the administrator only incorporates values provided by pricing sources, the AIFM or the external valuer(s). Share or unit concept in the context of private equity or real-estate AIFs It is not clear how the share or unit concept is to be applied in the context of AIFs that issue neither shares nor units (of the sort contemplated by the Directive), such as private equity or real-estate AIFs structured as limited partnerships. This may well need to wait for individual national regulators to make rules. The role of fund boards Another area that the Directive fails to address, and where industry is only now identifying issues, is the role of fund boards. As a general principal, fund directors or other governing bodies have fiduciary obligations to investors and generally include in the list of matters that would fall within their responsibilities issues of NAV and valuation. Traditionally they own valuation. Under the AIFMD model, valuation is owned, at least for Directive purposes, by the manager and while the AIFMD may be competent to impose statutory obligations on a manager, it is not competent to remove common law or equitable duties from boards. How this conflict will be resolved will depend not least on some quite interesting discussions between fund boards and their appointed managers. ESMA s final advice to the Commission on valuation Notwithstanding the issues mentioned, overall, the industry welcomed ESMA s proposed measures on valuation, which provide a robust framework adaptable to the specific characteristics of the diverse range of assets in which AIFs can invest and the rules in different jurisdictions. The final advice also provides some useful clarifications: The requirement for valuations to be applied consistently across all AIFs managed by the same AIFM has been removed. ESMA recognises that different AIFs can need different valuation policies. The valuation of the AIF s assets can be performed by one or several external valuers or the AIFM. The AIFM s potential liability in case of improper valuation is unaffected by the the appointment of an external valuer. As discussed above, ESMA has clarified who would fall into the category of external valuers. ESMA makes it clear that, as an example, a fund administrator performing the NAV calculation, which does not provide the valuations for individual assets or exercise any subjective judgement on such valuations, would not be 36 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

40 United Kingdom Overall, the industry welcomed ESMA s proposed measures on valuation, which provide a robust framework adaptable to the specific characteristics of the diverse range of assets in which AIFs can invest and the rules in different jurisdictions. considered the external valuer as long as the administrator only incorporates values provided by pricing sources. Third-party pricing vendors/sources are also not considered to be external valuers. Rules applicable to the calculation of the NAV are subject to the national law of the country where the AIF has its registered office or those laid down in the AIF s rules or instruments of incorporation. As a general rule, valuation of financial instruments must take place every time the NAV is calculated. However, the valuation of assets that are not financial instruments must take place at least once a year. The advice also sets out some general principles on the calculation of the NAV: For open-ended funds, the valuation of financial instruments must be carried out each time a NAV is calculated. The valuation of other assets (such as real estate or participations in non-listed companies) must be carried out at least annually, unless the last determined value is no longer considered fair or proper. For closed-ended funds, valuation must be carried out at least annually and whenever there is an increase or decrease in capital. ESMA does not provide any additional guidance in its final advice. This leaves it unclear whether, for example, a valuation is needed every time a private equity manager calls upon pre-existing commitments. Conclusion There remain uncertainties in the context of valuation. ESMA s final advice has not addressed the governance role and responsibilities of AIFs and their governing bodies in valuation. Also, for many managers, there will be conflicts to manage and operational issues with how administrators, prime brokers and depositaries will work together. While it is understandable that many in the industry will now be waiting to see how the Level 2 advice is finally shaped, for those who wish to intervene proactively the next few months represent the last real opportunity to lobby for meaningful changes in any remaining areas of concern that could adversely affect the industry. James Greig Partner PwC Financial Services Regulatory Practice Peter Wilson Senior Associate PwC Financial Services Regulatory Practice 1 Proposal for a Directive of the European Parliament and of the Council on Alternative Investment Fund Managers and amending directives 2003/41/EC and 2009/65/EC, April ESMA s technical advice to the European Commission on possible implementing measures of the Alternative Investment Fund Managers Directive, November European Commission provisional request for a technical advice on the Directive for AIFM Level 2 measures, 2 December European Fiduciary Services News and Views First Edition 2012 AIFMD Special 37

41 United Kingdom Leverage, transparency and supervision under ESMA s technical advice to the EC on AIFMD implementing measures This article summarises certain key aspects that relate to leverage, transparency and supervision in the European Securities and Markets Authority s (ESMA s) technical advice to the European Commission (EC) on possible implementing measures of the Alternative Investment Fund Managers Directive (the AIFMD or the Directive) dated 16 November 2011 (ESMA s advice). The calculation of leverage ESMA s advice addresses the methodologies for the calculation of leverage under Article 4 of the Directive, taking account of the methods by which alternative investment fund managers (AIFMs) increase the exposure of alternative investment funds (AIFs) under their management through the borrowing of cash or securities, through leverage embedded in derivative positions or by any other means. ESMA s advice aims for a harmonised regime for calculating an AIF s exposure. In doing so, ESMA draws on CESR s Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS (CESR Guidelines), noting that, in comparison to UCITS, the population of AIFs is significantly more heterogeneous. Many AIFs use financial derivative instruments as part of complex investment strategies, and it is important to ensure that methods of calculating leverage capture all the investment strategies pursued by AIFMs. Despite general disagreement on the part of respondents to ESMA s previous consultation, the exposure of an AIF is to be calculated in accordance with two mandatory methods referred to as the gross method and the commitment method. A third method (which would in all cases be in addition to these two mandatory methods) can be adopted by an AIFM at its request and after notifying its regulator. Many respondents to the consultation would have preferred the use of the value-at-risk (VaR) method and asked ESMA to reconsider it. Having analysed the different comments received during the consultation, ESMA decided not to change the approach to the calculation of leverage. 38 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

42 United Kingdom The overall leverage of an AIF should be expressed as a ratio between the exposure of an AIF and its net asset value (NAV). The gross method The exposure of an AIF calculated in accordance with the gross method is the sum of the absolute values of all positions subject to: a) The value of any cash and cash equivalents that are highly liquid investments held in the base currency of the AIF that are readily convertible to a known amount of cash, subject to an insignificant risk of changes in value and provide a return no greater than the rate of 3-month high-quality government bonds being excluded from the calculation. b) Financial derivative instruments being converted into the equivalent position in their underlying assets. c) Cash borrowings that remain in cash or cash equivalent and where the amounts of that which is payable are known to have been excluded from the calculation. d) The exposure resulting from the reinvestment of cash borrowings should be included in the calculation. e) And positions within repurchase or reverse repurchase agreements and securities-lending or -borrowing agreements should be included. The commitment method The exposure of an AIF is calculated according to the commitment method by: a) Converting each financial derivative instrument position into an equivalent position in the underlying asset of that derivative. b) Applying netting and hedging arrangements. c) And calculating the exposure created through the reinvestment of borrowings where such reinvestment increases the exposure of the AIF. The exposure of an AIF under the commitment method will be the sum of a) less b) plus c). The advanced method An AIFM, which has notified its regulator must calculate the exposure of an AIF it manages in accordance with the advanced method for all assets of the AIF on the basis of the following requirements: a) It must calculate the exposure for each financial derivative instrument position under the commitment method where that calculation provides a meaningful result. b) In all other cases, the AIFM should employ a calculation method that it considers will result in an appropriate approximation of the AIF s exposure, which may include the estimated maximum loss. c) Offsetting arrangements may be taken into account in relation to all assets if they offset risks linked to all or part of an asset or liability of the AIF and if the following conditions are satisfied: i) The AIFM can demonstrate that the arrangements are likely to remain materially effective in times of stressed market conditions. ii) And there is a verifiable reduction in risk at the level of the AIF. In calculating the exposure of an AIF under the advanced method, the AIFM should take the following principles into account: a) The methodology should be fair, conservative and not underestimate or give a misleading view to investors of the exposure of the AIF. b) The approach must be consistently applied over time and, where applicable, between AIFs. c) And the AIFM should demonstrate that the calculation method employed and the positions that are offset in it as described above are consistent with how the AIFM manages risk within that AIF. Limits to leverage or other restrictions on the management of AIFs The AIFMD requires regulators to exercise supervisory powers to impose limits on the level of leverage that AIFMs are entitled to employ or other restrictions on the management of the AIF with respect to the AIFs under its management to limit the extent to which the use of leverage contributes to the build-up of systemic risk in the financial system or risks of disorderly markets. ESMA s advice sets out principles specifying the circumstances under which regulators will exercise these powers. The regulators of the home Member State of an AIFM are required to assess the risks that the use of leverage by that AIFM with respect to the AIFs it manages, could entail, having regard to the extent to which the use of leverage by an AIFM, or by a group of AIFMs, could contribute to the build-up of systemic risk in the financial system, or risks creating disorderly markets. If, following such assessment, the regulators deem it necessary to ensure the stability and integrity of the financial system, after following the notification procedures in the Directive they should impose limits or other appropriate supervisory restrictions on the use of leverage by such AIFMs. ESMA s advice lists illustrative circumstances and criteria that should guide the assessment undertaken by regulators to ensure the stability and integrity of the financial system, including circumstances where the activities of an AIFM or a group of AIFMs in particular with reference to the types of assets in which the AIF invests and the techniques employed by them that contribute or may European Fiduciary Services News and Views First Edition 2012 AIFMD Special 39

43 United Kingdom contribute, through the use of leverage, to the downward spiral in the prices of financial instruments, or other assets in a manner which threatens the viability of such financial instruments or other assets. ESMA believes that it is not appropriate to set any predetermined timeframes for any supervisory intervention by regulators on the use of leverage by AIFMs. ESMA considers that the question of appropriate timing for the imposition of measures should be a matter for the judgment of regulators in each case. It also believes that the competent authority s judgment on appropriate timing should be determined with reference to avoiding or minimising any potential manifestation of systemic risk, with the principal objective of maintaining the stability and integrity of the financial system. Transparency requirements Annual reporting ESMA was requested to advise the Commission on the content and format of the Directive s annual reporting provisions and to cover specific information about the content and format of the balance sheet (or statement of assets and liabilities), the income and expenditure account and the report on activities of the financial year. ESMA was also requested to advise on how material changes in the information covered should best be presented in an AIF s annual report and advise on the content and the format of the remuneration disclosure required under the Directive. ESMA s advice notes major recent changes in financial reporting internationally, including the convergence of international financial reporting standards (IFRSs). ESMA s advice recognises that there are national and international accounting standards in place that set out prescriptive rules in this area, and it seeks to set out a framework that will take account of, and work in parallel with, those existing standards. ESMA considers it important that the Commission s measures on annual reporting provisions should provide for high-level principles that can be applied proportionately to AIFs and should be sufficiently flexible to allow for differentiated and proportionate application that takes account of the nature, scale and complexity of an AIFM s business and the nature and size of the AIF it manages. The Directive requires disclosure of the aggregate amount of remuneration broken down by senior management and members of staff of the AIFM whose actions have a material impact on the risk profile of the AIF. ESMA suggests that account should be taken of the work undertaken as part of the European Banking Authority s guidelines on the identification and categorisation of staff whose actions have a material impact on the risk profile of the AIF to ensure a consistent and proportionate approach. But additional tailoring would be required to reflect the specifics of asset management. ESMA seeks to ensure proportionate application of the Directive to avoid situations where disclosure would be required for smaller AIFMs, which would identify the remuneration of an individual member of staff. Disclosure to investors ESMA was requested to provide advice in relation to the appropriate frequency, content and format of certain key disclosure obligations on AIFMs, as outlined below. The key recommendations emerging from that are: Periodic disclosure to investors Percentage of assets subject to special arrangements (such as side pockets and other similar arrangements) must be disclosed as part of the AIF s periodic reporting to investors, as required by the AIF rules or instruments of incorporation, prospectus and offering documents and, at a minimum, in the annual report of the AIF. New arrangements for managing the liquidity of the AIF: AIFMs must immediately notify investors where they activate gates, side pockets or similar special arrangements or where they decide to suspend redemptions. The risk profile of the AIF: AIFMs must disclose the current risk profile of each AIF as part of their obligations relating to periodic disclosure to investors as required by the AIF rules or instruments of incorporation, prospectus and offering documents and, at a minimum, in the annual report of the AIF. Risk management systems employed by the AIFM: the main features employed to manage the most relevant risks to which each AIF the AIFM manages is or may be potentially exposed must be made available to investors prior to investment. Thereafter, disclosure obligations are triggered where there are material changes. Regular disclosure to investors ESMA proposes that disclosure should occur whenever a material change is made to the maximum leverage level of an AIF or to the rights of re-use of the collateral and to the nature of guarantees granted. Reporting to regulators The majority of respondents to the consultation disagreed with ESMA s proposal to require information on a quarterly basis for all AIFMs. In the final advice, ESMA recommends that the reporting frequency should be annually, semi-annually or quarterly, depending on the amount of assets managed by the AIFM for information to be reported at the level of the AIFM and on the size of each fund for AIF-related information. The final advice recommends that AIFMs should report on an annual basis for each unleveraged AIF under its management, 40 European Fiduciary Services News and Views First Edition 2012 AIFMD Special

44 United Kingdom which, in accordance with its core investment policy, invests in non-listed companies in order to acquire control. The template developed by IOSCO, published on 25 February 2010, concerning reporting by hedge funds, has been used as a starting point and has been expanded to apply to AIFs of all types. The Commission also requested that ESMA consider the criteria to be used to determine under which conditions leverage is to be considered as being employed on a substantial basis. ESMA does not consider it appropriate to specify a quantitative threshold. Instead, it is proposed that a distinction be drawn based on whether the degree of leverage employed could contribute to the buildup of systemic risk in the financial system or the risk of disorderly markets. Cooperation arrangements for supervision Third countries ESMA was requested to advise the Commission on a common framework to facilitate the establishment of cooperation arrangements between EU and non-eu AIFs, covering: EU AIFMs managing non-eu AIFs that are not marketed in Member States. EU AIFMs marketing non-eu AIFs in the EU without a passport. Non-EU AIFMs marketing EU or non- EU AIFs in the EU without a passport. EU AIFMs marketing non-eu AIFs in the EU with a passport. Non-EU AIFMs authorised to manage EU AIFs and/or market AIFs in the EU with a passport. And non-eu AIFMs marketing non-eu AIFs in the EU with a passport. The cooperation arrangement with the third-country regulator should be in writing and provide for: a) The exchange of information for supervisory and enforcement purposes. b) The ability to obtain all information necessary for the performance of the duties provided for in the Directive. c) The ability to carry out an on-site inspection where required for the exercising of the EU regulator s obligations under the Directive. The on-site inspection should be performed directly by the EU regulator or by the third-country regulator with the assistance of the EU regulator. The third-country 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 third country. Where specific reference is made to the exchange of information for the purpose of systemic risk oversight, the arrangement should allow the EU regulator to receive information on a regular basis to discharge its duties under the Directive. The cooperation and exchange of information between EU regulators ESMA s advice sets out a pro forma reporting template for information to be communicated by AIFMs to regulators. Outstanding issues, such as the data format and conditions of secured data transmission, will be addressed in additional ESMA guidelines. Member State of reference: the authorisation of non-eu AIFMs In cases of conflict between regulators of several Member States as to which should be the Member State of reference of a non-eu AIFM, the Member State of reference should be identified taking into account the Member State in which the AIFM intends to develop effective marketing for most of its AIFs. ESMA s advice sets out the procedure and timetable for achieving agreement and states that ESMA should facilitate agreement between the relevant regulators. In the event that the requesting non-eu AIFM is not informed in writing of the decision within the deadlines provided for under Art. 37(4), it can inform in writing all the authorities originally contacted about its choice of the Member State of reference. The Member State where the AIFM intends to develop effective marketing for most of its AIFs should mean the Member State where the AIFM intends to target investors by promoting and offering, including through third-party distributors, most of the AIFs. In order to determine where the effective marketing will take place, the following non-exhaustive criteria should be considered: i) the Member State where the distributors (and the AIFM in 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. The procedure to be followed when a non-eu AIFM opts in to benefit from the EU marketing passport should be the same. Implementing measures The Commission will now work to prepare the implementing measures required by the Directive in light of ESMA s advice. Ronald Paterson Partner Eversheds LLP European Fiduciary Services News and Views First Edition 2012 AIFMD Special 41

45 Sweden Implementing the AIFMD in Sweden Traditionally, the Swedish approach to financial regulation has been viewed as more liberal than some of its EU counterparts, particularly for non-ucits funds. However, given that the AIFMD is driven by European law, this is set to change. The Swedish government has appointed a committee to draft legislation to implement the Directive and new regulations are expected to be put in place once a consultation process has been undertaken with industry representatives. There are a number of concerns that need to be addressed during this process, and these are explained later in this article. There are no reasons to think that Sweden will not be ready for the transposition deadline of July During the last several decades, the Swedish approach to financial regulation, including various types of funds, has been markedly liberal. Outside the UCITS space, the regulation of funds has been light or practically non-existent. Private equity funds have been viewed favourably by governments on both sides of the political spectrum. When MiFID was implemented, the Swedish government went to some lengths to argue that advisers in private equity structures should not require authorisation as investment advisers under MiFID. The marketing of closed-ended funds (such as limited liability partnerships) into Sweden has essentially been unregulated, at least to the extent that the marketing of units in such funds has not been caught by the prospectus rules (which allow for a number of exemptions). Interests in limited partnerships have not been deemed to constitute transferable securities and therefore they have not been subject to the prospectus requirements. The marketing of openended funds has also (until very recently) for all practical intents and purposes been unregulated (in the summer of 2011 the marketing of such funds became regulated for the first time by being subject to an authorisation requirement without exemption). Swedish hedge funds have been subject to regulation for a long time primarily to provide for the legal form of contractual funds with individually approved fund by-laws. Hedge funds have not been identified as a problematic segment of the financial markets (research at the Riksbank [the Swedish Central Bank] has confirmed that hedge funds have not contributed to the detriment of either the soundness or stability of financial markets). Unlike certain other jurisdictions, there has been until quite recently virtually no meaningful political concerns about the private equity industry. The pooling of venture capital for the Swedish industry in the form of private equity funds has generally been regarded as benign by Swedish politicians from various parties. More recently, though, certain tax concerns have become subject to some political interest, in particular, in respect of investment in private suppliers of publicly funded welfare services, such as healthcare and education. However, the political concern has focused on how to craft appropriate tax laws and laws on the private provision of publicly funded Mar-00 Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 1, European Fiduciary Services News and Views First Edition 2012 AIFMD Special

46 Sweden services, rather than on regulating the private equity industry itself. Investment in various fund structures is widespread among Swedish households. Investors choose to invest not only in domestic funds but also to a large extent in foreign funds. Both the private and the public segments of the pensions industry invest heavily in various funds, including public investments in private equity and hedge funds. The development of the aggregate of fund investments by Swedish investors is set out in the graph opposite (from March 2000 to September 2011; figures in billions of SEK1). According to the statistics published by the Swedish Investment Fund Association, Swedish investors invested the majority of their fund savings in equity funds during the period between 2000 and It was only in 2008, and as a result of the financial crisis, that equity funds accounted for less than 50% of total fund assets. Swedish fund assets increased during the period from 2000 to 2010 from SEK888 billion to SEK1,928 billion. Net savings in funds have, on average, totalled almost SEK70 billion a year from 2000 to In 2009, levels of fund investments reached record levels, with net investments totalling SEK135 billion. A net total of SEK86 billion was invested in funds in The biggest deposits were made in global funds (SEK14 billion) and Swedish funds (SEK13 billion), but investments in other markets (BRIC, Latin America and Africa) were also popular in 2010 (SEK11 billion). However, net withdrawals were made from Swedish and global funds (SEK6 billion), which primarily comprise the former public savings programmes, and withdrawals from European funds (SEK5 billion), which were negatively affected by the financial problems in southern Europe. Net savings in pension-linked fund savings have remained high throughout the first decade of the current century and have comprised at least half of total new savings. In 2010, pension-linked fund savings accounted for 64% of net inflows. Pension-related savings in investment funds account for an increasingly large percentage of total fund savings in Sweden. European Fiduciary Services News and Views Investment in various fund structures is widespread among Swedish households. Investors choose to invest not only in domestic funds but also to a large extent in foreign funds. Both the private and the public segments of the pensions industry invest heavily in various funds, including public investments in private equity and hedge funds. First Edition 2012 AIFMD Special 43