The Alternative Investment Fund Managers Directive. March 2012

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1 The Alternative Investment Fund Managers Directive March

2 The Alternative Investment Fund Managers Directive Introduction We should now work from the assumption that the question is "how" rather than "when" or "if" implementation of the AIFMD will occur. The AIFM Directive was published in the Official Journal on 1 July ESMA published its technical advice to the European Commission on possible implementing measures on 16 November 2011 and a Discussion Paper in February 2012 regarding Key Concepts of the Alternative Investment Fund Managers Directive and types of AIFM. We also have the FSA's Discussion Paper on implementation of the Directive in the UK (DP12/1). In the relatively near future, AIFMs should be in a position to plan ahead to accommodate the AIFMD. A key challenge is to focus efforts on ensuring that the level 2 and 3 implementing measures, and consequential implementing provisions in the UK are workable. Many interesting issues had been deferred to the Level 2 underlying levels and so they will need some careful consideration during The expectation is that the Commission will issue proposals for these implementing measures soon and there will be delegated and implementing acts by mid It is also expected that some measures may be enacted as regulations that are directly applicable in Member States. There is though an aggressive and tight timetable for implementation. Consequently there is a need for alternative fund managers to plan ahead quite quickly. AIFMs, and also depositaries, valuers and administrators, now need to review the details of the likely provisions and consider how they can best adjust so as to comply with the Directive and what if any amendments are required for their Funds' documentation for the AIFs with which they are involved. Timeline The basic time line through to the Directive's transposition date of 2013 is relatively clear. As mentioned above, the timescales for the implementation are aggressive and tight. An outline timeline for transposition of the Directive is attached as Appendix 1 to this Briefing Paper. There is also however a second time line we ought to be considering. For this second timeline, the provisions are less certain and it runs on until Whilst we also outline, in Appendix 2, this second timeline which runs from the transposition date, this will of course need to be treated with caution. Some of the events it contemplates will depend on future events as explained in the discussion of the third country issues below. The AIFMD's objective(s) The expressed objective is: to ensure that there are some common requirements governing the authorisation and supervision of alternative investment fund managers in order to provide a coherent approach to the related risks and their impact on investors and markets in the EU because, whilst the impact of AIFMs on the market in which they operate is largely beneficial, recent financial difficulties have underlined how the activities of AIFMs may also spread or amplify risks through the financial system. (Article (2)) The focus is of course principally on hedge funds in making this comment. Of course the underlying concerns were in origin more politically driven and may, to some extent, be unrelated to the consequential provisions we now see in the Directive. It was generally accepted that hedge funds had not been a cause of difficulty. In the published papers, the list of purposes included: regulating AIFMs appropriately; protecting European investors; providing mechanisms to prevent systemic risks (which is really the expressed objective now contained in the recital mentioned above); providing an alternative investment fund with a passport for marketing EU alternative funds to professional investors; providing a passport for an alternative investment fund manager to manage funds in other European countries; and possibly offering a new brand for alternative funds (as UCITS is now a global brand for retail funds)? 2

3 It is perhaps important though, when looking at the implementation measures - and when considering how you adapt to accommodate this Directive - not to be too much influenced by some of the original reasons behind the Directive. Perhaps we should now focus on the possible consequences that may be achieved as a result of the Directive. These may be somewhat different from what might originally have been envisaged. Its scope Much of the concern from the outset of the consideration of this Directive has been that it does not hit the target at which it was originally aimed principally hedge funds. It has turned itself into a measure which covers everything which is not a UCITS fund. It will be imposing a level of regulation on all manner of fund managers many of whom will have had no connection with some of the perceived ills to be sorted. Consequently the better course may be to start from a position of seeing the Directive now as a way of achieving a co-ordinated approach to management of investment funds, with this Directive to sit alongside the UCITS Directive, and try to seek some clarity from this starting point? What is an AIF? Whilst the Directive of course purports to deal with alternative investment fund managers, the first necessary step is to identify what is an alternative investment fund or AIF. AIFs are defined to mean: collective investment undertakings, including investment compartments thereof which: a. raise capital from a number of investors, with a view to investing it in accordance with a defined investment policy for the benefit of those investors; and b. do not require authorisation pursuant to Article 5 of [the UCITS Directive [Directive 2009/65/EC]. ESMA, in its recent Discussion Paper, is rightly focusing on the criteria to identify an AIF which arise from this definition. It is consulting on the criteria: Perhaps fundraising should involve capital raising for an investment primarily undertaken for commercial purposes intended to deliver an investment return or profit? Capital raising must involve some kind of communication by way of business? (Use of this criteria may though lead to debates similar to those which we have had in the UK regarding what might constitute "by way of business," with a consequent reluctance to rely on this point?) A fund which has a constitution which does not restrict the sale of units or shares to a single investor could potentially be an AIF and even where there is a single investor, if that investor might represent a number of underlying beneficial owners, the fund could still fall within the AIF definition; various others of the criteria suggested look suspiciously like elements from our collective investment scheme definition of which the UK has a long history such as that the investors have no day to day discretion or control over assets and investors usually have entitlement to profits or income arising from their investment in the AIF's assets. Even if ESMA finalise a list of criteria, the definition is likely to have some uncertainty at the edges as to its scope. The range of AIFs is extremely wide and, at the edge, is still arguably uncertain, although many fundamental points will likely now have been clarified. It will effectively cover all investment funds which are not UCITS funds. It will therefore encompass: open and closed ended funds Note that ESMA puts forward in its Key Concepts Discussion Paper a notion that open ended funds should be defined as funds the units/shares of which may, at the holder's request, be repurchased or redeemed without any limitation directly or indirectly out of the assets of these undertakings at least annually. This would be solely for the purposes of AIFMD; listed funds; regulated non-ucits funds as well as those funds which we thought were intended to be encompassed by the Directive: hedge funds; private equity funds; and property funds. 3

4 The Alternative Investment Fund Managers Directive There are some exemptions contained within Articles 2 and 3. The Directive will therefore not cover: holding companies; occupational pension scheme arrangements and the authorised entities responsible for managing such; supra and national institutions such as the European Central Bank, European Development Financial Institutions, The World Bank, the IMF etc, in the event that such institutions or organisations manage AIFs and insofar as those AIFs act in the public interest; national central banks; local governments and bodies and other institutions which manage funds supporting social security and pension systems; employee participation schemes or employee savings schemes; and securitisation special purpose entities. In addition there should be effective exclusions for: joint ventures: Recital 8 states that the Directive should not apply to a joint venture. This probably relates to a commercial joint venture where participants are all actively involved in its management and control but the precise characteristics of such will need to be further developed; and family investment vehicles: Recital 7 of the Directive states these will not be considered to be an AIF. This will cover a vehicle investing private wealth of related investors without the raising of external capital but again the details of its extent need to be defined. The FSA identify key characteristics as where there is a family relationship between the investors; the money or assets are in someway connected to the relationship and there is no raising of capital for investors outside the relationship; and the money or assets and the relationship between investors are likely to pre-date the relationship between the investors of the AIF or AIFM. Not unexpectedly, the FSA Discussion Paper highlights the fact that the UK needs to consider its definition of "alternative investment fund" and its implications for the section 235 FSMA definition of a collective investment scheme. As you might expect, the UK is carefully considering the specific limits of the exemptions and may develop permitted guidance in respect of them. At the moment, around the edges, it is too early to say quite how some of these might be defined. It does however seem likely that some of the above will not sit entirely easily alongside our existing UK definition of a collective investment scheme and there will need to be some consideration given to whether we keep that definition. It would seem possible that we will end up with additional defined terms, which could well lead to some new areas of confusion. Some of the relevant categories are set out in the diagram in Appendix 3 to this Briefing Paper. UCITS funds will remain and are easy to see and identify. But non-ucits AIFs may encompass non-ucits regulated CIS, unregulated CIS and then an additional category of AIFs which are outside of the UK CIS definition. Items to be considered in this area by the UK will be whether or not it decides to retain its UK specific additional restrictions on promoting unregulated collective investment schemes in the UK. Just to add to potential confusion, ESMA is carrying out a mapping exercise among Member States' regulators to establish, to the extent possible, the types of AIF which currently exist in the EU. Any such developed list may simply add additional complication and indeed ESMA acknowledge that a categorisation by reference to asset classes might not be the correct approach. ESMA therefore see merit in developing other criteria to identify AIFs with a view to establishing a harmonised application of the AIFMD. Who is the AIFM? Assuming we are in AIF territory, the focus of the Directive is of course on the alternative investment fund manager rather than the AIF itself (although in fact, for reasons we will see later, the funds will inevitably themselves be affected). The definition of an AIFM is suspiciously simple meaning: legal persons whose regular business is managing one or more AIFs. The key criteria to note are as follows: it must be a legal person; there will only be a single AIFM for each AIF this being an entity which shall be responsible for ensuring compliance with the AIFM Directives; it can be an external manager (a legal person appointment by the AIF or on behalf of the AIF and which through this appointment is responsible for 4

5 managing the AIF) or, where the legal form of the AIF permits internal management and where the AIF s governing body chooses not to appoint an external AIFM, the AIF itself which shall then be authorised as an AIFM; ESMA in its Key Concepts Discussion Paper highlights that, depending on the structure of the AIF, there may be more than one legal entity which could be appointed as AIFM to that AIF and seems to indicate that limited partnerships may be capable of internal management as with corporate AIFs. The likely difficulty though is where more than one entity might be involved. ESMA indicate that the AIF is free to appoint any legal person as AIFM provided this entity is authorised under the AIFMD because there are no provisions in the Directive which impose conditions or criteria on the AIF for the appointment or selection of the AIFM. Also, they emphasise that it is important to distinguish between the circumstances where there is an investment manager performing investment management functions and an entity which is the appointed AIFM for the AIF. The terms of any agreement should be clear as between the AIF and a third party regarding the nature of the relationship and the responsibilities of each party. This will likely have consequences for the terms of material contracts for investment funds. Managing AIFs means performing at least investment management functions referred to at points (a) or (b) of Annex I for one or more AIFs. Paragraph 1 of Annex 1 states: Investment management functions which an AIFM shall at least perform when managing an AIF are: i. portfolio management; ii. risk management. There has been much debate as to whether this should mean portfolio management and risk management have to be performed by an AIFM or whether it in fact does mean what the definition actually says, which is portfolio management or risk management. The recent ESMA Discussion Paper on Key Concepts indicates that ESMA considers that this means that an entity performing either of the two functions is to be considered as managing an AIF and must consequently therefore seek authorisation as an AIFM subject to it being understood that no such authorisation is required when the performance of either the portfolio management or the risk management function is done under a delegation arrangement with an AIFM under Article 20. They seem to be interpreting Article 6(5) (d) to require an AIFM to be capable of providing and to take responsibility for both portfolio management and risk management functions in order to obtain AIFM authorisation however. Small AIFMs are excluded. There is an exemption for: AIFMs which either directly or indirectly through a company with which the AIFM is linked by common management or control, or by a substantive direct or indirect holding, manage portfolios of AIFs whose assets under management, including any assets acquired through use of leverage, in total do not exceed a threshold of 100 million; and AIFMs which either directly or indirectly through a company with which the AIFM is linked by common management or control, or by a substantive direct or indirect holding, manage portfolios of AIFs whose assets under management in total do not exceed a threshold of 500 million when the portfolios of AIFs consist of AIFs that are unleveraged and have no redemption rights exercisable within a period of five years following the date of initial investment in each AIF. ESMA s advice is helpfully indicating that it recommends that AIFMs have the option to exclude cross holdings between AIFs managed by the same AIFM, provided that assets acquired through leverage are included in the threshold calculation; there was pushback on thinking of a quarterly calculation of this threshold and it is proposed that it be calculated annually using net asset value of AIFs and that the AIFM should monitor (but not recalculate) their assets under management on an ongoing basis to establish whether a more frequent calculation should be required. The advice does not stipulate the values to be used to monitor assets under management. The ESMA advice seeks to address the possibility of temporary breach of the thresholds, indicating that the AIFM should assess situations where the value of total assets exceeds the threshold and, if it considers that the situation is not likely to be of a temporary nature, seek authorisation indicating that the situation should not be considered to be of a temporary nature if it is likely to continue for a period in excess of three months. It is important to note small AIFMs will not escape the Directive altogether, even if within these small AIFM exemption terms. They will still need: to register with the competent authorities of their home member states they do not escape altogether. 5

6 The Alternative Investment Fund Managers Directive 6 They have to identify themselves and the AIFs that they manage, provide information on the investment strategies of the AIFs that they manage to the competent authorities, regularly provide the competent authorities with information on the main instruments in which they are trading and on the principal exposures and most important concentrations of the AIFs that they manage in order to enable the regulators to monitor systemic risk effectively; and to notify the competent authorities in the event that they no longer meet the exemption conditions. In the UK one would have assumed that identifying the single AIFM would be easy for a UK non-ucits retail scheme expecting it to be its Authorised Fund Manager for UK COLL regulatory purposes. Certainly, ESMA have confirmed in its Key Concepts Paper that a single entity may hold both a UCITS and AIFMD authorisation which would suit the managers of regulated funds. (ESMA though assert that a firm which is authorised under MiFID or the Banking Consolidation Directive cannot be the appointed AIFM for an AIF nor obtain authorisation under the AIFMD.) Interestingly the FSA in its Discussion Paper indicates that discussions with stakeholders suggest that investment fund structures which are corporate vehicles, including OEICs, are likely to be deemed internally managed. Certainly, some models outside the UK may be in this position but, for the UK model, one would have assumed that one still looked to the Authorised Fund Manager as the AIFM, given that ICVCs were designed to be corporate versions of UK authorised unit trusts which focus on the role of the authorised fund manager. The FSA do though indicate that the UK authorities are going to review the UK OEIC Regulations and rules applicable to authorised investment funds to ensure that they are compatible for the Directive requirements of internally managed AIFs, which would indicate that this need not necessarily be the case. The issues of internally managed funds would have been apparent for some offshore fund structures but it now looks as though it may also be relevant onshore fund structures. One reaction to the implementation of the AIFMD may be that some fund structures are organised or re organised in future to refer to one or other particular result, and this will be an area to review carefully, and perhaps cautiously. One particular challenge is for investment funds which are closed ended corporate vehicles, such as UK investment trusts. The FSA continue to believe that the emphasis on the ability of such a vehicle's board of directors to deliver robust oversight for and on behalf of shareholders, in particular over any external portfolio manager, should continue because this should deliver high standards of governance in investor protection in the listed investment funds sphere. Consequently the FSA is considering perhaps introducing a requirement into Chapter 15 of its Listing Rules to set out that, in the case of a premium listed closed ended investment fund, its board of directors must be able to exercise ultimate and unfettered oversight over certain matters. This would include supervision of delegated tasks such as delegation of portfolio management. It may also be that the investment fund itself should hold the AIFM permission as a way of ensuring that the regime for premium listed funds post AIFMD implementation will continue to adhere to UK principles of governance. A further challenge is whether HM Treasury and the FSA follow the "copy out" approach to EU legislation so that small AIFMs would be subject only to the de minimis AIFMD registration regime mentioned above because this could result in what HM Treasury's Discussion Paper refers to as "a considerable and indiscriminate reduction in UK investor protection, including for funds marketed to retail investors". Giving the example of the requirement to avoid conflicts of interest not being applied, the HM Treasury document refers to the potential for this to damage perception of the efficacy of the regulatory regime and lead to the detriment of retail investors such that the Government is minded to apply a more selective approach. Various approaches are therefore being discussed and there is of course a risk of regulatory arbitrage and certainly confusion on this point between jurisdictions or on a case by case basis when applying the provisions. This could involve fund managers in quite difficult issues where they are operating in a number of jurisdictions. And indeed these AIF funds typically involve entities in various jurisdictions. Application for AIFM authorisation The application process Once one has established who is the AIFM, the intention is that that entity must apply for authorisation in their home member state, providing the necessary information which, under the Directive, needs to include: information on the persons effectively conducting the business of the AIFM;

7 information on its shareholders or members, whether direct or indirect, natural or legal persons, that have qualifying holdings (meaning 10% or more of the capital or of the voting rights (in accordance with Articles 9 and 10 of Directive 2004/109/EC) or which makes it possible to exercise a significant influence over the management of the AIFM in which that holding subsists note it is not a straight 10% point); a programme of activity setting out the organisational structure of the AIFM including information on how the AIFM intends to comply with its obligations [under Chapters II, III and IV, and where applicable V, VI, VII and VIII]; information on the remuneration policies and practices (pursuant to Article 13); and information on arrangements made for delegation and sub delegation to third parties of factors as referred to in Article 20; and, in relation to the AIFs, in addition: information about the investment strategies including the types of underlying funds if the AIF is a fund of funds, and the AIFM s policy as regards the use of leverage, the risks profiles and other characteristics of the AIFs it manages or intends to manage, including information about the member states or third countries in which such AIFs are established or expected to be established; if the AIF is a feeder AIF, information on where the master AIF is established; the rules or instruments of incorporation of each AIF the AIFM intends to manage; information on the arrangements made for the appointment of the depositary for each AIF the AIFM intends to manage; and any additional information referred to in Article 23(l) which is the same list of information as will have to be disclosed to investors under Article 23 for each AIF the AIFM manages or intends to manage. Given that UK based AIFMs are used to FSA regulation, one would assume that this could be very much an adjustment process not least because, over the last 2 years or so, the FSA have been in the vanguard of collecting data on hedge funds and this could in effect be viewed as an extension of their work to date. However, it might well be that the specifics which will result in the Level 2 and 3 measures will require UK authorised fund managers to adjust specifics of the nature of the information they need to supply to the FSA. And inevitably they will need to make sure they have actually applied for authorisation as an AIFM. The application can be made from 22 July 2013 and must be made by 22 July (The application must be made for authorisation within one year of 22 July 2013.) The FSA has indicated that it, or rather its successor of the Financial Conduct Authority (FCA), aims to be in a position to receive potential AIFM applications for authorisation from Quarter 2 of The intention is that this would also enable potential FCA authorised AIFMs who wish to use AIFM EU-wide passports for marketing and/or AIF management from 22 July For the key activity of managing AIFs, the FSA is not unexpectedly anticipating that there may be a new regulated activity created under the Regulated Activities Order and that Part IV FSMA authorisation would be required for the managing AIF activity by an AIFM subject to the Directive's full requirements. What might be slightly unexpected is that it is conceivable that there will be three levels and more jargon to learn: most mainstream Alternative Investment Fund Managers becoming classified as an authorised AIFM but there also being the possibility of a registered AIFM (covering the small AIFM exemption terms for those small AIFMs who need to register although not be authorised) and also the notion of a notified AIFM, which would cover non-eu AIFMs from which the FSA have received notification of the marketing of AIFs to UK professional investors so that intermediaries and investors could have an easily accessible list of non- EU AIFMs marketing AIFs to UK professional investors. Please see Appendix 3 for a diagrammatic representation of the possible authorisation/registration activities. Capital requirements The relevant recital to the Directive indicates that it is thought necessary to provide for the application of minimum capital requirements to ensure the continuity and the regularity of the management of AIFs provided by an AIFM and to cover the potential exposure of AIFMs to professional liability in respect of all of their activities, including the management of AIFs under a 7

8 The Alternative Investment Fund Managers Directive 8 delegated mandate. AIFMs are to be free to choose whether to cover potential risks of professional liability by additional own funds or by an appropriate professional indemnity insurance contract. Under Article 9: an AIFM which is an internally managed AIF must have initial capital of at least 300,000; where an AIFM is appointed as an external manager of AIFs, the AIFM must have initial capital of at least 125,000 and, where the value of the portfolio of AIFs exceeds 250 million, the AIFM must provide an additional amount of own funds equal to 0.02% of the amount by which the value of the portfolios of the AIFM exceeds 250 million, provided the total of initial and additional capital amounts shall not exceed 10 million. For this purpose, one includes AIFs for which the AIFM has delegated functions under Article 20 but are deemed to be portfolios of the AIFM. The ESMA advice proposes calculating additional funds to cover potential liability risks based on variable assets under management. This is implied already in the Article 9 text and follows the approach of Article 7 of the UCITS Directive too, after a consultation indicated that a large majority of respondents would prefer this. It is therefore basing the approach on an existing method and one which assumes that liability risks increase with the value of the portfolios under management. This is another area where there are various potential categories of AIFM (excluding smaller AIFMs). These might be: an internal AIFM, managing a single AIF for which the AIF itself has been authorised as the AIFM and subject to a 300,000 initial capital requirement and the requirement to have additional own funds or PII to cover potential liability risks arising from professional negligence; an external AIFM appointed by or on behalf of one or more AIFs and subject to a 125,000 initial capital requirement, the additional own funds requirement based on portfolios under management and the requirement of additional own funds or PII to cover potential liability risks arising from professional negligence; and an AIFM investment firm an external AIFM which also provides the core service of individual portfolio management subject to the requirements for external AIFM and BIPRU limited licence firm requirements. AIFM operational requirements With the Directive focusing on AIFMs, it is logical that there are a host of AIFM operational requirements. We will come on later to the points which are put in the Directive as obligations but in fact are not within the AIFM s control, such as the requirement for the AIF to appoint a depositary. It is almost inevitable that there are various provisions relating more to the AIFs than to the AIFM itself. Some of the provisions are therefore a little uncomfortable but let us, for the moment, focus on those provisions which are directly within the AIFM s control. Section 1 of Chapter III of the AIFM Directive sets out operating conditions for an AIFM and are much along the lines as you might expect to see, given that we are all used to FSA regulation of asset managers, with details both at high level and on specifics. This might be new to some of the other EU member states but most of it will probably be more of a set of amendments of how we do things currently rather than something entirely new. This approach might be subject to a few specific areas where specific concerns are being addressed e.g. on valuation. To run through the principal Articles under the heading of Operating Conditions for AIFMs : General requirements General principles Article 12 sets out high level general principles such that AIFMs must act honestly with due skill, care and diligence and fairly in conducting their activities; act in the best interests of the AIFs or the investors of the AIFs they manage and the integrity of the market; have and employ effectively the resources and procedures that are necessary for the proper performance of their business activities; take all reasonable steps to avoid conflicts of interest and, where they cannot be avoided, to identify, manage and monitor and, where applicable, disclose those conflicts in order to prevent them from adversely affecting the interests of the AIFs and their investors and to ensure that the AIFs they manage are fairly treated; comply with all regulatory requirements re conduct of business activities so as to promote the best interests of the AIFs or the investors of the AIFs they manage and the integrity of the market; and to treat all AIF investors fairly. It is then stated specifically that no investor in an AIF shall obtain

9 preferential treatment unless such preferential treatment is disclosed in the relevant AIF s rules or instruments of incorporation. AIFMs will need to be aware of several new general principles on top of those which currently apply in the UK, notably additional due diligence responsibilities, requirements relating to the appointment of counterparties and prime brokers and the introduction of a "fair treatment" definition. Rather like the FSA s Principles, you can see that these high level general principles could be used in due course to try to prevent undesirable conduct which is not caught by one of the more specific rules which follows: Specific requirements conduct of business provisions Hiding behind the general requirements under the Directive, ESMA s draft Guidance indicates that various very familiar conduct of business rules which will fall under Article 12 entitled general principles, mostly by a dint of the paragraph (e) provision which refers to conduct of business activities. Underlying these general provisions, there will be the very familiar conduct of business rules which will correspond to a large extent to the conduct of business rules under Article 14(1) of the UCITS Directive subject to adjustments or exemptions for such AIFs that are not open-ended and invest in other assets other than financial instruments. Also, ESMA are taking into account the fact that AIFMD regulates the marketing of AIFs to professional investors whereas UCITS are designed to protect the retail investors. As a result, ESMA is taking the approach that sometimes the MiFID provisions may be of greater use for the implementing provisions. In either event though, the basis for the new provisions will be relatively familiar to existing fund managers. They will include provisions relating to arrangements for executing deals on behalf of a managed AIF, placing orders, handling of orders and aggregating and allocating trading orders as one would expect with the AIF itself being treated as the client for the relevant purposes. remuneration policies functions and any employees 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 AIFMs or of the AIFs they manage, that are consistent with and promote sound and effective risk management and do not encourage risk taking which is inconsistent with the risk profiles, rules or instruments of incorporation of the AIFs they manage. The policies and practices must be determined in accordance with Annex 2 of the Directive. The UK's options could include bringing an AIFM within the scope of its existing remuneration code (possibly including revising the current tier structure) or developing a remuneration code to apply specifically to AIFMs but modelled closely on the existing code. conflicts of interest As flagged by one of the general principles above, Article 14 expands on the requirement for AIFMs to take all reasonable steps to identify conflicts of interest that might arise and note that it is set out that this must be looking for conflicts that arise in the course of managing AIFs between: the AIFM, including its managers, employees or any person directly or indirectly linked to the AIFM by control, and the AIF managed by the AIFM or the investors in that AIF; the AIF or the investors in that AIF, and another AIF or the investors in that AIF; the AIF or the investors in that AIF, and another client of the AIFM; the AIF or the investors in that AIF, and a UCITS managed by the AIFM or the investors in that UCITS; or two clients of the AIFM. The notion of needing to minimise conflicts of interest is based on existing UCITS and MiFID level 2 provisions. Note however that AIFM provisions may be somewhat more specific, seeking to have situations described as possible conflicts of interest which may arise and with a list of examples in the draft ESMA guidance. Under Article 13, AIFMs must have remuneration policies and practices for those categories of staff, including senior management, risk takers, control 9

10 The Alternative Investment Fund Managers Directive 10 The FSA's requirements of SYSC 10 are already broadly aligned to the Directive's provisions and ESMA's advice but firms will need to note the examples of conflicts of interest indicated in ESMA's advice (and subsequent level 2 measures). risk management Article 15 concerns risk management. AIFM shall functionally and hierarchically separate the functions of risk management from the operating units, including from the functions of portfolio management. They have to implement adequate risk management systems in order to identify, measure, manage and monitor appropriately all risks relevant to each AIF investment strategy and to which each AIF is or may be exposed. There is clearly emphasis on appropriate risk management. AIFMs must functionally and hierarchically separate the functions of risk management from the operating units, including the functions of portfolio management. For a robust risk management framework, an AIFM should establish a permanent risk management function whose role is to implement the policies, procedures or systems developed by the AIFM and regularly report to the governing body or, where it exists, the supervisory function on matters pertaining to the consistency with the limits that have been set for the AIFs that it manages, the adequacy of the procedures or systems in place and any current or anticipated breaches of this framework. UK authorised firms will of course already have well established arrangements. Helpfully, MiFID and UCITS precedents are being used as a benchmark for ESMA s advice with regard to an AIFM s risk management policies and procedures. The FSA is clearly concerned about proportionality, which should remain a fundamental principle in the approach to organisational requirements. However, irrespective of the size of its business, an AIFM will need a permanent compliance function although, following the ESMA indicated approach, hopefully whether that function operates separately from other AIFM functions will be determined by the application of the proportionality principle. The example the FSA gives is that the appointment of a separate compliance officer may be a disproportionate requirement for a small AIFM. Similarly for the required internal audit function which must be established by an AIFM this might be disproportionate, an AIFM may rely on another business unit of the AIFM to meet the relevant requirements. The Directive and ESMA advice detail minimum requirements for systems and governance arrangements required of AIFMs. Although generally the risk management requirements for AIFMs will be broadly similar to those under the UCITS Directive, there are areas of material difference for example on setting investment risk limits. This though is an inevitability given that the UCITS Directive has specific investment parameters whereas AIFs will set their own for their AIFs. There are then some further organisational arrangements which affect the management of AIFs, concerning proper and independent valuation, liquidity management, leverage and investment in securitisation positions. Leverage Within the same Article 15 there is a requirement for AIFMs to set a maximum level of leverage which they may employ on behalf of each AIF they manage, as well the extent of the right to reuse collateral or guarantee that could be granted under the leveraging arrangement, taking into account various relevant matters, such as the investment strategy of the AIF. Indeed, leveraged funds are the subject of particular attention. Leverage is defined in the Directive to mean any method by which the AIFM increases the exposure of an AIF it manages whether through borrowing of cash or securities, or leverage embedded in derivative positions or by any other means. This last phrase means that basically it can be anything which achieves a leveraged effect. The possible ways in which this should be assessed in the terms set out in the ESMA guidance is relevant for various purposes because: in their authorisation, an AIFM must set out the policy as regards the use of leverage (and therefore needs to know what counts as leverage) (Article 7(3)); the AIFM must set a maximum level of leverage which it may employ on behalf of each AIF it manages (and again therefore needs to know what counts as leverage) (Article 15(4)); there must be leverage disclosed to investors (see further below) (Article 23(5));

11 there must be leverage disclosed to regulators (Article 24(4); and there is a requirement that the AIFM must demonstrate the leverage limits it sets for each AIF it manages are reasonable and that it complies with those limits at all times. (Article 25(3). Three methods have emerged from the ESMA work by which a leverage of an AIF should be calculated: gross method: the sum of the absolute values of all the AIF's positions including leverage positions that are considered to be risk neutral; commitment method: allowing netting and hedging so that risks of the trade can be netted/off-set against the risks of another leaving no material residual risk; and advanced method, with certain preconditions including prior notification to the regulator: which allows, amongst other things, consideration of estimated maximum losses and additional offsetting of positions. This may be used where the AIFM considers that neither of the two previous methods provides a fair reflection of the levels of leverage within a given AIF. It is expected that ESMA will issue detailed guidelines on the advanced method of calculation. liquidity management The AIFM Directive includes a specific provision on liquidity management in Article 16. AIFMs shall, for each AIF that they manage which is not an unleveraged closed ended AIF, employ an appropriate liquidity management system and adopt procedures which enable them to monitor the liquidity risk of the AIF and to ensure that the liquidity profile of the investments of the AIF complies with its underlying obligations. There must be regular stress tests under normal and exceptional liquidity conditions which enable them to assess the liquidity risk of the AIFs and to monitor the liquidity risk of the AIFs accordingly. Logically, the Article also provides that the investment strategy, liquidity profile and redemption policy must be consistent with each other. ESMA is proposing a definition of special arrangement which is to mean an arrangement that arises as a direct consequence of the illiquid nature of the assets of an AIF which impact the specific redemption rights of investors in a class of units or shares of the AIF and which is a bespoke or separate arrangement from the general redemption rights of investors. Such special arrangements could catch side pockets and other mechanisms, and other mechanisms where certain assets of the AIF are subject to similar arrangements between the AIF and its investors. Arrangements such as gates should be considered as special arrangements where they achieve similar outcomes to those achieved by side pockets. The point of such special arrangements is that Article 23(4)(a) requires periodic disclosure to investors of the percentage of the AIF s assets which are subject to such special arrangements arising from their illiquid nature. So, once the special arrangements are identified, the percentage of the AIF s assets which are subject to them must be calculated and then disclosed to investors. The Directive and ESMA advice cover both these AIFM responsibilities to investors and also AIFM responsibilities to counterparties. Firms existing systems and procedures will need to be reviewed, particularly those relating to stress testing and measurement of the liquidity profile of assets. Attention needs to be given to proposed investments in the illiquid investments and, pre launch of a new fund, consideration given to appropriate unit redemption restrictions and appropriate subscription/ redemption frequency, and regard being given to whether an assurance can be given that dealing with the frequency selected is appropriate for the fund's investment strategy and assets. securitisation positions Article 17 deals with investment in securitisation positions which will need delegated acts. One of the core tenets of this aspect of the Directive is the requirement that an AIFM should only assume exposure to tradable securities and other financial instruments based on repackaged loans if the originator, sponsor or original lender has explicitly disclosed that it will retain, on an ongoing basis, a net economic interest which must not be less than 5%. ESMA note the requirement that net economic interest should not be subject to any credit risk mitigation or any short positions or any other hedge and should not be sold. 11

12 The Alternative Investment Fund Managers Directive 12 AIFM organisational requirements Organisational requirements for AIFMs are set out in Section 2 of Chapter 3 of the Directive. As you might expect, it starts with generalisations such as the AIFMs must at all times have adequate and appropriate human and technical resources that are necessary for the proper management of AIFs. There are though some points of interest which come out of the more detailed requirements. The focus on organisational matters fits with the introduction of the new operational requirements for AIFMs. The bulk of the regulation is to do with the fund managers rather than the funds themselves: there is a degree of consistency emerging in the references in this area. In Box 48 of ESMA s advice regarding control by senior management and supervisory function, it is clear that, in allocating functions internally, AIFMs should ensure that senior management, and where appropriate the supervisory function, are responsible for the AIFM s compliance with its obligations under the Directive which harks back to the wording considered above in relation to how we should be seeking to identify the AIFM. Consequently it will be important that the AIFM through its senior management can at least do the following: be responsible for implementation of the general investment policy as defined in the fund rules, instruments of incorporation, prospectus or offering documents; oversee the approval of investment strategies; be responsible for ensuring the valuation procedures according to Article 19 of the Directive are established; be responsible for ensuring that the AIFM has a permanent and effective compliance function (even if performed by a third party); ensure and verify on a periodic basis that the general investment policy, investment strategies and risk remits are properly and effectively implemented and are complied with (even if the risk management function is performed by third parties); approve and review on a periodic basis the adequacy of the internal procedures for undertaking investment decisions so as to ensure that such decisions are consistent with the approved investment strategies; approve and review on a periodic basis the risk management policies and arrangements, processes and techniques for implementing that policy, including the risk limit system for each managed AIF; and be responsible for establishing and applying a remuneration policy in line with Annex II of the Directive. Note that, as regards resources, the ESMA guidance is clear that the AIFM should employ sufficient personnel with the skills, knowledge and expertise necessary for the discharge of the responsibilities allocated to them. An AIFM should ensure that the performance of multiple functions by relevant persons does not and is not likely to prevent those relevant persons from discharging any particular function soundly, honestly and professionally (Box 45 ESMA draft advice). For these purposes, an AIFM must take into account the nature, scale and complexity of their business, and the services undertaken in the course of that business. Whatever is the finalised wording in level 2 measures, it might helpfully be accommodated in appointments of external AIFMs in due course. Interestingly HM Treasury ask in their Discussion Paper whether the UK's approved persons regime should be applied to internally managed non-cis companies and what the costs and benefits might be. They acknowledge though that directors of companies are subject to company law requirements and, for listed funds the Listing Rules, which therefore impose corporate governance requirements. Once the FSA has indicated that, if the regime is applied, it would exercise its powers in a proportionate manner, the question really is whether this is a good idea. In order to provide a sound system it may well be prudent, but it would be another area for gold plating because it would likely be inconsistent with the approach taken to AIFMs passported into the UK from other member states because it cannot be assumed that a comparable regime would be applied in those states. Delegation Given the issue about who is the AIFM, we should expect considerable attention to be focused on the Article 20 provisions regarding delegation. Delegation of AIFM functions is, as you will expect, permitted, and the new requirements for AIFMs will be very similar to those which currently exist within the MIFID approach on delegating tasks to third parties: in particular, the principle of senior management s sole responsibility not being affected due to delegation and nor should the obligations to the AIFM towards its investors under the AIFMD be altered by any delegations. Senior management remains fully responsible for the delegated tasks.

13 The Article 20 provisions include the following: the need to justify the entire delegation of structure on objective reasons; the delegate must have sufficient resources to perform its respective tasks and the persons who effectively conduct the business of the delegate must be of sufficiently good repute and sufficiently experienced; if there is portfolio management or risk management delegation, these functions must only be deleted to those authorised or registered for the purpose of asset management and subject to supervision (or, if this condition cannot be met, subject to prior approval of the AIFM home state regulator); if there is portfolio management or risk management delegation to a third country undertaking, in addition there needs to be cooperation between the AIFM s home regulator and supervisory authorities of undertaking concerned; a delegation must not prevent the effectiveness of supervision of the AIFM (and in particular must not prevent the AIFM from acting or the AIFM from being managed in the best interests of its investors); and the AIFM must be able to demonstrate that the delegate is qualified and capable of undertaking the functions in question; that it will select with all due care and that the AIFM is in a position to monitor effectively at any time the delegated activity; to give at any time further instructions to the delegate; and to withdraw the delegation with immediate effect when this is in the interests of investors. The AIFM must review services provided by its delegates on an ongoing basis. There should be no delegation of portfolio management or risk management to the depositary or a delegate of the depositary or any other entity whose interests may conflict with those of the AIFM or the investors of the AIF, unless functionally and hierarchically separated by such entity and potential conflicts of interests are identified managed monitored and disclosed. One of the most important points to note is that an AIFM cannot delegate functions to the extent that, in essence, it can no longer be considered to be the manager of the AIF and to the extent that it becomes a letterbox entity. ESMA has indicated two situations where an AIFM would be considered a letterbox entity: i. where the AIFM is no longer able effectively to supervise the delegated tasks and to manage the risks associated with the delegation; and ii. where the AIFM no longer has the power to take decisions in key areas that fall under the responsibility of the senior management or to perform senior management functions. The recent ESMA Discussion Paper on Key Concepts comments that ESMA considers that an AIFM may delegate both portfolio management and risk management either in whole or in part but on the understanding that "an AIFM may not delegate both functions in whole at the same time." A delegate may sub-delegate if the AIFM has consented prior to the sub-delegation; notified its home state regulator before sub-delegation arrangements become effective; and if the above conditions are applied through from the delegate to the sub-delegate. The UK has established FSA Handbook provisions relating to delegation in SYSC 8. The new regime will not be significantly different to that currently required by MiFD, and reflected in SYSC 8, but it does require advance notification to the competent authorities before delegation arrangements become effective and so this will need to be built into timetables for new outsourcings. There are also new requirements in relation to separation within the AIFM where portfolio or risk management is delegated to an entity that may have conflicting interests to the AIFM or the investors of the AIF. Valuation There are also specific management issues which go more to the actual management of the funds rather than the AIFM s organisation and operational requirements. Article 19 makes detailed requirements regarding valuations. Note this refers to the valuation itself rather than the NAV calculation. There will need to be an independent performance of the valuation, which can be done either within the AIFM (in which case there must be safeguards for it to be functionally independent from the portfolio management and the remuneration policy and other measures ensuring that conflicts of interest are mitigated and undue influence upon the employees is prevented) or by an external valuer. 13

14 The Alternative Investment Fund Managers Directive Basically one is looking at the position under national law and the AIF s constitutional documents. The valuation procedures used must ensure that the assets are valued and the NAV per share or unit share calculated at least once a year and investors must be informed. If the fund is open ended, the frequency should be as appropriate. If the fund is closed ended, the valuation will be required if there is an increase or decrease in capital. It is important to note the emphasis which ESMA gives to IOSCO s work the 1999 Valuation Paper and its work on reviewing this on an ongoing basis regarding valuation and pricing of collective investment schemes and the specific one regarding valuation of hedge fund portfolios. The FSA is aware of its need to review the COLL 6 provisions for authorised investment funds relating to valuation to ensure compatibility with the AIFM Directive. More generally, where there is external valuer involvement, the AIFM will need to be able to demonstrate that it is subject to mandatory professional registration, can provide sufficient professional guarantees to be able to effectively perform the valuation function and is appointed in accordance with the required conditions of delegation. The Depositary s role The first question to address is who can be a depositary. For UK implementation purposes: A UK AIFM will be required to ensure that a single depositary is appointed for each UK AIF it manages and a UK AIF must have a depositary established in the UK (although there is some limited discretion to allow, until 22 July 2017 at the discretion of the UK authorities, a UK AIF to use a depositary established in another member state). Non EU AIFMs marketing EU or non EU AIF are not required under Article 42 to have a depositary. UK AIFM marketing non EU AIF are not required to have a single depositary but are required to ensure one or more entities are appointed to carry out certain depositary functions. Note there are three categories of firms which may act as a depositary - an authorised EU credit institution; an authorised EU investment firm providing the service of safekeeping and administration of financial assets that meets prescribed prudential requirements; and a prudentially regulated firm subject to ongoing supervision of a type which is eligible to be a UCITS depositary (including obviously the depositary of an OEIC and a trustee of an authorised unit trust). In addition to the three categories of firms, where there is a closed ended fund (no redemption rights exercisable within five years from the initial investment date) and generally it is not investing in financial instruments that must be held in custody, or invests in issuers or non listed companies to potentially acquire control (and so covering probably private equity and real estate AIFs), there may be permission for other entities to act as depositary as a Member State decides. The FSA is reviewing whether an option should be devised for this purpose and, if so, what is deemed "sufficient financial and professional guarantees" for these types of firms. Whilst the Directive focuses on AIFMs, one key area of focus in the Directive is increasing the role for a depositary. There has been considerable variation in the interpretation of the extent of the oversight duties of a depositary under the UCITS Directive and the draft ESMA work in this area for the AIFM Directive provides quite specific information as to what they think should be required in respect of AIFs. The Depositary s roles are to be as follows: Safekeeping: The first core role has two component options: for financial instruments which can be registered in financial instruments accounts or can be physically delivered to the depositary in line with Article 21(8) should be held in custody or, for other assets, in recordkeeping. 14 The FSA is considering whether the current own funds requirement will need to be changed from the current 4 million required of depositaries of authorised investment funds, which might include a flat rate increase in line with inflation or average of a firm's net income or a percentage of funds under management for which the depositary is appointed. Following through the devil in the detail will be essential to make sure that depositaries have a liability position which is acceptable to them. The depositary s liability regime is a central issue to the Directive and possibly one of the most controversial. Although the specifics added by the ESMA s draft guidance are helpful in that they are looking to limit the responsibility for loss

15 situations to those where financial instruments are permanently lost, as opposed to temporarily unavailable, and there are various pragmatic indications within that draft guidance text, depositaries will still be keen to know exactly what will be regarded as financial instruments which will end up with this risk applying to them in the first place. Further, there is an issue with sub-custody where, although both Directive and the ESMA guidance recognise that subcustodians are a necessary part of custody arrangements and, by accepting this, it is logical to impose severe obligations on the depositary to monitor sub custodians performance etc. there seems to be no indication that such robust requirements will not alter the extent to which the depositary is liable for its sub-custodian s actions will this in effect mean that the depositary can be liable for events outside its reasonable control? Oversight The second key role is oversight. The Level 1 Directive requires a depositary to ensure that sales, issues, repurchases, redemptions and cancellations of units are carried out properly in accordance with applicable local law and the AIF s rules or instruments of incorporation and ensure the value of shares or units is calculated in accordance with applicable law and the fund s constitutional documents under Article 19 procedures. This is very similar to the role we have accepted for UK regulated fund s depositaries, although the extent of those roles can themselves of course be debated at length. ESMA has taken a clear line that the depositary s oversight duty in the UCITS Directive and the AIFMD should be considered to be trying to achieve the same objective, although there are slightly different words. ESMA point out that it would seem incoherent to define a regulation that, at a prohibitive cost for depositaries, would provide a more protective framework for professional investors as compared to retail investors. It does look as though some pragmatic view is starting to prevail in this area indicating some backtracking from a rather extreme starting point. For example, the AIFM is confirmed to be fully responsible for the valuation process and the depositary is expected to adopt an ex-post approach and sample check matters but not on a literal interpretation of the words in the Directive. Monitoring cash flows In addition to the two key roles outlined above, there is a third role assigned to the depositary which is to ensure that cashflows of the AIF are properly monitored. ESMA believes that the depositary should have a clear overview of all cash inflows and outflows in all instances and so the depositary must receive timely and accurate information including from any third party where the cash account is opened in order to have access to all information relating to cash flows. Under the Box 78 requirements for proper monitoring, the depositary's obligations consist and verify that there are procedures in place to appropriate monitor the AIF's cash flows and that they are effectively implemented and periodically reviewed. ESMA is resisting the suggestion that they produce a model depositary agreement (Box 74 of their advice setting out simply specifics to be included within one) but it is certainly the case that depositary agreements will require review to ensure that they are adequate. The UK authorities may decide to distinguish between the activity of being a depositary from other activities associated with the management or operation of an AIF and CIS. This though would be a procedural matter for the terms of their Part IV permissions. One area of concern will likely continue to surround the safekeeping and liability issues. In particular, it will be a concern that it is difficult for depositaries for verify conclusively ownership of some types of assets that cannot be held in custody, and there will be a concern that there is a need for depositaries to exercise professional judgment, which might introduce an element of uncertainty for a depositary's position. A second issue concerns segregation of assets by a sub-custodian where the national law does not recognise segregation of assets during insolvency proceedings. The FSA is enquiring in its Discussion Paper about the main changes that depositaries will have to take into account given the AIFMD requirements in relation to depositary liability and the estimated direct and indirect costs of such changes. 15

16 The Alternative Investment Fund Managers Directive 16 Third country issues The Directive is stated to apply to: a. EU AIFMs which manage one or more AIFs, irrespective of whether such AIFs are EU AIFs or non EU AIFs; b. non EU AIFMs which manage one or more EU AIFs; and c. non EU AIFMs which market one or more AIFs in the EU, irrespective of whether such AIFs are EU AIFs or non EU AIFs. A basic principle of the Directive should be that a non-eu AIFM is to benefit from the rights conferred under the Directive (such as to market units or shares in AIFs throughout the EU with a passport subject to its compliance with the Directive). There should be a level playing field between EU and non-eu AIFMs. For example, it is most encouraging that, on one of the most difficult issues, the third country aspects, ESMA s Chairman has acknowledged the importance of ensuring that an effective and efficient regulatory framework is in place in Europe for recognition of third country service providers. Given the staggered implementation for non-eu third country passport provisions with authorisation and passporting processes for non-eu AIFMs only becoming available from 2015 at the earliest, it is too early to see what the practical effect of Articles might be we shall need to await the relevant Level 2 measures and ESMA's technical standards and guidelines. For the initial period, private placement arrangements may continue. This means that it is likely that HM Treasury will continue to permit the marketing of non EU AIF managed by EU AIFM and EU and non EU AIF managed by an non EU AIFM to UK professional investors, subject to compliance with minimum requirements specified in the Directive. Consequently, subject to these additional requirements, the usual private placement arrangements for non EU AIF and EU AIF managed by non EU AIFM in the UK will continue to be available. An issue will arise for an authorised UK AIFM as the Directive requires the AIFM to comply with all AIFMD requirements except certain of those requirements which apply to depositaries. For a non EU AIFM, there needs to be compliance with the Directive's transparency requirements. Both circumstances require prerequisites including co-operation arrangements between the relevant regulators. There is therefore some work to be done to ensure that the private placement arrangements remain practicable. One area for consideration currently will be the FSA's suggestion that they might consider the merits of including a separate list from the registered and authorised UK AIFMs of non-eu AIFMs from which they have received notification of marketing AIFs to UK professional investors pursuant to Article 42. Their aim would be that this list, which could be termed "notified AIFM", would be available so that intermediaries and investors could have an easily accessible list of non-eu AIFMs marketing AIFs to UK professional investors. They are though aware of the challenges which this would have, particularly of maintaining an up to date list also a concern of what it might signal by acknowledging the distinction between fully authorised UK AIFMs and non-eu AIFMs on the list who intend to market an AIF in the UK through national private placement. As to the general approach, HM Treasury has confirmed that it sees a national private placement regime continuing and that it is minded not to impose additional requirements for third country managers of third country funds above the Directive minimum provisions on transparency and, if applicable, the rules on private equity disclosure. Extending the passporting regime The attached time line running from the transposition date shows how the registration by EU firms as AIFMs in the year following 2013 is only the starting point. From the third country perspective, one has to focus on the proposal that, by two years after the transposition date, ESMA should have produced an opinion on extending the passport for EU AIFMs marketing non-eu AIFs in the EU and to non-eu AIFMs managing and/or marketing AIFs in the EU, with a view to the Commission adopting a delegated act within three months of that opinion. Three years after that delegated act, assuming that there is positive ESMA advice in this connection, it will be proposed that there be a further delegated act under which the temporary national regimes under Articles 36 and 42 would be terminated and the passport regimes under Articles 35 and would become the sole and mandatory regimes applicable in all member states.

17 Temporary provisions Pending such a widening of the passporting regime, there are two temporary provisions: Article 36 whereby conditions are set out for marketing in member states without a passport of non-eu AIFs managed by an EU AIFM. This facilitates member states being permitted to allow an authorised EU AIFM to market professional investors in their territory only units or shares of non-eu AIFs it manages and via an EU feeder AIFs that do not fulfil the requirements in Article 31(1) provided that: the AIFM complies with all requirements established in the Directive with the exception of Article 21 regarding depositaries but, even so, the AIFM must ensure that one or more entities are appointed to carry out the duties mentioned in Articles 21(7), (8) and (9). The AIFM must not perform those functions. The AIFM has to provide the regulator with information about the identity of the entities responsible for carrying out the duties referred to in Articles 21(7), (8) and (9); appropriate cooperation arrangements for the purpose of systemic risk oversight and in line with international standards are in place between the regulators of the home member state of the AIFM and the supervisory authority for the third country where the non-eu AIF is established in order to ensure an efficient exchange of information that allows competent authorities of the home member state of the AIFM to carry out their duties in accordance with the Directive; and the third country in which the non-eu AIF is established is not listed as a Non-cooperative Country and Territory by FATF. Article 42 which sets out conditions for marketing in member states without a passport of AIFs managed by non-eu AIFM. Member states may allow non-eu AIFMs to market to professional investors in their territory only units or shares of AIFs they manage subject at least to the following conditions: i. the non-eu AIFM complies with Articles 22, 23 and 24 in respect of each AIF marketed by it pursuant to Article 42 (the transparency requirements) and with Articles 26 to 30 (obligations reacquiring control of non-listed companies and issuers) where the AIF to be marketed falls within the scope of Article 26(1); ii. appropriate co-operation arrangements for the purpose of systemic risk oversight and in line with international standards are in place within the competent authorities of the member states where the AIFs are marketed, in so far as applicable, the competent authorities of the EU AIFs concerned and the supervisory authorities of the third country with a non-eu AIFM is established and, in so far as is applicable, these supervisory authorities of the third country with a non-eu AIF is established in order to ensure efficient exchange of information that allows competent authorities of the relevant member states to carry out their duties in accordance with the Directive; and iii. the third country where the non-eu AIFM or the non-eu AIF is established is not listed as a Non-cooperative Country and Territory by FATF. Member states have the choice of imposing stricter rules on the non-eu AIFM in respect of the marketing of units or shares or both to investors in their territory for the purposes of this Article (one assumes they mean stricter than those strictly required under the above conditions). These temporary provisions in Articles 36 and 42 are of course matters for member states to decide individually it is conceivable that member states may switch off their private placement regime early if they wished to do so. One would hope though that this is unlikely. HM Treasury has provisionally indicated an intention to permit marketing of non-eu AIF managed by EU AIFM and EU and non EU AIF managed by non EU AIFM to UK professional investors subject to compliance with the minimum requirements in the AIFMD. Subject to additional requirements, the private placement of a non EU AIF and EU AIF managed by non EU AIFM in the UK should therefore be able to continue. Assuming that these temporary Articles are followed through so that existing funds arrangements for private placements can continue to be effective for a few more years, the next hurdle will be how they might be switched off. One might have hoped that the arrangements could continue to run alongside, as some funds simply might not wish to use the new passporting 17

18 The Alternative Investment Fund Managers Directive arrangements and would never need to do so. It will be interesting to see how ESMA formulates its opinion in due course on the termination of these arrangements and whether or not it feels it can give positive advice which would be the precursor to further a delegated act switching these national regimes off, such that the passport regimes under Articles 35 and would become the sole and mandatory regimes applicable in all members states. Whilst the UK authorities might be right in deferring discussion of the longer term position until further details are available of the Level 2 measures and ESMA Guidance in the area, these matters remain of key importance to the UK based alternative investment fund managers and their critical importance should mean that the issue remain high on the UK industry's agenda. Marketing Marketing is described in the Directive as "a direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM" in relation to AIF under management. This definition of marketing does need some further consideration and the FSA mention that it is possible that the Commission with national regulators may consider the definition of marketing in its transposition workshops in Various complications might arise in this area: For example, an AIFM also distributing shares or units of AIFs managed by other UK AIFMs needs to be considered, together with the MiFID complications. The FSA's current view is that the AIFMD restriction may prevent other types of firms, including intermediaries which are MiFID investment firms and credit institutions, from directly or indirectly offering or placing units or shares of AIFs to EU investors. It might prevent MiFID firms and credit institutions (including those outside the EU) from offering or placing AIFs with EU investors unless the AIFM for that particular AIF is permitted to do so. A further area of concern is the fact that, in the UK, various entities may undertake marketing and so there may be considerable activity which is not within the scope of activities undertaken on behalf of the AIFM. For example, wealth managers or independent intermediaries who may distribute funds may have no previous contractual or commercial relationship with the AIFM although some may have distribution agreements which could cover the issue. The question arises as to how such activity undertaken by a third party should be regulated. For any authorised UK AIFM, it must, before it markets a UK or other EU AIF in the UK or in another member state to professional investors, notify the FSA of its intention to do so. This will require timetables to allow a 20 working day time period from receipt of the complete notification by the Regulator. In addition, there are particular challenges for marketing AIFs to retail investors. HM Treasury is aware of the need to review the current UK restrictions on the promotion of unregulated collective investment schemes and, in its Discussion Paper, asks for views as to whether these should be retained and if not why not and related costs and benefits. Effectively, it may be that the only two types of AIF within the scope of the Directive that may be marketed retail would be NURS schemes and AIFs which are not within the collective investment scheme regime such as investment trusts, together with section 270 and section 272 recognised schemes. The Treasury Paper does not though go into detail as to the current particular exemptions to the general prohibition on the promotion of unregulated schemes although impliedly these might also be up for discussion. Transparency Much is made of providing information to investors in the Directive annual reporting, disclosure to investors and reporting to competent authorities too. The overall objective is to increase considerably the transparency required of AIFMs. Whilst this may not introduce much which is new for non UCITS regulated funds in the UK, it will introduce new requirements of unregulated collective investment schemes and also listed AIFs. Issues to consider may include: in relation to QIS the level of detail of the requirements; for NURS funds for retail investors, the level of detail and the format of disclosure which is required; in aiming for mandatory disclosure concerning the fair treatment of investors (although note not identical treatment), how side letters may be dealt with in respect of hedge fund and other private fund offerings; 18

19 how to deal with the quite specific disclosure requirements required relating to liquidity management as expanded upon by ESMA's advice, which of itself might not be entirely helpful to managers in maintaining confidence if there happens to be a liquidity issue. In some instances special arrangements might be envisaged for example side pockets etc will be viewed as relatively acceptable standard practice for particular circumstances - but one can see the possibility where it might cause investor concern? another concern will be mandatory periodic disclosures to disclose current risk profiles; again there may be concern about specific disclosure requirements where an AIFM manages and/or markets AIFs in relation to which it uses leverage for changes to the maximum level of leverage, the right to re-use any collateral or any guarantee granted under the leverage arrangements and the total amount of leverage employed; and further, there must be disclosure of remuneration elements in the annual report. Firms will need to make sure that there is at least this minimum amount of annual reporting and the updates where required for changes on the items mentioned above. Consequently firms will need to review the reporting to investor provisions for each of their types of AIF to see how best they can be adjusted to comply appropriately. Introducing logic? At the beginning of this briefing paper, it was suggested that we should perhaps not look at the evolvement of this Directive and its original politics but rather at whether or not it will be (or perhaps can be made to be?) a good proposal as implemented. So, endeavouring to take a positive approach, can we sense if there is now some emerging logic? If you take matters cynically, one might be tempted to observe that ESMA are now trying to impose some logic. In particular ESMA seeks to ensure that there is some consistency with other existing Directives with which fund managers are already coping in order to make the system practicable - but the regulators within ESMA are probably all too aware that there are still underlying illogicalities in the Directive s provisions. It is vital that pragmatic views prevail. For example, on who is an AIFM, it is important that there is a workable approach. There is scope for restructuring of some AIFs outside of the Directive which one would expect the Commission to have wanted the Directive to cover so that they avoid the AIFM requirements. One would hope though that a level of international co-operation would eventually achieve some workable solution on the third country issues such that such technical interpretations (dodges) do not drive fund structuring. But there is still some way to go? There perhaps also remains a real risk for regulatory arbitrage between member states? There is certainly the remaining and difficult issue that one size cannot easily fit all purposes. Perhaps the key remaining concern will be that this Directive tries to cover too much ground. One size does not fit all, and particularly not in relation to alternative investment funds. Even within a particular asset class there can be a wide diversity of types of funds property funds being one example of this. It will be critical for the eventual proposals to be workable which will likely inevitably mean that these should be tailored to some extent in certain areas to particular types of funds. Contributing to the debate There is an interesting plea in the consultation from ESMA that they would like feedback and when responding not just negative comments but also describing alternatives which ESMA should consider. In other words, commentators should try to offer solutions. It is vital that the industry help provide possible solutions at this point so as to ensure that this rather difficult Directive is introduced in a workable way. UK based fund managers are, ironically, in perhaps the best position to put forward alternative solutions because they already live with considerable regulation of their fund management entities and are well accustomed to much of the Directive s provisions. They also have the keenest interest in trying to make the proposals workable, given that most of the alternative investment fund managers in Europe are actually based in London and logically should be AIFMs which seek registration. UK fund managers are perhaps best placed to comment on Level 2 work, as the majority of AIFMs in Europe are based in London - and we perhaps have the greatest range of interests by asset class and fund type and so have perhaps a broader range of experiences. Indeed, it 19

20 The Alternative Investment Fund Managers Directive is very important that UK fund managers do contribute to the Level 2 process and provide feedback to the FSA and HM Treasury on their consultations because, whilst we may perhaps have the strongest understanding as to how to comply with the Directive, as a consequence, we perhaps have the greatest to lose from problems with its implementation. Of course the international response on how to regulate funds, and in particular hedge funds, is still evolving. It will likely remain critical that, in devising the Level 2 and 3 implementing measures, and in particular finalising the third country provisions, the UK - meaning regulators, fund managers and trade associations alike - continues to lobby for a sound global approach which will not in any way isolate the EU operations, such as might further prejudice the UK s leading role in the alternative fund management sector in Europe. 20

21 Appendix 1 AIFMD Timeline AIFMD Timeline UK The Directive enters into force on the twentieth day following its publication in the Official Journal HM Treasury/FSA Consultation(s) HM Treasury/FSA Consultation(s) HM Treasury/FSA Policy Statement(s) Transposition date Directive adopted 27 May 2011 by the Council Directive of 8 June 2011 EU ESMA main Directive consultation published ends on 13 in the September Official 2011 Journal on 1 July 2011 Second ESMA Consultation Paper published August 2011 with one month consultation period ESMA s advice presented to the Council by 16 November 2011 EU Commission proposes detailed rules EU Commission adopt detailed rules ESMA Standards and Guidelines produced Directive to be transposed in Member States laws by 22 July 2013 ESMA Consultation Paper on possible implementation measures published July 2011 with two month consultation period But a 2 nd timeline is needed too 21

22 Appendix 2 AIFMD timeline post July 2013 AIFMD Timeline (2) Transposition date 22 July 2013 Two temporary provisions: conditions for marketing in Member States without a passport of non EU AIFs managed by an EU AIFM but only in so far as they comply with the Directive with the exception of the Depositary requirements (Article 36) AIFMs must take all necessary measures to comply with national law stemming from the Directive and shall submit an application for authorisation within one year of 22 July 2013 conditions for marketing in Member States without a passport of AIFs managed by a non EU AIFM but only if non EU AIFN complies with disclosure requirements in Articles (Article 42) provided cooperation arrangements in place between regulators and the 3 rd country is not listed as a non cooperative country or territory by FATF, By 22 July 2015 Two years after transposition date : - ESMA should issue an opinion on the functioning of the passport then in force and on the functioning of national private placement regimes and also issue advice on the extension of the passport for EU AIFMs marketing non EU AIFs in the EU and to non EU AIFMs managing and/or marketing AIFs in the EU. The Commission should adopt a delegated act within three months after having received that Opinion [and advice from ESMA] and taking into account the criteria listed in and the objectives of the Directive (including regarding the internal market, investor protection and effective monitoring of systemic risk); - in principle authorised EU AIFMs intending to market non EU AIFs to professional investors in their home member state and/or other member states should be allowed to do so with a passport (subject to notification procedures and conditions in relation to the third country of the non EU AIF). Four years after transposition date: By 22 July 2017, Commission start a review of the application and scope of the Directive (Article 69) Three years after delegated act under Article 67(6): if positive ESMA advice, delegated act to specify date on which national regimes under Articles 36 and 42 are to be terminated, and the passport regimes under Articles 35 and 37 to 41 shall become the sole and mandatory regimes applicable in all Member states. (Article 68) Result should be a delegated act under Article 67(6) within 3 months of positive advice from ESMA. 22

23 Appendix 3 The investment funds picture in the UK post AIFMD The investment funds picture in the UK post AIFMD 23

24 The Alternative Investment Fund Managers Directive This is an update of our September 2011 Briefing Paper, and now incorporating reference to recent FSA and ESMA papers. We hope this preliminary outline of the AIFMD's general objectives and scope, and comments on particular issues which arise, will be helpful. It is impossible to cover everything in a single Briefing Paper, but our aim is to draw attention to some of the topics which are causing most concern for a number of interested parties. If you have any specific questions on aspects of the AIFMD which are relevant to you, please do not hesitate to contact Kirstene Baillie or your usual contact at Field Fisher Waterhouse LLP. Contacts Kirstene Baillie Partner t: +44 (0) e: kirstene.baillie@ffw.com This publication is not a substitute for detailed advice on specific transactions and should not be taken as providing legal advice on any of the topics discussed. Copyright Field Fisher Waterhouse LLP All rights reserved. Field Fisher Waterhouse LLP is a limited liability partnership registered in England and Wales with registered number OC318472, which is regulated by the Solicitors Regulation Authority. A list of members and their professional qualifications is available for inspection at its registered office, 35 Vine Street London EC3N 2AA. We use the word partner to refer to a member of Field Fisher Waterhouse LLP, or an employee or consultant with equivalent standing and qualifications. 24