The Alternative Investment Management Association has published an analysis of the divergences it has identified between the European Commission’s draft Level 2 regulation implementing the Alternative Investment Fund Managers Directive and the technical advice provided to the Commission last November by the European Securities and Markets Authority.
Aima, a global organisation representing members of the hedge fund industry including managers and service providers, highlights a number of “unintended consequences” of the changes proposed by the Commission, which it says cannot be attributed to the restatement of technical recommendations into legal language to provide greater clarity or legal certainty.
The association says that in fact in a number of cases the changes introduce new policies that either have not been recommended by Esma, ignore Esma’s advice completely, or reconfigure the parameters that Esma put forward following industry consultation and technical discussions with experts.
Aima says the changes comprise the addition of new legal obligations to those proposed by Esma, the deletion without replacement of entire policy areas within Esma’s advice, subtle drafting modifications that result in potentially large policy changes, the alteration or replacement of technical parameters proposed by Esma, the restriction of the provision of certain services to EU entities only, the deletions of proportionality or materiality provisions, and the replacement of clear provisions with ambiguous language.
The differences between the Commission draft regulation and the Esma advice, which Aima says appear to be “both significant and wide-ranging”, cover areas including the definition of assets under management, own funds, leverage, professional indemnity insurance, organisational requirements, delegation, risk management, transparency, depositaries and third countries.
The association comments: “If implemented without modification, the proposed Commission text could be disruptive to the asset management industry in the EU and globally, potentially undermining some of the stated policy goals of investor protection and financial stability.”
New legal obligations
As an example of the addition of new legal obligations, Aima cites the directive’s prohibition on managers outsourcing their tasks to the extent of becoming a letterbox entity that can no longer be considered to be managing the fund portfolio. Esma was asked to clarify the meaning of this requirement, carried over from the Ucits and MiFID directives.
In its technical advice, Esma said the manager would no longer meet the AIFMD requirements if it did not retain the necessary expertise and resources to supervise delegated tasks effectively and manage the risks associated with delegation, and if it no longer had the legal powers to take decisions in key areas of its responsibility.
The Commission’s draft regulation adds two additional conditions, one of which provides that the totality of the individually delegated tasks cannot exceed the tasks remaining with the manager. This restriction on delegation, says Aima, not only is much more onerous than existing practice in most EU fund jurisdictions but goes beyond both MiFID and Ucits obligations, and if implemented would entail significant restructuring of their business on the part of the vast majority of EU-based funds and managers.
Deletion of entire policy areas
Regarding the deletion of entire policy areas, Aima points to Esma’s clarification of which assets are capable of being held in custody by the depositary, which states that assets subject to security and title-transfer collateral arrangements cannot be considered to be in the depositary’s custody since it no longer has any control over these assets.
Counterparty trading arrangements negotiated and controlled by the manager on behalf of the fund place financial instruments legitimately beyond the control of the depositary. They cannot be held in custody because the arrangements require the counterparties to “possess” or “control” the collateral to perfect the security interest.
Under the Commission’s proposals, depositaries may be required to treat third parties such as brokers appointed by managers, collateral agents and central counterparties as delegates of the custody function whenever these parties hold most financial instruments of the fund as collateral for either party to a particular transaction. Aima says this could potentially cause major disruptions in global capital markets and would impose stress on banks that perform depositary functions, since they would become liable for losses caused by the failure of third parties, exacerbating the ‘too-big-to-fail’ problem.
Other examples highlighted by the association include the omission of the advanced method for the calculation of leverage, and of the possibility to combine professional indemnity insurance and own funds to meet the directive’s requirements.
Far-reaching drafting modifications
An example identified by Aima of subtle drafting modifications potentially resulting in large policy changes lies in the proposals regarding co-operation arrangements to enable the functioning of the AIFMD third country regime. It says that in general, the language and drafting of the Commission’s third-country provisions are inflexible and appear to create obligations for EU regulators to enter into agreements with third-country counterparts that must achieve a number of outcomes, irrespective of context or other relevant conditions.
Whereas Esma’s advice stated that the co-operation agreements should “provide for” areas such as exchange of information or assistance in enforcement between regulators, the Commission’s text requires EU regulators “to ensure” that the co-operation agreements provide access to all necessary information, the ability to carry out on-site inspections and the assistance of non-EU regulators.
The directive states that co-operation agreements should be in line with international standards, and Esma’s advice cites as a model the Iosco Multilateral Memorandum of Understanding. The MMoU is based on provision of the fullest possible mutual assistance between regulators but does not confer any enforceable legal rights upon its signatories, recognising that requests for information exchange or other assistance may be legitimately denied, for example, if such requests would be contrary to the relevant country’s law, or on grounds of public interest.
According to Aima, the draft regulation seems to introduce strong and unqualified obligations for EU authorities to obtain all information and assistance necessary for the performance of their tasks under the AIFMD. It argues that without clarification that such agreements should be concluded on a best-efforts basis and cannot legally bind the EU and third country regulators, the third-country regime could prove unworkable.
Alteration or replacement of technical parameters
An example of the alteration or replacement of technical parameters relates to the insurance regime applicable to managers desiring to cover through professional indemnity insurance any risks to investors arising from their professional activity. Esma advised that the minimum insurance coverage for each claim must be at least equal to the higher of 0.75 per cent of the amount by which the value of the manager’s portfolios exceeds €250m (up to a maximum of €20m) or €2m.
However, the Commission proposes that the insurance coverage for an individual claim must be at least equal to 0.7 percent of the value of the manager’s fund portfolios, with neither the €20m cap nor the €2m alternative. Aima says this change could result in professional indemnity insurance becoming unavailable to fund managers.
Limiting the provision of services to EU entities
Esma advised that managers should selecting counterparties and appoint prime brokers that are subject to ongoing supervision by a public authority, are of financial soundness and have the necessary organisational structure to provide the services in question to the manager or fund. The Commission’s draft regulation states that in appraising the financial soundness of counterparties or prime brokers, the manager must take into account whether they can comply on an ongoing basis with prudential requirements under EU law.
Aima says this appears to restrict prime brokers and OTC derivative counterparties to EU entities, which would “clearly go beyond Esma’s advice and does not seem justified in terms of the Level 1 text”. This provision appears particularly restrictive given typical prime brokerage models and the desire to source best terms in relation to credit and counterparty risk profiles across global OTC derivative counterparties generally.
The association argues that forcing EU managers to transact solely with EU prime brokers and banks could be to the detriment of investors in a number of areas. Another example of the restriction of services to EU entities involved limiting the provision of professional indemnity insurance only to EU companies.
Deletion of proportionality or materiality provisions
Esma proposed various proportionality provisions designed to ensure that due regard would be paid to the nature, scale and complexity of businesses in applying the provisions of the directive. Some of these provisions have been embraced by the Commission but others have been omitted, inexplicably in Aima’s view.
Esma advised that the functional and hierarchical separation of portfolio or risk management tasks from other potentially conflicting tasks within a delegate or sub-delegate entity should be calibrated to the nature, scale and complexity of the entity’s business and to the nature and range of activities undertaken, on the understanding that the company should in any event implement safeguards against conflicts of interest and ensure the independent performance of risk management activities.
The draft regulation does not include this calibration. Other examples of deletion of materiality provisions cited by Aima include financial statement provisions or rules on depositaries. The association says that since most asset managers are small businesses, deleting proportionality provisions could prevent them operating under the directive.
Ambiguous language
Whereas Esma advised that the additional own funds requirement should be recalculated at the end of each financial year, the Commission has added that where the value of fund portfolios under management increases significantly during the year, the manager must recalculate the additional own funds and make necessary adjustments without undue delay. However, the draft regulation does not indicate what a significant increase in assets under management could be.
Another example concerns the fair treatment of investors. While Esma says fair treatment by a manager includes no investor obtaining preferential treatment that creates an overall material disadvantage to other investors, the Commission proposes in addition that the principle of fair treatment of investors must remain a crucial part of the manager’s business philosophy. It is not clear what the requirement would mean in practice or how compliance could be demonstrated or enforced.
Aima also identifies a number of other areas in which the Commission’s divergence from Esma’s advice could prove seriously disruptive:
• The draft regulation does not consider Esma’s advice to exclude foreign exchange or interest rate hedging positions from the calculation of assets under management.
• The Esma proposals allowed managers to use third-country firms to provide professional indemnity if they could demonstrate the insurer’s viability, but the draft regulation appears to prohibit use of a non-EU insurer.
• Omitting the advanced approach for calculation of leverage could create serious problems for the industry, investors and regulators, Aima says, because use of the Ucits commitment approach does not reflect the role of leverage in alternative funds and could provide a misleading picture of leverage in the industry.
• While Esma says it is impossible to use a single figure to designate the use of leverage on a substantial basis, the Commission’s draft proposes that a fund will be considered as using substantial leverage on a basis if the leverage ratio exceeds two times NAV as calculated under the commitment method.
• Delegation to third-country entities seems to be restricted by unworkable co-operation arrangements.
• The Commission’s refusal to follow Esma’s advice on excluding assets subject to collateral arrangements from the scope of custody could lead to a conflict with the EU’s Financial Collateral Directive as well as with the European Market Infrastructure Regulation.
• Esma’s advice that external events the depositary should monitor to qualify for a liability discharge being “reasonably identifiable” has not been included in the draft regulation.
The Commission has not commented on whether it plans to make further changes to the regulation as a result of feedback from industry participants and EU member states, although Michel Barnier, Commissioner for the Internal Market and Services, stated that the draft regulation published in April was “still work in progress and no final decisions have been taken.”
Barnier insists that the measures being developed will not alter the substance of the principles contained in the legislative text of the AIFMD. The Commission has indicated its intention of publishing the final version of the Level 2 implementation measures in July.
The Commission says it has chosen to implement Level 2 measures through a regulation rather than one or more sub-directives because the latter would require adoption by each EU member state into its legislation, whereas a regulation takes automatic effect throughout the EU.
In addition, a regulation provides no scope for adaptation of the legislation to local factors of differences in difference member state. The Commission argues that this is necessary to ensure a single, uniform set of rules applicable throughout the EU without delay.