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.

The European Securities and Markets Authority will take charge of negotiating regulatory co-operation agreements with non-European Union countries required by the Alternative Investment Fund Managers Directive, but the national regulators of EU member states will have to sign such agreements themselves.
Esma announced on Thursday, April 26, that it would begin discussions with the non-EU regulators of entities outside the union that are subject to the requirements of the directive regarding supervisory co-operation issues.
The move follows agreement by Esma’s board of supervisors – made up of the heads of the EU’s 27 national financial regulators – to follow a common policy regarding the co-operation arrangements required under the AIFM Directive that should be in place between EU and non-EU securities supervisors by July 2013.
Esma says it will take the lead on the negotiation of co-operation arrangements with non-EU authorities on behalf of EU regulators through a common Memorandum of Understanding.
This will facilitate the cross-border supervision of entities subject to AIFMD including managers of alternative investment funds, depositaries and entities performing tasks under delegation by the manager. The MoU will be based on the Principles Regarding Cross-Border Supervisory Co-operation published by the International Organization of Securities Commissions (Iosco) in May 2010.
While Esma will negotiate on behalf of all EU financial regulators, the final signature of individual MoUs with non-EU authorities will be the responsibility of each EU national regulator.
Esma says its co-ordination of the negotiation process should allow both EU and non-EU regulators to put in place consistent co-operation arrangements for the AIFM Directive “in an efficient and timely fashion”.

The European Commission’s proposals for level 2 implementation measures for the Alternative Investment Fund Managers Directive has been circulated to European Union member states and to the European Parliament.
The Commission’s draft has prompted criticism from hedge fund managers quoted in media reports and from a hedge fund industry body, the Alternative Investment Management Association, that in certain areas its proposals differ significantly from those put forward by the European Securities and Markets Authority (Esma) in its advice delivered to the Commission on November 16.
According to Aima, the Commission plans to put the level 2 measures into effect in the form of a regulations which applies directly to member states, rather than a directive that would have to be adopted into their national law in a separate legislative process. The association says that using directives would give member states greater flexibility in implementing the measures.
Aima also notes that member states and the European Parliament had only two weeks to respond to the text following its circulation by the Commission in the final week of March. No further consultation period is planned before the Commission adopts the level 2 measures in their definitive form, due by July this year.
In a statement, the hedge fund association says the draft regulation “appears to significantly and substantially diverge from the Esma advice in … key areas including third country provisions, depositaries, delegation, leverage, own funds, professional indemnity insurance, appointment of prime brokers and calculation of assets under management.” It argues that while the Commission is not bound to follow Esma’s advice, if it does so there should be more transparency and better consultation.
Hedge fund managers quoted by publications such as Financial News and the Financial Times complain that the Commission’s text would increase the liability of banks in the event of loss of fund assets for which they were acting as depositary and their responsibility for assets subject to collateral arrangements, that a more flexible method of calculating a fund’s leverage has been removed from the available options, and that the rules on delegation of functions such as asset management to non-EU companies have become more restrictive.
Aima says it is particularly concerned about proposed changes in the way co-operation arrangements between EU and third-country regulators are organised. It argues that a requirement that EU and non-EU regulators sign co-operation agreements legally binding on both parties and requiring that third-country regulators enforce EU law in their territories “would be extremely problematic if not impossible to conclude”.
Without such co-operation agreements, asset managers based outside the EU would be able to access investors inside only through reverse solicitation, described in the directive as ‘passive marketing’. Aima says this would effectively render inoperative existing national private placement regimes available in some EU countries and prevent delegation of portfolio management outside of the EU.
“Esma has made it clear in its advice that cooperation agreements are to be signed on a best-efforts basis and are meant to reflect international norms such as the Iosco Multilateral Memorandum of Understanding,” says Aima chief executive Andrew Baker. “We hope the Commission follows this advice.”
For details of Esma’s advice to the Commission, please see our article of January 21 entitled Esma Advice Increases Certainty on Third-Country AIFMD Level 2 Measures, which can be found by clicking on the link below.
Chevalier & Sciales will analyse the Commission’s proposals in detail once they are made publicly available.

Luxembourg’s Parliament has adopted on March 6 legislation amending the February 2007 law on Specialised Investment Funds, adapting the highly successful SIF regime to European and international developments regarding regulation and transparency of alternative investments.
The revised legislation reflects in particular the requirements of the European Union’s Directive on Alternative Investment Fund Managers, which will take effect on July 22, 2013. It also follows some aspects of Luxembourg’s funds legislation of December 17, 2010, which transposed into national law the Ucits IV Directive governing cross-border distribution of retail funds within the EU and introduced other changes affecting non-Ucits funds.
In addition, the revisions to the SIF regime reflect the experience of Luxembourg’s regulator, the Financial Sector Supervisory Authority (CSSF), over the more than five years since it was established by legislation of February 13, 2007. Over that period the number of SIFs has grown from around 220 (vehicles recategorised from Luxembourg’s previous regime from institutional funds) to 1,387 at the end of January 2012, and they account for more than one-third of all investment funds domiciled in the grand duchy.
The revised legislation was submitted to the Chamber of Deputies on August 12 last year. Although it was originally hoped that the law could be adopted by the end of the year, it was not until January that Parliament’s Finance and Budget Committee approved an amended version of the draft bill. The committee finalised its report on the legislation to the full Chamber on February 28, and it received almost unanimous approval from deputies a week later. The law will come into force on the day following its publication in the Mémorial, Luxembourg’s official journal.
The revisions to the legislation include measures to bring the SIF law into line with AIFM Directive rules covering areas including delegation, risk management and the handling of actual or potential conflicts of interest. Following the December 2010 legislation, it will allow sub-funds of a SIF umbrella structure to invest in other compartments of the same structure in the same way that Ucits funds can do.
The most notable change abolishes an eye-catching, but not heavily used, provision of the 2007 SIF that allowed fund promoters to wait until up to a month after the launch of a fund to submit it to the CSSF for approval. Henceforth funds must be authorised by the regulator before they can be launched.
In its advice to Parliament, Luxembourg’s Chamber of Commerce noted that “one might regret the disappearance of certain advantages relating to the approval and information procedures that up to now have made [SIFs] particularly flexible investment vehicles”.
However, the Council of State, which is responsible for scrutinising legislation, said in its report that this change was “more a measure of legal security and a codification of existing practice than a restriction, since almost all promoters applied for approval before launching their funds in order to avoid the risks and costs entailed by any changes to the documentation, operating model or investment policy that the CSSF might have required in the case of approval sought following the launch of the fund”.
The legislation is relatively short, consisting of just 18 articles covering five A4 pages. The first article states that the activity of management of a SIF must comprise at a minimum management of the investment portfolio. This explicitly excludes from the SIF regime passive funds that seek to create value solely by the long-term holding of assets and creates a distinction between SIFs and private wealth management companies created under Luxembourg’s law of May 11, 2007, but it does not exclude private equity or real estate funds.
Article 2 requires SIFs to have in place procedures to verify that its investors qualify as sophisticated rather than retail clients. The Council of State argued that this measure was superfluous, but the Finance and Budget Committee decided to retain it as a means of reminding SIFs and their promoters of their obligations.
Article 3 allows SIFs created as open-ended investment companies (Sicavs) to benefit from measures in the 2010 law under which fund articles of association drawn up in English no longer need to be translated into French or German. In addition, such funds no longer need to send shareholders physical (as opposed to electronic) copies of their annual reports unless this is specifically requested, Finally, given potential for high turnover of shareholdings in a SIF, they may establish a registration date five days preceding an annual general meeting of shareholders for the purposes of determining voting rights and what constitute a quorum.
Article 5 of the draft law amends Article 42 of the 2007 SIF legislation, which allowed promoters of a fund to apply for approval of their articles of association, choice of custodian and their executives and portfolio managers after the fund’s launch rather than before. This change brings SIFs into line with funds created under the 2010 legislation.
A new requirement makes authorisation subject to notification of the persons responsible for management of the SIF’s investment portfolio to the CSSF, which must certify that they are of good reputation and have the experience necessary to manage the type of alternative investment fund in question. Any changes in the identity of the fund’s portfolio managers must also be notified to the regulator.
Article 6 creates a new Article 42bis of the legislation requiring SIFs to implement systems to detect, measure, manage and monitor the investment risk of its individual positions and their contribution to the portfolio’s overall risk profile. They must also be structured and organised to minimise the risk of conflicts of interest, and draw up rules to manage such conflicts that do arise to prevent any harm to investors. The CSSF is mandated to draw up regulations setting out detailed requirements in these areas.
Reflecting the CSSF’s experience in supervising SIFs since 2007, Article 7 defines the conditions under which SIFs may delegate various tasks and functions to third-party providers. The CSSF must be informed in advance and delegation should not affect oversight of the fund; individuals or legal entities to which portfolio management is delegated must be authorised or licensed for that function and subject to prudential regulation, unless the CSSF grants permission for delegation to individuals or entities that do not meet this requirement.
A fund’s managers must be able to determine that the delegated provider is qualified and capable, and they must retain ultimate control over the fund’s activities and the ability to revoke the delegation. Delegation should not create conflicts of interest – so, for instance, investment management may not be delegated to the fund’s custodian – and the delegation of functions must be revealed in the fund’s offering documents.
The CSSF’s powers of supervision and enquiry over SIFs are set out in Article 8, which brings the legislation into line with the requirements of the Ucits IV Directive, while Article 9 set out circumstances in which the CSSF or the Luxembourg prosecutors may apply to the courts for the dissolution and liquidation of one or more fund compartments.
Article 10 deals with administrative fines, which the CSSF may publish unless this would seriously affect financial markets, damage the interests of investors or cause disproportionate prejudice to the parties affected. On the insistence of the Council of State, a clause has been inserted into the text confirming that firms may appeal against such penalties.
Under Article 12, the CSSF’s approval is now required for any substantial change made to the SIF’s offering documents, such as the name of the fund or of sub-funds, the replacement of the custodian, administrator, auditor or manager, the creation of new sub-funds or a significant change in investment policy.
Article 13 states that funds are not prohibited from deviating from their investment policy for the purposes of liquidity management, hedging or efficient portfolio management, while Article 14 bars SIFs in the form of companies that are in the course of being liquidated from issuing new shares, except where this is beneficial to the outcome of the liquidation itself. Article 15 allows the CSSF to withdraw authorisation for one or more sub-funds of a SIF while maintaining the authorisation for other sub-funds of the same structure.
Article 16 of the new law follows the 2010 legislation in allowing one sub-fund of a SIF to invest in another. This article clarifies that the rules regarding a company’s investment in its own shares set out in Luxembourg’s 1915 company law do not apply to SIFs. Sub-funds of the same SIF may not cross-invest in each other, and voting rights of shares held by one sub-fund in another are suspended.
Finally, Article 17 stipulates that SIFs established before the date of entry into force of the revision law will have a transitional period up to June 30, 2012 before they are obliged to comply with its requirements on ascertaining that their investors are sophisticated (Article 2, paragraph 3) and risk management and conflicts of interest (Article 42bis), and up to June 30, 2013 to comply with the new rules on the delegation of functions (Article 42ter).

The European Securities and Markets Authority has published on November 16 its final advice to the European Commission on the detailed rules underlying and implementing the Alternative Investment Fund Managers Directive. The Commission is expected to issue the rules in the form of subsidiary legislation and regulation by the middle of next year.
According to Esma, its proposed rules should establish a comprehensive framework for alternative investment funds, their managers and depositaries, and by achieving the directive’s aim of increasing transparency and mitigating systemic risk, ultimately contribute to improved protection of investors.
Esma’s advice is in response to a 2010 request originally sent by the Commission to Esma’s predecessor, the Committee of European Securities Regulators. An advisory body comprised of EU securities regulators that advised the European Commission from 2001 to 2010 on securities legislation policy issues, Cesr was replaced by Esma at the beginning of this year.
November 16 was the deadline for delivery of Esma’s advice to the Commission. The 500-page document takes into account industry feedback received by Esma in response to two consultation papers, published in July and August. The Commission has indicated that it remains open to further input from the industry and other stakeholders before it finalises the rules.
Esma says that while not binding on the Commission, the proposed rules will bring greater clarity on the application of the thresholds that determine the scope of the AIFM Directive, while the provisions regarding operating conditions impose stronger organisational and conduct rules for alternative fund managers, on top of increased reporting requirements to investors and regulators and the rules governing use of leverage.
The advice seeks to clarify the duties of depositaries to alternative investment funds, such as monitoring funds’ cash flows, as well as defining the circumstances in which assets held in custody can be deemed to be lost and the consequences. It also fleshes out the framework under which third-country firms and managers will be able access European investors, both before and after the AIFM Directive’s marketing ‘passport’ is due to be extended to non-EU firms and funds after mid-2015.
The advice document covers four broad areas. The first part, covering general provisions for managers, authorisation and operating conditions, clarifies how the asset thresholds determining whether a manager is subject to the directive will operate. It also details how managers should cover risks arising from professional negligence through the holding of additional capital or insurance. Esma notes that many of its rules in areas such as conflicts of interest, recordkeeping and organisational requirements are based on equivalent provisions of the Mifid and Ucits legislative frameworks.
The second part of the advice proposes a framework governing depositaries of alternative funds, include the criteria for assessing whether the prudential regulation and supervision applicable to a depositary established in a third country has the same effect as the provisions of the AIFM Directive.
In response to protests from industry bodies such as the Alternative Investment Management Association (Aima), Esma has dropped the nebulous concept of ‘equivalence’ of third-country regimes with the directive’s provisions. Instead it sets out criteria such as the independence of the financial regulator, the eligibility requirements for organisations seeking to act as a depositary, and the existence of sanctions to punish violations.
Esma says that determination of the circumstances in which a financial instrument held in custody should be considered as lost is crucial in determining whether a depositary is required to return an asset or its value. It proposes that an asset should be considered lost if financial instruments supposedly owned by a fund either cease to exist or are found never to have existed, if the fund has been permanently deprived of its right of ownership over the instruments, or if it is permanently unable to dispose of the instruments directly or indirectly.
The document also aims to clarify what constitutes external events beyond the reasonable ability of the depositary to control or protect against. It also clarifies the reasons that would allow a depositary contractually to discharge its liability to make restitution of the assets.
To assist in preventing the build-up of systemic risk, Esma’s advice clarifies the definition of leverage, how it should be calculated and in what circumstances a regulator should be able to impose limits on the leverage used by a particular manager. It confirms the proposal set out in one of the consultation papers to prescribe two different calculation methodologies for leverage, the commitment and gross methods, as well as a further option, the advanced method, which can be used by managers on request. To increase transparency of alternative funds and their managers, Esma sets out the form and content of information to be reported to regulators and investors, and what information should be included in a fund’s annual report.
Regarding the regulatory co-operation and exchange of information arrangements required to allow non-EU funds or funds from non-EU managers to be marketed in Europe, Esma proposes the institution of written agreements allowing for exchange of information for both supervisory and enforcement purposes.
Agreements should be signed by the European regulators concerned and the third-country regulator of the manager and/or fund, which could take the form of a multilateral memorandum of understanding centrally negotiated by Esma. The detailed content of the co-operation arrangements would take into account international standards, notably the Iosco Multilateral Memorandum of Understanding on co-operation for enforcement purposes and the Iosco Technical Committee Principles for Supervisory Co-operation.
The AIFM Directive was first proposed by the European Commission in April 2009 and agreed by the European Parliament and EU member states in November 2010. The directive was formally signed on June 8 this year, published in the EU Official Journal on July and came into force on July 21; the deadline for transposition into the national legislation of EU member states is July 22, 2013. The marketing passport provisions may, by decision of the Commission, be extended to non-EU jurisdictions any time after July 22, 2015.

Four and a half years after Luxembourg introduced the law creating the Specialist Investment Fund regime for alternative vehicles, the grand duchy’s government has drafted legislation amending the SIF rules.
The new legislation, which was placed before the Chamber of Deputies (Parliament) on August 12 and which is expected to become law before the end of this year, aims principally to adapt the SIF law to the requirements of the European Union’s Directive on Alternative Investment Fund Managers, which will take effect in July 2013, including rules on delegation, risk management and the handling of actual or potential conflicts of interest.
In addition, in some instances the proposed changes will bring the SIF regime into line with Luxembourg’s funds legislation of December 17, 2010, which transposed into national law the Ucits IV Directive governing cross-border distribution of retail funds within the EU as well as introducing other changes affecting non-Ucits funds. For example, the law will enable sub-funds of a SIF umbrella structure to invest in other compartments of the same structure, as is already now the case for Ucits funds.
Moving early to adopt requirements to be introduced by the AIFM Directive is in keeping with Luxembourg’s tradition, maintained over more than two decades, of putting EU legislation in place ahead of many competing European jurisdictions, enabling promoters to plan future fund launches with confidence about the stability of the country’s regulatory regime.
The first of 18 articles of the draft legislation states that the activity of management of a SIF must comprise at a minimum management of the investment portfolio. This stipulation aims explicitly to exclude from the SIF regime passive funds that seek to create value solely by the long-term holding of assets and to create a distinction between SIFs and private wealth management companies governed by Luxembourg’s law of May 11, 2007. However, it does not exclude private equity or real estate funds from the SIF regime. Article 2 requires SIFs to have in place procedures to determine that its investors qualify as sophisticated rather than retail.
Article 3 aligns the SIF rules with various features of the 2010 law. Where the fund’s articles of association are drawn up in English, the legislation no longer insists that these be translated into French or German. Funds no longer need to send shareholders physical copies of their annual reports unless this is specifically requested, and in addition, SIFs may establish a registration date five days preceding an annual general meeting of shareholders for the purposes of determining voting rights and what constitute a quorum.
Article 5 of the draft law amends Article 42 of the 2007 SIF legislation, which allowed promoters of a fund to apply for authorisation by Luxembourg’s regulator, the Financial Sector Supervisory Authority (CSSF) up to one month following their launch. This provision, which in any case was not widely used by the promoters, is now abolished; once the law comes into force funds must have received approval from the CSSF before they can be launched, as is the case for funds created under the 2010 legislation.
A new requirement makes authorisation subject to notification of the persons responsible for management of the SIF’s investment portfolio to the CSSF, which must henceforth ascertain that they are of good reputation and have the experience necessary to manage the type of alternative investment fund in question. Any changes in the identity of the fund’s portfolio managers must also be notified to the regulator.
Under Article 6, SIFs must implement systems to monitor, measure and manage the investment risk of its individual positions and their contribution to the portfolio’s overall risk profile. They must also be structured and organised to minimise the risk of conflicts of interest, and draw up rules to manage such conflicts that do arise. The CSSF may draw up further regulations setting out detailed requirements on risk management and conflicts of interest.
Article 7 defines the conditions under which SIFs may delegate various tasks and functions to third-party providers. Such delegation should not affect regulation of the fund; entities to which portfolio management is delegated must be approved for that function and subject to prudential regulation, unless the CSSF grant permission for delegation to individuals or entities to which this condition does not apply.
A fund’s directors must be able to determine that the delegated provider is qualified and capable, and they must retain ultimate control over the fund’s activities. Delegation should not create conflicts of interest – so, for instance, investment management may not be delegated to the fund’s custodian – and the delegation of functions must be revealed in the fund’s offering documents.
The CSSF’s powers of supervision and enquiry over funds set out in Article 8 aligns the provisions of the SIF legislation with those laid down by the Ucits IV directive, while Article 9 set out circumstances in which the CSSF or the Luxembourg prosecutors may apply to the courts for the dissolution and liquidation of one or more fund compartments. Article 10 deals with administrative fines, which the CSSF may publish unless this would seriously affect financial markets, damage the interests of investors or cause disproportionate prejudice to the parties affected.
Under Article 12, the CSSF’s approval is now required for any substantial change made to the SIF’s offering documents, such as the name of the fund or of sub-funds, the replacement of the custodian, administrator, auditor or manager, the creation or new sub-funds or a significant change in investment policy.
Article 13 authorises funds to deviate from their exclusive investment policy for the purposes of liquidity management, hedging or efficient portfolio management, while Article 14 bars SIFs in the form of companies that are in the course of being liquidated from issuing new shares, except where this is beneficial to the outcome of the liquidation itself. Article 15 allows the CSSF to withdraw authorisation for one or more sub-funds of a SIF while maintaining the authorisation for other sub-funds of the same structure.
The draft law follows the 2010 legislation in allowing one sub-fund of a SIF to invest in another, although not all provisions are identical. This clarifies that the rules set out in Luxembourg’s 1915 company law regarding a company’s investment in its own shares do not apply to SIFs. Sub-funds of the same SIF may not cross-invest in each other, and voting rights of shares held by one sub-fund in another are suspended.
Finally, Article 17 stipulates that SIFs established before the date of entry into force of the revision law will have a transitional period up to June 30, 2012 before they are obliged to comply with its requirements on ascertaining that their investors are sophisticated (Article 2, paragraph 3) and risk management and conflicts of interest (Article 42bis) and up to June 30, 2013 to comply with the new rules on the delegation of functions (Article 42ter).

The European Securities and Markets Authority (Esma) has published a consultation paper on August 23 setting out its proposals for the detailed Level 2 rules on supervision and third-country entities underlying the Alternative Investment Fund Managers Directive.
According to Esma, the proposed rules have been drafted to reflect the global nature of the alternative investment management industry and the need for a framework covering entities outside the European Union.
The consultation paper, which follows an earlier document published in July inviting comment on its Level 2 proposals for other aspects of the directive, is Esma’s response to the European Commission’s request for technical assistance from the organisation’s predecessor, the Committee of European Securities Regulators (Cesr).
Esma is due to deliver its finalised advice to the Commission by November 16 this year, and it requests responses to the consultation to be delivered by September 23 in order for it to meet the deadline.
Admission of third-country managers and funds to EU markets through national private placement regimes or, after 2015, a passporting regime for alternative funds will involve a framework of supervisory co-operation and exchange of information between EU regulatory authorities and their counterparts in non-EU countries.
According to Esma’s proposals, these co-operative arrangements should be organised through written agreements allowing for exchange of information for both supervisory and enforcement purposes. The agreements should impose a duty on the third-country authority to assist the EU regulator in question where it is necessary to enforce EU or national legislation, and provide for exchange of information for the purposes of systemic risk oversight.
The 30-page paper also invites comment on Esma’s proposals for the additional requirements to be applied when alternative fund managers delegate portfolio or risk management functions to a provider based in a third country. They cover the content of the written agreement to be concluded with the regulator of the third country, which would have to allow for access to information, the possibility of on-site inspections of the entity to which functions are delegated and enforcement actions in the event of a breach of the AIFM Directive rules.
Under the directive, a fund’s depositary may be established in a third country subject to certain conditions. Esma sets out its proposals on the elements to be taken into account when assessing whether the prudential regulation and supervision applicable to a third-country depositary is equivalent to the AIFM Directive provisions, and whether it can be considered to be effectively enforced.
Esma lists a number of criteria such as the independence of the third-country regulator, its eligibility requirements for depositaries, the equivalence of capital requirements and the existence of sanctions in the case of violations.
Regarding the co-operation arrangements with third country regulators in general, Esma expresses a preference for a single agreement to be negotiated by itself in each case to ensure consistency and avoid a proliferation of bilateral agreements. It has also identified documents produced by the International Organisation of Securities Commissions as benchmarks for the written agreements.
The AIFM Directive was first proposed by the European Commission in April 2009 and agreed by the European Parliament and EU member states last November. On December 2 last year the Commission formally sent a request for technical advice on Level 2 measures to Cesr, Esma’s forerunner. The directive was formally signed on June 8 this year and came into force on July 21; the deadline for transposition into the national legislation of EU member states is July 22, 2013.
The Commission’s request for technical advice has been divided into four parts covering general provisions, authorisation and operating conditions, implementing measures regarding the depositary, transparency requirements and leverage, and implementing measures on supervision. Esma’s proposed advice on Parts I to III was covered by a consultation paper published on July 13, responses to which are due by September 13.