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AIFMD II: The commission’s proposals to reform AIFMD and the UCITS directive

  • United Kingdom
  • Financial services and markets regulation
  • Investment funds and asset management

14-02-2022

As part of the EU’s 2020 Capital Markets Union Action Plan, at the end of 2021 the European Commission adopted a package of four legislative proposals:

(i)           a regulation establishing a European single access point

(ii)          a regulation amending MiFIR (Markets in Financial Instruments Regulation) to enhance market data transparency

(iii)         a regulation amending the ELTIF (European Long Term Investment Fund) Regulation

(iv)        a directive amending AIFMD (Alternative Investment Funds Managers Directive) and the UCITS (Undertakings for Collective Investments in Transferable Securities) directive in respect of delegation arrangements, liquidity risk management, supervisory reporting, provision of depositary and custody services and loan origination by alternative investment funds (“AIFs”)

The legislative proposals 

The Commission commenced a review of AIFMD in 2017, commissioning a report from KPMG and obtaining input from industry, national supervisors and other stakeholders. While the Commission concluded that AIFMD provides a high level of protection for investors, it identified what it considers specific shortcomings, which the legislative proposals are intended to address.

Ancillary Functions

The legislative proposals expand the ancillary functions which an AIFM is permitted to perform to include:

  • originating loans
  • servicing securitisation special purpose entities

AIFM authorisation

The legislative proposals require AIFMs to provide their national competent authorities (“NCAs”) with the following information when applying for authorisation:

  • details of the persons conducting the business of the AIFM including descriptions of their roles, reporting lines, responsibilities both internally and externally, overview of time allocated to each responsibility, and their technical and human resources support
  • a programme of activity and an organisational structure of the AIFM
  • details of delegation and sub-delegation arrangements, including the human and technical resources used to monitor and control delegates

The legislative proposal requires that the business of an AIFM must be conducted by at least two natural persons who must be:

  • employed by the AIFM or committed full time to the conduct of the AIFM’s business
  • resident in the EU

This is an attempt to increase the requirements for AIFMs operating in the EU to have a substantive presence there.  The potential reward for the EU is the onshoring of AIFM management teams to the EU. The potential risks are the restriction of the talent pool available to manage EU AIFMs, a reduction in the quality of EU AIFM management and a reduction in choice and competition in the EU market.

Delegation

Delegation to third-country entities

The legislative proposal contains a requirement for NCAs to notify ESMA if an AIFM delegates more portfolio management or risk management mandates to entities located outside the EU than it retains. To this end the legislative proposal empowers ESMA to develop regulatory technical standards in relation to the bureaucratic detail of such notifications. ESMA will be required to use the data from those notifications to analyse market practices regarding delegation to entities domiciled outside the EU.

The UCITS Directive’s provisions on delegation by management companies and when they may be deemed letter-box entities are also proposed to be aligned with the existing more detailed provisions of the AIFMD in relation to AIFMs.   

  1. Markets in Financial Instruments Regulation.
  2. European Long Term Investment Fund.
  3. Alternative Investment Fund Managers Directive.
  4. Undertakings for Collective Investments in Transferable Securities.

ESMA is certainly focussing on delegation, even though it famously declared some years ago that “delegation is not a dirty word”. There are legitimate reasons to delegate portfolio and risk management. A portfolio manager based in Tokyo is likely to be better placed to manage a Japanese small cap fund than an AIFM based in Luxembourg. But equally, there is a legitimate argument to be made that nominally EU based AIFMs which substantially delegate functions outside the EU may not have as much substance in the EU as a counterparty might reasonably expect. The question is where should the line be drawn.

Delegation rules under article 20 AIFMD 

The legislative proposals confirm the requirement in article 20(1) AIFMD for an AIFM to notify its NCA before delegation to third parties of the functions listed in Annex I of AIFMD or the services listed in Article 6(4) of AIFMD.

Lending Activities 

  • The legislative proposals set out detailed requirements for loan making AIFs: 
  • the AIFM must implement, keep updated and review at least annually policies, procedures and processes for granting credit, assessing credit risk, and administering and monitoring their credit portfolio 
  • no loan to a borrower which is a financial undertaking or collective investment undertaking for the purposes of AIFMD or the UCITS Directive may exceed 20% of the AIF’s capital. There are complex rules as to the calculation of capital for this purpose
  • there is a prohibition on loans to the AIFM, the AIFM’s staff, the depositary or any entity to which the AIFM has delegated functions 
  • if the AIF sells the loans it originates on the secondary market, it must retain at least 5 per cent of the value of those loans 

Liquidity risk management 

The legislative proposals amend article 16 AIFMD: 

  • if an AIF originates loans exceeding 60% of their net asset value, it must be structured as a closed-ended fund 
  • for open-ended AIFs, the AIFM must select and implement policies and procedures regarding the use of at least one liquidity management tool from the list set out in new Annex V 
  • ESMA will develop draft regulatory technical standards to specify the characteristics of the liquidity management tools 
  • for open-ended AIFs, the AIFM may temporarily suspend the purchase or redemption of AIF units in exceptional circumstances or activate other Annex V liquidity management tools in the interests of investors.

Depositaries 

  • The legislative proposals introduce changes to the rules on the appointment of depositaries: 
  • an AIF’s NCA may allow the appointment of a depositary from another EU Member State provided that the entity is a credit institution. If the AIF is not regulated, the AIFM’s NCA may give permission
  • ESMA must review the legislative proposals 60 months after they come into force, at which time ESMA must consider the possibility of creating a passport regime for depositaries
  • a prohibition on the appointment of non-EU depositaries located in countries identified as high risk countries under the AML directive
    • this replaces a prohibition on the appointment of non-EU depositaries domiciled in countries listed as non-cooperative by the Financial Action Task Force (“FATF”)
  • a prohibition on the appointment by AIFs of non-EU depositaries located in countries on the EU list of non-cooperative jurisdictions for tax 
  • the appointment of a central securities depository (“CSD”) by a depositary will be subject to the delegation requirements set out in AIFMD, unless CSD is an issuer CSD
    • the appointing depositary will be liable if the CSD loses the assets it holds on behalf of the fund

Allowing AIFs to appoint a depositary from another Member State appears to confer a competitive advantage on those EU financial centres with greater depositary capabilities which will in turn drive a concentration of depositary activity, with Amsterdam, Dublin, Frankfurt, Luxembourg and Paris the likely beneficiaries. It may become uneconomic to offer depositary services out of smaller financial centres. Concentrating depositary services in a smaller number of financial centres may help build the critical mass necessary to compete with non-EU depositary centres. The possibility of the introduction of a depositary passport on a future review would also tend to drive concentration in the depositary market by allowing larger depositaries from the larger financial centres to bring their greater economies of scale to smaller financial centres, most likely at the expense of national players.   

Marketing rules for third-country AIFs/AIFMs  

The legislative proposals prohibit non-EU AIFs and AIFMs from marketing into the EU if the country in which they located is on the list of high risk countries under the AML directive or on the EU list of non-cooperative jurisdictions for tax.

Disclosure to investors 

Pre-contractual disclosures

The legislative proposals requires the following additional pre-contractual disclosures to investors under Article 23(1) AIFMD: 

  • in what circumstances and how the AIFM will use its chosen liquidity management tools 
  • a list of fees and charges which the AIFM or its affiliates will charge in connection with the operation of the AIF 

Periodic reporting 

The legislative proposals add additional disclosure requirements for periodic reporting to investors under Article 23(4) AIFMD: 

  • if an AIF originates loans, details of its loan portfolio
  • quarterly disclosure of all direct and indirect fees and charges charged or allocated to the AIF or its investments
  • quarterly disclosure of information about the AIFM’s structure and the establishment of any parent company, subsidiary or special purpose entity in relation to the AIF’s investments, the AIFM’s staff and the AIFM’s direct or indirect affiliates 

Regulatory reporting 

The legislative proposals include clarifications of article 24 AIFMD and the limitations on data reporting obligations, while mandating ESMA to draft regulatory and implementing technical standards to replace the current supervisory reporting template in Annex IV of AIFMD.

UCITS Directive Amendments 

  • The legislative proposals seek to align AIFMD and the UCITS regimes as closely as possible, and to that end make reforms to the UCITS directive to add the obligations on UCITS management companies:
  • applications for authorisation as a UCITS management company will require greater detail
  • similar to the requirements for AIFMs, to justify delegation of portfolio management and risk management functions, including notification of NCAs if more portfolio or risk management functions are delegated than retained
  • changes to liquidity management which largely reflect the proposed amendments to AIFMD
  • a new obligation to report to NCAs on trading on behalf of the UCITS they manage, equivalent to reporting under Annex IV AIFMD reporting

Post Brexit

EU led divergence

The AIFMD II legislative proposals are the first substantial divergence from the legacy rules relating to asset management shared by the EU and the UK at the end of the Brexit transition period (31 December 2020). 

The legislative proposals have a protectionist flavour to them. The requirements to notify NCAs of delegation of portfolio and risk management functions to firms outside the EU is likely to operate as a disincentive for EU domiciled firms to enter into such delegation unless strictly necessary. The requirement for ESMA to report upon the scale of delegation outside the EU is likely to provoke demands from the European Parliament and others for steps to be taken to curtail the volume of delegation in the name of the EU’s strategic autonomy and to protect EU markets from systemic risk, concerns which some may think more political and mercantilist than driven by protecting financial markets and consumers.

Were the UK still a member state of the EU, it is unlikely that the legislative proposals would be so protectionist and the UK would have led the charge to soften them during the legislative process.

How may the UK respond

Divergence

The UK government has said that it isn’t seeking to diverge from EU law for divergence’s sake in terms of the regulations and reforms it enacts, however, it has not made any commitment to adopt new measures similar to those which the EU adopts. While the UK and the EU may share regulatory goals, for instance when implementing global standards, the UK government states that it intends to regulate in a fashion which promotes outcomes but does not rigidly prescribe the processes by which those outcomes are achieved.  

The UK regulators will most likely monitor the appropriateness of delegation without introducing any additional reporting mechanisms. Some aspects of the AIFMD II legislative proposals, in particular in relation to delegation, run contrary to the UK government’s stated aim of ensuring an open, global financial services market. Instinctively, the UK government and regulators avoid protectionist measures, and it is to be hoped that they will not follow the EU’s lead in this regard.

Loan origination funds

The legislative proposal to create a regulatory framework for loan origination funds is a development which may give the EU a competitive advantage. In this instance we think it possible that the UK government will respond in kind, although if it does, we would expect it to formulate a lighter and less prescriptive regime.

Depositaries

The changes to the rules applicable to the appointment of CSDs by depositaries may present problems for depositaries which operate in both the UK and the EU. If the UK government does not adopt equivalent rules, depositaries may be compelled to choose between either running two parallel operating models or voluntarily applying the EU rules to their UK operations. If one depositary voluntarily offers to assume liability for UK assets for which it has delegated custody to a CSD, other depositaries may be forced to follow suit in order to remain competitive. The EU has long spoken of its ambition to be a regulatory superpower. Compelling private companies to voluntarily adopt its regulations in relation to their activities outside of the EU would see this ambition coming of age.

Next steps

The European Council and European Parliament will consider the legislative proposals. Due to the relatively contentious nature of some of the proposals and the prolonged timescale of the review to date, we expect multiple revisions of the text and for that process to take at least six months and probably longer. 

Practical implications 

While we must await the finalisation of the proposals and the RTS to know exactly what the practical implications of these legislative proposals may be, we can foresee the following:
  • many funds will need to repaper, if only in respect of informing investors about their approach to liquidity management
  • the increased reporting requirements will require firms to reassess their internal procedures and data collection processes
  • the new delegation rules, while they will not prohibit delegation, will increase the regulatory burden when delegating and NCA scrutiny of firm’s delegation strategies  
  • firms may want to take advantage of the new depositary rules to have a single EU depositary to hold all their EU assets, which may enable those firms to achieve cost savings. Consolidating all their assets to a single depositary will require careful planning and execution, as well as the termination of contracts 

How can Eversheds Sutherland help? 

Our in depth understanding of the sector means that we are well placed to advise you on the scope and implications of the amendments to the AIFM and UCITS regimes. Our team are available to discuss the legislative proposals in detail and to analyse the impact they may have on your business.

ESMA is certainly focussing on delegation, even though it famously declared some years ago that “delegation is not a dirty word”.  There are legitimate reasons to delegate portfolio and risk management.  A portfolio manager based in Tokyo is likely to be better placed to manage a Japanese small cap fund than an AIFM based in Luxembourg.  But equally, there is a legitimate argument to be made that nominally EU based AIFMs which substantially delegate functions outside the EU may not have as much substance in the EU as a counterparty might reasonably expect.  The question is where should the line be drawn.

 

Delegation rules under article 20 AIFMD

 

The legislative proposals confirm the requirement in article 20(1) AIFMD for an AIFM to notify its NCA before delegation to third parties of the functions listed in Annex I of AIFMD or the services listed in Article 6(4) of AIFMD.

 

Lending Activities

 

The legislative proposals set out detailed requirements for loan making AIFs:

·       the AIFM must implement, keep updated and review at least annually policies, procedures and processes for granting credit, assessing credit risk, and administering and monitoring their credit portfolio

·       no loan to a borrower which is a financial undertaking or collective investment undertaking for the purposes of AIFMD or the UCITS Directive may exceed 20% of the AIF’s capital.  There are complex rules as to the calculation of capital for this purpose

·       there is a prohibition on loans to the AIFM, the AIFM’s staff, the depositary or any entity to which the AIFM has delegated functions

·       if the AIF sells the loans it originates on the secondary market, it must retain at least 5 per cent of the value of those loans

 

Liquidity risk management

 

The legislative proposals amend article 16 AIFMD:

·       if an AIF originates loans exceeding 60% of their net asset value, it must be structured as a closed-ended fund

·       for open-ended AIFs, the AIFM must select and implement policies and procedures regarding the use of at least one liquidity management tool from the list set out in new Annex V

·       ESMA will develop draft regulatory technical standards to specify the characteristics of the liquidity management tools

·       for open-ended AIFs, the AIFM may temporarily suspend the purchase or redemption of AIF units in exceptional circumstances or activate other Annex V liquidity management tools in the interests of investors.

 

Depositaries

 

The legislative proposals introduce changes to the rules on the appointment of depositaries:

·       an AIF’s NCA may allow the appointment of a depositary from another EU Member State provided that the entity is a credit institution.  If the AIF is not regulated, the AIFM’s NCA may give permission

·       ESMA must review the legislative proposals 60 months after they come into force, at which time ESMA must consider the possibility of creating a passport regime for depositaries

·       a prohibition on the appointment of non-EU depositaries located in countries identified as high risk countries under the AML directive

o    this replaces a prohibition on the appointment of non-EU depositaries domiciled in countries listed as non-cooperative by the Financial Action Task Force (“FATF”)

·       a prohibition on the appointment by AIFs of non-EU depositaries located in countries on the EU list of non-cooperative jurisdictions for tax

·       the appointment of a central securities depository (“CSD”) by a depositary will be subject to the delegation requirements set out in AIFMD, unless CSD is an issuer CSD

o    the appointing depositary will be liable if the CSD loses the assets it holds on behalf of the fund

 

Allowing AIFs to appoint a depositary from another Member State appears to confer a competitive advantage on those EU financial centres with greater depositary capabilities which will in turn drive a concentration of depositary activity, with Amsterdam, Dublin, Frankfurt, Luxembourg and Paris the likely beneficiaries.  It may become uneconomic to offer depositary services out of smaller financial centres.  Concentrating depositary services in a smaller number of financial centres may help build the critical mass necessary to compete with non-EU depositary centres.  The possibility of the introduction of a depositary passport on a future review would also tend to drive concentration in the depositary market by allowing larger depositaries from the larger financial centres to bring their greater economies of scale to smaller financial centres, most likely at the expense of national players.