Olivier Sciales Investments Law Blog on Lawyers.com

After more than 18 months of often-heated debate and a succession of at
times contradictory drafts seeking to reconcile strongly-held opposing
positions, European Union economic affairs and finance ministers and then the
European Parliament finally agreed last November on a final version of the
Directive on Alternative investment Fund Managers.

The directive has attracted the disapproval of industry members for failing
to take into account the specific nature of different types of alternative fund
but also of critics who argue that it fails to rein in the industry
effectively. However, there is a broad consensus that the changes made during
the drafting and negotiating process have resolved many of the more controversial
aspects of the legislation.

Most notably, the directive will offer non-EU-based funds and managers the
opportunity to benefit from its ‘passporting’ provisions for the marketing of
products to sophisticated investors throughout the 27-member union, albeit two
years after EU managers with funds also domiciled in Europe. The extension of
the passport is likely to lead to the abolition of private placement
distribution arrangements under national rules, but not before at least five
years after the directive comes into force in 2013.

The final version also gives European sophisticated investors freedom – for
now, at least – to invest on their own initiative with whichever managers they
choose, and dilutes slightly the new responsibility laid on fund depositaries
for the loss of assets in their custody, by allowing them to pass on liability
to a sub-custodian.

Agreement on the legislation, in combination with other legislative changes
elsewhere in the world, has helped to bring greater certainty to the alternative
investment fund industry by providing a clearer picture of the future
regulatory landscape in which managers, service providers and investors will
have to operate and to a certain extent enshrine in written rules practices
that investors are already requiring in the wake of the recent financial
crisis.

 Why the AIFM Directive?

The preamble to the directive states that managers of alternative
investment funds are responsible for both a significant amount of invested
assets in Europe and of trading in markets for financial instruments, and can
exercise a significant influence on markets as well as companies in which they
invest. It argues that the recent financial crisis has shown how alternative managers
can spread or amplify risks through the financial system, and that efficient
management of these risks is difficult through unco-ordinated national
responses.

The directive therefore seeks to establish common authorisation and
regulatory requirements for alternative managers in order to create a coherent
approach to the management of such risks as well as the impact on investors and
markets within the EU. It aims to provide a framework capable of addressing
risks to investors, markets and other participants through comprehensive and
common supervisory arrangements. Applying to all types of fund not covered by
the Ucits directives governing cross-border retail funds, the AIFM Directive
seeks to take into account the diverse range of investment strategies,
techniques and assets employed by the diverse managers covered by the
directive.

Aim of the directive

The directive aims to create a single European internal market for
alternative fund managers and a harmonised regulatory framework for all
alternative managers active within the EU, whether they are based within the
union or not. It provides for a two-year transition period, after which non-EU
managers and EU managers of non-EU funds will gain access to the internal
market, followed by a three-year period during which the harmonised passport
regime will coexist with existing national private placement rules.

Subject to an assessment about the passport regime is working
satisfactorily, the national private placement regimes will be terminated at
the end of this five-year period. In addition, the European commission will
review the scope of application of the directive four years after it comes into
force in the national legislation of member states, to determine whether or not
the single market for alternative managers has caused market disruption and
whether it is consistent with the principles of the EU internal market and has
created a level playing field.

Scope of the directive

The directive applies to entities that manage alternative investment funds
as a regular business, including both open-ended and closed ended funds,
regardless of the funds legal form or whether it is listed, and that raise
capital from investors in order to invest according to a defined policy.

The directive is not intended to apply to vehicles for private wealth
management such as family office structures, nor to holding companies (although
this does not exclude managers of private equity funds, nor of funds traded on
regulated markets). Also excluded from the remit of the directive is the
management of pension funds, employee benefit or saving schemes, institutions
such as central banks, local or national government bodies that manage social
security and pension systems, securitisation SPVs, insurance contracts and
joint ventures. Nor does it apply to individual portfolio management services
provided by investment firms authorised under the MiFID directive in respect of
alternative investment funds.

The directive does not regulate alternative investment funds, which
continue to be regulated and supervised at national level. It therefore allows
member states to continue to set national requirements regarding alternative
funds established on their territory.

The directive provides for a less burdensome regime for alternative
managers whose combined assets under management total less than ¿100 million,
and for managers of unleveraged funds with assets totalling less than ¿500
million where investors do not have redemption rights for at least five years.
Managers meeting these conditions should be subject to registration in their
home member state and provide regulatory authorities there with information
about the instruments in which they are trading and the principal exposures and
concentrations of the funds they manage. These managers also have the choice to
opt for full regulation under the AIFM directive.

Authorisation of alternative fund managers

The directive provides that only managers authorised under the directive
may manage or market alternative funds in Europe, and that they must continue
to comply with its rules at all times. Authorised managers are limited in scope
to the management of alternative and Ucits funds and of segregated portfolios
under individual mandates, as well as providing certain non-core services such
as providing investment advice and the safekeeping and administration of fund
shares or units.

In order to become authorised, managers must apply to the financial
regulator of their home member state (or member state of reference in the case
of managers based outside the EU), providing information on the shareholders of
the company and those involved in carrying out its business, its organisational
structure, remuneration policies and practices, and any delegation and
sub-delegation of management functions. They must also provide information
about the strategies, risk profiles, leverage use and other characteristics of
the funds it intends to manage, information on the fund domicile, fund rules or
incorporation documents, and details of the appointed depositary.

For authorisation to be granted, the national regulator must be satisfied
that the manager is capable of complying with the directive, has sufficient
capital and assets, and is run by individuals with sufficient experience and of
good reputation. If the manager is a subsidiary of an investment or other
business authorised in another member state, their regulator must be consulted.

The regulator may restrict the scope of a manager’s authorisation, notably
in relation to the strategies they are allowed to manage. A decision on a
manager’s application for authorisation must be delivered within three (or in
exceptional cases six) months. Authorisation may be withdrawn if the manager
does not make use of it within 12 months or otherwise ceases activity, if
authorisation has been obtained through false information or if the manager no
longer fulfils the conditions laid down in the directive or infringes
subsidiary conditions.

National authorities will provide information about the grant or withdrawal
of authorisations to the European Securities and Markets Authority (Esma),
which will keep a public record of all managers authorised under the directive.

Governance, capital and remuneration

The directive lays down that alternative investment funds may be managed
either externally or internally. In the latter case, the fund is subject to the
requirements upon managers laid down under the directive, and may not manage
other funds. An alternative investment fund manager should provide at least
investment management services, although they may also offer other services
including administration and marketing of funds, management of discretionary
accounts, the provision of investment advice and of shareholder services and
record-keeping.

Under the directive, alternative managers should operate under robust
government controls and should be managed and organised to minimise conflicts
of interest. It lays down minimum capital requirements designed to ensure the
stability of the management of funds and cover exposure to professional
liability in respect of the manager’s activities. Internally-managed funds must
have initial capital of at least ¿300,000 and an external manager of one or
more funds must have initial capital of at least ¿125,000, increasing on a
sliding scale according to the level of assets under management up to a maximum
of ¿10 million.

Fund managers are required to devise remuneration policies and practices
consistent with sound and effective risk management for staff whose roles have
a material impact on the risk profile of the funds managed. These provisions
may be applied in different ways depending upon the size of the manager and of
the funds they manage, their internal organisation, and the scope and
complexity of their activities. Guidelines on remuneration policy for
alternative fund managers will be overseen by Esma, in line with existing EU
recommendations applicable elsewhere in the financial services sector.

Depositary and other services

The directive requires the appointment of a depositary separate from the
manager to ensure functions such as the safekeeping of assets. The rules
applying to the role of depository vary according to the type of business model
followed by the fund manager and the kind of assets in which the funds are
investing. For funds with lock-up periods of at least five years from the date
of initial investment and that invest in illiquid assets for which custody may
not be appropriate, including private equity, venture capital and real estate
funds, member states may allow service providers such as notaries, lawyers or
registrars to carry out depository functions.

For other types of fund the depositary should be a credit institution,
investment firm or other type of financial institution permitted under the
Ucits directive. This rule does not apply to non-EU funds, but the depository
must be a similar type of institution and subject to regulation and supervision
equivalent to that in force within the EU. The depositary must have its
registered office or a branch in the same country in which the fund is
domiciled, although the preamble to the directive invites the commission to
propose a legislative framework governing the provision of services in one
member state by a depositary based in another.

The depositary is responsible for monitoring of the fund’s cash flows and
the allocation of investor funds, for the safekeeping of the fund’s assets,
including the custody of financial instruments, and the verification of other
assets held by the fund or by the manager on the fund’s behalf. Safekeeping of
assets can be delegated to a third party or sub-delegated, as long as the
depository can justify the suitability of the third party entrusted with this
function. A prime broker can only act as a depository if the prime brokerage
and depository functions are kept separated and any potential conflicts of
interest are identified and disclosed to fund investors.

The depositary is liable for the loss of financial instruments in its
custody unless it can prove that the loss was an external event and unavoidable
despite all reasonable care. It is liable in the event of other losses in case
of intent or negligence. In the event of losses under a sub-custody
arrangement, the depositary may escape liability if there is a contractual
transfer of liability to the sub-custodian in agreement with the fund and with
the manager.

The directive also requires alternative fund managers to implement
valuation procedures for the proper valuation of assets and the funds they
manage, a function that should be independent of the portfolio management
activity of the business. The remuneration policy of the manager and other
measures should be designed to avoid conflicts of interest or undue influence
on employees.

Alternative managers may appoint an external provider to carry out the
valuation function. They may also delegate responsibility for some management
functions to increase the efficiency of the business and sub-delegation is also
allowed, as long as the manager remains at all times responsible for the proper
performance of these functions as well as compliance with the rules set out in
the directive.

Reporting and transparency

The directive requires that a manager must issue an annual report for each
EU-based fund it manages or for funds it markets in the EU. Managers must also
disclose information on the level of leverage used by funds they manage
including details of leverage through borrowing of cash or securities or
through derivative positions and the reuse of assets. This provision is
justified on the grounds that it may help to identify systemic risk.

The directive also requires managers to demonstrate that the leverage
limits it sets for each fund managers are reasonable and that it complies with
these limits. Additional disclosure requirements apply to companies over which
funds managed by an alternative manager exert control (in practice, usually
private equity managers), especially in the case of unlisted companies.

Marketing and distribution

A manager authorised under the directive may market shares or units of
EU-domiciled funds to professional investors within the union as long as the
manager complies with the provisions of the directive. In order to market a
fund in its home country, the manager must submit a notification to that effect
to the regulator. The regulator must deliver a decision within 20 working days
and may only refuse permission if the manager is not in full compliance with
the provisions of the directive. If the decision is positive, the manager may
begin marketing the fund as soon as it has received notification from the
regulator.

To market a fund in a different EU member state, the manager must similarly
submit a notification to its home regulator in respect of each fund and each
targeted market. The notification file, including supporting documentation,
must be transmitted to the regulator of the target market within 20 working
days as long as the manager meets the terms of the directive. Once it has
received notification that the application has been transmitted, the manager
may immediately begin marketing in that country.

Authorised managers may also manage funds domiciled in another member state
either directly or through a branch, as long as it is authorised to manage the
particular type of fund in question. It must submit details of the management
activities or branch to its home regulator, which in turn must transmit the
documentation within two months to the authorities of the member state where
the manager proposes to carry out management activities

Member states may allow the marketing of alternative funds to retail
investors on their territory if they so desire, irrespective of whether the
funds are located in that country, another EU member state or in a non-EU
country or territory. In this case, member states may impose stricter
requirements on the manager or the fund than those applicable to funds marketed
to professional investors under the directive, but they may not impose stricter
or additional requirements on funds from other member states than those that
apply to domestic funds.

Third-country managers and funds

The directive introduces a two-year transition period after the final
deadline for transposition of the directive into national law in early 2013
before non-EU alternative fund managers can become eligible for a passport to
perform management and/or marketing activities within the EU, and for EU
managers to market non-EU funds under the passporting arrangements.

Esma will have oversight authority, power to decide authorisation questions
on which regulators from different EU member states disagree, and a
co-ordinating role in the exchange of information between national regulatory
authorities. The comprehensive passport regime will coexist for a further three
years with existing national private placement arrangements for alternative
funds, which are then scheduled to be abolished.

An EU manager may manage non-EU funds that are not marketed within the
union as long as the manager complies with the terms of the directive apart
from its depositary and annual report requirements in relation to those funds.
Co-operation arrangements must be in place between the supervisory authorities
of the manager’s home member state and the regulator of the fund domicile to
facilitate regulation of the manager and monitoring of systemic risk. As with
other provisions regarding non-EU domiciled funds and managers, the directive
requires the Commission to establish a framework for establishing co-operation
arrangements with third countries, and Esma to draw up guidelines on how these
measures are to be implemented.

Once the passporting system has been extended, EU managers may market
non-EU funds (or EU-domiciled feeder funds invested in non-EU master funds) to
sophisticated EU-based investors subject to various conditions. These include co-operation
arrangements between the manager’s home regulator and that of the fund
domicile, certification that the domicile meets Financial Action Task Force
standards on countering money laundering and terrorist financing, and the
conclusion of OECD-standard tax information exchange agreements (Tieas) between
the fund domicile and the manager’s home member state as well as all other EU
countries in which the fund is to be marketed.

An EU manager seeking to market a non-EU fund in its home market may do so
on receipt of confirmation from the local regulator, due within 20 working days
of the submission notifying its intention to the regulator). Where the manager
seeks to market the fund in other EU member states, the home regulator must
transmit notification of marketing intentions to those states within 20 working
days of reception, and the manager may begin marketing once it has been
notified of the transmission.

Until private placement regimes are abolished, member states may continue
to allow non-EU funds to be marketed by EU managers on their territory without
a passport as long as depository arrangements are in place equivalent to those
stipulated for EU funds, as well as co-operation arrangements with the fund
domicile and certification of AML compliance.

Non-EU managers intending to manage or market EU-based alternative funds
must receive prior authorisation from a “member state of reference”, which
plays the same role as the home state of EU-based managers. They must appoint a
legal representative in the member state of reference as a contact point in the
EU and conduit for any official correspondence with EU regulators and
investors, and to carry out compliance functions.

The manager’s home jurisdiction must also have concluded regulatory
co-operation arrangements with the member state of reference, the fund domicile
and any other EU countries where the funds are to be marketed, and meet money
laundering and tax information exchange conditions.

The member state of reference is determined according to where the
manager’s funds are domiciled (if within the EU) or where they will be
marketed. If there are several possibilities, the manager may submit a request
to all the member states that would qualify, which should decide between them
within a month. Any disagreement on the designation of a member state of
reference can be referred to Esma.

Where non-EU managers seek to market EU or non-EU funds within the European
Union with a passport, the regulator of the member state of reference is
subject to the same 20-working day deadline for a decision on marketing of the
fund on its territory or transmission of marketing notification to other EU
member states. Non-EU funds are subject to the fund domicile having
co-operation arrangements and complying with money laundering and tax
information exchange standards.

Asset-stripping rules

The directive imposes special rules on ownership on unlisted companies,
aimed at private equity firms. As well as additional reporting requirements
(for instance, any planned changes in employment or job conditions), for a
period of two years following the acquisition of control such managers are
barred from carrying out, facilitating or encouraging any distribution, capital
reduction, share redemption or repurchase that would reduce the company’s
capital base or that would exceed its distributable profits and reserves.

Oversight, regulation and enforcement

Oversight and enforcement of the provisions of the directive are largely in
the hands of the home member state of the fund manager in question, or the
member state of reference in the case of managers based outside the EU,
although in some cases member states where funds are being marketed can take
direct action regarding enforcement of the directive. Member states are
responsible for laying down rules on sanctions applicable in the event of
infringement of the directive’s provisions.

Esma will have a co-ordinating role and in some cases mediate between
member states in the event of disagreements. It will also be responsible for
drawing up standards on the content of the co-operation arrangements to be
concluded by member states with supervisory authorities outside the EU and on
arrangements for exchange of information. It may for instance provide a
standard format for co-operation arrangements.

Delegated legislation

Various provisions of the directive should be implemented through delegated
acts adopted by the European Commission. These should cover areas including
thresholds for the lighter regulatory regime, the treatment of managers whose
assets move temporarily above or below the threshold for compliance with the
directive, defining methods and calculation of leverage, capital levels and
professional indemnity insurance, and the assessment and management of conflicts
of interest.

Delegated acts will also set out rules on risk management, liquidity
management, administrative and accounting procedures, valuation procedures, and
permitted levels of outsourcing. They will also be used in setting standards
for third-country depositories, as well as the due diligence duties of
depositories and the definition of the type of external event that may relieve
depositories of liability for losses.

Finally, delegated acts will be used to implement the extension of the
European passport to non-EU funds and managers, as well as to terminate
national private placement regimes, should the Commission decide that this is
appropriate. Either the European Parliament or the European Council may object
to a delegated act within a period of three months from the date of
notification, which can be prolonged for an additional three months.

Review of the directive

Two years after the final date for transposition of the directive into
national law, Esma should issue an opinion on the functioning of the passport
regime in force and of national private placement regimes, and will issue
advice to the Commission on the extension of the passport to non-EU funds and
managers. The Commission will adopt a delegated act within three months of
receiving Esma’s advice, taking into account criteria such as the effectiveness
of the internal market, investor protection and monitoring of systemic risk.

Three years after the European passport is extended to non-EU managers and
funds, Esma will issue an opinion on the functioning of the regime and issue
advice on the termination of national private placement regimes, upon which the
commission will again have three months to adopt a delegated act.

Four years after the transposition date, the Commission will launch a
review of the application and scope of the directive, including its impact on
investors, funds and managers both inside and outside the union and the extent
to which the objectives of the directive had been achieved, as well as the
respective roles of Esma and national authorities in supervising alternative
fund managers operating in EU markets. If necessary, the Commission may propose
amendments to the directive. It may also examine whether legislation is
necessary to regulate the due diligence procedures to be undertaken by European
professional investors when investing on their own initiative in non-EU
products including funds.

By Olivier Sciales, partner of Chevalier & Sciales (Luxembourg). You
may find more information on our AIFM blog at http://www.cs-avocats.lu/aifm-directive.

The purpose of this blog aims to provide up to date news coverage and timely
analysis of the legislative process and issues raised by the European union’s
Directive on Alternative Investment Fund Managers.



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