Permitted activities for AIFMs
AIFMD II will extend the scope of permitted activities for alternative investment fund managers (AIFMs) to include benchmark administration under the EU Benchmarks Regulation and credit-servicing under the forthcoming EU credit servicers legislation as additional "top-up permissions". Other similar extensions sought by some trade associations are unfortunately not proposed.
Originating loans and servicing securitisation SPVs will also be included as permitted activities for AIFMs. This would allow for loan origination activities to be carried on in other Member States on a cross-border basis. However, it is not explicitly clear whether this would amount to some form of "passport".
AIFM delegation arrangements have been a concern of the EU authorities for some time. Although "letter-box entities" are already prohibited, the authorities remain concerned about the scope of many delegation arrangements and about differences in approach between EU Member States, fearing a race to the bottom. As a result, delegation is a key issue for the AIFMD review.
The Commission has put forward a number of proposals including:
- A requirement for competent authorities to determine, as part of the authorisation process, whether the AIFM will delegate more portfolio management or risk management functions to non-EU entities than it retains. The basis on which this determination is to be made is not yet clear. Interestingly, it is not proposed to restrict such arrangements (although the existing 'letterbox entity' test would still need to be satisfied) but competent authorities must notify ESMA annually of all such situations and ESMA must report to the Commission every two years on developing market practice. ESMA will also be conducting regular, two-yearly peer reviews of measures taken by competent authorities to prevent letter-box entities, which is intended to address inconsistencies in approach between Member States. This suggests that ESMA is generally keeping a watching brief for now, with the prospect of further restrictions in future if circumstances warrant it. A 5-year review by the Commission is hard-wired into the proposals.
- Competent authorities are also required to assess, at the point of authorisation, the "human and technical resources" to be used by the AIFM to monitor and control its delegates. It is implicit in the proposals that competent authorities are expected by ESMA to supervise delegation arrangements effectively, so the current focus from certain regulators on the practicalities of delegation arrangements is unlikely to abate.
- The AIFMD delegation requirements will also be extended to cover delegations of Article 6(4) "top-up services". In practice, this will mainly affect delegations of portfolio management services provided to individual clients.
Some of these requirements may require existing delegation arrangements to be re-papered.
AIFMD II would also introduce new EU substance requirements as a condition of authorisation. Again, EU authorities have been concerned about the level of substance, and particularly EU-based substance, within AIFM arrangements for some time.
Under the proposals, the business of the AIFM would need to be conducted by at least two natural persons, resident in the EU, who are either employed full-time by that AIFM or who are committed full-time to conduct the business of that AIFM. This standard is lower than the expectations which currently prevail in some prominent centres such as Luxembourg. Nevertheless, this may require some AIFMs to re-examine their management structures.
AIFMs would also have to provide to the relevant competent authorities, for the persons effectively conducting the business of the AIFM: a detailed description of their role, title and level of seniority; a description of their reporting lines and responsibilities in the AIFM and outside the AIFM; an overview of their time allocated to each responsibility; and a description of the technical and human resources that support their activities.
ESMA will be empowered to create supervisory forms and templates through Regulatory Technical Standards (RTS) and Implementing Technical Standards (ITS). Across the topics of delegation and substance, the devil will be in the detail of these proposals. It is rumoured that drafts of the implementing measures already exist and are with the European Commission, but they have not been published yet.
AIFMD II also proposes new provisions in respect of loan origination activities by AIFs. In addition to the new Annex I activity of originating loans (see above), there are proposed new risk management provisions. The existing provisions of AIFMD were not thought sufficient to provide for direct lending by AIFs and the associated risks. In particular, there were concerns about investor protection and regulatory arbitrage due to differing approaches to such lending by Member States.
These new provisions would include a requirement for AIFMs engaging in loan origination activities to implement effective and up-to-date policies, procedures and processes for the granting of credit, assessing credit risk and administering and monitoring their credit portfolio. Such policies, procedures and processes would also have to be kept up to date, reviewed regularly and at least once a year.
In order to avoid maturity mismatches due to redemption demands, any AIF which originates loans exceeding 60% of its net asset value would have to be closed-ended.
AIFMD II would also impose restrictions on loan origination activities aimed at preventing excessive interconnectedness in the financial system and conflicts of interest, including prohibiting direct lending funds from lending to:
- any single borrower which is a financial undertaking or a collective investment undertaking where the loan is in excess of 20% of the AIF’s capital; and
- the AIFM (or its staff), the depositary or any delegate of the AIFM.
Finally, in order to reduce incentives to originate poor quality loans to be immediately sold off on the secondary market, an AIFM would also have to ensure that the relevant AIF retains, on an ongoing basis, 5% of the notional value of the loans it has originated and subsequently sold on the secondary market.
These proposals are much more proportionate and nuanced than might have been feared.
It is proposed to extend the existing liquidity management provisions in AIFMD, with new obligations and powers for AIFMs that manage open-ended AIFs.
AIFMs that manage open-ended AIFs would be permitted temporarily to suspend the repurchase or redemption of the AIF units, in exceptional cases, where this is necessary in the circumstances and justified in the interests of the AIF investors.
They would also be required to select at least one additional liquidity management tool from a specified list set out in a new Annex V: redemption gates; notice periods; and redemption fees. Further guidance on liquidity management tools will be provided by ESMA in RTS.
AIFMs would have to implement detailed policies and procedures for the activation and deactivation of any selected liquidity management tool and the operational and administrative arrangements for the use of such tool. They would have to notify competent authorities of the activation or deactivation of the tools and provide information on selected liquidity management tools to investors.
In most cases, AIFMs would have the final decision as to whether to make use of their suspension power or a selected liquidity management tool in the appropriate circumstances. However, competent authorities would also have the power to require AIFMs to suspend (or resume) redemptions and subscriptions or impose or terminate redemption gates and/or activate or deactivate their selected liquidity management tools if necessary due to investor protection or financial stability concerns. Significantly, this power would also apply in respect of non-EU AIFMs marketing in the EU.
The AIFMD II proposal would relax the requirement for a depositary to be established in the same Member State as the relevant AIF. This reflects the limited market in depositaries in certain Member States and is expected, in due course, to be replaced by a passporting system for depositaries. This relaxation is balanced with a new requirement for depositaries to co-operate not just with their own competent authorities but also those of the AIF and (if different) the AIFM.
Where a third country depositary is used, the criteria would be amended slightly to exclude depositaries in jurisdictions which are identified as high-risk under the Fourth Anti-Money Laundering Directive (MLD 4) or on the EU list of non-co-operative tax jurisdictions.
Finally, to level the playing field with depositaries, AIFMD II would effectively clarify that central securities depositaries (CSD) providing custody services (rather than acting in the capacity of an issuer CSD) will be treated as delegates of the depositary and therefore subject to the custody delegation rules. When making use of a CSD acting in the capacity of an issuer CSD, depositaries will not be subject to the requirement to exercise all due skill, care and diligence in the selection and the appointment of that CSD. This is because authorised CSDs are already subject to regulatory requirements and supervision.
Disclosure to investors
Under the proposals, additional line items would have to be included in Article 23 investor pre-contractual disclosures, specifically:
- following the existing disclosure of the fees, charges and expenses to be borne by investors, a list of the fees and charges in connection with the operation of the AIF that will be borne by the AIFM or its affiliates; and
- (for open-ended funds) as part of the disclosure relating to the fund's liquidity risk management, information on the possibility and conditions for using liquidity management tools.
It is also proposed that, going forward, AIFMs would be required to report the following to investors on a quarterly basis:
- all direct and indirect fees and charges directly or indirectly charged or allocated to the AIF or to any of its investments and
- any parent company, subsidiary or special purpose entity established in relation to the AIF’s investments by the AIFM, the staff of the AIFM or the AIFM’s direct or indirect affiliates.
Whilst some of this information will already be covered as part of standard quarterly investor reporting, some of it will not be.
AIFMs would also be required to provide periodic reports to investors on the fund's originated loan portfolio (if applicable).
Annex IV regulatory reporting
Contrary to market perception, the Commission is of the view that data reported under the "Annex IV" reporting framework has supported effective macro-prudential supervision. However, it considers that the granularity of data collected could be improved, and so proposes that the reporting obligations to competent authorities under Article 24 are extended. Whereas currently, an AIFM has to report on the principal markets and instruments in which it trades and provide information on the main instruments in which it is trading and on the principal exposures and most important concentrations of each of the AIFs it manages, under AIFMD II AIFMs would need to report on all markets, instruments and exposures. ESMA will be tasked with developing draft RTS and ITS on the details to be reported and the frequency of reports and the impact of these changes will largely depend on the approach taken by ESMA. ESMA has been given a three-year period in which to develop the proposed technical standards, so these changes are not imminent.
Third country marketing arrangements (NPPRs)
The Commission has also proposed stronger AML and tax compliance requirements in respect of third countries accessing the EU single market.
Currently, non-EU AIFMs can market into the EU only under National Private Placement Regimes (NPPRs). The existing requirement for non-EU AIFMs and non-EU AIFs to be established in jurisdictions that are not Financial Action Task Force non-cooperative countries or territories (NCCTs) would, under the Commission's proposals, be replaced with a requirement that they must not be established in jurisdictions identified as high risk under MLD 4. As a new requirement, those jurisdictions would also need to have signed an agreement with each Member State in which the fund is to be marketed which fully complies with the standards laid down in Article 26 of the OECD Model Tax Convention on Income and on Capital and ensures an effective exchange of information in tax matters, including any multilateral tax agreements and they must not be on the EU list of non-cooperative tax jurisdictions.
Similar changes are made to the NPPRs for non-EU AIFs managed by EU AIFMs, and also to the third country passporting provisions (although there is still no indication that the third country passport is likely to be activated any time soon).