Implementing the AIFM Directive – The FSA Speaks
The Alternative Investment Fund Managers Directive – ESMA’s draft technical advice to the European Commission – Speech by Sheila Nicoll, Director of Conduct Policy at the Financial Services Authority, 21 July 2011
The Alternative Investment Fund Managers Directive1 (AIFM Directive) came into force on 21 July. The Financial Services Authority (FSA), its successor organisations, and HM Treasury, must transpose the Directive’s provisions into national law by 22 July 2013.2
Last year, the European Commission issued a request for advice to the Committee of European Securities Regulators (CESR, now the European Securities and Markets Authority (ESMA)), on the content of the detailed rules that will sit under the Directive.3 On 13 July, ESMA published its policy proposals for public consultation, specifically on authorisation and operating conditions, depositaries, and leverage and transparency.4
In a recent speech before the PwC Global Alternative Investments Seminar, Sheila Nicoll, Director of Conduct Policy at the FSA, outlines the regulator’s views on the development of the AIFM Directive, in view of ESMA’s latest offerings.
ESMA, remarks Nicoll, has been charged with no easy task. Working to a tight timetable, it must submit its final advice to the Commission by 16 November. After six months’ intensive consultation with industry, ESMA’s draft advice, which presently covers only three-quarters of the Commission’s request, stretches to some 438 pages. Its length is in part attributable to the complexity and political sensitivity surrounding some of the issues discussed.
In so far as it was possible, ESMA, for the sake of cross-sectoral consistency, has aligned its proposed advice to existing requirements set out in the UCITS Directive5 or MiFID6). Nicoll notes, though, that in some circumstances ESMA has had to tailor existing rules to the specificities of the alternative investment sector.
One of the most controversial, sensitive and therefore scrutinised aspects of the Directive concerns the role of the depositary.7 In Nicoll’s view, while ESMA’s draft advice on depositaries “joins up many of the dots which had been left unconnected by the Original Directive,” it nonetheless “raises as many questions as it answers.”
Perhaps the most contentious and sensitive aspects of the draft advice, Nicoll explains, relates to depositary liability. As a starting point, ESMA asks whether the depositary should be liable for the actions of its sub-custodians as if it had performed those actions itself.
Nicoll notes with interest that ESMA’s draft advice prescribes detailed due diligence provisions to be followed when delegating custodial duties and comprehensive monitoring rules to be adhered to thereafter. With these in mind, she finds it counterintuitive that such robust requirements will not change the extent to which a depositary is liable for its sub-custodian’s actions. Depositaries may, she fear, end up being held responsible for events outside their reasonable control.
While ESMA provides that depositaries, in some cases, must take “appropriate actions,” Nicoll seems somewhat disappointed that it fails to clarify what such actions should be. In her view, “practitioners would find it incredibly useful if ESMA explains what these additional actions look like and when they must be taken.”
One of the most technical parts of ESMA’s advice concerns leverage and the degree to which this should be restricted.8 For Nicoll, ESMA’s focus needs to be on two particular phases:
- Proportional application: to calculate leverage, ESMA recommends that fund managers should use the “gross method,”9 together with the “commitment method.”10 Seeking to take into account how the fund and its investors view leverage, ESMA proposes introducing an “advanced method.” This gives the AIFM some discretion to tailor the end result. As such, the disclosure needs of investors may be more easily met. The result can also act as a reasonable benchmark against which to assess maximum leverage limits.
- Robust methodology: in Nicoll’s view, ESMA’s advice should reduce the degree to which leverage can be concealed behind complex structures. Practitioners, she suspects, would probably want ESMA to go further by clarifying how borrowings within portfolio companies and fund of fund structures should be treated.
Seeking to increase transparency to the investment and regulatory community, the Directive imposes a number of specific disclosure requirements on AIFMs.11 “It has been challenging, on the one hand to achieve harmonisation,” acknowledges Nicoll, “while, on the other hand, respecting national practices and standards.” Annual reporting and accounting rules are a prime example of this.
The Commission’s mandate asked ESMA to advise on the appropriate frequency of reporting to the relevant regulatory authorities. ESMA has proposed that all AIFMs should report on a quarterly basis. Nicoll urges stakeholders to consider the degree to which they feel the mandate has been met, together with the practicalities and costs of such reporting in practice.
Conclusions arising out of the consultation will inevitably have a significant impact on existing practices. With this in mind, Nicoll urges stakeholders to reply to the consultation, explaining existing practices in this area and the likely implications of change.
Nicoll goes on to explain that the AIFM Directive requires independent valuation of the performance function. This can be achieved independently within the AIFM or by an external valuer. ESMA’s advice clarifies two points. First, the valuation function refers solely to the valuation of individual assets and not to the administrative function of calculating net asset value (NAV). Secondly, there can be more than one external valuer, although fund managers that calculate NAV should not in any circumstances be considered external valuers for these purposes. Nicoll notes, however, that where an AIFM performs the valuation function, it may still delegate or outsource the performance of some of the tasks involved, so long as it retains responsibility for the valuation function itself.
Turning to capital, Nicoll explains that the prudential framework for AIFMs will be broadly consistent with that for UCITS management companies, save for a small number of additional requirements concerning professional negligence related risk. In her view, ESMA’s proposals concerning capital requirements are unlikely to result in significant changes for many fund managers, especially those already subject to Pillar II requirements.12 There are fears though that this could create additional barriers to entry for smaller fund managers.
Nicoll expresses concern that the risks these policies may be required to cover, especially in relation to fraud, will go far beyond the coverage currently offered by professional indemnity policies. While, these days, policies cover fraud committed by AIFM staff, they are unlikely to cover fraud by what the Directive refers to as “relevant persons” – directors, partners, agents and delegates. Nicoll calls upon stakeholders to advise ESMA whether extended cover is or can be made available to them and, if so, how much it is likely to cost.
“Work on the AIFM Directive,” Nicoll comments, “has continued at quite a pace since the beginning of the year.” The next two months are crucial in terms of refining ESMA’s proposals. Nicoll therefore urges both UK and pan-European stakeholders to become involved in ESMA’s consultation and, as such, play an important part in shaping the future of the alternative investment industry.
Finally, Nicoll reaffirms the FSA’s continued commitment to ensuring that sufficient work is done to help ESMA finalise its proposals well ahead of its mid-November deadline.
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