AIFMD: Impact on US Investment Advisers - June 2013: Sub-adviser to an EEA manager

by Dechert LLP
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AIFMD will affect the operations of US investment advisers which undertake investment management functions and certain other so-called collective management functions in respect of the portfolios of EEA or non-EEA AIF under delegation (direct or indirect) from an EEA AIFM.  Arrangements in scope include, for example, a non-EEA domiciled fund marketed to EEA investors, managed by an EEA AIFM and sub-advised by a US investment adviser, such as some of the bank sponsored platforms.

Investment management functions comprise the functions of risk management and/or portfolio management. There is no definition per se of what these functions are and therefore the scope of activities covered is potentially wide.  Accordingly, US sub-advisers undertaking only aspects of risk management or portfolio management will potentially be in scope.

The definition of collective management functions is also wide and includes marketing functions, administration functions and other functions such as valuation. 

Arrangements involving non-discretionary investment advisory services (i.e. where the US sub-adviser makes recommendations only and cannot exercise discretion over the portfolio) should be out of scope, if properly structured. Individual arrangements should be carefully reviewed in order to ensure that the functions performed by the US investment adviser are indeed out of scope.

How are US sub-advisers affected if delegation is "in scope"?

US sub-advisers are potentially affected in a number of ways:

1. Under AIFMD, an EEA AIFM which wishes to delegate (or continue to delegate) in scope functions to a US sub-adviser will need to satisfy a number of detailed conditions and requirements, including:

  • The AIFM will only be able to delegate to the extent it does not become a “letter box” entity (see “Anti Letter-box Provisions”).
  • The delegation will need to be evidenced by a written agreement (see “What will the written agreement need to cover?” below).
  • The AIFM will be required to pre-notify the delegation to its EEA member state regulator and, potentially, obtain consents.
  • The AIFM will have to justify the entire delegation structure on objective grounds.
  • Delegation of portfolio management and risk management will only be permitted if the US investment adviser is registered or authorised for asset management and subject to supervision (e.g. registered with the SEC or CFTC).
  • Delegation will only be permitted if co-operation arrangements are in place between the relevant EEA member state regulator and the US sub-adviser’s supervisory authority (see “Co-operation Arrangements”).

2. The EEA AIFM will be required to be able to demonstrate that the US sub-adviser (delegate) has been selected with all due care and also that:

  • the delegate has sufficient resources to perform the delegated tasks;
  • the persons who conduct the delegate’s business are of sufficiently good repute and experience; and
  • the delegate is qualified and able to undertake the relevant delegated functions.

3. The AIFM will be required to ensure that the US sub-adviser undertakes the delegated tasks effectively and in compliance with its obligations as an AIFM under AIFMD. In connection with this, AIFMD imposes on the AIFM detailed obligations to monitor the delegation, to give instructions and supervise and review the delegation on an ongoing basis. Accordingly, the EEA AIFM may be forced to impose on the US sub-adviser a degree of indirect compliance with AIFMD. This could include requirements as to:

  • conflicts of interest policies (e.g. the EEA AIFM is required to ensure the delegate has conflict of interest policies and procedures in place corresponding to those required to be adopted by it under AIFMD);
  • risk and portfolio management functions;
  • valuation policies and functions;
  • the functional and hierarchical separation of personnel and reporting lines in relation to portfolio management, risk management and valuation functions, subject to principles of proportionality; and
  • reporting and transparency.

4. US sub-advisers may also be subjected to certain requirements relating to remuneration (see “Extension of remuneration requirements to US managers” below).

Are sub delegations affected?

Yes, the EEA AIFM will be required to:

  • impose on the US sub-adviser restrictions on its ability to further delegate functions without consent;
  • submit pre-notification of any sub-delegation to its member state regulator; and
  • impose similar compliance requirements to those discussed above throughout any sub-delegation chain.

What will the written agreement need to cover?

Most US sub-advisers will already have a written agreement in place evidencing a delegation. However, it is likely that EEA AIFM will wish to upgrade the scope of their delegation agreements to include some of these additional matters as well as, potentially:

  • rights of inspection, access, monitoring and supervision;
  • enhanced rights of termination on short or no notice;
  • restrictions on sub-delegation by the US sub adviser; and
  • disaster recovery assurances and obligations.

Furthermore, there are detailed requirements placed on the EEA AIFM to ensure the rights and obligations of the parties are clearly allocated in the agreement. As a result, agreements may need to become more detailed.

When will US sub-advisers be impacted by AIFMD?

The date from which an EEA AIFM will be required to comply with AIFMD, including the provisions on delegation, will depend on when the EEA AIFM is required to obtain authorisation under AIFMD. EEA AIFMs are required to seek such authorisation on and from 22 July 2013, subject to transitional provisions under which existing AIFMs may delay seeking authorisation for up to a 12 month period ending on 22 July 2014.

The UK has indicated that the transitional relief will be available to UK AIFMs, other EEA AIFMs and even non-EEA AIFMs for the full 12 month period. However, some other member states may place a requirement on EEA AIFMs seeking to rely on the transitional relief to nonetheless comply with AIFMD requirements on a “best efforts” basis from 22 July 2013.

Accordingly, US sub-advisers should engage with EEA AIFMs for whom they provide in-scope delegated functions and their advisers to agree a date from which compliance with the new arrangements will apply.

Furthermore, US sub-advisers may wish to consider compliance with certain aspects (e.g. remuneration reporting) from 1 January 2014 in order to tie in with financial reporting cycles.

Extension of remuneration requirements to US managers

There is concern that the rules on delegation will impose compliance with the remuneration provisions of AIFMD on US sub-advisers. Under the delegation rules, EEA AIFMs may require their sub-advisers to functionally separate remuneration structures as between those engaged in portfolio management, risk management, valuation and, potentially, other activities. In addition, in guidance issued in February, ESMA indicated that the AIFMD’s remuneration restrictions should be extended to entities to which EEA AIFMs delegate portfolio or risk management, and in relation to a delegate (such as a US based sub-adviser) that is not subject to regulatory restrictions on remuneration which are “equally as effective” as those in the AIFMD, the AIFM should put in place contractual arrangements to ensure there is no circumvention of the AIFMD remuneration rules.

Such a requirement could be interpreted to mean that in order for delegation from an EEA AIFM to a US sub-adviser to be lawful, the US sub-adviser would need to comply with the remuneration restrictions in AIFMD. These are onerous and include:

  • a requirement to appropriately balance fixed and variable compensation, which could result in the fixed component needing to increase; and
  • requirements for variable compensation to be deferred for between 3-5 years, payable partly in fund shares and subject to certain clawback provisions.

It remains to be seen whether the various EEA regulators will endorse this approach. ESMA’s guidelines do not have the force of law and they arguably seek to extend the effect of AIFMD beyond what was envisaged by the primary legislation. As such, if they are applied as stated it is possible that their lawfulness will be challenged.

Guidance from national regulators may not be forthcoming and EEA managers will need to form their own view about the ESMA guidance and how to deal with their delegates on this point. Accordingly, US sub-advisers to EEA AIFMs should review their position carefully in the jurisdictions that will affect them and engage with their EEA principals and their advisers about the approach they intend to take in this regard. Any onwards delegation by the US sub-adviser should also be considered.

Practical steps

US sub-advisers to an EEA AIFM should:

  • understand what the EEA AIFM's approach to the transitional period will be. If a UK AIFM, does it intend to make full use of the transitional period? If a non-UK AIFM, what level of compliance is required during the transitional period?
  • review with the EEA AIFM the approach it intends to take in respect of applying remuneration restrictions to the US sub-adviser;
  • understand what arrangements and procedures are to be put in place in terms of the delegation agreement and what compliance and operational changes will need to be implemented; and
  • review their own sub-delegation arrangements.

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