On 25 November 2021, the European Commission (the Commission) adopted a package of measures1 aimed to deliver on several key commitments in the 2020 Capital Markets Union (CMU) action plan. The package includes four legislative proposals relating to (i) the European Single Access Point (ESAP), (ii) review of the European Long-Term Investment Funds Regulation (ELTIF), (iii) review of the Alternative Investment Fund Managers Directive (AIFMD)2 (and, to the relevant extent, the Directive relating to Undertakings for Collective Investment in Transferable Securities Directive (UCITS))3 and (iv) review of the Markets in Financial Instruments Regulation (MiFIR).

This OnPoint looks at the proposals for amending the AIFMD.4 Our commentary is based on the Commission’s current proposals (the Proposals), and the final legislation may differ.

The Commission is proposing similar changes to the UCITS Directive on delegation, liquidity risk management, data reporting for market monitoring purposes and regulatory treatment of custodians.

Background

Article 69 of the AIFMD mandated the Commission to review the scope of the AIFMD by 22 July 2017. In October 2020, the Commission published a public consultation on the review of the AIFMD followed by publication of a roadmap5 and feedback to that roadmap.6 The current proposal represents the culmination of this process.

Timing

The Proposals are effectively the starting point. They will be reviewed and debated at both national level and by the Council and the European Parliament. Based on previous experience, it is anticipated that an agreement will be reached by mid to end 2022. This will lead to publication of the final directive in the official journal of the EU in early 2023, with Member States having 24 months to implement the changes. This means the Proposals, if adopted, are likely to start applying from the end of 2024 or early 2025.

It is understood that discussions in the Council are expected to start immediately with an initial reading of the text, with more intense negotiations beginning in January 2022.

Delegation

The AIFMD delegation structure allows alternative investment fund managers (AIFMs) to delegate certain tasks if prescribed conditions are met. The core requirement of the AIFMD is that an AIFM must not delegate its functions to the extent that, in essence, it is no longer the manager of the relevant AIF. The UK's departure from the EU gave rise to an increasing focus on delegation as the UK became a third country. ESMA issued an Opinion on supervisory convergence in the area of investment management following Brexit7 in 2017 (ESMA Brexit Opinion), but these views will now be given legislative effect. In August 2020, ESMA sent a letter to the Commission8 stating that, in its view, there should be additional legislative clarifications in the AIFMD framework in relation to delegation and substance requirements. There has been concern in the market as to what the Commission would actually propose with regards to delegation.

The positive news is that delegation is expected to continue. There may be some additional requirements in terms of supervision and administration, but it will still be possible for risk management or portfolio management functions to be delegated. In addition, it is clear that AIFMs may delegate more of the portfolio and risk management functions than they retain. There is no reference to a requirement that a minimum proportion of activities be retained “in-house.”

Some other points on delegation:

• Substance – The proposals require the AIFM to employ or commit to employ two natural persons who are resident in the EU on a full-time basis.9 While this level of clarity is to be welcomed, regulators have already been imposing a quantitative substance requirement on AIFMs. For example, in Ireland, the Central Bank’s expectation is: “… that all [AIFMs] should have a minimum of 3 FTEs, each of whom should be suitably qualified and of appropriate seniority to fulfil the role. This number is of course a minimum expectation and only relevant to the smallest and simplest of entities. Other firms will be expected to have a level and quality of resourcing determined by the nature, scale and complexity of its operations.”10 In Luxembourg, the Commission de Surveillance du Secteur Financier requires in Circular 18/698 that: “… The [AIFM] must employ at least two conducting officers in Luxembourg (i.e. bound to the [AIFM] by an employment contract and employees of the [AIFMs] … Every [AIFM] must employ at least three full-time people (FTE) at the head office in Luxembourg who perform key functions.”11
• Article 20 (Delegation) has been clarified as covering all functions listed in Annex I and the ancillary services referred to in Article 6(4).12 A practical consequence of this inclusion of ‘ancillary services’ is that a MiFID top-up activity would also be caught. . Other amendments to Annex I specifically recognise lending as a legitimate AIFM activity and legitimise the servicing of securitisation special purpose entities (SSPEs) by AIFMs. The delegation provisions are also proposed to be amended to provide for references to clients and the provision of services an AIFM may provide as ancillary services, particularly individual portfolio management.
• Reporting – whilst there is no requirement for an AIFM to retain more risk or portfolio management than is delegated, there are more onerous reporting requirements where this is the case. The proposal is that competent authorities notify the European Securities and Markets Authority (ESMA) on an annual basis of delegation arrangements where more risk or portfolio management is delegated to third-country entities than is retained. The proposals set out a list of what is to be reported as part of the “delegation notifications.” ESMA is mandated to develop Level 2 standards and procedures for the delegation notifications. The delegation notifications also seem to apply to existing delegation arrangements – there is no mention of grandfathering. Review of existing arrangements is likely to be onerous and time consuming and may require amendments to existing documentation.
• Review – the proposals provide that ESMA is required regularly to conduct a peer review of supervisory practices on delegation, with a particular focus on preventing the creation of ‘letter-box entities.’ The aim behind this may be to avoid regulatory arbitrage on delegation matters. A lot of this ground has already been covered by the ESMA Brexit Opinion and been implemented, e.g. in Ireland through the CP86 process. Related to the peer review, the Commission’s proposals require ESMA to provide the European Parliament, the Council and the Commission with regular reports, at least every two years, analysing market practices regarding delegation to entities located in third countries. Five years after the amending directive has taken effect, the Commission is required to initiate a review of the functioning of the new rules and the experience of applying them to, amongst other things, the delegation regime with a view to preventing the creation of EU letter-box entities.

The proposals also include similar amendments to the UCITS Directive on delegation. The key take-away is that while there are no substantial changes to the delegation provisions that are in place, ESMA’s more activist and central role regarding delegation will be codified.

Marketing AIFS under the National Private Placement Regime (NPPR)

It is proposed that, in the future, third country AIFs may only be marketed in the EU if their home states are not on the EU list of non-cooperative jurisdictions for tax purposes. In practice, this means that a non-EU AIF that wishes to market into the EU cannot be domiciled in either (a) a high-risk third country pursuant to Article 9(2) of the AML Directive13 or (b) a ‘non-cooperative jurisdiction’ as defined by the EU Council from a tax perspective.14

These changes are a significant deviation from the current reference to the FATF AML blacklist. Given that the Cayman Islands was previously on the EU list of ‘non-cooperative jurisdictions’ as defined by the EU Council from a tax perspective, there would be concerns if it or similar third country jurisdictions were added to the list, especially if this was to occur in the middle of a fund raising, since there is no reference to grandfathering or other similar provisions. In addition, under the current EU process, there may not be much time or warning before a jurisdiction is re-characterised as ‘non-cooperative’.

One observation is that changes are being proposed to be made to the Articles of the AIFMD that relate to third country passports, meaning that this might open up the possibility of discussion on further changes to these Articles – even if not linked to AML.

It is also worth noting that as no changes are being proposed for sub-threshold AIFMs, capital raising will continue to be subject to the relevant NPPR provisions or be based on reverse solicitation. The marketing of certain types of AIF (other than ELTIFs) to non-professional investors will also continue to be a matter of national law.

Liquidity risk management

The Proposals include specific provisions relating to liquidity risk management. By way of background, the European Systemic Risk Board (ESRB) and ESMA had made recommendations for harmonisation of the rules on the use of liquidity management tools (LMTs), which although they are widely used, are not currently explicitly referenced in AIFMD or UCITS. The Proposals aim to address this.

They provide that an AIFM that manages an open-ended AIF must select at least one appropriate LMT from a list (to be set out in a new Annex V) for possible use in the interest of the AIF’s investors – this is in addition to being able to suspend redemptions. The AIFM must also implement detailed policies and procedures for the activation and deactivation of its selected liquidity management tools and the operational and administrative arrangements for their use.

The Proposals also include provisions enabling the competent authorities to require that an AIFM activates or deactivates a relevant LMT, remarkably a power which is expressed to extend to cover non-EU AIFMs. Whether competent authorities will wish to be able to enforce the activation of LMTs – which may not be in the fund documentation – remains to be seen. Again, ESMA is tasked with developing Level 2 standards to provide definitions and specify the characteristics of the LMTs to be set out in the Annex V, and for selecting and using suitable LMTs by the AIFMs.

Most of the Proposals relating to LMTs will also apply to UCITS management companies. Another amendment proposed for UCITS is to require UCITS management companies to notify the competent authorities when they activate or deactivate an LMT. Again, ESMA is to develop Level 2 standards for UCITS for selecting and using LMTs.

The eventual detail of these Level 2 standards may result in the LMT provisions having significantly more impact than is perhaps envisaged under the Proposals.

AIFMs and UCITS management companies are reluctant to invoke liquidity management tools which, from an investor perspective, are typically utilised as a last resort. An instruction to activate or deactivate the use of an LMT would constitute a significant fettering on investment management discretion to which there may be industry resistance.

Loan Funds

The Proposals impose some general principles for AIFMs active in credit markets. The Commission recognises the importance and value that loan originating funds have on the wider economy, in particular their role in facilitating the transition to the sustainable future by investing in the green economy.

ESMA gave an Opinion on the key principles for a European framework for loan origination funds in 2016,15 which largely mirrored the loan fund regime implemented in Ireland16 and where certain requirements are already applicable to Luxembourg AIFMs managing loan originating funds.17

The proposed regime is not as prescriptive as the regime currently in place in Ireland or suggested by the Opinion, specifically with regard to leverage and diversification.

In specific reference to the COVID-19 pandemic, the Commission notes that loan-originating funds (L-AIFs) can also serve as a backstop or shock absorber when liquidity is constrained, by continuing to provide loan financing when more traditional lenders have pulled back from the market.

The Commission’s stated aim is to strike a good balance between preserving financial stability and facilitating the development of the market of L-AIFs in the EU. The changes being proposed represent the minimum number of safeguards it considers necessary for fund activities and risk profiles.

A few highlights:

• new retention requirements intended to “avoid the moral hazard” of originated loans being immediately sold off on the secondary market. Specifically, AIFs will be required to retain an economic interest of 5% of the notional value of any loans they grant and then sell off;
• new Proposals to address conflicts of interest. AIFMs and their staff should not receive loans from L-AIFs that they manage. Similarly, the AIF’s depositary and its staff or the AIFM’s delegate and its staff should be prohibited from receiving loans from the associated AIFs;
• AIFMs managing L-AIFs must implement effective policies, procedures and processes for granting such loans and in doing so, they must assess credit risk, and administer and monitor their credit portfolios. These policies, procedures and processes must also be reviewed periodically;
• an AIF that originates loans in excess of 60% of its net asset value must be closed-ended;
• a new concentration limit of 20% of capital for a loan originated to any single borrower that is a financial undertaking or a collective investment undertaking, but significantly not to other borrowers; and
• new reporting requirements under Article 23. AIFMs will also be required to report to investors the portfolio composition of originated loans.

Depositary

The current AIFMD requirement is that a depositary should be located in the same Member State as the appointing EU AIF. The Commission notes that in smaller, more concentrated markets, where there are fewer service providers, this requirement leads to a lack of competition, increased costs for fund managers and less efficient fund structures, impacting on investor returns. The introduction of a depositary passport was considered but was not deemed feasible without EU harmonisation of securities and insolvency laws. So rather than introducing a depositary passport, the Proposals contain an interim measure permitting depositary services to be sourced cross-border pending further review. Related to this, depositaries must cooperate, not only with their home state competent authorities but also with the competent authorities of the AIF’s and its AIFM’s home states.

For depositaries in non-EU jurisdictions, the depositary should not be established in a high-risk third country pursuant to Article 9(2) of the AML Directive.

The Commission notes that, under current AIFMD rules, depositaries are sometimes prevented from performing their duties where the fund’s assets are held by a Central Securities Depositary (CSD) as CSDs are not considered delegates of the depositary. In future, CSDs will be deemed to be delegates of the depositary where they are providing custody services, bringing the AIFMD into line with the UCITS rules.

Data Reporting

The Commission seems to be keen to increase the amount of data it receives, proposing that “limitations” are deleted from the data that competent authorities receive from AIFMs on their AIFs. In practice, this means that references will be to “the instruments traded” rather than “the main instruments traded.” Further changes are also in the pipeline regarding Annex IV reporting, as the Commission has mandated ESMA to develop level 2 standards to replace the current Annex IV supervisory reporting template.

Fees and Charges

To improve investor protection, the Commission wants more information to flow from AIFMs to AIF investors, particularly regarding fees. To allow AIFs’ investors better to track expenses, the AIFMs must identify fees that will be borne by the AIFM or its affiliates, and periodically report on all fees and charges that are allocated to the AIF or to any of its investments.

What next?

The Proposals will be debated among different EU agencies and at national level. ESMA has been charged with developing a significant amount of the Level 2 technical details. On both the original AIFMD and MIFID II, ESMA treated this as an opportunity significantly to expand the scope and burden of the Commission’s original proposals, to a point when they were teetering on ultra vires. We await with interest the next developments in this new legislative initiative.

Footnotes

1) The package of measures is available here.

2) Directive 2011/61/EU

3) Directive 2009/65/EC

4) The proposals for AIFMD are available here.

5) The roadmap/impact assessment is available here.

6) The feedback is available here.

7) The ESMA Brexit Opinion is available here.

8) ESMA’s letter is available here.

9) A similar provision is included for UCITS in that the UCITS management company is required to “employ at least two persons full-time or engage two persons, who are not employed by the UCITS management company but nevertheless are committed to conduct the business of that UCITS management company on a full-time basis and who would be resident in the EU.”

10) A similar provision is included for UCITS in that the UCITS management company is required to “employ at least two persons full-time or engage two persons, who are not employed by the UCITS management company but nevertheless are committed to conduct the business of that UCITS management company on a full-time basis and who would be resident in the EU.”

11) Circular 18/698 refers to the term Investment Fund Manager (IFM), which covers both UCITS management companies and AIFMs.

12) Similar provisions are made in respect of the UCITS Directive – the proposals are that delegation arrangements apply to all the functions listed in Annex II and to the ancillary services permitted under Article 6(3).

13) Directive (EU) 2015/849. The list of jurisdictions are identified by the Commission as having strategic deficiencies in their AML/CFT regimes is available here.

14) The list is available here.

15) The ESMA Opinion on loan origination is available here.

16) Please see our OnPoint discussing the loan fund regime implemented in Ireland available here.

17) CSSF FAQ on Luxembourg law of 12 July 2013 on alternative investment fund managers set the conditions to be required by a Luxembourg AIFM when managing loan originating funds and CSSF FAQ on the status of financial sector professionals clarifies the concept of a lending activity directed to the "public". Please see our OnPoint in this regard here.