Alternative Investment Funds Managers Directive: ESMA publishes Level 2 Advice

On 16 November 2011, the European Securities and Markets Authority (“ESMA”) issued its final technical advice on the Alternative Investment Fund Managers Directive (“AIFMD”) implementing measures(1). For the most part, the final report does not contain substantial changes to the draft advice but some of the changes introduced on the basis of the feedback received are noted below. Some of these changes represent welcome developments but many aspects of the advice continue to raise concerns.

Additional Own Funds and Professional Indemnity Insurance

The AIFMD follows the method of calculating the own funds requirement under the UCITS IV Directive by providing for a minimum level of capital plus an additional amount where assets under management exceed a set threshold. However, the AIFMD goes further by requiring that AIFM have additional own funds or professional indemnity insurance to cover risks arising from professional negligence, which renders the calculation of additional own funds uncertain.

The draft advice listed the types of risk which were required to be covered by additional own funds or professional indemnity insurance. The list in the draft advice included “risks in relation to fraud” which has been removed from the final advice based on submissions that such insurance cover would be extremely difficult to obtain. The final report adds a new risk to be covered of "failure by senior management to establish, implement and maintain appropriate procedures to prevent dishonest, fraudulent or malicious acts by the AIFM's directors, officers or staff or third parties for whom the AIFM has vicarious liability". It remains to be seen whether it will be any easier to obtain and maintain insurance to cover this risk than in respect of fraud and that the costs are likely to be very high.

The consultation paper had proposed that competent authorities could lower the percentage of additional own funds required based on an analysis of historical loss data over a five year period. This period has been shortened to three years in line with submissions made on the consultation paper.


The final report does not amend the advice in relation to valuation in any significant way. The clarification remains that where a third party carries out the calculation of net asset value (as distinct from a valuing the assets of the fund), it is not to be considered an external valuer for the purposes of the directive. Some concerns had been raised that this clarification might not be contained in the final report, so it is useful that it has been retained as it better reflects the way in which Irish funds are currently serviced by their administrators in practice than some earlier proposals.


In relation to the delegation of portfolio management and risk management to third country entities, the final report removes the requirement in the draft advice that the delegate be authorised or registered for the purpose of asset managed based on “local criteria which are equivalent to those established under EU legislation”. Many submissions had argued that this equivalence requirement went beyond the Level 1 text and would make delegation of the portfolio management and risk management functions very difficult.  Concerns had also been raised as to whether managers in certain countries would meet this test. In a welcome development, the final advice simply requires the delegate to be authorised and supervised based on local criteria.

The final report clarifies that in order to justify its entire delegation structure with objective reasons, the alternative investment fund manager (“AIFM”) must be able to demonstrate that the delegation is done for the purpose of more efficient conduct of the AIFM's management of the alternative investment fund (“AIF”). A non-exhaustive list of examples of objective reasons is provided. We believe that it should not prove overly problematic for most managers to justify the delegation on such grounds.

The directive requires that the AIFM evaluate whether the delegate has sufficient resources to perform the delegated tasks, and if the persons who effectively conduct the business of the delegate are sufficiently experienced and of sufficiently good repute. The advice provides guidance in determining whether the delegate meets these criteria. In determining whether a delegate meets the requirement of being of sufficiently good repute, this criteria will be deemed satisfied where the delegate is regulated in respect of its professional services within the EU. These measures, as with many other provisions of the AIFMD, generally impose greater record-keeping obligations by requiring a greater level of recording of due diligence carried out in respect of delegates.


Generally, we believe that depositaries are likely to be disappointed that ESMA appears to have failed to accept many of their detailed submissions on the draft advice, particularly in relation to the impact on costs to investors. The failure to elaborate on the meaning of “loss” of financial instruments in the context of the liability regime is especially regrettable in light of the strict liability standard that applies.

Monitoring of cash flows

In relation to the proper monitoring of the AIF’s cash flows, the consultation paper had put forward two options. The first required the depositary to act as a central hub to ensure an effective and proper monitoring of all cash movements and the second set out minimum requirements for the depositary to meet its monitoring obligations. The second option has been adopted in the final draft, which will be welcomed by industry. The depositary will not be required to mirror transactions but instead to “check the consistency of its own records of cash positions with those of the AIFM.”

Safekeeping duties

In relation the depositary’s safekeeping duties, the advice seeks to clarify the definition of financial instruments which can be held in custody and therefore subject to a more rigorous standard of liability. The draft advice had put forward two options, the first of which contemplated a definition by which all financial instruments registered or held in an account directly or indirectly in the name of the depositary through a subsidiary or sub-custodian would be considered as instruments held in custody. The second option proposed referring to the use of settlement systems to define what financial instruments should be held in custody. The final report adopts the first of these options.

Treatment of collateral

In relation to the treatment of collateral, the final report clarifies when collateral should not be held in custody. Financial instruments shall not be included in the scope of the depositary’s custody function when they have been provided as collateral under title transfer collateral arrangements. This approach had been criticised in submissions to the consultation paper due to the complexity and lack of certainty around determining the requisites for possession and control under the Financial Collateral Directive. This represents a real concern, particularly as these provisions are likely to be mirrored in the upcoming UCITS V legislation on depositaries’ duties.

Record-keeping obligations

As regards the depositaries record-keeping obligations in respect of “other assets” not held in custody, the final advice also clarifies that depositaries will not be required to mirror all transactions in a position keeping record but will be required to have procedures in place to so that assets cannot be assigned, transferred, exchanged or delivered without the depositary being informed.

The advice also clarifies the reporting obligations on prime brokers where they are appointed, requiring prime brokers to report daily positions to depositaries.

A new provision requires the depositary to notify the AIFM where the depositary becomes aware that the segregation of assets is not, or is no longer sufficient to ensure protection from the insolvency of a sub-custodian. Leverage

Clarification on the calculation of leverage using the gross, commitment and advanced methods is provided. The advice aligns the AIFMD with the measures applying to UCITS. While we appreciate ESMA’s desire for consistency, many managers have issues with the UCITS methods of calculating leverage as when applied to certain instruments, interest rate futures for example, they often result in what many managers regard as artificially high leverage figures. This may actually be misleading to investors and we believe that this opportunity should be taken to refine some of the methods for calculating leverage under both UCITS and AIFM legislation.

Reporting to Competent Authorities

In response to the submissions on the consultation paper, the final report introduces new provisions on the frequency of reporting which are dependent on the level of assets under management ("AUM") of the AIFM. AIFM managing AIFs whose AUM fall under the thresholds set out in Article 3 (€100 million (leveraged) or €500 million (unleveraged)) shall report on an annual basis; AIFM managing AIFs whose AUM are above the thresholds but below €1.5 billion shall report on a semi-annual basis; and those with AUM above €1.5 billion shall report on a quarterly basis. The original draft had provided for reporting on a quarterly basis for all AIFM. The amended advice will be welcomed by those funds with fewer reporting obligations and, presumably, by regulators who will have fewer reports to review.

Third Country Provisions

Interestingly, ESMA’s advice reiterates ESMA’s desire to ensure that funds from third countries do not have an advantage over EU based funds.  It also specifically states that mutual recognition arrangements with third countries which operate outside the scope of the AIFMD will not be permitted.

The final advice states that, as far as information which is necessary for the supervision for systemic risk purposes is concerned, it is important to ensure that the same information which is available for EU AIFMs and EU AIFs is available where relevant entities are established outside the EU. This means that many third country jurisdictions will have to develop systems for gathering this information, which is likely to be operationally challenging.

A number of provisions of the AIFMD require cooperation arrangements be put in place between EU competent authorities and supervisory authorities from the home state of the non-EU AIFM or non-EU AIF. ESMA’s advice proposes that ESMA will centrally negotiate a memorandum of understanding with each country of origin, which would then be signed by each member state. It appears that existing arrangements which have been put in place by individual member states will have to be revisited.

Non-EU AIFM will be required under the AIFMD to apply to their member state of reference (“MSR”) if they decide to avail of the passporting regime when it becomes available to them. The advice provides that in circumstances where there are several possible MSR, the MSR should be identified taking into account the member state in which the AIFM intends to develop effective marketing for most of its AIFs.  It is important to establish clear criteria to establish the MSR in cases where there are several possible MSRs. The criteria should lead to a single, objectively justifiable conclusion. The test put forward by ESMA has the potential to yield several competing answers and does not lend itself to providing one objectively certain response.  A more appropriate test would refer to the member state in which the marketing strategy, including the approval, review and oversight of marketing materials, is developed.


ESMA’s final report is over five hundred pages long and it will take time for industry participants to fully assess its impact. In light of the detailed provisions involved, the two month consultation period and the time ESMA had to consider the extensive consultation feedback it received before the 16 November deadline may not have been adequate to consider the ramifications for the industry. Perhaps what is most striking about ESMA’s final report is the lack of substantial change following the consultations and the large volume of feedback. In particular, the issues surrounding depositary duties and the depositary liability regime generated detailed and lengthy submissions by industry stakeholders who may feel that the lack of significant change to the depositary provisions, particularly those relating to liability, fails to address what many would see as some legitimate concerns.

Next Steps

The Commission will now have to prepare the implementing measures in light of ESMA's advice. The Commission is not bound to accept ESMA’s advice and therefore it remains to be seen what the final implementing measures will entail. It is expected that the Commission will adopt the vast majority of ESMA’s advice. The measures are likely to be in the form of regulations with direct effect to avoid disparities in transposition in different member states. ESMA will work on the other subordinate measures foreseen by the Directive (guidelines and regulatory and implementing technical standards).

A copy of ESMA’s advice can be accessed here.