The final report containing ESMA’s technical advice to the European Commission on possible implementing measures of the Alternative Investment Fund Managers Directive (AIFMD) was published on 16 November 2011.

The publication of the final report was another step in the journey towards the implementation of the AIFMD into English law (required by 22 July 2013). Compared to where we were when ESMA’s draft advice was published in July/August 2011, however, we have not come very far and there are not too many differences between the final advice and the original draft advice.

The Commission is not obliged to follow the final advice, so be prepared for more fun and games when it drafts its Level 2 implementing measures (see “Where to now?” below).

One step forward…

Article 20(1)(c) of the AIFMD provides that any delegation by an AIFM concerning portfolio management or risk management “must be conferred only on undertakings which are authorised or registered for the purpose of asset management and subject to supervision”.

Article 21(6)(b) of the AIFMD provides that in order to appoint a non-EU depositary, the non-EU depositary should be “subject to effective prudential regulation, including minimum capital requirements, and supervision which have the same effect as Union law and are effectively enforced”.

ESMA was asked by the Commission to advise on the conditions for fulfilling these requirements.

Its draft advice regarding the delegation of portfolio management or risk management to a non-EU undertaking provided that the non-EU undertaking “should be deemed to satisfy the requirement under Article 20(1)(c) when it is authorised or registered for the purpose of asset management based on local criteria which are equivalent to those established under EU legislation and is effectively supervised by an independent competent authority”.

Similarly, its draft advice regarding the appointment of a non- EU depositary required the non-EU depositary to be subject to eligibility criteria, capital requirements, operating conditions and specific duties under local law that are equivalent to those to which an equivalent EU depositary is subject.

These additional requirements for equivalence went beyond the requirements of the AIFMD and do not appear in ESMA’s final advice. This will make the delegation of portfolio management or risk management to a non-EU undertaking and the appointment of a non-EU depositary much more straightforward...provided, of course, that the Commission follows ESMA’s advice.

…two steps back…

Article 12 of the AIFMD provides “[i]n the case of [...] a loss of a financial instrument held in custody1 the depositary shall return a financial instrument of identical type or the corresponding amount to the AIF or the AIFM acting on behalf of the AIF without undue delay. The depositary shall not be liable if it can prove that the loss has arisen as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary”.

ESMA was asked by the Commission to advise on the conditions and circumstances for events to be considered as “external”.

Attempts to persuade ESMA that acts and omissions of an unaffiliated sub-custodian should be presumed to be “external” have been unsuccessful and ESMA has confirmed its advice that a depositary’s liability is not affected by any delegation. E

SMA advises that an event should be deemed “external” if it is not a result of an act or omission of the depositary or one of its sub-custodians to meet its obligations.

Generally, hedge fund custodians only accept liability for their own negligent acts and omissions or those of their affiliated sub-custodians. In order to be hedge fund depositaries, these custodians will now have to accept liability (in the case of “lost” financial instruments held in custody at least) for their own nonnegligent acts and omissions or those of their sub-custodians (whether affiliated or unaffiliated).

Whilst a depositary may contractually transfer its liability in respect of a loss of a financial instrument held in custody to a sub-custodian under Article 21(13) of the AIFMD, hedge fund sub-custodians will generally only accept liability for their own non-negligent acts and omissions.

Either way, the main concerns are that:

  • not many institutions will wish to be depositaries – which will obviously have an impact on choice but could also increase systemic risk
  • those custodians that do wish to be depositaries will significantly increase their charges

This could potentially deal a huge blow to the attractiveness of using an EU member state (e.g. Ireland, Luxembourg, Malta etc.) as a domicile for non-UCITS hedge funds from 22 July 2013 and of using the EU passport for non-EU AIFs, which may be available from the second half of 2015.

Where to now?

The Commission

The European Commission will now begin drafting implementing measures based on ESMA’s final report.

In early 2012 the European Commission should publish for public comment working papers on possible implementing measures. These working papers would be posted on its website and will contain draft implementing measures (i.e. draft directives and/or regulations).

There will be a short consultation period which will probably last about one month. This is likely to be the last chance for the industry to comment on these implementing measures.


ESMA will now take forward its work on the other subordinate measures foreseen by the AIFMD. ESMA has, rather ominously, “identified a number of areas in which it considers it appropriate to develop guidelines in order to foster a harmonised implementation of the new framework”.

In my opinion (and subject to the Commission not proposing anything radical in its working papers), ESMA’s guidelines on the sound remuneration policies that are required under Article 13(2) of the AIFMD is the next big issue to watch for.

Most hedge fund managers avoided having to comply with the worst of the provisions of the Capital Requirements Directive, which would have required them to set ratios between fixed and variable components of remuneration, to ensure that 50% of variable remuneration consisted of shares and to defer 40% of variable remuneration for three to five years. Whilst it is hoped that ESMA will take a similar proportionate approach and disapply most of the AIFMD’s remuneration principles to hedge fund managers there is no guarantee of this happening.

An unfavourable outcome could result in the mass exodus of hedge fund managers from the EU that has been predicted for several years.

How much further?

There is still a long way to go.

The Commission is aiming to have adopted the priority level 2 measures by July/August 2012 in order to give member states sufficient time to transpose them into national law by 22 July 2013.

Once this has happened, and possibly earlier in respect of the AIFMD level 1 provisions, the UK will begin its consultation process regarding the transposition of the AIFMD and its level 2 implementing measures into English law.

The hope is that, at some stage in 2012 (and surely by the end of 2012!), EU hedge fund managers will have the necessary certainty and clarity to know:

  • whether they wish to be EU AIFMs from 22 July 2013 and, if so, to know precisely what needs to be done before then or
  • whether they wish to become a non-EU AIFM managing non-EU AIFs instead.