On November 14, 2012, the UK Financial Services Authority ("FSA") published the first part of its long-awaited consultation paper "CP 12/32 Implementation of the Alternative Investment Fund Managers Directive ("AIFMD") Part 1" ("CP 32").
This alert summarises key points from CP 32 and includes a brief reminder of other key issues arising under AIFMD (which we have written about in the past and we assume that you are familiar with these issues). Please note that not all the requirements discussed below apply to all AIFMs and/or AIFs. If you require advice on the scope of application of the rules generally and/or in the case of a particular manager, fund or depositary, please contact us and we will endeavour to assist with your queries.
Why the delay and why is the consultation paper headed 'Part 1'?
The FSA (and indeed many other EU regulators) had waited (no doubt with eager anticipation) over the summer months on the EU Commission to publish its regulation on AIFMD implementing measures which is due to contain significant detail on certain key provisions and concepts in the AIFMD. Once it became clear that the EU Commission would not be publishing the implementing measures until at least the end of the year (in fact, now expected Q1 2013) and that the implementing measures are now to take the form of directly applicable regulations ("Level 2 Regulation"), the FSA decided that it could not delay any further publication of its domestic proposals on implementation. However, given the lack of clarity on certain key AIFMD concepts which are awaited from Europe and notwithstanding the FSA's best efforts at making intelligent guesses as to what the Level 2 Regulation will say in some areas based on previous technical advice, the FSA has been forced to split its consultation exercise into two parts. Part 1, which we summarise below, includes proposals on provisions in respect of which the FSA believes there is now reasonable certainty; Part 2 will consult on the remaining implementation matters and is due out in February 2013 (hopefully, after the date of publication of the Level 2 Regulations).
Wider regulatory changes in the UK
At the same time as battling with the regulatory challenges posed by the EU regulators, the FSA is also wrestling on the domestic front with its pending "retirement from service" and transfer of functions to its successor bodies, the Financial Conduct Authority ("FCA") and the Prudential Regulatory Authority. Going forward, HM Treasury is seeking to ensure that the FCA has the powers it needs to implement AIFMD and that there is a smooth transition over from the consultation exercise which has commenced under the helm of the FSA but which will end with the FCA. CP 32 describes the manner in which the relevant implementing regulations will be first promulgated and their subsequent 'shift' into new rules and regulations under the FCA, which appear, at least on paper, to be fairly straightforward and should not cause too much disruption for regulated persons.
Surely there is not really much for the EU member states to do to implement the maximum-harmonising AIFMD?
Yes, there is some truth to this assertion. The AIFMD is a maximum-harmonising Directive, which means that EEA Member States have very limited discretion to apply any additional requirements or to differ from the requirements in AIFMD and as the EU has decided to implement the Level 2 measures by directly applicable regulations, there is even less scope for member states to exercise discretion on implementation policy. There remain however a number of options or derogations which leave domestic regulators with some legislative choices and flexibility in rule application. One such area relates to the prudential regime for AIFMs and the regime for depositaries. Save for these areas, the FSA has made it clear in CP 32 that it has moved away from the notorious UK gold-plating model in implementing European directives and instead adopted a "copy-out" method (i.e., sticking to the text of AIFMD as closely as possible).
Where will AIFMD-related rules fit within the FCA Handbook?
Work has already started on the new FCA Handbook which is expected to replicate the relevant parts of the existing FSA Handbook with some new sourcebooks, including the new Investment Funds Sourcebook (FUND). FUND will replace the Collective Investment Schemes Handbook (COLL) and will contain regulations covering both AIFs and UCITS (unregulated collective investment schemes). The implementation proposals in the UK will also necessitate changes to the Senior Management Arrangements, Systems and Controls Handbook (SYSC) and the Conduct of Business Handbook (COBS) to cover the AIFMD requirements.
Summary of the key issues in CP 32:
CP 32 confirms that the FCA will implement the AIFMD requirement for AIFMs to report the following remuneration information:
- the total amount of remuneration for the financial year paid by the AIFM to its staff, split into (i) fixed and variable remuneration, (ii) the number of beneficiaries, and (iii) where relevant, carried interest paid by the AIF; and
- the aggregate amount of remuneration broken down by senior management and members of staff of the AIFM whose actions have a material impact on the risk profile of the AIF.
On June 28, 2012, ESMA published a consultation paper containing draft guidelines on sound remuneration policies under the AIFMD. The final text of these guidelines is expected to be published in Q1 2013. ESMA consulted on recommending in its Level 3 guidelines that the remuneration disclosures should be made on a proportionate basis "without prejudice to confidentiality". The FSA has proposed aligning the existing requirement under the FSA Remuneration Code with the new AIFMD remuneration rules (which could mean that some firms may end up having to comply with more requirements than has so far been the case under the FSA Remuneration Code).
The "private equity AIF depositary" model
AIFMD envisages that, for certain types of AIF, the role of depositary may be performed by an entity which "is subject to mandatory professional registration recognised by law or to legal or regulatory provisions or rules of professional conduct" and gives EEA Member States the flexibility to allow a notary, lawyer, registrar or other entity to be appointed, in accordance with the current practice for certain types of closed-ended funds. In CP 32, the FSA refers to these depositaries as "private equity AIF depositaries" because private equity funds are anticipated to be the main type of AIF for which such a depositary may be suitable. HM Treasury and the FSA consider that there is sufficient support for this option to justify implementing it in the UK. The FSA is seeking feedback on the types of firms it should permit to carry out this depositary function, the standards it should apply in assessing whether such firms are "fit and proper" to perform such function and whether a private equity AIF depositary would be required to hold financial assets in custody.
AIFMD does not place any specific prudential requirements on a private equity AIF depositary, other than it being able to provide sufficient professional and financial guarantees. The FSA has chosen to interpret "financial guarantees" as including a capital requirement of the kind to which most FSA authorised firms are subject. Clearly, a substantial capital requirement would deter firms from providing AIF depositary services. This is a valid concern for the private equity market where there are very few existing service providers that might become AIF depositaries. The FSA has recognised -- correctly in our view -- that, if they were to require private equity AIF depositaries to hold the same capital as a MiFID firm acting as a depositary to AIFs other than authorised funds (i.e., a minimum capital amount of €730,000), it is likely that this would act as a barrier to market entry for small firms. The FSA needs to balance the importance of promoting competition for financial services, while at the same time ensuring that firms are fit and proper to carry out the depositary function. Consequently, the FSA proposes that a firm acting as a private equity AIF depositary should, as a minimum, hold "own funds" of at least €125,000. This would apply where the depositary's safekeeping duty is limited to verifying the ownership of the AIF's assets. If the private equity AIF depositary intends to undertake higher-risk activities, such as providing custody of financial assets (to the extent that a private equity AIF depositary would be allowed to do so), the FSA may decide to set a higher figure (either by setting a higher "own funds" requirement or by setting an "expenditure-based" requirement).
Need for an independent compliance function?
There has been some discussion around whether or not an AIFM would be required to have an independent compliance function. The FSA has indicated in CP 32 that it expects that the Level 2 Regulation will require an AIFM to establish a permanent and independent compliance function commensurate with the size of its business and the types of AIF it manages and that any such requirements will be similar to those contained in the MiFID and UCITS Directives (and therefore may be new to many other firms becoming AIFMs). As the FSA notes, it remains to be seen whether the Level 2 Regulation permits a firm not to maintain an independent compliance function. There has been a good deal of lobbying and discussion on this issue, as well as the other issues awaiting clarification by the Level 2 Regulation, and it would be disappointing in light of such energetic lobbying if the Level 2 Regulation does not contain some flexibilities and some comfort for the lobbyists.
Fair treatment of investors
There has been much debate over whether or not it will be possible to differentiate between investors, especially professional investors, including by giving seed investors or larger investors reduced management fee deals or other improved terms. Although the Level 2 Regulation is expected to contain the detailed requirements on this topic, the FSA has indicated that treating professional investors differently is not inconsistent with the requirements of AIFMD, provided the terms agreed with investors are adequately disclosed and do not "result in an overall material disadvantage to other investors".
A brief reminder of some of the key issues arising under AIFMD:
AIFMD does not specify any process for the authorisation of depositaries or apply additional capital requirements in relation to depositaries. However, acting as a depositary of an AIF in the UK will be a specified activity under the Regulated Activities Order, and therefore any firm wishing to act as a depositary of an AIF will need to apply to the FCA for the relevant Part IV permission unless there is an exemption in place under FSMA.
The AIFM of a UK AIF or an EEA AIF must ensure that a single depositary meeting the eligibility criteria set out in AIFMD is appointed for each such AIF, the appointment is supported by a written contract, the assets of that AIF are entrusted to the depositary for safekeeping, and the depositary is eligible to act for the particular AIF (which in the case of a UK AIF means ensuring the depositary has the relevant FSA authorisation). The AIFM and the depositary each have a duty to perform their respective roles in the interests of the AIF and its investors by acting honestly, fairly and independently. The AIFM also has a duty to avoid conflicts of interest between itself, the depositary and the AIF, especially where a firm is acting as both depositary and prime broker to the AIF.
The FSA considers that the AIFM and the depositary of the same AIF (as long as the AIF is not an authorised fund) can be separate yet connected entities in the same group, provided that there is proper management and disclosure of potential conflicts of interest. The FSA has stated that it is of the view that applying a strict standard of independence to all AIF depositaries is likely to be disproportionate in relation to many professional funds.
AIFMD imposes a limited depositary requirement on a UK AIFM managing a non-EEA AIF that is to be marketed in the UK under the UK's national private placement regime. In such circumstances, the AIFM must ensure that one or more firms carry out the essential depositary functions of cash monitoring, safekeeping of assets and oversight, but the rest of the depositary provisions (for example, on independence, segregation and liability) do not apply. The FSA proposes requiring all UK firms offering this type of depositary service to be authorised as a full AIF depositary albeit only subject to the rules on cash monitoring, safekeeping of assets and oversight. It would be open to those firms to limit their activities to a particular type of AIF, such as private equity AIFs, to benefit from the specialised capital requirements proposed by the FSA (see above under the heading The "private equity AIF depositary" model). AIFMD provides a transitional period of four years until July 2017 during which time EEA AIFs may have a depositary that is authorised in any EEA Member State. The FSA proposes to permit UK AIFs (other than authorised funds) to appoint an EEA (non-UK) credit institution in this role during such transitional period.
Reporting and disclosures
AIFMD requires up-front disclosures to be made to potential investors as well as ongoing disclosure and reporting requirements both to investors and to regulators. The Level 2 Regulation is expected to provide further detail on the information to be disclosed to investors and to set out the required frequency of disclosure. It is likely that in most cases the information will have to be disclosed as part of the AIF's periodic reporting to investors and, at a minimum, along with the annual report. However, AIFMs should notify investors immediately if they activate any special liquidity arrangements permitted under the AIF's constitution, such as gates, side pockets or suspensions of redemptions. The Level 2 Regulation is expected to provide more detail on the content, format and frequency of information to be provided to the FCA, including reporting templates. In addition, ESMA intends to develop Level 3 guidelines on a more detailed and harmonised reporting template, which AIFMs can submit to all competent authorities in the EEA. This will be helpful to those AIFMs operating in more than one EEA Member State. The reporting requirements will apply to UK-authorised AIFMs for each EEA AIF that they manage and each AIF that they market in the EEA. Under the draft Treasury regulations, non-EEA AIFMs must comply with similar requirements for each AIF they market in the UK.
Marketing interests in an AIF
HM Treasury is expected to consult on this topic in Q1 2013. The AIFMD definition of marketing is "direct or indirect offering or placement at the initiative of the AIFM, or on behalf of the AIFM, of units or shares of an AIF it manages to or with investors domiciled or with a registered office in the Union". The FSA intends to transpose this definition into the Glossary of the FCA Handbook. Although there is significant overlap between the concepts of marketing under the AIFMD and a promotion under the FSMA financial promotion orders, marketing under the AIFMD contains distinctive features outside the FSMA definition. In particular, the prohibitions on financial promotions do not include the AIFMD concept of "the placing of units or shares of an AIF with investors", while some activities of placement agents to promote new AIFs may not be included in the AIFMD concept. AIFMD gives EEA Member States discretion to retain or put in place national marketing regimes for offerings to professional investors ("national private placement regimes"). It is expected that only minimal changes will be made to the UK national private placement regime. Where (i) a UK or EEA AIFM wishes to market a non-EEA AIF in the EEA or (ii) a non-EEA AIFM wishes to market any AIF in the EEA, AIFMD allows EEA Member States to maintain their national private placement regimes subject to certain conditions.
Use of leverage
AIFMD introduces significant new regulations regarding the use of leverage by AIFMs and the calculation of the exposure of AIFs under management and requires the EU Commission to adopt subordinate measures specifying the methods by which AIFMs will calculate leverage used by their managed AIFs, including any financial and/or legal structures involving third parties controlled by the relevant AIF. However, AIFMD excludes leverage at the level of a portfolio company for private equity and venture capital funds. The definition of leverage in AIFMD will be used by the FCA. An AIFM managing an AIF that employs leverage on a substantial basis must report additional information to the FCA on the level and type of leverage used and the source of funding for the leverage. The Level 2 Regulation is expected to explain what is meant by the use of leverage "on a substantial basis" and to specify more detailed requirements on how leverage is to be calculated.
AIFMs will be required to put appropriate and consistent procedures in place for the proper and independent valuation of the assets of each AIF they manage. In addition, the net asset value (NAV) per unit or share (or equivalent) of each AIF must be calculated and disclosed to investors at least annually. These requirements will be directly transposed into the FCA Handbook and should be incorporated into the constitutional documents of each AIF. The Level 2 Regulation is expected to contain further information on the valuation procedures that AIFMs must put in place. An AIFM must either carry out the valuation of the AIF itself or appoint an external valuer. An AIFM will be required to notify the FCA of the appointment of any external valuer and to demonstrate that the external valuer (i) is professionally registered and subject to legal or regulatory provisions or professional conduct rules, and (ii) can provide professional guarantees assuring effective performance. The AIFM must also establish that the delegation safeguards that will be set out in the Level 2 Regulation and in the FCA Handbook have been met. The AIFM will remain responsible for the proper valuation of AIF assets, the calculation of the NAV and its publication. The external valuer will be liable to the AIFM for any losses suffered as a consequence of its negligence or intentional performance failure. HM Treasury regulations will set out the obligations to be imposed on external valuers.
AIFMD transitional rules
AIFMD allows firms that are already managing or marketing AIFs before July 22, 2013 a transitional period of 12 months to comply with the relevant laws and regulations and to apply for authorisation. All these firms must, however, be AIFMD-compliant and have submitted an application for authorisation by July 22, 2014. AIFMD requires national competent authorities normally to decide applications for authorisation within three months of their submission. A UK firm that wishes to begin managing an AIF for the first time after July 22, 2013 will not benefit from any transitional provision. It will first have to apply to the FCA for authorisation and be fully compliant with AIFMD requirements before it can begin to manage an AIF. The same is true where the firm wishes to begin marketing AIFs in the UK or any other EEA Member State. There are no general transitional provisions relating to depositaries, in terms of their readiness to act for AIFs.
Next steps / key dates for UK implementation
- Q4 2012 / early Q1 2013 -- Draft regulatory technical standards and related material on types of AIFMs expected to be published by ESMA.
- February 1, 2013 -- The deadline for responses in respect of CP 32 to be submitted to the FSA.
- Q1 2013 -- Level 2 Regulation expected to be published.
- February 2013 -- FSA expects to publish part two of its consultation paper on the implementation of AIFMD in the UK.
- Q1 2013 -- Final Level 3 guidelines on remuneration policies and practices expected to be published by ESMA.
- Q1 2013 -- Financial Services Bill expected to be passed in to law by the UK Parliament.
- Q1 2013 -- HM Treasury expected to consult on various issues, including remuneration.
- April 1, 2013 -- FCA expected to assume its responsibilities.
- June 2013 -- FSA intends to publish one policy statement, relating to both parts of its consultation.
- July 22, 2013 -- Deadline for implementation of AIFMD.
- July 22, 2013 -- First date on which the FCA will accept applications for authorisation of new AIFMs requiring authorisation.
- July 22, 2014 -- Last date by which existing AIFMs which need to be authorised should submit applications for authorisation or variation of existing permissions to FCA.