In our recent Update AIFMD – European Commission Report – the Groundwork for AIFMD II?, we examined the European Commission’s Report on the EU Alternative Investment Fund Managers Directive (AIFMD), which was published on 10 June 2020.

On 28 August 2020, the European Securities and Markets Authority (ESMA) sent a letter to the European Commission (Commission), titled “Review of the Alternative Investment Fund Managers Directive” (the ESMA Letter).

It is clear that, like the Commission Report, the ESMA Letter is influenced by what the post-Brexit EU asset management landscape should look like.

We examine below the key aspects of the ESMA Letter and how, together with the Commission Report, it will form the basis for what will ultimately be “AIFMD II.”

The purpose of the ESMA Letter

The ESMA Letter’s stated aim is to “highlight some areas of AIFMD where improvements could be made” to the Commission, in the context of the Commission’s work in carrying on its review of the AIFMD.

Harmonisation of AIFMD and UCITS regimes

ESMA asks the Commission to consider closer harmonisation of the AIFMD and undertakings for the collective investment in transferable securities (UCITS) regimes, noting that, for example, there are different levels of granularity with respect to risk management and liquidity management requirements in the UCITS Directive as compared to AIFMD.

ESMA also notes that in relation to the issue of delegation, there are no granular Level 2 provisions in the UCITS framework as compared to the AIFMD.

ESMA’s call for harmonisation across the UCITS and AIFMD frameworks recalls a speech given by Robert Ophèle, Chairman of the AMF (the French regulator) in July 2019, where he noted:

Our suggestion is to take the opportunity to review AIFMD, to streamline the rules that apply to an asset manager in the EU by pulling together those requirements that are in the UCITS Directive and in AIFMD in order to have a single set of rules for the supervision of entities involved in the management of collective investment schemes.

 

Sidley Comments

It is interesting that, although the stated purpose of the ESMA Letter is to assist the Commission’s work on AIFMD, ESMA consistently refers to UCITS throughout. Although one can see the desire at the policy level to harmonise the UCITS and AIFMD frameworks, there would be a clear need to align only those aspects that would result in an appropriately consistent response.

Note that the call by ESMA for delegation standards under UCITS to be consistent with those under AIFMD is not new; ESMA said the following in its 2017 Opinion to support supervisory convergence in the area of investment management in the context of the United Kingdom withdrawing from the European Union (ESMA34-45-344):

ESMA is of the view that the interpretation of Article 13 of the UCITS Directive and the relevant national laws transposing this provision should be consistent with the principles set out in Articles 75 to 82 of the AIFMD Level 2 Regulation.

It will be interesting to see if the EU moves in time towards an overarching framework directive covering both AIFM and UCITS business (i.e., folding the current AIFMD and UCITS Directive texts into one piece of legislation). Indeed, in theory one could have a framework EU directive covering not only AIFMD and UCITS but also European Long-Term Investment Funds (ELTIF), European social entrepreneurship funds (EuSEF), European venture capital funds (EuVECA), and even portfolio management under the Markets in Financial Instruments Directive (MiFID).

Scope of additional MiFID services and application of rules

ESMA asks the Commission to help clarify the application of rules when providing services pursuant to Article 6(4) of the AIFMD and Article 6(3) of the UCITS Directive. Such services are often referred to as “MiFID top-up” services, in that AIFMs and UCITS management companies may, in addition to their core AIFM/UCITS permission, carry on certain limited MiFID activities. ESMA notes that the issue of MiFID top-up services is not applied consistently across the EU.

ESMA also notes that the transaction reporting obligation from Article 26 of MiFIR is not included in the list of MiFID provisions, which also apply to AIFMs/UCITS management companies. This means that AIFMs/UCITS management companies providing MiFID services are not subject to the requirement to report transactions in accordance with Article 26 of MiFIR.

 

Sidley Comments

ESMA does not make clear whether it is also asking for the Commission to impose the MiFIR transaction reporting obligations on AIFMs and UCITS management companies generally or only on those that have MiFID top-up permissions. AIFMs and UCITS management companies do not currently have to comply with the MiFIR transaction reporting obligation, and there has been some expectation that at some point, that obligation would be carried across to the AIFMD/UCITS framework.

Delegation

The ESMA Review contains a significant section on the issue of delegation (e.g., delegation by an EU-authorised AIFM of portfolio management or risk management to a third party). The key points include the following.

Extent of delegation

ESMA expresses a concern that “portfolio management functions are often largely or even entirely delegated to third parties,” with a large amount of the management fees thus paid to delegates. ESMA’s concern is whether the relevant alternative investment funds (AIFs) and UCITS can still be effectively managed by the licensed AIFM or UCITS management companies. In this regard ESMA recommends that the Commission consider imposing (either in addition to, or instead of, the qualitative criteria in the AIFMD Level 2 Regulation) quantitative criteria or a list of core or critical functions that must always be performed internally and may not be delegated to third parties. ESMA recommends that such changes should be carried over to the UCITS Directive, which at present has little by way of guidance in terms of delegation.

 

Sidley Comments

There is a clear desire on the part of ESMA to tighten the criteria for delegation. In particular, it will be interesting to see how quantitative criteria might be introduced; for example, might that result in a requirement to have specific numbers of investment professionals based on the investment strategy or assets under management of the AIFM/UCITS?

Separately, given that delegation under the UCITS framework has historically not been proscribed in the same manner as AIFMD, any significant uplift in terms of the delegation requirements for UCITS could have a material impact on the UCITS delegation model.

Regulatory arbitrage

ESMA notes that where delegation is to non-EU delegates, there are potential regulatory arbitrage and investor protection concerns, as the non-EU delegate will not be directly subject to the AIFMD or UCITS frameworks. ESMA recommends that delegates should be “subject to the regulatory standards set out in the AIFMD and UCITS frameworks” irrespective of the regulatory license or location of the delegate.

 

Sidley Comments

Although ESMA might be thinking in particular about UK delegates in a post-Brexit environment (were the UK to deregulate or diverge from EU regulation), ESMA’s recommendation would also have a material impact on existing AIFM and UCITS delegation arrangements. In particular, some U.S. managers are delegates of EU AIFMs and UCITS management companies; it would be difficult for U.S. managers to comply in full with the regulatory standards set out in the AIFMD and UCITS frameworks.

Interestingly, ESMA’s point on different standards is not expressed to extend to MiFID investment managers (since the ESMA Letter is only about the AIFMD and UCITS) — meaning a UK/US delegate of an EU MiFID investment manager might not be affected the same way, at least in theory.

Secondment arrangements

ESMA raises concerns about “secondment arrangements”, where staff from other entities are seconded to the AIFM or UCITS management company on a temporary basis; in a nod to Brexit, ESMA notes that some of these staff might not even be in non-EU member states. In particular, ESMA is concerned about whether such secondment arrangements are in line with the substance and delegation rules set out in the AIFMD and UCITS frameworks.

 

Sidley Comments

It is unclear precisely what kind of secondment arrangements ESMA is thinking of; for example, is ESMA thinking of portfolio/risk management staff or legal/compliance/IT/marketing?

Given that such secondment arrangements are likely to increase in relation to UK/EU firms post-Brexit, any tightening of the rules by the Commission could result in such arrangements not being viable, which could be problematic for some firms.

White-label service providers (i.e., third-party AIFMs)

ESMA expresses a concern about the use of third-party AIFMs (which ESMA refers to as “white-label service providers”); that is, the business model where a fund manager sets up a fund at the initiative of another entity (the “initiator”) and delegates investment management functions to the initiator following their guidance/instructions. ESMA notes that it has previously addressed risks stemming from white-label service providers in the context of Brexit-related relocations in its 2017 Opinion. ESMA’s primary concern here is that the initiator may effectively be able to exercise significant influence over the authorised AIFM or UCITS manager. Further, the delegating AIFM/UCITS management company may face conflicts of interest because challenging the initiator/delegate may come at the risk of losing a client/business partner and therefore losing its own revenue/management fees.

 

Sidley Comments

ESMA’s reference to its concerns with such white-label service providers in the context of Brexit-related relocations is apposite. Such providers have been particularly active in marketing their services to UK firms as a result of Brexit. It will be interesting to see if ESMA and/or the Commission places any pressure on this model in the months and years to come.

Loan origination in AIFMD

ESMA believes that there should be a specific framework for loan origination within the AIFMD, noting that it would be particularly helpful for the EU’s efforts to promote a capital markets union (CMU).

Reverse solicitation

ESMA notes that the concept of reverse solicitation (mentioned in Recital 70 of the AIFMD) is “currently subject to divergent practices and interpretation at national level” and calls for greater clarity to the definition and notion of reverse solicitation.

ESMA notes that the issue of reverse solicitation is already subject to an evaluation clause as required in the new EU Regulation ((EU) 2019/1156) on facilitating cross-border distribution of collective investment undertakings (the CBD Regulation); the Commission is required under the CBD Regulation to publish a report by 2 August 2021 on “reverse solicitation and demand on the own initiative of an investor.” However, ESMA says it would like to seize the opportunity to underline the importance of clarifying the notion of reverse solicitation mentioned in Recital 70 of the AIFMD.

 

Sidley Comments

The CBD Regulation accompanies the EU Directive (EU) 2019/1160 on the same subject (the CBD Directive). The CBD Directive does not provide a definition of “reverse solicitation” as such but provides that any subscription by professional investors, within 18 months of the AIFM beginning “pre-marketing” activities, to be “considered the result of marketing.” “Pre-marketing” is defined in the CBD Directive to mean, generally, the provision of information on investment strategies or investment ideas to investors by the AIFM in order to test their interest in an AIF. The result is that an AIFM would not be able to rely on reverse solicitation if it had conducted any premarketing in the 18 months preceding that subscription.

The CBD Directive and CBD Regulation apply only to intra-EU marketing of AIFs using the AIFMD passport and so does not apply to non-EU AIFMs marketing into EU member states using the AIFMD national private placement regimes. However, there is some expectation that the premarketing definition will be reflected in AIFMD II, and, given ESMA’s comments above, it is possible that the Commission could seek to introduce a specific definition of “reverse solicitation” in the text of AIFMD II.

Please see our previous Update EU AIFMD: New Rules on Pre-Marketing and Reverse Solicitation for a commentary on the CBD Directive and CBD Regulation.

Next steps and conclusion

The Commission’s and ESMA’s work is likely to lay the groundwork for what will ultimately become “AIFMD II.” It seems likely that some form of proposal for the amendment to the AIFMD will be published in Q1 or Q2 of 2021, and AIFMD II might eventually be adopted 12 to 18 months later. By that time, of course, the UK would have been some way down the road in terms of deciding whether, and how, it might wish to design its own asset management framework for UK managers. It will be interesting to see how the UK and EU frameworks compare by that time.