On 28 June 2012, ESMA released a consultation paper on its guidelines on sound remuneration policies under the AIFMD. ESMA will consider all comments received by 27 September 2012.
In 2009, the combination of the release of the first draft of the AIFMD and the confirmation that the top income tax rate would be increased from 40p to 50p prompted many existing and prospective hedge fund managers to question the attractiveness of London (or any other city in the EU) as the base for their management business. Whilst there was no exodus, it is undeniable that the popularity of non-EU, tax-favourable jurisdictions, like Switzerland, dramatically increased.
The concern is that, in 2013, the final AIFMD will prompt hedge fund managers to ask this question again. The AIFMD’s remuneration requirements will be a very significant factor when answering this question, particularly for smaller hedge fund managers.
How do the ESMA guidelines fit into the AIFMD?
Article 13 of the AIFMD provides that EU Member States shall require AIFMs to have remuneration policies and practices for relevant categories of staff (described below) that are “consistent with and promote sound and effective risk management and do not encourage risk-taking which is inconsistent with the risk profiles, rules or instruments of incorporation of the AIFs they manage”. AIFMs shall determine the remuneration policies and practices in accordance with Annex II of the AIFMD.
The AIFMD requires ESMA to ensure the existence of guidelines on sound remuneration policies which comply with Annex II of the AIFMD.
Whose remuneration will be affected?
Those “identified staff” whose professional activities have a material impact on the risk profiles of the AIFM or of the AIFs it manages.
Such staff would include (unless it can be demonstrated that they have no material impact on the risk profiles of the AIFM or of the AIFs it manages):
- members of the “governing body” of the AIFM1 (e.g. the directors, the CEO and partners);
- “senior management”2;
- “control functions”3;
- staff responsible for heading portfolio management, administration, marketing or human resources;
- “risk takers”4; and
- any other employees/persons receiving total remuneration that takes them into the same “remuneration bracket”5 as “senior management” and “risk takers”.
Does it apply to carried interest?
Yes. The AIFMD’s remuneration requirements shall apply to remuneration of any type paid by the AIFM, to any amount paid directly by the AIF itself, including carried interest6, and to any transfer of units or shares of the AIF.
What’s the worst that can happen?
There are many requirements, although the headlines are that:
- Fixed and variable components of total remuneration payable to “identified staff” should be appropriately balanced and the fixed component should represent a sufficiently high proportion of the total remuneration to allow the operation of a fully flexible policy on variable remuneration components (including the possibility to pay no variable remuneration component).
- A “substantial portion”, and in any event at least 40% (60% where the remuneration is “of a particularly high amount”7), of the variable remuneration component of any remuneration payable to “identified staff” should be deferred over a period which is appropriate in view of the “life cycle”8 and redemption policy of the relevant fund and should be correctly aligned with the nature of the risks of that fund. The deferral period should be at least three to five years unless the “life cycle” of the relevant fund is shorter.
For example, if £150,000 of variable remuneration were payable to an identified staff member, at least £60,000 would have to be deferred for at least three years and £90,000 could be paid out.
- A “substantial portion”, and in any event at least 50% of (a) the deferred part of this variable remuneration and (b) the part of this variable remuneration that is to be paid upfront should consist of units or shares of the relevant AIF(s).
Continuing the example: £90,000 would be paid out (consisting of £45,000 in cash and £45,000 in AIF shares) and £60,000 would be deferred for at least three years (consisting of £30,000 in cash and £30,000 in AIF shares).
- The deferred part of this variable remuneration should vest no faster than on a pro-rata basis.
The identified staff member in our example would get the deferred £60,000 in three instalments: £20,000 after the first year, £20,000 after the second year and £20,000 after the third year.
- Any part of this variable remuneration that consists of units or shares of the relevant AIF(s) must be subject to an appropriate retention policy designed to align incentives with the interests of the AIFM and the AIFs it manages and the investors of such AIFs.
Subject to the next requirement, any AIF shares received by the identified staff member in our example would be subject to a “retention period”, during which the staff member would not be able to sell (or, presumably, redeem) them.
- The amount of this variable remuneration that is actually paid out, including any deferred part, should be subject to an adjustment mechanism (which should include malus or clawback arrangements9). ESMA refers to this mechanism as “ex post risk adjustment”.
The cumulative effects of the above requirements on the identified staff member in our example are that (all things being equal):
- at the end of Year One, he will be paid £45,000 in cash. He will get £45,000 in AIF shares but won’t be able to redeem them for a retention period of, say, one year.
- at the end of Year Two, he will be paid £10,000 in cash and can redeem his £45,000 of AIF shares. He will get another £10,000 in AIF shares but won’t be able to redeem them for one year.
- at the end of Year Three, he will be paid £10,000 in cash and can redeem his £10,000 of AIF shares. He will get another £10,000 in AIF shares but won’t be able to redeem them for one year.
- at the end of Year Four, he will be paid £10,000 in cash and can redeem his £10,000 of AIF shares. He will get another £10,000 in AIF shares but won’t be able to redeem them for one year.
- at the end of Year Five, can redeem his £10,000 of AIF shares.
Leaving aside numerous commercial and practical issues, won’t this cause a tax issue for the identified staff?
In respect of Year One, the identified staff member in our example would get a tax bill in respect of the full £150,000. For a higher rate tax payer in the UK, this bill would be for £60,000, which is £15,000 more than the variable remuneration that he actually receives in cash.
AIFMs will therefore need to ensure careful treatment of identified staff and that the related structuring is put in place.
What is the proportionality principle?
The AIFMD provides that AIFMs should comply with the remuneration requirements in a way and to the extent that is appropriate to their size, the size of AIFs they manage (including any assets acquired through the use of leverage), their internal organisation and the nature, scope and complexity of their activities.
As a result, ESMA was required to take this proportionality principle into account when drafting its guidelines.
The ESMA guidance provides (on a non-exhaustive basis) that:
- The size criterion can relate to the value of the AIFM capital and to the value of the assets under management (including any assets acquired through the use of leverage) of the AIFs that the AIFM manages; liabilities or risks exposure of the AIFM and of the AIFs that it manages; as well as the number of staff, branches or subsidiaries of an AIFM.
- The internal organisation criterion can relate to the legal structure of the AIFM or the AIFs it manages, the complexity of the internal governance structure of the AIFM and the listing on regulated markets of the AIFM or the AIFs it manages.
- In considering the nature, scope and complexity of the activities criterion, the underlying risk profiles of the business activities that are carried out should be taken into account10.
The ESMA guidance also provides that the proportionality principle can also operate within an AIFM for some of the specific requirements.
This means that some AIFMs, either for the total of their identified staff or for some categories within their identified staff, can tailor the six headline requirements described above.
Can the proportionality principle disapply some or all of the AIFMD’s remuneration requirements?
No (as things stand).
The key difference between ESMA’s draft guidelines and the CEBS guidelines (which were in relation to remuneration policies and practices under the Capital Requirements Directive) is that the CEBS guidelines provided that the application of the proportionality principle may lead to the neutralisation (disapplication) of some requirements. Whilst ESMA’s draft guidelines do provide that “not all AIFMs should have to give substance to the remuneration requirements in the same way and to the same extent”, “[some] AIFMs can meet the [remuneration] requirements of the AIFMD in a simpler or less burdensome way” and that requirements “may be applied in a tailored manner”, they do not provide for neutralisation.
In fact, the ESMA guidelines explicitly state that any tailored application of the requirements “should not be understood as allowing an AIFM to disregard any of the requirements of Annex II of the AIFMD”.
It remains to be seen whether the final version of the ESMA guidelines will provide for neutralisation.
When it comes to implement the AIFMD, does the UK have to follow the final ESMA guidelines?
EU law requires competent authorities and financial market participants “to make every effort to comply with [ESMA’s] guidelines and recommendations”.
The FSA (or its successor, the FCA) could inform ESMA that it does not intend to comply with the final ESMA guidelines, stating its reasons. ESMA will publish that fact and may publish the FSA’s reasons. ESMA will also inform the European Parliament, the EU Council and the EU Commission and outline how it “intends to ensure that the [FSA] follow its recommendations and guidelines in the future”.
The short answer, therefore, is “no, the FSA does not”, although there will be considerable political and other pressures on the FSA to do so. If the final version of the ESMA guidelines do not provide for neutralisation of the requirements, then it is difficult to see how the FSA’s rules could do so.
What about the exemption for smaller fund managers?
According to the AIFMD, a smaller AIFM does not have to be authorised as an AIFM under the AIFMD where it can rely on one of the exemptions in Article 3(2) (i.e. (i) AIFMs who manage AIFs whose assets under management (including any assets acquired through leverage) do not exceed €100 million or (ii) AIFMs who manage AIFs that are unleveraged and have no redemption rights exercisable during a period of 5 years following the date of initial investment and whose assets under management do not exceed €500 million). Such an AIFM can instead be “registered” with its regulator and may only be required to comply with Article 3(3) and avoid, amongst other things, the AIFMD’s remuneration requirements.
It is important to note, however, that the AIFMD’s exemption for such “registered AIFMs” is “without prejudice to any stricter rules adopted by Member States”. The UK authorities have stated that they are considering two options – full application of the AIFMD to smaller AIFMs or the application of “a lighter regime selectively, differentiating between AIFM” – and have indicated that they are minded to choose the latter option. In the UK therefore smaller AIFMs could be subject to registration only, selective application of AIFMD authorisation requirements or full AIFMD authorisation.
So smaller managers in the UK may, or may not, have to comply with the AIFM remuneration requirements. There won’t be clarity on this until later in the year.
Are there any structures that would avoid the requirements?
Whilst there are structures available that can minimise the adverse tax consequences for identified staff, the AIFMD expressly states that variable remuneration must not be paid to identified staff “through vehicles or methods that facilitate the avoidance of” the remuneration requirements of the AIFMD.