Following the adoption of the Alternative Investment Fund Managers Directive (AIFMD) and its publication (eventually) in the Official Journal of the EU on 1 July 2011, the European Securities and Markets Authority (ESMA) has run detailed consultations on Level 2 measures to implement it. Industry did not have long to consider and respond to the papers, but did not need long to decide they did not like much of what they saw. In this article, Rosali Pretorius, Josie Day and Emma Radmore look at how we got here, what the consultations cover, with particular reference to depositaries and delegation, and how industry has reacted.
The Process So Far
The AIFMD came into force on 21 July 2011. That means it must be transposed into the national law of the EU’s Member States by 22 July 2013, when the majority of its requirements – although not all – come into effect. The notable exception is the third country passport provisions.
Why are the Level 2 Measures So Important?
The AIFMD is a Lamfalussy directive. This means that the primary legislative act (Level 1 – the AIFMD itself) is only the first, framework, part of a four-stage process. Level 2, which is now under way, is a critical part of the process. Post adoption of the Lisbon Treaty, it is the stage when the detailed technical requirements are formulated by way of delegated acts and implementing acts (together, implementing measures). Broadly, these include secondary directives or regulations drafted by the European Commission (Commission) or binding technical standards drafted by one of the European Supervisory Authorities (ESAs). They supplement, or amplify or amend non-essential parts of, the Level 1 Directive.
Level 3 follows, comprising advice to the Commission by the ESAs on the development of the Level 2 measures. The ESAs may also give non-binding advice. Level 4 comprises the measures EU Member States put in place to bring Levels 1 and 2 into force in their national law.
Despite the 18 months taken by the Council of the European Union and the European Parliament to debate and agree the Level 1 AIFMD text, much of the practical detail is effectively "parked" for design at Level 2. Although implementing measures can only be used where specified in the Level 1 AIFMD, and in accordance with the limits set on it there, ultimately Level 2 measures may well be very influential in shaping the detail and final requirements of the original legislative framework. The pivotal role of ESMA in doing so should not be underestimated.
Article 4(4) of the AIFMD is a case in point. This empowers ESMA to prepare a delegated act by way of regulatory technical standards for the Commission to adopt. It is ESMA that can set the technical standards in relation to different types of Alternative Investment Fund Manager (AIFM) and to ensure uniform application of the AIFMD. In other cases, such as in connection with the Article 3 exemptions, ESMA does not actually draft the technical standard but will advise the Commission. ESMA’s proposals respond to the Commission’s December 2010 request to the Committee of European Securities Regulators (CESR) for assistance formulating the AIFMD’s implementing measures.
Whether ESMA is drafting technical standards or advising the Commission on secondary legislation, it is a much more powerful body than its predecessor, the CESR. This underlines how important it is for industry to respond to the consultations.
The Process So Far: How did ESMA Divide the Work on the Proposal?
ESMA divided work on the proposal into different streams, each headed by a different regulator. Although the UK’s Financial Services Authority was given important tasks, for the purposes of this article it is the work of the German regulator (BaFin) and the French regulator (AMF) that is important, as they dealt with delegation and depositary issues respectively.
The First Consultation – ESMA’s Views on Depositaries
ESMA’s first consultation addresses depositaries among other issues. Its draft advice on depositaries covers their appointment, duties and liability.
Appointment. ESMA’s advice sets out its proposals for:
- the content of the contract appointing the depositary (without providing model terms, as funds covered by the AIFMD may take many different forms); and
- minimum requirements to ensure the flow of information to the depositary is such that it can perform its functions.
For consistency, the UCITS directive requirements were taken as a starting point.
Duties. Depositary duties include, and ESMA provides advice on the scope of:
- safekeeping (custody of financial instruments and record keeping for other instruments);
- oversight (in relation to: reconciliation and verification of subscriptions and redemptions; valuations; investment restrictions; and settlement and income distribution, including carried interest);
- monitoring the AIF's cash movements by either having access to information about all the AIF’s cash accounts, and therefore being a hub to record and reconcile cash flows centrally, or having a monitoring obligation; and
- due diligence of any third parties to whom it delegates functions.
As requested by the Commission, the advice addresses the types of financial instrument that should be included in the scope of the depositary’s custody function. Whichever of the two approaches outlined by ESMA is adopted, it seems derivatives, physical assets that cannot be delivered to the depositary and financial instruments registered with the issuer (such as shares in private companies) will not be “financial instruments” for this purpose. The depositary’s duties are generally more onerous where financial instruments, such as transferable securities, are involved.
Liability. The liability of the depositary has, since the start of the debates over the drafting of the Level 1 Directive, been an area of intense lobbying by industry. ESMA says it has aimed to set an appropriate balance between the AIFMD’s objective of ensuring a high level of investor protection, whilst not making the depositary wholly responsible for doing so.
Level 1 provides for two sources of liability for a depositary: first, failure or negligence and, secondly, loss of a financial instrument (unless the loss arises as a result of an external event beyond the control of the depositary, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary). It provides for an implementing measure to amplify the second head of liability. ESMA’s approach has been to define each of the limbs of the sources of liability and exclusions from it. Thus it provides advice on the meaning of:
- “loss” of a “financial instrument”;
- “external events” beyond the “reasonable control” of the depositary; and
- objective reasons that could enable a depositary to discharge its liability, by transferring it to a sub-custodian.
Responses to the First Consultation
After the consultation, industry had two months to respond to ESMA on the draft advice. The deadline was 13 September 2011. In light of these responses, ESMA will present its formal advice to the Commission by 16 November 2011. This Consultation Paper is therefore a key step on the AIFMD’s journey to implementation. For industry, there was limited time for lobbying, for considering the proposal and commenting on it. More than 100 responses are now available to view on the ESMA website.
On depositaries, no response supported the proposal that accounts should be opened with the depositary, nor that the depositary should become the hub for cash flow. Most respondents also commented it should not be mandatory to hold instruments in the name of the depositary, and that it is unnecessary to require the depositary to mirror transactions in a position-keeping record. Generally, respondents favoured a system of notifying the depositary of relevant issues, rather than seeking its prior consent.
Unsurprisingly, most respondents expressed views on the liability of sub-custodians and how to ensure liability sits with the appropriate entity. The Investment Management Association (IMA) has significant concerns on the provisions relating to depositary liability, which it says has focused on limited circumstances in which there may be loss, rather than on the wider importance of proper due diligence. It also thinks the concept of "loss" is too tightly drawn, but cautions against any interpretation that would mean the depositary would at all times have to make restitution of assets held by a non-affiliated sub-custodian.
Some respondents raised their concern over the form of the Level 2 measures, strongly supporting a directive over a regulation. The Alternative Investment Management Association (AIMA) said it would be "nothing short of devastating" to put the provisions on depositaries in a regulation. However, the European Banking Federation (EBF) comments that there should be no barriers between Member States caused by gold plating the directive.
Many respondents felt ESMA has gone too far, interfering in matters that were not within the Commission’s request and may not therefore be within ESMA’s remit. Some, such as the British Private Equity and Venture Capital Association (BVCA), worried that ESMA had not fully appreciated how the private equity markets work. That said, others welcomed ESMA’s recognition of the need for a flexible and proportionate approach to implementation. The European Fund and Asset Management Association (EFAMA) says ESMA's work on defining different types of AIFs will be key in this respect.
A key concern is the costs of implementing the changes, exacerbated by a worry that some of the proposals will merely cause the depositary to duplicate checks and functions already being performed adequately by another person. AIMA specifically commented that, although some recommendations stem from MiFID or the UCITS Directives, ESMA’s proposals go beyond those equivalent provisions.
The Second Consultation – Delegation to Third Country Entities
ESMA’s second consultation covered further key areas, including delegation of portfolio or risk management functions to third country entities.
The draft advice concentrates on what the written agreement between the competent authorities of the home Member State and those of the third country concerned should contain. ESMA says the content should be based on existing international standards. The Multilateral Memorandum of Understanding (MMoU), centrally negotiated by ESMA, should address this.
ESMA must send its final advice to the Commission by 16 November. It is a major concern that it will have received many detailed and critical responses to its consultations which it cannot possibly have had time properly to assimilate. Industry is worried the short timescales imposed by the legislative process do not allow sufficient leeway for negotiation.