AIFMD 2020 – ESMA’s Recommendations on the AIFMD Review

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.

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.

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.

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.

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 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.

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.

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.

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.