On 22 October 2020, the European Commission launched its public consultation (Consultation) on the EU Alternative Investment Fund Managers Directive (AIFMD).
The Consultation marks the next step in the Commission’s formal review of the AIFMD. It follows the Commission’s June 2020 report to the European Parliament and the Council assessing the scope and application of the AIFMD (the Commission Report), and European Securities and Markets Authority (ESMA) August 2020 letter to the Commission highlighting areas for improvements to the AIFMD (the ESMA Letter); see our previous Update on the Commission Report and Update on the ESMA Letter.
The Consultation is wide-ranging and addresses a number of key aspects of the AIFMD, including the scope of its application and the conditions for authorisation of alternative investment fund managers (AIFMs) as well as matters relating to investor protection and financial stability. However, this Update focuses on the more politically controversial topics covered by the Consultation.
In particular, as noted in our previous Updates, it is clear that both the Commission Report and the ESMA Letter were influenced by what the post-Brexit EU fund management landscape should look like. This theme continues in the Consultation and is reflected strongly in the questions relating to delegation by EU AIFMs and the national private placement regimes (NPPRs) for the marketing of non-EU alternative investment funds (AIFs).
In this Update we discuss the potential for future legislative changes implied in the Consultation’s questions and the implications of such changes.
The Consultation contains 102 questions grouped thematically under the following headings:
(i) functioning of the AIFMD regulatory framework, scope and authorisation requirements
(ii) investor protection
(iii) international relations
(iv) financial stability
(v) investing in private companies
(vi) sustainability/environmental, social, and governance matters (ESG)
The Consultation does not itself contain any proposals for legislative changes under a future “AIFMD II”; however, the questions asked clearly relate to a number of the themes explored in the Commission Report and the ESMA Letter (and earlier publications). As such, it is possible to draw inferences as to the possible shape of AIFMD II.
For UK and other non-EU fund managers affected by prospective amendments to the delegation rules and marketing regimes discussed below, this is an important opportunity to try to influence the Commission’s strategy. In particular, non-EU fund managers have the opportunity to ensure that measures designed to combat perceived Brexit-related risks to the EU do not create barriers to entry that would deprive EU investors of access to global markets for financial services and the ability to diversify their investment allocations.
The Consultation is open to responses until 29 January 2021, and the Commission intends to hold a conference to discuss the Consultation in November 2020.
Concerns with delegation structures
Delegation under the AIFMD has been an area of focus for ESMA for a number of years, particularly in light of Brexit, and coverage of the topic formed a significant part of the ESMA Letter. ESMA’s concerns stem from a perception that delegation structures can be used to circumvent the requirements of the AIFMD, or otherwise present a regulatory arbitrage opportunity, with the result that investors’ interests are at risk of not being adequately protected. ESMA also expressed concerns with the use of third-party AIFMs (which ESMA refers to as “white-label service providers”) that potentially allow a firm (including from third countries), being the AIFM’s client, to exercise significant influence over the authorised AIFM in respect of an AIF sponsored by that client.
Questions on delegation
ESMA’s recommendations regarding delegation are carried through by the Commission’s questions. In particular, the Consultation seeks views as to whether the AIFMD rules on delegation
- are effective in preventing the creation of “letter-box” entities in the EU
- ensure effective risk management
- should be complemented by additional measures such as quantitative delegation criteria, a list of core or critical functions that must always be retained by the AIFM, or any other requirements
- are consistently enforced throughout the EU
- should be extended so as to apply to Undertakings for the Collective Investment in Transferable Securities (UCITS)
In addition, the Commission asks whether the AIFMD standards should apply “regardless of the location of a third party, to which AIFM has delegated the collective portfolio management functions, in order to ensure investor protection and to prevent regulatory arbitrage.”
ESMA has already made clear its desire to tighten the criteria for delegation, and it is not surprising to see ESMA’s proposals carried through into the Consultation. The Commission is alive to the risk that after the Brexit transitional period expires on 31 December 2020, UK firms may be incentivised to restructure their arrangements to rely on EU AIFMs that delegate portfolio or risk management and other critical functions back to UK firms. Such structures would enable continued access to the EU marketing passport but with EU AIFMs that retain little substance, causing supervisory risks.
Although UK AIFMs and Markets in Financial Instruments Directive (MiFID) investment firms will be subject to substantively the same requirements as those in the EU on 1 January 2021, UK standards could diverge from the EU’s over time, potentially resulting in investor protection concerns on the EU side.
Implications of compliance uplift
If delegation standards are significantly uplifted, in particular if delegation requires full compliance by the delegate with AIFMD standards, this could pose significant obstacles for non-EU AIFMs, particularly in the U.S. and Asia, where investment advisers are subject to a significantly different framework. Currently, only a limited subset of the AIFMD requirements is generally contractually imposed upon a delegate. Requiring full compliance with the AIFMD by U.S. or other non-EU firms would result in significant costs, making it difficult for EU AIFM investment platforms to attract non-EU managers to act as submanagers, thereby potentially limiting the range of strategies that such platforms can offer to their clients.
Given that delegation under the UCITS framework has historically not been subject to detailed requirements in the same manner as the AIFMD, any significant uplift in terms of the delegation requirements for UCITS could have a materially negative impact on the UCITS delegation model.
National private placement regimes (NPPRs)
As we noted in our Update on the Commission Report, while the Commission Report acknowledged the important role the NPPRs have played in market development, it found that the NPPRs create an “unlevel playing field” between EU and non-EU AIFMs, notably because the NPPRs require non-EU AIFMs to implement only a very limited number of the AIFMD requirements while EU AIFMs marketing non-EU AIFs remain subject to all the requirements of the AIFMD save for certain flexibility regarding the appointment of a depositary.
It is therefore not surprising that the Consultation specifically asks participants whether they believe that the NPPRs create an unlevel playing field between EU and non-EU AIFMs and, if so, what action can be taken to address the issue.
However, there is no request from the Commission for any other specific feedback on the NPPRs (e.g., whether they should be harmonised or phased out in favour of the passport). In addition, despite the introductory text of the relevant section of the Consultation noting that the “focus” of the section is on “the appropriateness of the AIFMD third country passport regime and delegation rules,” there is no specific reference to the third country passport in any of the questions.
The Commission has previously expressed its own view that the NPPRs do create an unlevel playing field between non-EU AIFMs and EU AIFMs. It is not clear that a harmonised set of NPPRs would necessarily address this problem (unless harmonisation was set at a significantly higher level of compliance than now).
The lack of specific questions in the Consultation regarding the NPPRs, beyond whether they create an unlevel playing field, could imply that the Commission is not actively considering ways to reform (i.e., harmonise) the NPPRs. If that is indeed the case, then it is possible that the Commission is considering introducing the third country passport and phasing out the NPPRs.
Because the original activation date of the third country passporting regime under the AIFMD (as early as 2015 or 2016) was delayed as a result of Brexit, and because the Brexit transitional period between the UK and the EU will expire on 31 December 2020, the remaining political obstacle to the activation of the passport will soon have passed. This would allow the Commission a means of addressing the NPPRs without having to make any legislative changes.
If the NPPRs were to be phased out/terminated (under the existing AIFMD text, the date of termination would be at least three years after the introduction of the third country passport), the only option left for non-EU AIFMs marketing their funds into the EU would be the third country passport.
If the UK is included in the third country passport regime, UK AIFMs might not find the third country passport too difficult to operate under, given that UK AIFMs are already subject to full authorisation under the AIFMD. However, if the UK’s AIFMD regime were to deviate from the EU’s over time, UK AIFMs intending to market their funds under the EU third country passport would nonetheless have to remain compliant with any future EU AIFMD standards. In particular, the third country passport would require such UK AIFMs to be fully authorised by the regulator in their EU member state of reference (MSR) and to comply with the EU AIFMD as implemented in that MSR.
In addition, the third country passport regime as it stands would create significant difficulty for U.S. and other non-EU AIFMs that would otherwise rely on the NPPRs to market their funds into the EU. Although the third-country passport would provide greater freedom to market a fund across the EU, as noted above it requires the non-EU AIFM to be authorised by its MSR and fully compliant with the EU AIFMD. Such requirements are unlikely to be attractive to the majority of U.S. and other non-EU AIFMs.
Further areas of interest
The Consultation also contains a number of other areas that may be of interest to non-EU AIFMs.
The Consultation invites opinions as to the necessity and sufficiency of the mandatory disclosures to investors under Articles 22 (Annual report) and 23 (Disclosure to investors) of the AIFMD. It also asks whether mandatory disclosure requirements should differ depending on the type of investor and whether AIFMs ought to be required to make interim disclosures to investors in addition to the annual report. Any rationalisation of disclosure obligations under Articles 22 and 23 of the AIFMD would affect non-EU AIFMs that market under the NPPRs.
The Consultation asks whether there should be greater harmonisation between the AIFMD and UCITS frameworks, such as equivalent leverage calculation methods, supervisory reporting requirements, delegation rules, or even a single license and rulebook for UCITS management companies and AIFMs.
While such changes would not be directly relevant to non-EU firms, there would be a knock-on effect on non-EU firms that may be sub-managers to EU UCITS, particularly if the delegation rules are tightened across the board for AIFMs and UCITS. As we noted in our Update on the ESMA Letter, given that delegation under the UCITS framework has historically not been subject to detailed requirements 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.
Periodic reporting to regulators
There are a large number of technical questions relating to the obligation for AIFMs (including non-EU AIFMs) to make periodic reports to regulators under Article 24 (Reporting obligations to competent authorities) of the AIFMD (commonly known as Annex IV reporting). A number of the questions seem to suggest that the Commission is considering requiring more granular detail from AIFMs. Such detail would assist national competent authorities and ESMA in more closely monitoring the build-up of systemic risk, including in relation to stressed market conditions.
One question raised by the Commission in this section of the Consultation is of particular interest to non-EU AIFMs: the Commission asks if supervisory reporting by AIFMs “should be submitted to a single central authority such as ESMA.” Such an outcome would be beneficial to non-EU AIFMs marketing under the NPPR because, at the moment, Annex IV reports are individually submitted, in slightly different formats, to each EU member state regulator. A single submission to ESMA or some other central authority would greatly simplify the Annex IV submission process for non-EU AIFMs.
The Consultation includes a number of questions on leverage that must be reported by non EU AIFMs to their investors and to the regulators in periodic reports. Among other things, the Commission asks whether the existing AIFMD gross and commitment methods of calculating leverage are appropriate and whether leverage calculations should be harmonised between AIFMs and UCITS.
The Consultation also seeks views on IOSCO’s two step approach for assessing leverage in its Framework Assessing Leverage in Investment Funds, published in December 2019, suggesting this is being considered as a potential new model for the EU.
CLOs and leveraged loans
The Commission acknowledges the growth of markets for leveraged loans and collateralised loan obligations (CLOs) in recent years and the exposure of investment funds to such products. The Commission opines that it would be valuable to collect data on leveraged loans and CLOs in order to assess risks to financial stability and their regulatory implications. In addition, the Commission seeks views as to the optimal harmonisation for rules that could apply to loan originating AIFs.
The Consultation dedicates a whole section to questions on sustainability and ESG. The Consultation notes that the new EU Sustainable Finance Disclosure Regulation (SFDR) will require a significant part of the financial services market, including AIFMs, to integrate assessments of relevant sustainability risks into their investment and due diligence processes. The section sets out a number of questions that seek to facilitate an understanding of whether and how sustainability can be more closely integrated into the AIFMD framework.
Interestingly, the Consultation includes a question as to whether AIFMs should, when considering investment decisions, be required to take account of sustainability-related impacts (such as environmental pollution and degradation, climate change, social impacts, and human rights violations) beyond what EU law currently requires, alongside the interests and preferences of investors. Depending on its implementation, such a requirement could represent a very ambitious expansion of the reach of the EU sustainability framework.
For more information on the SFDR and its impact on non-EU managers, please see our update ESG Disclosures for Asset Managers Under the EU Sustainable Finance Disclosure Regulation and Taxonomy Regulation.
The Consultation represents a wide-ranging and thorough review of the AIFMD. A number of the most obviously politically contentious areas, particularly regarding Brexit and the AIFMD’s third country reach, are likely to affect the interests of non-EU fund management firms globally and not only in the UK; the Consultation therefore demands attention.
Outside these contentious areas, the Commission’s questions indicate that it seems to be considering a number of important changes to the AIFMD framework. In some cases these changes would be technical in nature, but in other areas, it seems clear that the Commission is keen to bring the AIFMD up to date, given that the AIFMD was adopted and published in the EU Official Journal almost 10 years ago (in 2011).
The UK will not, however, automatically adopt any future amended framework, and so AIFMD II may represent one of the first significant moments of regulatory divergence for the fund management industry between the UK and the EU in a post-Brexit environment.
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