- whether real estate investment trusts (REITs)2 might be considered to be alternative investment funds (AIFs) under the AIFMD and relevant guidance published to date; and
- the potential impact of the AIFMD on the marketing in the EU of equity interests of REITs that are categorised as AIFs.
For further information on the AIFMD, please refer to other Sidley Updates on the AIFMD which are available on the Sidley website.3
Definition of “AIF” under the AIFMD
The AIFMD applies to alternative investment fund managers (AIFMs), but not directly to alternative investment funds (AIFs). An AIFM is the undertaking that manages one or more AIFs. If an AIF does not have an external manager (i.e., it is self-managed by its board or a similar governing body), the AIF itself will be considered to be the AIFM (i.e., it is both an AIF and an AIFM).
Accordingly, the first step in determining whether or not the AIFMD is applicable is to consider whether or not there is an “AIF”. It is worth noting at this juncture that, as the AIFMD is an EU “directive” and thus needs to be implemented or transposed into local law in each EU Member State before becoming law,4 it is possible that the definition of “AIF” may differ slightly across Member States. In addition, individual Member State regulators may have different views as to when an entity might fall within the definition of “AIF”. The result is that, in nuanced situations (including in relation to many REITs), it may be necessary to carry out a survey of each relevant Member State’s implementation (and guidance, if any) of the AIFMD definition.
The AIFMD defines “AIFs” to mean:
“collective investment undertakings, including investment compartments thereof, which... raise capital from a number of investors, with a view to investing it in accordance with a defined investment policy for the benefit of those investors...”5 (Emphasis added).
All four elements of the definition must be present before an undertaking can be considered to be an AIF.
The European Securities and Markets Authority (ESMA) has issued guidelines (the ESMA Guidelines)6 in relation to each of the four elements of the AIF definition, which are discussed below.
“Collective investment undertaking”
The ESMA Guidelines provide that a “collective investment undertaking” is an undertaking having all of the following characteristics:
- It does not have a “general commercial or industrial purpose”.
A “general commercial or industrial purpose” refers to the purpose of pursuing a business strategy which includes characteristics such as running predominantly: (i) a commercial activity, involving the purchase, sale, and/or exchange of goods or commodities and/or the supply of non-financial services; (ii) an industrial activity, involving the production of goods or construction of properties; or (iii) a combination of both.
- It pools together capital raised from its investors for the purpose of investment with a view to generating a “pooled return” for those investors.
“Pooled return” is, in essence, the return generated by the pooled risk arising from acquiring, holding or selling investment assets, including the activities to optimise or increase the value of these assets.
- Its investors, as a collective group, do not have “day-to-day discretion or control”.
“Day-to-day discretion or control” means, in essence, a form of “direct and on-going power of decision” (whether exercised or not) over operational matters relating to the daily management of the undertaking’s assets, which extends substantially further than the ordinary exercise of control through voting at shareholder meetings.
This condition should still be considered to be met even if some (but not all) of the investors are granted day-to-day control.“Raise capital”
The ESMA Guidelines provide that an undertaking raises capital for the purposes of the AIF definition where it takes direct or indirect steps (by itself or another on its behalf, e.g., the AIFM) to procure the transfer or commitment of capital by investors to the undertaking for the purposes of investing it in accordance with a defined investment policy (see below).
In the UK, the Financial Conduct Authority (the FCA) is of the view that, for an undertaking to be regarded as an AIF, it needs to raise “external capital” (e.g., in contrast to a manager investing its own money or a joint venture where the parties are investing/managing their own money).
“A number of investors”
According to the ESMA Guidelines, an undertaking which is not prevented by its national law, the rules or instruments of its constitution or any other legally binding provision or arrangement, from raising capital from more than one investor is to be regarded as raising capital from “a number of investors”. The ESMA Guidelines further provide that “[this] should be the case even if it has in fact only one investor”. That is, if a single investor fund intends to argue that it is not an AIF on the basis of there being only one investor, the key point is that it must be prevented by law or its constitutional documents from having more than one investor; the fact that it actually has only one single investor is irrelevant.
The FCA is of the view that an investor who only makes a nominal capital contribution (e.g., £1) should be ignored when determining whether there is more than one investor.
“A defined investment policy”
The ESMA Guidelines provide that an undertaking which has “a policy about how the pooled capital in the undertaking is to be managed to generate a pooled return for the investors” should be considered to have a defined investment policy. The ESMA Guidelines set out multiple factors that would “singly or cumulatively” tend to indicate the existence of such a policy, including (among others): (i) the investment policy is determined and fixed by the time investors are committed to investing; (ii) the investment policy is set out in a document that is part of or is referenced in the undertaking’s rules or instrument of constitution; and (iii) the undertaking or its manager has an obligation, which is legally enforceable by investors, to follow the investment policy.
The FCA notes that this part of the ESMA Guidelines is aimed at arrangements that, whilst in form do not meet the definition, may in practice do so. The FCA has provided an example where the manager of a fund has a legal discretion that is too wide to meet the definition of a defined investment policy but publishes a detailed investment policy (which is not legally binding) and leads the investors to expect that it will follow it. The FCA is of the view that under those circumstances, the vehicle may still be an AIF.
Is the type of asset relevant?
The FCA’s view is that the definition of AIF is not restricted to funds investing in any particular types of assets. Assets, for the purposes of the AIF definition, can include assets of any kind or combinations, e.g., traditional financial assets (equity, debt, etc.), real estate and non-traditional assets (ships, forests, wine, etc.).
Do REITs fall within the AIF definition?
The FCA has stated that, as a REIT is a concept used for tax purposes, there is no presumption either way as to whether or not a REIT is an AIF.7 That is, each case will need to be analysed on its own facts. In determining whether or not a particular entity is an AIF, the FCA has provided multiple factors in relation to each of the four elements of the AIF definition (in addition to those set out in the ESMA Guidelines) and has stated that all relevant factors should be considered together.
Although not specific to REITs, the following factors from the broader FCA guidance may be helpful in the analysis of whether a particular REIT may be an AIF:
- whether it constructs, develops or otherwise creates the properties it is holding (if so, that would point away from it being an AIF);
- whether it has a substantial number of employees (if so, that would point away from it being an AIF);
- whether it outsources a significant portion of its functions to third-party service providers (if so, that would point towards it being an AIF);
- whether the board has executive directors and meets regularly to make major decisions (if so, that would point away from it being an AIF); and
- whether it is set up and being marketed like a fund (if so, that would point towards it being an AIF).
The FCA recognises the broad scope of the AIF definition and notes that, without a proper consideration of the policy objective of the AIFMD, an ordinary commercial entity could fall within the definition of AIF. The FCA appears to be of the view that the policy objective of the AIFMD is to regulate collective investment undertakings (with the emphasis on the term “investment” which is being used in contrast to “commercial”). Therefore, in the assessment of whether or not a REIT might be considered to be an AIF, it is important whether or not it can be considered to be a “collective investment undertaking” as used in the definition.8
Equity vs. debt offerings
In the FCA’s view, an ordinary commercial or financial company issuing debt securities will not generally be considered to be an AIF. This is because, in general, an issuer of debt securities does not invest the capital it raises for the benefit of the subscribers for the debt securities and the debt holders can only obtain fixed income (i.e., there is no “pooled return”).
However, the FCA notes that, in cases where the debt essentially functions like equity (e.g., all the profits and losses flow through to the holders via return on their debt securities), the debt issuer could be considered to be an AIF.
This generally means that there should not be any AIFMD issues if a REIT is simply issuing/marketing plain vanilla debt instruments to EU investors. However, each case will need to be analysed on its facts.
Implications of REITs as AIFs – marketing in the EU
If a REIT is an AIF and the AIFM managing it (either the REIT itself or an external AIFM) is established in the EU, that AIFM will need to be authorised as such in the EU Member State where it is established and comply with the AIFMD in full. If the REIT/AIF is domiciled in the EU, its shares will be capable of being marketed across the EU on the basis of the AIFMD marketing “passport”.
Consequence of breaching the AIFMD marketing rules
The AIFMD does not set out specific penalties or sanctions for a breach of the marketing restrictions; accordingly, a breach of the AIFMD marketing restrictions in a particular EU Member State will be subject to the local sanctions regime. In the UK, for example, where a non-EU AIFM unlawfully markets an AIF:
- that non-EU AIFM would be committing a criminal offence (with possible fines and imprisonment); and
- the agreement (e.g., the subscription agreement) entered into with the investor resulting from the unlawful marketing would be unenforceable against the investor, and the investor would be entitled to recover any money invested as well as seek compensation for any loss sustained as a result of the investment.
As a result, non-EU AIFMs should note that non-compliance with the AIFMD marketing regime raises not only the risk of regulatory enforcement actions by Member State regulators, but also the risk of challenges by disgruntled investors, who may seek to recover their investment by claiming that the AIFM engaged in unlawful marketing.
In the context of REITs, if the REIT is considered to be a self-managed AIF, then the REIT itself would be the AIFM and it, and potentially its directors, would face the relevant sanctions.
The REIT underwriters/placement agents may also be affected, in that the sanctions may also apply to persons who market the AIF interests on behalf of the AIFM.
Certain EU Member States, including Belgium and Spain, have put in place domestic legislation creating new categories of regulated real estate companies (that have the characteristics of REITs) or otherwise clarifying that such real estate companies fall outside the local AIFMD framework. However, there is no guarantee that such a characterisation in one Member State would necessarily be respected in another. At the same time, REITs from outside those particular Member States will not typically be able to satisfy the local conditions to fall within those categories and so such legislation would not be of assistance to such foreign REITs.
Until any guidance is given at an EU level on REITs (which does not seem likely given the fact that REITs are not a homogenous class of entities), REITs and their sponsors will continue to have to carry out an AIFMD analysis before undertaking marketing efforts in the EU.
If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or
1 For ease of reference, in this Update, “EU” should be read to include Iceland, Liechtenstein and Norway which, together with the 28 European Union Member States, form the European Economic Area.
2 A “REIT” is a concept under the applicable tax legislation in each country. REITs in different countries may thus have different characteristics.
4 As compared with an EU “regulation” which is directly applicable in every EU Member State without the need for local transposition.
5 UCITS, however, are outside of the scope of the AIFMD altogether.
6 Note that ESMA’s guidelines are not legally binding in EU Member States, but Member State regulators must make every effort to comply and must justify/explain to ESMA if they do not intend to comply.
7 PERG 16, Question 2.30.
8 We note that a number of UK REITs have characterised themselves as AIFs. Some other REITs and property-owning companies do not, however, appear to have characterised themselves as such.
Sidley Investment Funds Practice
Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship.
Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, 212.839.5300; One South Dearborn, Chicago, IL 60603, 312.853.7000; and 1501 K Street, N.W., Washington, D.C. 20005, 202.736.8000.