The European Securities and Markets Authority (ESMA) has published its Final Report (Advice), containing advice to the European Commission on possible implementing measures of the Alternative Investment Fund Managers Directive. Based on this Advice, the Commission will draft Level 2 implementing measures. Firms can now form a reasonably clear view of the obligations they will face from July 2013, when the Directive and Level 2 implementing measures will come into force.

Furthermore, on 23 January 2012, the UK Financial Services Authority published a discussion paper on the implementation of the AIFMD. It is the first step in the UK implementation of the AIFMD and sets out the FSA’s provisional thinking around the implementation, aiming to develop regulatory policy and assist stakeholders towards AIFMD-readiness. This note provides a brief summary of some important aspects of the Advice and highlights some key changes compared to ESMA’s previous consultations.

Overview
• Industry input and robust negotiation eventually produced a final Directive which created the expectation that many current structures would be able to continue relatively intact, at least until 2018. However, ESMA’s July and August 2011 consultations undermined this assumption, especially for businesses which delegate functions cross-border or use private placement regimes.

• Many industry concerns regarding the more unworkable proposals have been addressed by ESMA’s Advice. Although the Advice contains few major changes compared to the consultations, there are certain significant differences.

• Importantly, the Advice replaces the term “equivalence” with “to the same effect” in the context of third country regulatory regimes. Without this (deceptively minor) change in wording, the requirements would have effectively prevented the delegation of portfolio or risk management to an entity, or the appointment of a depositary, in a jurisdiction lacking a regulatory regime “equivalent” to that of the EU.

• While generally helpful that the UCITS and MiFID rules and reviews have been taken into account by ESMA, the quantity of regulatory initiatives underway may result in over-complicated and potentially conflicting frameworks, which will be difficult and costly to comply with.

Own funds and indemnity insurance
The Directive requires alternative investment fund managers (AIFM) to maintain additional own funds or professional indemnity insurance to cover professional negligence risks. Helpfully, ESMA no longer proposes that the insurance policy contains no exclusions. Instead, it lists specific risks which must be covered. The Advice now allows AIFM to use a combination of additional own funds and professional indemnity insurance to cover risks. A further improvement means the requirement now only includes the AIFM’s directors, officers or staff and third parties for which the AIFM has vicarious liability. It no longer applies to the much wider “relevant persons”. ESMA now recognises that fraud generally is not an insurable risk. The AIFM is only responsible for losses linked to fraud where these arise from failure by senior management to put in place procedures to prevent dishonest, fraudulent or malicious acts within the AIFM. ESMA consulted on two different options to calculate additional own funds. It has selected the first option (additional own funds equal to 0.01% of the AIFM’s assets under management), which should prove less costly and simpler to calculate than the alternative option (a calculation linked to the income of an AIFM, viewed by many as illogical).

Delegation
The Directive allows AIFM to delegate functions, including portfolio and risk management, to third parties subject to a number of restrictions and requirements. There is a change to the requirement that the AIFM justify its entire delegation structure with “objective reasons”. The Advice now combines the two options previously consulted on. Thus, the AIFM must demonstrate that “the delegation is done for the purpose of a more efficient conduct of the AIFM’s management of the AIF”. Objective reasons include optimising of business functions and processes; cost saving; expertise of the delegate in administration/specific markets/investments; and access of the delegate to global trading capabilities.

Further changes relate to the requirement that the AIFM must ensure that a delegate has sufficient resources, experience and is of sufficiently good repute. In determining good repute, criminal offences must be considered by the AIFM but they are no longer necessarily a decisive factor. The AIFM may presume good repute if the delegate is regulated in the EU.

Where portfolio or risk management functions are delegated to a non-EU entity, the delegate should be authorised or registered for the purpose of asset management (otherwise prior approval from the AIFM’s competent authority is required). There must be a co-operation arrangement between the competent authorities of the AIFM and the delegate’s third country supervisory authority.

There is no longer a need for third country regulatory requirements applying to the delegate to be “equivalent” to those in the EU. Supervisory cooperation arrangements no longer need to entitle EU competent authorities a “right” to carry out on-site inspections on the delegate but must still “allow” them to do so.

An AIFM must not delegate its functions to the extent it becomes a “letter box entity”. The Advice states that an AIFM would become a “letter-box” entity if it: (i) no longer retains the necessary expertise and resources to supervise the delegated tasks effectively and manage the risk associated with the delegation; or (ii) no longer has the power to take decisions in key areas which fall under the responsibility of the senior management or no longer has the power to perform senior management functions in particular in relation to implementation of the general investment policy and investment strategies.

Valuation
The Directive requires AIFM to have procedures for proper and independent valuation of each of their AIF’s assets. The net asset value (“NAV”) of the AIF’s assets per share or unit must be calculated and disclosed to investors. Valuation may be performed by the AIFM or an external valuer. AIFM that carry out valuations must ensure independence between the valuation and portfolio management functions.

Despite concerns raised during the consultation, ESMA’s stance remains that a third party entity (such as an administrator) which carries out the calculation of the NAV of an AIF is not considered to be an “external valuer”, if it does not provide valuations for individual assets but instead incorporates values which are obtained from the AIFM, pricing sources or the external valuer(s) into the calculation process. This unfortunately means the Directive’s investor protection requirements relating to independent valuers do not apply equally to such administrators or other entities in these circumstances.

Depositaries
The Directive requires AIFM to ensure a single depositary is appointed for each AIF managed. It lists the functions depositaries must perform, including but not limited to cash flow monitoring; safekeeping of assets of the AIF or the AIFM acting for the AIF; and oversight duties relating to subscriptions, redemptions and valuation, due diligence and segregation. Fortunately, the Advice does not maintain previous proposals that the depositary mirror all AIF cash flows on a real time basis. Instead, to ensure the AIF’scash flows are properly monitored, the depositary should at least carry out specified oversight, review and monitoring tasks.

The depositary liability regime is one of the most controversial issues which ESMA has had to deal with. The depositary is only liable for losses other than losses of financial instruments held in custody if these result from its negligent or intentional failure to perform its obligations.

However, where financial instruments held in custody are lost, the depositary is obliged to return identical financial instruments or the corresponding amount to the fund (or the AIFM on its behalf) without undue delay. This liability is subject to an exception where the depositary can prove that the loss resulted from an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary.

The definition of “external event” is key. The Advice proposes that an act or omission of a sub-custodian, including an unaffiliated sub-custodian, to meet its obligations, would not be regarded as an external event. Thus, if loss was due to accounting error or operational failure at the level of the sub-custodian, that would be considered an “internal” event triggering the depositary’s obligation to return a financial instrument of an identical type or a corresponding amount. Similarly, the depositary would be held liable for a sub-custodian’s fraud. A depositary may therefore be liable for events at sub-custodian level over which it may not have control. Depositaries may find such quasi-strict liability unpalatable, at least in relation to some jurisdictions or investments. There is no longer a need for third country regulatory requirements applying to the depositary to be “equivalent” to those in the EU.

Leverage
The Directive makes AIFM responsible for setting leverage limits for each AIF under management. They must at all times be able to demonstrate that these limits are reasonable and complied with. Competent authorities of the AIFM’s home Member State may impose their own limits where they feel that the stability and integrity of the financial system may be threatened by the AIFM’s activities. ESMA, too, may determine that an AIFM’s leverage is too high, and may advise competent authorities what remedial action should be taken to combat risks.

The Advice states that an AIF’s leverage should be expressed as a ratio of exposure between the AIF’s exposure and its NAV. It requires AIFM to calculate exposure in accordance with the “gross method” and the “commitment method”. In addition, an AIFM may, upon notifying its home Member State competent authorities, calculate leverage according to the “advanced method”.

ESMA acknowledges feedback received during the consultation that the gross method would not reflect exact leverage and potentially mislead investors but decided not to change approach. ESMA believes that information on the gross level of leverage to be of “the utmost importance” and, as to why competent authorities need two mandatory measures of leverage, that the further information based on the commitment or advanced method would give a fuller picture. While the gross method may be misleading as to the actual level of risk a fund is exposed to, it appears easier to calculate than the commitment method, which requires judgement as regards hedging and netting arrangements.

ESMA has considered the CESR Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS, allowing AIFMs which also manage UCITS to reduce their administrative burden.

The Directive requires competent authorities to “impose limits on the level of leverage that AIFM are entitled to employ” to “limit the extent to which the use of leverage contributes to the build-up of systemic risk in thefinancial system or risks of financial disorder”. Such powers have potential to impose losses on funds and investors so the specific circumstances in which they may be exercised are key. However, notwithstanding concerns raised during the consultation, those contained in the Advice are still too broad. For example, the proposals enable competent authorities to limit leverage where the AIF’s exposures could constitute an important source of market, liquidity or counterparty risk to a financial institution (meaning any financial institution) without linking this power of intervention to “systemic risk in the financial system and risks of financial disorder”. Furthermore, competent authorities could impose restrictions where an AIFM’s use of leverage “may contribute or contributes to the downward spiral in the prices of financial instruments or other assets, in a manner which threatens the viability of such financial instruments or assets”. “Viability” seems too vague a concept on which to base this power. Limiting leverage because it could be the cause of a downward price spiral in a single instrument again fails to link the power of intervention to “systemic risk in the financial system and risks of financial disorder”.

Reporting to competent authorities
The Directive requires an AIFM to regularly report to its home Member State competent authorities on the principal markets and instruments in which it trades for the AIF it manages. It must provide specified information (including regarding liquidity, risk, asset types and stress testing results) relating to each AIF it manages or markets in the EU and also, on request, an annual report of each AIF it manages or markets in the EU and a list of all the AIF it manages. AIFM managing AIF employing substantial leverage will also need to provide related information. Additional reporting requirements may be imposed by ESMA in exceptional circumstances.

The Advice sets out a tiered reporting regime depending on the size of the AIFM’s AUM. The required content is the same for all AIFMs but the tiers govern the frequency of reporting. Annex V to the Advice contains a pro-forma for reporting to competent authorities.

EU and non-EU co-operation
The Directive requires there to be co-operation arrangements between Member States and relevant third countries in certain cases.

In the Advice ESMA proposes requirements the supervisory co-operation arrangements between EU competent authorities and third country supervisory authorities should meet. ESMA fails to differentiate between situations where the passport is used and where the national private placement regime is used. Nor does ESMA make a distinction between the information to be provided for the purposes of systemic risk oversight versus that for supervision and enforcement purposes, being of the view that systemic risk is sufficiently important to justify the exchange of the same level of information in both cases. Furthermore, ESMA did not consider it appropriate to limit the information sharing to ad-hoc requests only, on the basis that systemic risks could arise quickly and could be monitored more effectively if information was provided on a more regular basis.However, the Advice contains various helpful changes to previous proposals, including a closer reflection of the text of the IOSCO memorandum of understanding. It no longer requires EU competent authorities to have the “right” to obtain all information necessary from third countries, or to request on-site inspections in third countries. (Such requirements appeared not to respect legitimate issues of national sovereignty, meaning jurisdictions potentially declining to enter into co-operation agreements and access to investors being blocked.) However, the arrangements must still provide for the “ability” to obtain all information necessary and to carry out on-site inspections, with the option of these inspections being performed by the third country competent authority.

ESMA reiterates its preference for a centralised memorandum of understanding covering all EU competent authorities. ESMA’s aim is to finalise such a memorandum ahead of the July 2013 deadline. It will be challenging for ESMA and EU competent authorities to ensure the necessary cooperation arrangements are in place with all relevant third country authorities prior to the implementation deadline. Subject to this important caveat, the proposals appear workable.

Next steps
Level 2 implementing measures should be adopted in July 2012. They may take the form of regulations and/or directives. Directives must be transposed by Member States into national laws while regulations are directly applicable in each Member State. Member States will be required to transpose the Directive and implementing directives by July 2013, when implementing regulations would also come into force.