Vol. 20, No. 5 • May 2013
Alternative Investment Fund Managers
Directive—The Registered Investment Adviser’s
Implementation Checklist
By Sean Donovan-Smith, Stuart E. Fross
and Michael Rohr
T
he Alternative Investment Fund Managers Directive (the Directive or AIFMD)1 is
now fast approaching its July 22, 2013 transposition date; the date for enactment
across the European Union (EU) in each of its member states. Much of the work at
the EU level that needed to be done to implement the Directive has indeed been done.
The focus now begins to turn to the member state transposition efforts, which are rapidly being introduced. Indeed, individual member states are busily at work on legislation to transpose the Directive into
local law. Member state regulators are likewise at work on their rule books. We are now in implementation
mode. AIFMD is here and now is time to take stock of key checklist items for US investment advisers.
By way of background, the member states
will be guided in their transposition efforts by
Mr. Donovan-Smith is a Partner in the London
office of K&L Gates LLP. Mr. Fross is a Partner,
and Mr. Rohr is an Associate, in the Boston office
of K&L Gates LLP. This publication is for informational purposes and does not contain or convey
legal advice. The information herein should not be
used or relied on in regard to any particular facts or
circumstances without consulting a lawyer.
the Directive itself and a series of milestones
at the pan-European level that have already
been achieved. The Directive itself came into
force on July 21, 2011, setting in motion
calls for consultations that would lead to
regulations to be adopted by the European
Commission. After an elaborate consultation process led by the European Securities
Markets Authority (ESMA) involving four
consultation papers, the European Commission
adopted regulations on exemptions, general
I. Defining AIFs with the Aid of
the Draft Key Concepts
operating conditions, depositaries, leverage,
transparency, and supervision (the Level 2
Regulations).2 The Level 2 Regulations were
finalized on December 19, 2012. These Level 2
Regulations are essentially a pan-European
rule book for alternative investment fund managers (AIFMs). The rule book, as comprehensive as it is, left to ESMA additional work to
flesh out the overall body of work on AIFMD.
While AIFMD’s Annex II sets out some
20 principles on remuneration, it was left
to ESMA to provide detailed remuneration
guidelines by operation of Article 13(2) of the
Directive. Accordingly, on February, 11, 2013,
ESMA issued a final report on “Guidelines
on Sound Remuneration Policies under the
AIFMD” (the Remuneration Guidelines).3
These 170 guidelines will, in effect, be the
remuneration policy handbook for all authorized AIFMs, shaping and defining their future
remuneration policies for the foreseeable
future.
ESMA has also published consultation
papers on final Guidelines on Key Concepts
(the Key Concepts)4 and Regulatory Technical
Standards (RTS). These Key Concepts and
RTS can be expected to be adopted much
as proposed, and therefore give us a clear
picture of which funds are AIFs and which
are not.
Thus, we have at hand, the Directive itself,
a pan-European rule book for AIFMs in the
form of the Level 2 Regulations, Remuneration
Guidelines, and definitions of funds to be
covered in the Key Concepts. But for Level 2
Regulations on defining the “member state
of reference” to be adopted by the European
Commission and anticipated guidance from
ESMA on the length and nature of transition
periods, it would appear that AIFMD’s main
features and significant details are now largely
known.
What began as an initial proposal published
in April 2009 as a commitment to register,
require disclosure, oversee and require risk
management for hedge fund managers is now
(almost) in full form, and (almost) ready for
implementation across Europe. It is time for
US registered investment advisers to build
a checklist to assess if the Directive will
apply to them, and if so, how to adapt to its
implementation.
THE INVESTMENT LAWYER
The first task of each US registered investment adviser is to find its existing or proposed
AIF clients in its current product launch
pipeline. AIFMD applies to either the management of AIFs in Europe or the marketing
of AIFs to investors in Europe.5 An “AIF” is
defined in Article 4(1)(a) of the Directive as
“collective investment undertakings, including
compartments thereof, which: (i) 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;
and (ii) do not require authorization under
[the Undertakings for Collective Investment
in Transferable Securities (UCITS) Directive].”
The Key Concepts consultation paper furthers our understanding of the meaning of
the italicized terms. While each of these key
concepts merits close parsing beyond the
scope of this article, some key checklist items
emerge.
ESMA indentified, as categories of EU
domiciled AIFs, over 18,000 funds that fall
into the definition of EU domiciled AIFs.6
Prima facie AIFs include Special/Institutional
Funds, German “Spezialfonds,” British
investment trusts, French employee savings
funds, Luxembourg “other” (or Part II) funds,
real-estate funds, and other offshore (for
example, Cayman) funds. Of course, it
would behoove US investment advisers to
survey their clients to look for these client
categories as prima facie AIFs. Indeed, all
non-UCITS funds marketed in Europe or
managed from Europe, regardless of domicile of the fund or the fund manager, are
prima facie AIFs.
The determination that London listed
closed-end “investment trusts” are AIFs
shows that, along the way, the rulemaking process has swept up many fund types
that were not on the original agenda. Small
wonder, then, that it appears that US registered investment companies (RICs) managed from Europe are also swept up in
the AIFMD net, although no one could
mistake them for hedge funds. Still, they
too are “in” for checklist purposes, and
US RICs managed from Europe will call
2
II. National Private Placements
out for special attention by their managers
and home country regulators as the poster
child for inadvertent over-reach. So too, US
RICs managed from the US but marketed
in Europe are also AIFs. While widespread
marketing of US RICs into Europe may be
a distant memory for most fund organizations, it was once not uncommon, leaving many US firms with a legacy list of
European investors to contend with in the
context of the AIFMD. Thus, the checklist
should include consideration of policies to
address these legacy investors.
Turning to the Key Concepts themselves,
the definition of AIF is broad enough to
sweep up single investor “funds-of-one,”
particularly German Spezialfonds. The Key
Concepts release makes plain that the concept
of collective investment extends to a fund that
collects investments from only one investor
(unless the fund’s organizational documents
preclude it from ever having more than one
investor in it).7
Also for those US registered investment
advisers seeking to discern if their activities
in Europe are “marketing,” or something
less, the definition of “capital raising” may
be of interest. Capital raising consists of
“taking direct or indirect steps to procure
the transfer of commitment of capital by
one or more investors for the purpose of
generating a pooled investment return.” 8
Also within the scope of capital raising is a
“commercial communication” between the
AIFM and prospective investors.9 One can
imagine that the application of these Key
Concepts will be critical to completion of
the first of the checklist steps: indentifying
AIFs already under management, or in the
pipeline.
For the foreseeable future, non-EU domiciled AIFMs may not manage an AIFM
marketed in Europe to professional investors
utilizing an AIFMD passport, and may only
do so by means of national private placements
or as the delegate to an EU AIFMD. Therefore
the next checklist item is determining the viability of an ongoing private placement in Europe.
The Directive permits the continued operation of the national private placement regimes
in each Member State of the EU for nonEU AIFs until such time as the European
Commission, on the advice of ESMA, has
proposed legislation to remove them.
Furthermore, on the advice of ESMA, the
earliest that this will take place is 2018 and a
pilot program may be introduced in 2015 to
permit an EU “passport” for non-EU AIFs
that would operate alongside the national private placement regimes.10
However, it is open to each EU Member
State whether it wishes to continue with the
national private placement status quo. As
such, some Members States are considering amending their national private placement regimes. For example, Germany is
amending its regime to only permit full
Directive-compliant offerings for marketing in Germany, and the Netherlands are
considering a similar position to be effective
from July 2014. Given the antipathy to private placements in much of Europe before
AIFMD, the elimination of Germany and
the Netherlands as markets for privately
placed funds has to be seen as a signal of
likely adverse future developments for privately placed AIFs in Europe.
AIFMs will be required to register all nonEU AIFs in each of the EU Member States in
which they are marketed and, if the AIFM’s
portfolio of such AIFs is above the relevant
thresholds (EUR 100 million in assets under
management (AUM) for open-ended funds;
EUR 500 million in AUM for five-year fixed
term, closed-ended funds), they must also
comply with the Directive’s transparency provisions set out in Chapter IV of the Directive
(minimum disclosure, annual reports to investors and periodic regulatory reporting).
The UK Treasury is proposing to retain
its existing private placement regime and to
Practice Note: US registered investment advisers must categorize their
fund clients to find each AIF, including potentially US registered investment companies, and determine
how EU investors have come into
the fund. Ongoing patterns or plans
for commercial communications for
each fund should be considered to
confirm whether or not the fund is
an AIF.
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Vol. 20, No. 5 • May 2013
States will be adverse to continuing
the national private placement regimes
prior to their likely termination as early
as 2018.
only introduce the minimum requirements of
the Directive for the marketing in the UK of
non-EU AIFs. As such, a non-EU AIFM that
is not able to rely upon an Article 3 exemption from the Directive that wishes to market
non-EU AIFs in the UK must ensure that it
has complied with Chapter IV of the Directive
and that is has applied for and obtained
approval from the UK regulator11 prior to
marketing. Smaller AIFMs that are relying
upon an Article 3 exemption simply need to
register with the UK regulator.
The Directive only applies to a non-EU
AIFM to the extent that the non-EU AIFM
manages EU AIFs and/or markets EU or
non-EU AIFs to investors in the EU.12 For
US managers and other non-EU AIFMs,
this means that AIFMD does not apply with
respect to AIFs that are sold in the EU only
via true reverse solicitations.13 The Directive
does, however, apply with respect to AIFs
marketed directly or indirectly.14 As such,
assuming a conservative view that what qualifies as a true “reverse solicitation” is an escaping concept that creates regulatory uncertainty
(at best) or does not truly exist (at worst), after
transposition of the AIFMD by EU Member
States in July 2013, US managers’ involvement
with EU AIFs will be limited to either managing EU AIFs or non-EU AIFs marketed in
the EU as a delegate/sub-adviser (addressed in
Section IV) or marketing AIFs in accordance
with national private placement rules subject
to the “transparency” requirements addressed
in the next section.15
III. Transparency
(Articles 22-24 of AIFMD)
Assuming that national private placements
may be pursued by US managers until at least
2018, US managers may market non-EU AIFs
(assuming that the AIFM’s portfolio of such
AIFs is above the prescribed thresholds of
AUM €100 million for open-ended funds and
AUM €EUR 500 million for five-year fixed
term, closed-ended funds) in the EU after
July 22, 2013 only if the following conditions
are met:
(1) With respect to each AIF marketed in the
EU, the US manager must comply with
the AIFMD’s “transparency” requirements,
which include: annual regulatory reporting
(Article 22 of AIFMD); disclosure to
investors—both before such investors invest
in an AIF and on a periodic basis (Article 23
of AIFMD); and reporting obligations to
regulators (Article 24).16
(2) Cooperation agreements must be in place
between authorities of each Member
State where the AIF is marketed and
the authorities of the third country
where the AIFM is established (the US
Securities and Exchange Commission
(SEC) for US investment advisers and/
or the Commodities Futures Trading
Commission (CFTC) with respect to
commodity pool operators and trading
advisers).
Practice Note: For the time being,
national private placements seem
unavoidable if US registered investment advisers seek to continue asset
raising in those remaining places in
Europe that will accept private placements until this business model comes
to an end. Therefore, the next checklist
item is to take on board and prepare for
the AIFMD registration requirements
by adjusting existing private placement
materials and documents. We do, however, anticipate some jurisdictions will
have a relaxed interpretation of what
constitutes “marketing” (directly or
indirectly), and thus, not all Member
THE INVESTMENT LAWYER
Practice Note: In a welcome breath of
fresh air, Norman Champ, the SEC’s
Director of the Division of Investment Management (Division), in an
address to the Investment Company
Institute (ICI) on March 18, 2013,
assured ICI members that the Division and the SEC’s Office of International Affairs were both committed
to implementing cooperation agreements in collaboration with ESMA
on a timely basis.
4
private placement rules during the AIFMD’s
transition period (other than with respect to
AIFMs managing a small portfolio of AIFs
below the AIFMD’s AUM thresholds).
(3) Cooperation agreements must be in place
between authorities of each Member
State where the AIF is marketed and the
authorities of the third country where the
non-EU AIF is established (for example,
the Cayman Islands for a Cayman fund
marketed into the EU by a US manager).17
A. Annual Reports—Article 22 of AIFMD
Article 22(1) of AIFMD requires an AIFM,
for each AIF marketed in the EU, to provide
an annual report within six months of the
end of the AIF’s fiscal year to the AIFM’s
“home member state” and, where applicable,
the AIF’s “home member state.” The annual
report must also be made available to investors
upon request. For non-EU AIFMs, references
to “home member state” should be interpreted
to mean “member state of reference” (MSR).20
For non-EU AIFMs, the mechanism for determining MSR (and, thus, the “home member
state” for purposes of the transparency requirements) will differ depending on whether the
AIFM is marketing one versus multiple nonEU AIFs into one versus multiple Member
States. If the US manager is marketing several
non-EU AIFs in the EU, the MSR will turn on
where the US manager intends to develop effective marketing for most of the AIFs.21
Practice Note: The Level 2 Regulations call into question whether
the Member State(s) where an
AIF is marketed is required to
enter into a cooperation agreement with both the authorities of
the third country where the AIFM
is established and the authorities of the third country where
the non-EU AIF is established
(for example, for non-US AIFs
managed by US-based AIFMs),
or whether the relevant Member State(s) must only enter into
a cooperation agreement with
either the third country where the
AIFM is established or the third
country where the non-EU AIF
is established.18 Such ambiguity
will likely be resolved when the
European Commission delivers
the entire package of AIFMD
implementing legislation, which
is expected prior to the end of the
transposition period (July 2013).19
Practice Note: Member state of reference is relevant, as any required
reporting to an AIFM’s “home” Member State requires non-EU AIFM
to report to MSR. However, it is not
clear how MSR is to be determined.
Article 37 of AIFMD provides the
mechanism for determining MSR;
however, it technically only applies
to non-EU AIFM to the extent the
AIFM manages EU AIF or markets non-EU AIFs with a passport.
Presumably, Article 110(7) of the Level 2
Regulations intends that the Article 37
mechanism for determining MSR also
apply with respect to non-EU AIFM
marketing AIFs in the EU via national
private placements. Further note that
the Level 2 Regulations do not incorporate ESMA’s technical advice for
determining MSR in case of a conflict.
In addition, there is an argument that is
being debated in the EU as to whether
the MSR mechanism works given that
(4) If the US manager manages an AIF that
acquires majority control of a non-listed
company, the AIFM must comply with the
provisions of Article 26 of the AIFMD
(relating to AIFMs managing AIFs that
acquire majority control of non-listed
companies and issuers) and Article 30 of
AIFMD (relating to asset-stripping).
The sections that follow will address
the transparency requirements of AIFMD
Articles 22-24, as supplemented by the Level 2
Regulations, in further detail. The AIFMD’s
transparency provisions apply both to AIFMs
authorized to market AIFs in the EU under
the AIFMD’s “passporting” provisions and,
pursuant to Article 42 of AIFMD, to managers continuing to market AIFs under national
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Vol. 20, No. 5 • May 2013
explained in sufficient detail to permit an investor to understand the AIF’s risk profile and
measures in place to manage conflicts of interest. In addition, an allocation or breakdown
with respect to each AIF must be provided and
the disclosure must specify the proportion of
total AIFM staff remuneration attributable to
the AIF; however, remuneration disclosures do
not touch on any one person’s compensation.
Article 37 will not be implemented
until July 2015. We understand at the
moment that funds will have to submit
copies of the annual report as well as
periodic reporting to each EU Member State in which they are marketed.
Pursuant to Article 22(2) of AIFMD, the
annual report must include: (1) core financial
statements (balance statement, statement of
assets and liabilities, income/expenditures);
(2) a report on activities for the fiscal year;
(3) any material changes in information during
the fiscal year covered by the report; (4) remuneration disclosures (including splits between
variable and fixed compensation broken down
by staff members that impact the material
risk profile); and (5) auditing and accounting
information.
Article 103 of the Level 2 Regulations
provides the minimum requirements for the
core financial statements included in the
annual report to comply with Article 22(2)
of AIFMD. Non-EU AIFMs managing
non-EU AIFs will be relieved that the
accounting standards applicable to the
financial and accounting information
are determined based on where the AIF is
established.22 Further, Annex IV of the Level 2
Regulations provides detailed reporting templates for both AIFMs and AIFs. Pursuant to
Article 105(4) of the Level 2 Regulations, the
report on activities for the fiscal year should
accompany the financial statements as the
directors’ or portfolio managers’ report (to
the extent such a report typically accompanies
an AIF’s financial statements), and should
include discussions of the AIF’s investment
activities, portfolio, performance and material
changes (among other things). A change is
material, and thus must be disclosed, if there
is a substantial likelihood that a reasonable
investor would reconsider its investment in the
AIF based on the change, expressly including changes regarding the investor’s rights in
relation to the investment or changes prejudicing the interests of one or more of the AIF’s
investors.23 In accordance with Article 107
of the Level 2 Regulations, remuneration
disclosures included in the annual report
must be fairly detailed at the firm level, and
the AIFM’s remuneration policies must be
THE INVESTMENT LAWYER
Practice Note: “Material” changes
required to be reported in the annual
report include changes other than
to the items required to be reported
under the AIF’s accounting rules. Any
changes to information required to be
reported to investors under Article 23
of AIFMD must also be disclosed in
the annual report.
B. Prospectus and Periodic Disclosure
to Investors (Article 23 of AIFMD)
In accordance with Article 23(1) of
AIFMD, AIFMs must disclose certain information to prospective AIF investors before
they invest and AIF investors in the event
of any material changes to the information.
Prospectus disclosure includes information
relating to: the AIF’s investment strategy,
objectives, risks, and investment restrictions;
the use of leverage (including permitted types
and sources of leverage and the maximum
leverage); the identity of the AIF’s depository, auditors and other service providers; a
description of how the AIFM complies with
AIFMD’s additional own funds/indemnity
insurance requirements; a description of all
management functions delegated to a third
party (for example, sub-advisory relationships); a description of the AIF’s valuation
procedures and latest net asset value (NAV),
calculated in accordance with Article 19 of
AIFMD; the AIF’s latest annual report; all
fees and charges; a description of all circumstances under which investors receive
preferential treatment (for example, side letters); purchase and redemption procedures;
and performance (among other disclosures).
Material changes with respect to any item
disclosed in the prospectus must also be
disclosed to investors, with the materiality
6
standard being identical to that for annual
reporting disclosures discussed in the previous section. The Level 2 Regulations contain
extensive details regarding the items required
to be disclosed, and a reporting template is
included in Annex IV.
change to an AIF’s liquidity management systems and procedures, and must immediately
notify investors in the event that redemption
gates or arrangements for illiquid assets (that is,
side-pockets) are activated or redemptions are
suspended.
Practice Note: The AIFMD’s additional own funds/indemnity insurance
requirements, valuation requirements,
and NAV calculation requirements
are not, under their own terms, applicable to non-EU AIFMs managing
non-EU AIFs or marketing AIFs in
the EU without a passport. It is not
clear whether the investor prospectus disclosure obligations incorporate
those underlying requirements by reference (requiring a US manager to
comply with the respective substantive
requirements) or whether a US manager is simply required to disclose that
the manager is not required to comply with AIFMD’s requirements with
respect to these provisions.
Practice Note: Leverage must be disclosed using the “gross” and “commitment” methods, each of which is
described in detail in AIFMD and the
Level 2 Regulations. The gross method
gives the overall exposure of the AIF
exclusive of any netting or hedging
arrangements, whereas the commitment method reflects certain netting
and hedging arrangements. The Level 2
Regulations do not permit calculating
leverage using the “advanced” method,
which was permitted in ESMA’s draft
technical advice.
US managers considering utilizing
EU-specific or Member State-specific
disclosure supplements or “wrappers”
for fund offering documents (in order
to comply with the AIFMD’s investor
disclosure and reporting obligations)
must be mindful that much of the
information required to be reported
under AIFMD would likely be considered “material” by non-EU investors
as well. Though private funds are not
subject to the fair disclosure requirements that Regulation FD imposes on
registered funds (and other companies
that publicly offer securities), US managers should consider the selective disclosure implications of delivering such
information to certain investors, but
not other investors (such as US-based
investors).
In addition to disclosing the foregoing
information to investors prior to their investment and in the event of a material change to
such information, AIFMs are also required
to periodically disclose to investors: the percentage of an AIF’s assets subject to “special arrangements arising from their illiquid
nature” (such as side-pockets, redemption
gates, etc.); any new arrangements for managing the AIF’s liquidity; the AIF’s current
risk profile and risk management systems
employed by the AIFM to manage those risks;
and any changes to an AIF’s maximum leverage or right to re-use collateral.
For funds that are required (per their organizational documents or local country rules)
to make periodic investor reports, Article 108
of the Level 2 Regulations provides that
the information required to be periodically
reported to investors must be disclosed at the
time of such reports. In any event, such disclosures must be made at the same time the fund’s
prospectus or offering document is delivered
and at the time of the fund’s annual report
required by Article 22 of AIFMD. In addition,
AIFMs must notify investors upon any material
C. Reporting to Regulators
(Article 24 of AIFMD)
Article 24 of AIFMD requires “regular”
reporting by an AIFM to its home Member
State regulator with respect to each EU AIF
it manages and each EU or non-EU AIF it
markets in the EU. As previously discussed,
for non-EU AIFMs managing EU AIFs or
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Vol. 20, No. 5 • May 2013
the AIFM at quarter-end. AIFMs managing
AIFs that employ leverage on a substantial
basis—defined in the Level 2 Regulations to
mean leverage that exceeds three times NAV,
calculated in accordance with the commitment
method—must also make information available about the overall level of leverage and
a break-down between leverage arising from
borrowing cash/securities and leverage embedded in derivatives (including identifying the
source and amounts of the five largest sources
of borrowed cash/securities).
marketing AIFs in the EU, the “home member
state” means the AIFM’s MSR. As a result,
Article 24 reporting should only be required
for one Member State regardless of the number of Member States in which the AIFM
markets AIFs.
Practice Note: As previously discussed, it is not clear whether the MSR
mechanism works currently given
that Article 37 of AIFMD will not be
implemented until July 2015. Our view
at the current moment is that AIFs will
have to submit copies of the annual
report as well as periodic reporting to
regulators of each EU Member State
in which they are marketed.
Practice Note: In addition to required
leverage reporting to the MSR’s regulator, Member States are permitted
to impose substantive leverage limits
“or other restrictions on the management of the AIF … where they deem
this necessary in order to ensure the
stability and integrity of the financial
system.”24
AIFM regular reporting includes: holdings data (information on the main instruments in which it is trading, markets of
which it is a member or actively trades, AIF
portfolio diversification, and principal exposures and concentrations of each managed
AIF); and additional data for each AIF marketed in the EU, including the percentage of
assets subject to special arrangements arising from their illiquid nature, new arrangements for managing liquidity, the current
risk profile, information on the main categories of assets held, and the results of stress
tests conducted in accordance with Articles
15 and 16 of AIFMD.
Regulators may require additional information where necessary for effective monitoring.25
Substantively, however, the information
required to be reported to the AIFM’s MSR
is not more intrusive than the information
required to be reported periodically to investors pursuant to Article 23, and AIFMs are
instructed to use the same reporting template included in Annex IV of the Level 2
Regulations.26 Reporting frequency will
depend on the AIFM’s AUM according to the
following schedule, with the report due to
the regulator not later than one month after
the end of the deadlines set forth below.27
Practice Note: As with valuation and
additional own funds/professional
indemnity insurance, the AIFMD
is not clear regarding whether nonEU AIFMs are required to conduct
the stress tests required pursuant to
Articles 15 and 16. Technically speaking, non-EU AIFM are not subject to
Articles 15 or 16 of AIFMD; however,
compliance with the Article 24 reporting requirements may require non-EU
AIFMs to conduct these stress tests.
Semi-Annually: AIFMs managing
AIFs with combined AUM greater
than €100 million (leveraged)/€500
million (unleveraged) but less than
€1 billion.
Quarterly: AIFMs managing AIFs
with combined AUM greater than
€1 billion; AIFMs managing individual AIFs with an AUM exceeding
€500 million (leveraged).
Additionally, an AIFM must, upon request,
provide regulators in its MSR with a copy of
the annual reports filed under Article 22 for
each AIF marketed in the EU, in addition
to a detailed list of all AIFs managed by
THE INVESTMENT LAWYER
Annually: AIFMs managing unleveraged AIFs that invest in non-listed
8
must be able to demonstrate that: (i) the
delegate is qualified and capable of undertaking the delegated activities, (ii) the delegate was selected with all due care; and
(iii) the AIFM is in a position to effectively
monitor the delegate.29
(3) With respect to portfolio management or
risk management activities, the delegation must only be made to firms that are
registered or licensed to carry out such
activities and are subject to appropriate
regulatory supervision (although this condition may be waived with the consent of
the EU AIFM’s regulator).
(4) Where the proposed delegation of portfolio management or risk management is
to a non-EU based firm, an appropriate
cooperation agreement must be in place
between the delegate’s home state and the
EU AIFM’s home state.
(5) The delegation must not prevent the
effectiveness of supervision by the AIFM
and, in particular, must not prevent the
AIFM from acting, or the AIF from
being managed, in the best interests of its
investors.
companies and issuers in order to
acquire control (that is, unleveraged
private equity funds).
Practice Note: Where an AIF is a
fund-of-funds, the AIFM has an additional 15 days to submit its required
reports. In addition, the MSR is
permitted to require more frequent
reporting as it deems it appropriate
and necessary.
IV. Delegation (Article 20 of AIFMD)
A. Scope and General Requirements
The Directive expressly permits EU
AIFMs to delegate some of their functions
in order to more efficiently conduct its business provided that such delegation is for an
objective reason and that the AIFM remains
responsible to the performance of the delegated activities, including for compliance
with the Directive.28
Delegation is not a right, however. In order
to take advantage of this provision, an EU
AIFM must notify its home state regulator
and comply with certain conditions set out
in Article 20(1)(a)-(f) of the Directive and
Articles 75 to 82 of the Level 2 Regulations.
Many of these requirements will also apply to
a sub-delegation.
Specifically, EU AIFM must be able to
demonstrate compliance with the following
conditions:
In addition, the delegation arrangements
must demonstrate compliance with the general principles established by Article 75 of the
Level 2 Regulations.
The Directive also prohibits delegating
portfolio management or risk management
activities to the relevant AIF’s depositary (or
its delegates) or any entity that may have a
conflict of interest with the AIFM or with the
AIF’s investors. However, if such a conflict
is present, a delegate may be able to “functionally and hierarchically separate” the relevant activities from the potentially conflicting
activities, provided that the potential conflicts
of interest are properly identified, managed,
monitored, and disclosed to the investors of
the AIF.30
Responsibility for the delegation must be
retained by the EU AIFM and accordingly
the EU AIFM remains potentially liable to
the AIF’s investors for the delegated functions. Sub-delegation is permitted subject to
compliance with Article 20(4) of the Directive
which requires that: (i) consent is obtained
in advance from the AIFM; (ii) the AIFM’s
(1) The AIFM must be able to justify its entire
delegation structure on objective reasons.
Article 76 of the Level 2 Regulations sets
out various criteria that will be considered in assessing this justification, including: cost savings; improving the efficiency
and effectiveness of business functions/
processes; accessing different expertise;
and access of the delegate to global trading
capabilities.
(2) The delegate (the US investment adviser)
must have sufficient resources to perform
the delegated tasks and the persons who
effectively conduct the business of the delegate must be of sufficiently good repute
and sufficiently experienced. The AIFM
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Vol. 20, No. 5 • May 2013
(4) The type of investment strategies.
(5) The types of tasks delegated in relation to
those retained by the AIFM.
(6) The organizational structure of the delegate (and its sub-delegates).
regulator is notified in advance; and (iii) the
conditions set out at Article 20(1) are met, as
summarized above.
B. “Letter Box Entities”
Whether an AIFM becomes a “letter box
entity” is a question of fact. Further guidance
is still expected from ESMA, but most industry participants are assuming that a retention
of supervision over a delegate and risk monitoring activities will be sufficient to ensure
that an AIFM may continue to be treated as
such. However, there is some concern as to the
extent of the expertise and resources that must
be retained by an AIFM in order to satisfactorily demonstrate this to its relevant regulator
(for example, the Financial Services Authority
in the UK).
An EU AIFM must not delegate its activities to the extent that it becomes what the
Directive refers to as a “letter box entity,” 31
meaning a shell company that does not retain
for itself meaningful substantive activities.
Article 82 of the Level 2 Regulations sets out
further the circumstances when an AIFM
will be considered to be a “letter box entity”
and as such no longer the manager of an AIF.
Specifically, to avoid becoming a “letter box
entity” an AIFM must retain the necessary
expertise and resources to effectively supervise the delegated tasks effectively and manage the associated risks that arise. The AIFM
must also retain the ability to direct delegates
and to continue to perform the senior management functions, in particular in relation to
the implementation of the general investment
policy and investment strategies of the AIF.
Where the AIFM delegates the performance of investment management functions
to an extent that exceeds by a substantial
margin the investment management functions
retained by it, it will no longer be deemed to
be the manager of the AIF. This remains an
area of active discussion between the industry
and ESMA. To determine if there has been an
excessive delegation, regulators are directed
to assess the entire delegation structure, taking into account the level of the assets under
management that have been delegated (and,
by implication, the assets under management
retained by the AIFM) as well as a number of
additional criteria, namely:
C. “Anti-Avoidance” Measures
(Article 75 of the Level 2 Regulations)
To ensure that the Directive’s requirements
cannot be avoided, Article 75 of the Level 2
Regulations includes what is effectively an
anti-avoidance provision that requires EU
AIFMs that delegate activities to ensure that
such delegation does not circumvent compliance with the Directive. Specifically, Article 75
of the Level 2 Regulations requires an AIFM
to ensure that delegation does not allow for
the circumvention of the AIFM’s responsibilities or liability and that the obligations of the
AIFM towards the AIF and its investors are
not altered as a result of the delegation.32
Accordingly, Article 75 requires subdelegates of an EU AIFM to comply with
the Directive’s restrictions on remuneration,
conflicts of interest policies, and the other
operating conditions set out in Chapter III of
the Directive.
(1) The types of assets the AIF or the AIFM
acting on behalf of the AIF is invested in,
and the importance of the assets managed
under delegation for the risk and return
profile of the AIF.
(2) The importance of the assets under delegation for the achievement of the AIF’s
investment objectives.
(3) The geographical and sectoral spread of
the AIF’s investments and the risk profile
of the AIF.
THE INVESTMENT LAWYER
D. Remuneration
AIFMs are subject to 20 principles set
out in Annex II of the Directive relating to
remuneration. Of course, delegation raises the
question of whether or not these remuneration principles apply to the AIFM and to the
delegate. The sting in the tail of the ability
of AIFMs to delegate is that by accepting a
10
$1 billion. Joint rulemaking by the SEC and
other federal agencies was proposed in April
of 2011, and remains pending. It would appear
that, as of this writing, there is no requirement applicable to US investment advisers
per se that would meet ESMA’s requirements.
Advisers with less than $1 billion in assets on
their balance sheet will be exempt in any event
from Section 956. As such, it is likely that most
US advisers acting as delegates will be subject
to contractual requirements to abide by the
Directive’s remuneration principles and the
170 Remuneration Guidelines.
Guideline 18(b) applies the Remuneration
Guidelines to any “payments made to the delegates’ identified staff as compensation for the
performance of portfolio or risk management
activities on behalf of the AIFM.” Evidently,
the notion is that compensation can be segregated between those activities on behalf
of the AIFM and those on behalf of other
clients. While this “on behalf of ” test has
some surface appeal, the application of two
compensation plans with respect to the same
group of employees will present a puzzle for
US investment advisers sensitive to avoiding
conflicts of interest. In addition, the definition
of “identified staff ” that are acting on behalf
of the AIFM is bound to give rise to another
riddle. “Identified staff ” are all senior management (including the delegate’s board of directors, including the independent directors),
risk takers, and any employee in the same
remuneration bracket as the risk takers, whose
professional activities have a material impact
on the risk profiles of the AIF. “Control
functions,” including risk management, compliance, internal audit, and similar functions
(ESMA, in its commentary, included human
resources personnel in this category) are also
subject to the Remuneration Guidelines. It is
not immediately obvious, for example, if the
control functions of a firm acting as a delegate are or are not acting “on behalf of the
AIFM.” The authors would argue that they
are not, and that only those indentified staff
working directly on the AIF managed by the
AIFM would be working “on behalf of the
AIFM.”
mandate to advise an AIF, a US registered
investment adviser will become subject to
these remuneration principles.
This outcome was not inevitable based
upon the text of the Directive itself. Instead,
it was left to ESMA to make the determination during the consultation process on
the Remuneration Guidelines whether and
how to apply Annex II remuneration principles to delegates. With that in mind, various trade associations sought to persuade
ESMA that delegates should not be subjected to the Directive’s remuneration principles. Arguments were made that within the
European Union a multiplicity of compensation guidance is under development and that
firms that act as delegates of the AIFM might
be subjected to multiple compensation regulations in their capacity as credit institutions,
for example. As to delegates located outside
the European Union, it was argued that local
rules on compensation should apply. Having
the opportunity to think about this matter,
ESMA determined to apply its Remuneration
Guidelines to delegates without regard to
overlapping remuneration rules within the
European Union or local conditions applicable to the delegate. EMSA noted that “it considered it appropriate to change its approach
[from the consultation proposals] and to insert
a specific provision according to which either
(i) the entities to which portfolio management
and risk management activities have been delegated should be subject to regulatory requirements on remuneration that are equally as
effective as those applicable under the AIFMD
Guidelines or (ii) appropriate contractual
arrangements should be put in place in order
to ensure that there is no circumvention of
the remuneration rules.”33 Thus, among the
170 Remuneration Guidelines adopted by
ESMA, Guideline 18 applies them all to US
investment advisers acting as delegates to an
AIFM, unless subject to an equally effective
US regulatory requirement.
For US registered investment advisers, as
of this writing, there is no specific regulation
in effect relating to remuneration. Section 956
of the Dodd Frank Wall Street Reform and
Consumer Protection Act mandates the adoption of rules relating to incentive based compensation for firms with assets in excess of
Practice Note: US Investment adviser
delegates will want to categorize and
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Vol. 20, No. 5 • May 2013
the firm should have the flexibility to pay
no variable compensation (that is, minimum
bonus of zero). The firm’s financial health
can affect compensation, particularly the
determination to pay variable compensation.
Firms must be sure that the overall pool of
remuneration does not adversely affect its
financial condition.
Compensation must be aligned with the
firm’s business plan (indirectly mandating
that the firm have such a plan) and the
“risk appetite” of the firm and of the AIFs
managed by the firm. Bonus accrual periods
must be at least a year, but may be longer.
Variable compensation should be linked to the
AIF’s achievement of its investment strategy.
Bonuses should be risk-adjusted, which may be
implemented after the fact. The Remuneration
Guidelines also require inclusion of what they
call “Malus” factors to penalize employee
misbehavior by allowing for loss of variable
compensation, but also include business unit
risk management failures and the firm’s subsequent financial set backs.
At least 40 percent (and up to 60 percent)
of variable compensation should be deferred
depending on the impact of the staff on the
risk profile of the AIFs being managed. The
time horizon of variable compensation plans
should link to the AIF’s investment time
horizon. Variable compensation should be
deferred, subject to vesting (no faster than on
a pro rata basis) and subject also to ex post
facto risk adjustments. The variable compensation should be subject to a deferral period
of at least three to five years, although it can
be less if the AIF’s life cycle is shorter. The
management body should have longer deferral periods. Ex post facto adjustments are to
be implemented by claw backs in the case of
fraud or misleading information. Typically, at
least 50 percent of the deferred component
should be paid in interests issued by the AIF
or of the firm, subject to a “retention policy”
(presumably a vesting schedule).
A number of the 20 compensation principles set out in Annex II of the Directive, and
their related Remuneration Guidelines are
subject to exceptions (or “disapplication”) on
the basis of a concept of “proportionality.”
The policies that may be waived are those
set out in the preceding paragraph and the
identify all “identified staff ” by carefully defining staff that provide portfolio or risk management on behalf of
the AIFM, and those staff members
that do not do so.
By way of a quick summary, the 20 remuneration principles to which the 170 Remuneration Guidelines relate will affect the process
for determining compensation arrangements,
the timing and manner of compensation paid,
and the potential to defer, cancel or claw back
compensation.
The Remuneration Guidelines specify the
process for determination of a compensation policy within an AIFM or its delegate
with the goal of moving compensation decisions away from managers of risk takers in
favor of a system of checks and balances. To
that end the Remuneration Guidelines detail
and mandate the role of the “supervisory
function” (typically a board of directors or
managing members), the establishment of a
compensation committee (subject to exceptions for smaller firms), the role of management and of shareholders of the AIFM or of
its delegates. The Remuneration Guidelines
further detail the appropriate structure, composition, role, and compensation of the compensation committee, reporting to the body
charged with the supervisory function of the
firm. While compensation policies can be
submitted to shareholders for approval, their
approval does not discharge the responsibility of the supervisory function vis-a-vis the
regulator to establish an appropriate policy.
The Remuneration Guidelines also detail
that the body charged with the supervisory
function should determine compensation
policy, but that the executive members of the
supervisory function should not be excessively dominant. Ultimately, for most firms,
compensation policy making will fall to a
compensation committee under the supervision of the board of directors.
In terms of timing and manner of compensation, the Remuneration Guidelines
require a high enough level of fixed remuneration to compensate for qualifications
and experience (particularly for members of
the risk management and compliance functions). This is coupled with a guideline that
THE INVESTMENT LAWYER
12
to be reviewed and arrangements made to
review current compensation arrangements
in light of the Remuneration Guidelines, with
an eye to determination of proportionality.
Armed with an implementation checklist,
we believe that US advisers will be able to
adapt to AIFMD before the expiration of any
transition periods.
obligation to have a compensation committee. No doubt, much time and effort will be
spent on making the case for waiver of one or
more of these principles on the basis of proportionality. The criteria relevant for determining that a particular firm need not be
subject to one of these principles is the size
of the firm, and of the AIFs that it manages,
its internal organization and the nature,
scope and complexity of its activities. The
concept of proportionality can apply with
respect to different categories of staff, taking
into account the degree to which that staff
may or may not affect the risk profile of the
firm or of the AIF.
Notes
1. See European Parliament and Council Directive (EU)
2011/61/EU of 8 June 2011 on Alternative Investment
Fund Managers and amending Directives 2003/41/EC and
2009/65/EC and Regulations (EC) No 1060/2009 and (EU)
No 105/2010.
2. See Commission Delegated Regulation (EU) No … /..
of 19.12.2012 supplementing Directive 2011/61/EU of the
European Parliament and of the Council with regard to
exemptions, general operating conditions, depositaries,
leverage, transparency, and supervision.
Practice Note: In the context of a US
investment adviser acting as a delegate
to an AIFM, consideration should be
given to the application of the proportionality principle to those persons
within the investment adviser who do
not affect the risk profile of the AIF
managed on behalf of the AIFM.
3. See ESMA Final Report on Guidelines on Sound
Remuneration Policies under the AIFMD, ESMA/2013/201
(Remuneration Guidelines).
4. See ESMA Consultation Paper on Guidelines on
Key Concepts of the AIFMD, ESMA/2012/845 (the
Guidelines on Key Concepts).
Hedging of variable components of compensation is prohibited, even by private insurance. Specific guidance is provided for pension
benefits, discretionary pensions, and severance pay (generally prohibiting golden parachute arrangements defined as pay without
performance).
5. The AIFMD’s passporting authorization mechanism
applies only with respect to AIFMs managing AIFs in
Europe or marketing AIFs in Europe to professional
investors. However, the substantive provisions of AIFMD
will also apply to AIFMs marketing AIFs to retail investors without a passport (assuming that Member States
permit such marketing and subject to Member States’
authority to impose stricter requirements on AIFM or
AIF marketed to retail investors). See AIFMD, Article 43.
V. Conclusion
6. See Guidelines on Key Concepts, Table 1.
AIFMD is fast approaching implementation. Precise timing of its effectiveness in
each Member State of the EU awaits further
ESMA guidance and national rule making.
In this environment, US investment advisers
should now identify their AIF clients and
decide if they are the AIFM or a delegate of
an AIFM. If the US adviser is the AIFM, the
US adviser needs to prepare for a new regime
for national private placements. Preparations
for registration in each member state of the
EU in which the private placement will take
place will need to be undertaken. This means
reviewing existing offering materials and preparing to make filings with local regulators.
If the US adviser is not the AIFM, but is
a delegate, contractual provisions will need
7. See Guidelines on Key Concepts, Recital (28); Annex V,
Draft Guideline 15.
8. See Guidelines on Key Concepts, Annex V, Draft
Guideline 11.
9. See id.
10. See AIFMD, Articles 67 and 68.
11. From April 2013, the relevant UK regulator will be the
Financial Conduct Authority (FCA).
12. See AIFMD, Recital (13) and (14).
13. See AIFMD, Recital (70) (“This Directive should not
affect the current situation, whereby a professional investor established in the Union may invest in AIFs on its own
initiative, irrespective of where the AIFM and/or the AIF
is established.”)
14. See AIFMD, Article 6(7).
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Vol. 20, No. 5 • May 2013
15. By way of reminder, the marketing passport will not
be available to non-EU AIFMs and non-EU AIFs until,
at the earliest, July 2015. During a three-year transition
period following July 2015, non-EU AIFMs may opt-in
to the passporting provisions (which requires full compliance with AIFMD) or may continue to operate under
local private placement rules. After this transition period
it is expected that national private placement regimes will
be terminated.
this Directive shall be read as the ‘Member State of reference’, as provided for in Chapter VII [Article 37]”); Level 2
Regulations, Article 110(7).
16. See AIFMD, Article 42(1).
22. See AIFMD, Article 22(3); Level 2 Regulations, Article
104(3).
17. In addition, the US must not be listed as a NonCooperative Country and Territory by the Financial
Action Task Force. The US is not currently, and is unlikely
to be placed, on such list.
18. The Level 2 Regulations provide, in relevant part:
“There are a number of provisions in the AIFMD that
require cooperation arrangements to be established
between European competent authorities and supervisory
authorities from the country of origin of a non-EU AIFM
or a non-EU AIF” (emphasis added) (Level 2 Regulations,
Explanatory Memorandum at 10); “To allow … non-EU
AIFMs to manage and market AIFs in the Union,
[AIFMD] requires appropriate cooperation arrangements
to be put in place with the relevant supervisory authorities
of the third country where the non-EU AIF and, as the
case may be, or the non-EU AIFM is established” (emphasis added) (Level 2 Regulations, Article 134).
21. For a more complete discussion of the mechanisms for
determining Member State of reference, please refer to the
authors’ previous article: “Authorization for US Managers
under the AIFMD,” The Investment Lawyer, Vol. 19, No. 4
(April 2011).
23. See Level 2 Regulations, Article 106(1).
24. See Level 2 Regulations, Recital (133).
25. See AIFMD, Article 24(5).
26. See Level 2 Regulations, Article 110(6).
27. See Level 2 Regulations, Article 110.
28. See AIFMD, Recital (30) and Article 20.
29. The AIFM must also be able to demonstrate that it
can, at any time, give instructions to the delegate and can
withdraw the delegation immediately when doing so is in
the interest of investors. See AIFMD, Article 20(1)(f).
30. See AIFMD, Article 20(5)(b).
31. See AIFMD, Article 20(3).
19. See Level 2 Regulations, Explanatory Memorandum at 3.
32. See Level 2 Regulations, Article 75(a)-(b).
20. See AIFMD, Article 4(1)(q) (“for non-EU AIFMs,
all references to ‘home Member State of the AIFM’ in
33. See Remuneration Guidelines, ESMA’s response to
Comment 28 (Question 5).
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Reprinted from The Investment Lawyer May 2013, Volume 20, Number 5, pages, 1, 15–27,
with permission from Aspen Publishers, Wolters Kluwer Law & Business, New York, NY,
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