The “AIFMD II” proposals continue their progress through the EU legislative process with more detail provided, but in many areas specific criteria will not be known until Level 2 measures are developed.
On 9 February 2023, the European Parliament’s Economic and Monetary Affairs Committee (ECON) published a report on the amendments it has adopted to the European Commission’s legislative proposal for a directive (the Directive) amending the Alternative Investment Fund Managers Directive 2011/61/EU (AIFMD) and Directive 2009/65/EC (UCITS Directive). The proposed new legislation arises out of the Commission’s AIFMD review and the identification of specific areas where the AIFMD framework could be improved, as well as the Commission’s view that a number of those issues were equally relevant for the activities of UCITS. As such, both directives will be amended to better align their requirements.
In particular, the proposed new legislation:
- addresses the need to harmonise rules for AIFMs managing loan-originating AIFs;
- clarifies standards applicable to managers that delegate their functions to third parties;
- covers equal treatment of custodians, cross-border access to depositary services, supervisory data collection, and the use of liquidity management tools (LMTs) across the EU;
- sets out required information for authorisation applications on senior management and human resource needs, and clarifies those requirements where AIFs are marketed to retail investors;
- updates AIFMD’s national private placement regime; and
- covers ESG risks in remuneration policies, as well as the issue of misleading fund names (although this is not expressly dealt with as an ESG risk).
ECON’s report contains draft text setting out its amendments to the Directive. Once finalised, the resulting new legislation would need to be implemented by each EU Member State two years after coming into force, meaning changes will not likely take effect until 2025.
It is not clear at this stage if the FCA is planning equivalent changes. Nevertheless, the proposed changes will impact UK (and global) funds marketing cross-border into the EU in addition to existing permitted global delegation arrangements.
This blog post summarises the Directive’s key proposals.
The Directive clarifies that the “management of AIFs” also comprises “loan-originating AIFs” (defined as AIFs whose principal activity is to originate loans and for which the notional value of its originated loans exceeds 60% of its net asset value) and servicing securitisation special purpose vehicles. The Directive lays down harmonised rules for AIFMs managing loan-originating funds designed to improve risk management and increase transparency for investors.
By way of example, AIFMs managing AIFs that engage in lending activities, including purchasing loans on the secondary market, will be required to have effective policies, procedures, and processes for the granting of loans, assessing credit risk, and administering and monitoring their credit portfolio, which must be reviewed periodically and at least once a year. Shareholder loans (defined as loans granted by an AIF to an undertaking in which the AIF holds directly or indirectly at least 5% of the capital or voting rights where the loan cannot be sold to third parties independently of the capital instruments held by the AIF in the same undertaking) will be exempt from this requirement.
If the AIFM is not able to demonstrate to the competent authorities that the AIF has a sound liquidity risk management system that ensures the compatibility of its liquidity management system with its redemption policy, the AIF will need to be closed-ended. The Commission will adopt regulatory technical standards (RTS) to establish the relevant criteria for the determination of whether a loan-originating AIF can maintain an open-ended structure.
The AIFM will need to ensure that a loan originated to any single borrower by the AIF it manages does not exceed 20% of the AIF’s capital if the borrower is a financial undertaking or a collective investment undertaking.
Investment strategies to originate loans with the sole purpose of transferring those loans to third parties will be prohibited. Further, under the current proposal, the AIF will not be able to grant loans to its AIFM or the staff of its AIFM, an entity within the same group as the AIFM (except in certain limited circumstances), its depositary, and delegates of its depositary and the entity to which its AIFM has delegated functions in accordance with Article 20 of the AIFMD.
Harmonised Liquidity Management Tools
The Commission’s proposal includes a set of liquidity management tools (LMTs) (in line with recommendations by the European Systemic Risk Board and ESMA) to better facilitate liquidity risk management by managers of open-ended funds, since the current AIFMD and UCITS do not provide for a minimum set of LMTs. To enable managers of open-ended AIFs to deal with redemption pressures under stressed market conditions, AIFMs will be required to select at least two appropriate LMTs from the list provided in Annex V of the Directive (e.g., gates, suspensions, and redemption fees). The AIFM may select only one LMT for an AIF it manages if that AIF is authorised as a money market fund.
When an AIFM decides to activate or deactivate certain LMTs in situations of liquidity stress or in other defined circumstances, it will need to notify the supervisory authorities. In relation to the ability of a Member State to request a manager to activate or deactivate the appropriate LMT, the Directive stipulates the condition of “exceptional circumstances and after consulting the manager concerned” before this investor protection mechanism would be available.
The Commission will adopt RTS to specify the rules on disclosure to competent authorities and investors of information related to the selection and calibration of LMTs in order to facilitate market and supervisory convergence. ECON’s text stipulates that those standards should recognise that the AIFM retains primary responsibility for liquidity risk management.
The above rules will also apply to UCITS managers.
Rules of Delegation
The Commission’s original proposal aimed to provide clarity on the rules of delegation and achieve a coherent approach to delegation activities by European investment fund managers and supervisors, ensuring high standards across Member States. The Directive distinguishes between arrangements whereby a distributor operates on behalf of the AIFM (which is considered to be a delegation arrangement) and arrangements whereby a distributor acts on its own behalf. In the case of the latter, the Directive’s provisions regarding delegation will not apply.
Delegation will apply beyond portfolio management and risk management to all functions listed in Annex I of AIFMD (amended to now include management of joint ventures and of mandates in respect of immovable property, originating loans, and servicing securitisation special purpose entities) and to the ancillary services permitted under Article 6(4) of AIFMD (also amended to include benchmark administration and credit servicing).
More detailed text is included on the delegation information an AIFM must provide in its authorisation application. This covers, for example, the legal name and legal identifier (AIFM, the AIF, and each delegate), the AIF’s investment strategy, and brief descriptions of the delegated functions (risk management, portfolio management, and other functions listed in Annex 1 that the AIFM performs). More specific human and technical resource descriptions are needed relating to delegation (e.g., an explanation of the added value of the delegation to the investor). The Directive also contains regulatory reporting requirements around delegation arrangements, including how the AIFM oversees, monitors, and controls the delegate. Any “material changes” that may affect the scope of authorisation must be reported, including any modifications of the delegation arrangements and sub-delegation to third parties provided at the time of authorisation.
The same delegation requirements will also apply to UCITS managers.
In relation to delegated management, AIFMs will be permitted to perform their activities on behalf of a third party. However, if the third party is to have significant control over the fund’s design, distribution, and management, the manager will be required to employ heightened scrutiny of the potential for conflicts of interest and submit detailed explanations (e.g., specifying how the manager prevents systematic conflicts of interest or other material conflicts of interest arising from the relationship) and evidence on their compliance with this obligation to their respective competent authorities.
The same rules will apply to UCITS managers.
Authorisation, Human Resources, and Retail Marketing
Information requirements for applications for AIFM authorisation are covered. The requirements relating to the necessary human resources for authorisation must be clarified at the time of making the application. The Directive requires that at least two senior managers be employed for conduct of the business of the AIFM on a full-time or full-time equivalent basis and reside in the EU.
If an AIFM manages an AIF that is marketed to retail investors, at least one member of the AIFM’s governing body should be an independent non-executive director. Information about the persons effectively conducting the AIFM’s business needs to include, for example, a description of their role, title, and level of seniority; reporting lines and responsibilities; and the time allocated to each responsibility. In addition, a description of the technical and human resources that support their activities must be included in the application. (Also see delegation information requirements above).
The same requirements will apply to UCITS managers.
As for the previously proposed amended definition of “professional investor” (aiming to expand the category for the purposes of marketing under AIFMD), the definition in the Directive remains the MiFID “professional client” definition.
National Private Placement Regimes
Another noteworthy proposal concerns the updates to Articles 36 and 42 of AIFMD affecting EU AIFMs and non-EU AIFMs, respectively, marketing non-EU AIFs in the EU. Instead of requiring non-EU AIFMs or non-EU AIFs to be established in a third country that is not listed as a “non-cooperative country and territory” by the Financial Action Task Force (FATF), the Directive requires that the non-EU AIFM and non-EU AIF is not domiciled in a “high risk country” pursuant to the EU Anti-Money Laundering Directive.
In addition, each of the non-EU AIFM and the non-EU AIF’s jurisdiction (i) must have signed an agreement with each Member State in which the AIF is to be marketed that fully complies with the standards laid down in Article 26 of the OECD Model Tax Convention on Income and on Capital and ensures an effective exchange of information in tax matters, including any multilateral tax agreement, and (ii) must not be on the EU list of non-cooperative tax jurisdiction. All three requirements will need to be complied with at the time the Member State allows the non-EU AIF to be marketed to professional investors in its territory. If the third country is added to the list of non-cooperative jurisdictions for tax purposes after this time, the Directive draft legislation provides that closed-ended funds will continue to be considered to meet the relevant criterion for a period of two years.
The aim of the proposals is to improve supervisory authorities’ access to relevant data collection and address inefficiencies caused by reporting duplications that may exist under other European and national legislation. ECON’s text now calls for an alignment of the reporting requirements on the obligation to report information on the assets and liabilities of investment funds to the national central bank.
The Directive envisages a broader scope of standardised regulatory reporting obligations and empowers the Commission to adopt RTS setting out the contents, forms, and procedures. To help prepare for the changes to the supervisory reporting obligations, the Directive widens the scope of data that can be required from AIFMs by adding other categories of data to be supplied to competent authorities (e.g., the total amount of leverage of the net asset value employed by the AIF and detailed information regarding delegation arrangements). To standardise the supervisory reporting process, the Commission is empowered to adopt implementing technical standards (ITS) developed by ESMA setting out the forms/data standards, reporting frequency, and timing that AIFMs will need to comply with.
Broader regulatory reporting obligations will also apply to UCITS managers.
To address a shortage of service providers of depositary services in some markets, the Directive enables Member States to authorise, on a case-by-case basis, AIFMs or AIFs to procure depositary services located in other Member States. This possibility of appointing a depositary in another Member State is accompanied by increased supervision. Notably, such case-by-case access would be an interim measure while the Commission assesses whether a more integrated market is appropriate. The Directive’s provisions dealing with a Commission review on the functioning of this Directive (60 months after it comes into force) now include a depositary passport. In preparation for that, a comprehensive study will commence 24 months after the Directive enters into force on the potential benefits and risks of introducing an EU depositary passport.
The Directive includes central securities depositories (CSDs) in the custody chain when they provide custody services to AIFs or UCITS in order to ensure that, in all cases, there is a stable information flow between the custodian of an AIF’s/UCITS’s asset and the depositary. Without the need to perform additional diligence, CSDs providing custody services will be deemed delegates of the depositary (except when the CSD is acting as an issuer CSD (i.e., a CSD that provides the notary service or the central maintenance service in relation to a securities issue).
ESG Risks and Remuneration
EU AIFMs, in compliance with the Sustainable Finance Disclosure Regulation (SFDR), should ensure that their remuneration policies are consistent with long-term risks, including ESG risks and sustainability goals. The Directive highlights that this is particularly important when AIFMs make claims as to the sustainable investment policies of the AIFs that they manage. ESMA is expected to update its guidelines on sound remuneration policies under AIFMD as regards aligning incentives with ESG risks in remuneration policies. (Read this Latham recent blog for information on the FCA’s steps in the same area under its discussion paper DP23/1 on sustainability-related remuneration issues.)
It should also be noted that the Directive provisions for enabling RTS on authorisation requirements also enable ESMA to specify situations where the name of an AIF/UCITS that a manager intends to manage could be materially deceptive or misleading to the investor. Whilst this provision does not expressly refer to the concerns around greenwashing risks arising from funds’ names, it is particularly relevant in the context of ESMA’s current consultation on guidelines for funds’ names with ESG or sustainability-related terms. (Read this Latham blog for information on ESMA’s consultation.)