AIFMD review – ESMA’s recommendations for change

The European Commission is underway with its review of the AIFMD regime. An important part of this process involves taking on board views of stakeholders, national competent authorities (NCAs) and other bodies.

One important contributor is ESMA, which has now published a letter to the Commission in which it sets out 19 key areas where it thinks AIFMD could be improved and which it thinks the Commission should take into account as part of its review.

A number of ESMA's recommendations would involve the Commission also considering changes to the framework under the UCITS Directive.

The AIFMD review

Article 69 of AIFMD requires the Commission to review the application and scope of the Directive. Having commissioned KPMG to undertake an initial survey, the Commission submitted a short report to the European Parliament and to the Council of the EU in June, setting out its preliminary thoughts.

As our summary notes, though, the Commission is giving little away about its approach on some of the key debates, such as whether the NPPR regime, which currently allow non-EU AIFMs to market to investors in the EU, should be switched off.

A detailed consultation paper is due in the coming weeks, and it's hoped that this might shed some light on the Commission's likely direction of travel.

That said, it is unlikely the Commission would publish proposed amendments to the Level 1 or Level 2 texts of AIFMD until mid-2021. Add on time for these proposals to be negotiated over and adopted by the EP and Council, and then an additional period for the new rules to be implemented and it may well be two years before they came into force.

Where does ESMA's letter fit into this? and what does it cover?

So, ESMA's letter should be seen in this context - it carries some weight, of course, and ESMA and the Commission will very likely have already discussed ESMA's concerns. What's not clear at the moment is which, if any, of the recommendations the Commission will take up.

Although ESMA's letter has no formal force, it does give us an idea of ESMA's thinking and sheds some light on where it stands on a variety of issues - not least on the topic of delegation (see below).

One other thing. Even though the letter's subject is the AIFMD review, in several areas (not least, regulatory reporting), ESMA pushes for changes to the UCITS Directive as well, in order to align the AIFMD and UCITS regimes. All will, of course, depend on what the final rules look like but this potentially offers some good news for firms running both AIFs and UCITS, who might expect the two regimes to become more consistent at some stage in the future.

This note first looks at what ESMA says about the areas which we regard as being of greatest interest to asset managers - delegation, reverse solicitation, remuneration, leverage and cross-border supervision.

We then summarise, in turn, the remaining issues that ESMA comments on.

A. Key areas:

1. Delegation and substance

ESMA's comments to the Commission on delegation are, to some degree, a natural extension of the Opinion it published in 2017, in the aftermath of the UK's Brexit referendum. Indeed, the letter makes explicit reference to that Opinion. In 2017, ESMA was worried about a 'race to the bottom' once the UK left the EU and wanted to ensure consistency among the NCAs of the EU27 in how they would interpret and enforce the rules meant to prevent an AIFM becoming nothing more than a letter-box entity.

Three years later, it continues to push the case for clarification to (or, put another way, a tightening up of) the rules around delegation, seeking to close what it sees as loopholes in order to "avoid regulatory arbitrage and protect EU investors, legislative amendments should ensure that the management of AIFs and UCITS is subject to the regulatory standards set out in the AIFMD and UCITS frameworks, irrespective of the regulatory license or location of the delegate".

But even though ESMA is being consistent in its position, its comments will come as something of a surprise to some as it seemed that the initial concerns about delegation in light of Brexit were on the wane and that a peace (of sorts) had broken out among managers and regulators. ESMA's letter makes it clear that, as far as it is concerned, delegation is still a political hot potato - this is a topic that needs to be watched carefully as the debate proceeds.

Looking, then, at ESMA's specific comments on delegation:

(a) Extent of delegation

ESMA foresees an increase in delegation of collective portfolio management functions to non-EU third parties following the UK's departure from the EU, with authorised AIFMs and UCITS ManCos performing only some control functions (notably risk management) internally.

ESMA has a number of concerns with this:

• delegation arrangements could result in most of the human and technical resources needed for a fund's day-to-day operations being maintained by third parties outside the EU;
• the majority of operational staff which perform portfolio/risk management, administration and other functions on a delegation basis might work for the relevant fund rather than be directly employed by the authorised AIFM or UCITS ManCo;
• a significant amount of the management fees generated by the AIFM or UCITS ManCo are paid to delegates, which could increase operational and supervisory risks; and
• can the fund can still be effectively managed by the authorised AIFM or UCITS ManCo?

ESMA would like to see clarification around the maximum extent of delegation to ensure supervisory convergence and ensure authorised AIFMs and UCITS management companies maintain sufficient substance in the EU.

In particular, ESMA suggests a clearer redraft of Article 82 of the AIFMD Delegated Regulation including reconsideration of the qualitative criteria under Article 82(1)(d) or provision of a list of core functions that cannot be delegated to third parties. These would be matched in the UCITS Directive.

(b) Applicable regime in case of delegation and regulatory arbitrage

Where a delegate is established in another Member State or outside the EU and is subject to a different regulatory regime, questions arise as to a regulatory level playing field and possible circumvention of regulatory standards.

ESMA would want to see legislative amendments to ensure that the management of AIFs and UCITS is subject to the regulatory standards set out in the AIFMD and UCITS frameworks, wherever the delegate may be located.

(c) Use of seconded staff

ESMA wishes to see clarification as to whether arrangements (which it considers are increasingly common) where staff from professional services firms are temporarily seconded to an AIFM or UCITS ManCo are in line with the substance and delegation rules set out in the AIFMD and UCITS frameworks - especially where the secondee does not operate in the home Member State of the AIFM or UCITS ManCo.

(d) List of collective portfolio management functions and distinction from 'supporting tasks'

Without clear legal definitions, or an exhaustive list of collective portfolio management functions in Annex I of the AIFMD and Annex II of the UCITS Directive, it is often difficult for NCAs to assess whether 'supporting tasks' provided to the AIFM or UCITS ManCo by a group entity are subject to the relevant delegation rules.

ESMA recommends implementing legislative clarifications in line with the interpretation it sets out in Section VIII of its AIFMD Q&As, which, in its view, would resolve uncertainty around an AIFM's responsibility for ensuring that collective portfolio management functions set out in Annex I of AIFMD are performed in compliance with the AIFMD rules.

(e) White-label service providers

Finally, ESMA argues in favour of more specific requirements on white-label service providers (ie, managers that 'provide a platform to business partners by setting up funds and typically delegating investment management functions to the business partners or appointing them as investment advisers or informally following their guidance/instructions') since there is a disparity among NCAs as to whether such business models are in line with the AIFMD and UCITS regimes.

If the Commission considers them to be permissible, ESMA argues for more granular provisions in both AIFMD and the UCITS Directive to address the specific conflicts of interest and investor protection risks faced.

2. Reverse solicitation

ESMA accepts that the concept of 'reverse solicitation' in Recital 70 of AIFMD is "currently subject to divergent practices and interpretation at national level". This will come as no surprise to many asset managers trying to avail themselves of it.

While ESMA realises that the AIFMD review may not be the ideal forum for this, it pushes for greater clarity on the definition of the actual term 'reverse solicitation'.

This is one to keep an eye on as the wider argument continues around whether the Commission will advocate extending the AIFMD passport to non-EU AIFMs (which currently seems unlikely) and/or 'switching off' the ability to rely on NPPRs.

3. Proportionality principle for remuneration requirements

Having written to the Commission in 2016 to seek clarification of the application of the proportionality principle in both AIFMD and the UCITS Directive, ESMA is again pushing for clarification that the proportionality principle applies to all remuneration requirements in paragraph 1(a) to (r) of Annex II of AIFMD (Article 14b(1)(a) to (r) in the UCITS Directive).

4. Leverage

ESMA supports the two-step approach included in IOSCO's December 2019 Recommendations for a framework assessing leverage in investment funds.

• Step 1 provides regulators with a means of identifying funds more likely to pose risks to the financial system using at least one notional exposure metric of the metrics which IOSCO outlines.

• Step 2 entails a risk-based analysis of the subset of funds identified in Step 1.

As a result, ESMA proposes:

• amending the current reporting of the gross method calculation in Article 7 of the AIFMD Delegated Regulation to ensure alignment with the IOSCO framework; and
• considering amendments to the commitment amount calculation in AIFMD by adjusting the notional amounts of interest rate derivatives contracts by the duration of the ten-year bond equivalent. This allows comparability among contracts with different underlying durations, in turn making aggregation and comparison possible for systemic risk monitoring purposes.

5. Harmonising supervision of cross-border entities

ESMA points out that there is still a lack of clarity under AIFMD as to where responsibilities of home and host NCAs start and end when it comes to instances of cross-border marketing, management and delegation.

ESMA is pushing for clarification to reduce uncertainty around cross-border activities within the internal market, not least because AIFMs often use branches or delegate a variety of functions to third parties across different Member States.

The letter also encourages the Commission to provide greater clarity on what analysis the host NCA must undertake when an AIF is marketed cross-border basis under Article 32 of AIFMD (EU AIFM marketing an EU AIF in a different Member State). While the home NCA normally assesses the relevant fund documents at the authorisation stage, Article 32(5) is unclear about the tasks attributed to the host NCA.

Similarly, ESMA thinks that the roles of the home and host NCA where an AIF is managed cross-border basis under Article 33 AIFMD (EU AIFM managing an EU AIF established in a different Member State) would also benefit from clarification.

B. Other areas where ESMA's letter pushes for amendments to AIFMD and/or the UCITS Directive

1. Harmonising the AIFMD and UCITS regimes

In some cases, AIFMD provisions (such as risk management and liquidity management requirements) are more specific than the comparable ones under the UCITS Directive, a situation which ESMA refers to as 'not ideal' since applying different requirements to management companies which manage both UCITS and AIFs creates additional burdens for the firms concerned and divergences in supervisory/regulatory outcomes.

ESMA proposes that the Commission should consider aligning the frameworks 'where appropriate'.

2. Harmonising UCITS reporting

In its letter, ESMA:

• agrees with the ESRB's recommendation that the Commission should introduce legislation for a harmonised reporting regime for UCITS ManCos, with both manager and fund-specific data reporting obligations;
• considers that harmonised UCITS reporting should generally be aligned with (improved) AIFMD requirements, while allowing them to be tailored to the characteristics of UCITS funds. This would, among other things, avoid duplications or unnecessary burdens for supervised firms;
• proposes that, following the recent MMF model, the information reported should be used not only for supervisory purposes but also for monitoring systemic risk; and
• notes that, although it can use AIFMD reporting data, it does not have access to UCITS data. This is sub-optimal, leads to extensive ad-hoc data requests and slows down the time available for analysis.

3. Scope of additional MiFID services and application of rules

Since the outset, NCAs have taken different views on whether AIFMs / UCITS ManCos can be permitted to perform business activities apart from those explicitly listed in Article 6(4) of AIFMD / Article 6(3) of the UCITS Directive. This means that the list of permissible business activities is broader in some Member States than in others.

ESMA wants to see clarification, pointing out that there is legal uncertainty as to how the rules apply when services are provided under Article 6(4) or Article 6(3) as relevant. By way of example, when investment management functions for an AIF/UCITS are performed on a delegation basis, some NCAs consider this to be discretionary portfolio management (so MiFID rules would need to be applied), while others argue that it is not (so the relevant AIFM or UCITS ManCo performing functions on such a basis would be subject to AIFMD/UCITS rules).

ESMA also sees merit in clarifying the AIFMD, UCITS and MiFID frameworks to ensure that AIFs/UCITS and their managers and MiFID investment firms are always subject to the same regulatory standards when providing the same type of services.

Finally, ESMA suggests updating the references in Article 6(6) of AIFMD and Article 6(4) of the UCITS Directive which refer to MiFID I so these reflect the requirements introduced under MiFID II.

4. Availability of additional liquidity management tools

ESMA recommends that the Commission should take the opportunity of the AIFMD review to include availability of all the liquidity management tools (LMT) outlined in the ESRB's 2017 Recommendation on liquidity and leverage risks in investment funds throughout all EU jurisdictions. These include, for example, enhanced provisions to clarify the role of NCAs when using their powers to suspend redemptions in situations where there are cross-border financial stability implications.

ESMA also proposes including the availability of LMT in the UCITS Directive (although it notes that some will not be suitable or necessary for all types of funds, eg side pockets).

5. AIFMD reporting regime and data use

ESMA has conducted a separate analysis of issues regarding the AIFMD reporting regime and use of data.

These include:

• clarifying the definition of 'leveraged fund';
• removing the reference in Recital 78 of AIFMD which mentions that private equity funds do not have to report leverage at the level of an SPV;
• the requirement to report ESG metrics; and
• restrictions in the use and publication of the reported data.

ESMA's full analysis is set out in Annex II to the letter.

6. Semi-professional investors

ESMA has previously identified a wide variety of definitions across the EU as to what constitutes a "professional investor", and a wide variety of treatments of the status of "semi-professional" investors under NPPRs.

As a result, ESMA would like to see the definition of "professional investors" under AIFMD clarified and for any new categories of investors which may be introduced (such as "semi-professional") to be accompanied by appropriate investor protection rules.

Finally, ESMA would limit passporting activities to marketing to professional investors only.

7. Loan origination in AIFMD

ESMA argues for a specific loan origination framework within AIFMD and refers to its own April 2016 Opinion, which makes recommendations covering authorisation for loan originating funds, fund types and leverage, liquidity, stress testing, reporting, diversification, etc. requirements for loan-originating funds.

8. Application of depositary rules to CSDs

ESMA recommends that AIFMD be clarified to allow depositaries not to apply the delegation rules to CSDs in their capacity as Issuer CSDs, though they should be required to apply them to CSDs in their capacity as Investor CSDs. ESMA argues that this change should also be made in the UCITS Directive in due course.

9. Sub-thresholds AIFMs

Member States currently have discretion as to what rules they impose on sub-threshold AIFMs. Noting that 'some NCAs' would prefer to have an explicit EU legal basis under which Member States would introduce additional local requirements, ESMA recommends that the Commission consider further clarifying what powers Member States have to apply additional requirements nationally to sub-threshold AIFMs.

10. External valuer liability

In some jurisdictions, the provision in AIFMD that "the external valuer shall be liable to the AIFM for any losses suffered by the AIFM as a result of the external valuer's negligence or intentional failure to perform its tasks" is taken to cover not only 'gross negligence' but also 'simple negligence'. As a result, external valuers may be unwilling to accept valuation mandates from AIFMs if their liability would be unduly extended by the negligence provisions.

ESMA's view is that "negligence", in this context, should be limited to "gross negligence" and that the point should be addressed directly in the legislation rather than through ESMA guidance.

11. Amendments to definitions

ESMA sees merit in:

• further defining 'AIFs' consistent with the ESMA guidelines on key concepts of the AIFMD through implementing a definition of (1) general commercial or industrial purpose in connection with real estate projects, (2) pooled return in general and (3) investment policy;
• specifying the distinction between holdings and private equity funds;
• clarifying the definition of a joint venture; and
• clarification as to whether the issuance of certificates, and crypto assets fall within the scope of AIFMD so a harmonised approach can be reached across the EU.

12. Convergence in treatment of significant influence

ESMA suggests that further consideration be given to the possible significant influence that fund managers may exercise over the management of an issuing body, an issue covered in Article 56(1) of the UCITS Directive but not specifically dealt with in AIFMD.

Since Article 56(1) is limited to investment companies and management companies acting in connection with all of the common funds managed by them, ESMA sees merit in clarifying that the calculation of the limit in Article 56(1) covers not only common funds or UCITS alone but also:

• voting rights stemming from AIFs managed by the same fund manager with similar strategies in relation to the exercise of significant influence, ie excluding for example private equity funds;
• portfolios managed on a discretionary basis by the manager; and
• where permitted, investments made by the fund manager on its own account.

ESMA would also wish to see further EU harmonisation on what constitutes "significant influence" (eg expressed in terms of harmonised EU thresholds) in both AIFMD and the UCITS Directive.

13. Increasing digitalisation in AIFMD

ESMA encourages the Commission to take the opportunity afforded by the AIFMD review to permit more digital communication instead of paper form. For example, Article 8(5) of AIFMD could be amended to allow an NCA to inform an applicant for authorisation in electronic format rather than "in writing".

14. Depositary passport

While not recommending the creation of a depositary passport in AIFMD and the UCITS Directive, ESMA "believes the Commission may study the benefits and risks further" in the context of the AIFMD Review.