Commission proposes new rules for AIFMs on undue costs

On 24 May 2023, the European Commission published a legislative proposals which would introduce amendments to the AIFMD on the issue of costs.

The proposal is part of the Commission’s wider work on its Retail Investment Strategy (RIS) – many of the RIS changes relate to MiFID and we will be reporting in detail on those separately.

The amendments also largely follow the recommendations set out in ESMA’s Opinion on which we reported last week (see here).

What is being proposed?

As far as AIFMs are concerned the key items of interest in the Commission’s proposals are contained in what would be a new Article 12(1bis) to the AIFMD.

This would require AIFMs to

• prevent the AIF and its investors from being charged ‘undue costs’ (as for what these are, see below)
• maintain, operate and review an effective pricing process which (a) identifies and quantifies all costs borne by the AIFs or its investors and (b) ensures that
  • costs are not undue; and
  • in the case of retail investors, the costs they bear are justified and proportionate, with regard to the AIF’s investment objective, strategy, expected returns, level of risks and other relevant characteristics
• at least annually, assess whether investors have been charged undue costs. If they have, the AIFM must
  • reimburse these to investors and
  • report to (among others) its own and the AIF’s home NCA(s) the fact that undue costs have been charged
• at least annually, assess that costs borne by retail investors are justified and proportionate (see above) including by a comparison with a costs and performance benchmark which ESMA will develop and publish (for more about the benchmark, see below).

Similar changes would affect UCITS since equivalent amendments are also being proposed to the UCITS Directive.

One point worth drawing out about the proposals as drafted is that, while some provisions – those on costs being justified and proportionate and those regarding the benchmark which ESMA is to develop - refer specifically to retail investors, the others would seem to apply to all investor types.

The legislative proposal, of course, was published under the Commission’s Retail Investment Strategy and it remains to be seen (a) whether it was the Commission’s intention for some rules to apply equally to professional investors or whether this was an oversight which will be corrected in due course and (b) what stance the Council of the EU and the European Parliament will take as they now review the proposals.

Who would this affect?

As drafted, the new provisions would very largely be relevant only to EU AIFMs – the vast majority of the changes are to Article 12 of the AIFMD, which does not apply to non-EU AIFMs marketing into the EU under an NPPR.

There are three main ‘buts’, though.

1. The proposals could change between now and finalisation
2. It’s always open to individual Member States to ‘gold plate’ the requirements by making them applicable to non-EU AIFMs
3. There is one change to Article 24, which would require the AIFM to include, in its regulatory reporting, “information on the costs borne by investors and performance of the AIF”. As things stand there appears to be no guidance as to what such information should include.

What are ‘undue costs’?

To risk stating the obvious, an ‘undue’ cost is one that isn’t a due cost.

Costs are ‘due’ where they

• are in line with disclosures in the prospectus, the fund rules or instruments of incorporation (in Article 23 of the AIFMD) and the key investor information under the PRIIPs Regulation
• are necessary for the AIF to operate in line with its investment objective or to fulfil regulatory requirements and
• are borne by investors in a way that ensures fair treatment of investors (except where the AIF’s rules or instruments of incorporation provide for preferential treatment).

We can expect some clarification thanks to a proposed Level 2 measure.

This would specify minimum requirements to ensure the AIFM’s pricing process prevents undue costs from being charged to the AIF by:

• ensuring that costs are in line with the prospectus and fund constitutional documentation (as in the first bullet point above)
• identifying which costs can be charged to the AIF by reference to a list of eligible costs which meet the conditions in the second and third bullets above

It should be noted that (subject to certain conditions) NCAs would be able to authorise costs not included in the list of eligible costs, on a case-by-case basis.

ESMA’s costs and performance benchmark

ESMA is charged with developing and making public benchmarks which enable the comparative assessment of costs and performance of AIFs.

Where feasible, common benchmarks are to be developed for AIFs which are marketed to retail investors and have “similar levels of performance, risk, strategy, objectives, or other characteristics”.

The benchmarks are to “display a range of costs and performance, especially cases where costs and performance depart significantly from the average” and will be updated on a regular basis.

Where, before it’s marketed to a retail investor, an AIF deviates from the ESMA benchmark for the relevant product category, the AIF will not be able to be marketed to retail investors until a further assessment has confirmed that the costs are not undue.

Where an AIF that is already marketed to retail investors deviates from the benchmark, the AIFM must subject the AIF to enhanced monitoring. If this demonstrates that corrective measures are needed, the AIFM must take such measures within a reasonable timeframe to ensure that costs are not undue.

AIFMs must document and keep records of assessments, including the comparison to the relevant ESMA benchmark, the reasons which justify a deviation from the benchmark (where applicable) and an explanation as to how the AIF meets the above requirements for costs to be ‘due’.

Level 2 measures

The Commission will develop a delegated act to ensure that AIFMs comply with the above requirements.
These will, among other things

• specify minimum requirements for the pricing process to:
  • ensure that costs are correctly identified and quantified
  • identify which costs can be charged to investors taking into account the level and nature of the costs by reference to a list of eligible costs that meet the conditions referred to above regarding (a) being necessary for the AIF’s operation and (b) around fair treatment
  • identify potential conflict of interests and measures to mitigate their occurrence
  • establish the level of compensation where undue costs have been charged to investors.
• provide for criteria to determine whether costs are ‘justified and proportionate’ (see above)
• specify the methodology for ESMA to use when developing its benchmarks.

When would these changes come into effect?

Almost certainly not until 2025.

The next step is for the Council of the EU and the European Parliament to review the Commission’s proposals and, in due course, the three institutions will reach an agreement on a final text. This will then be tidied up, translated into the official languages of the EU and published in the Official Journal.

Each of these steps, obviously, takes time.

The Commission is proposing (and the Council and Parliament are likely – but not certain - to agree) that, following publication in the OJ, Member States would have 12 months in which transpose the provisions into their national law and 18 months in which to apply them.