European Union: Esma Finalises Advice To European Commission On AIFMD Level 2 Measures

Last Updated: 12 January 2012
Article by Olivier Sciales

The European Securities and Markets Authority has published on November 16 its final advice to the European Commission on the detailed rules underlying and implementing the Alternative Investment Fund Managers Directive. The Commission is expected to issue the rules in the form of subsidiary legislation and regulation by the middle of next year.

According to Esma, its proposed rules should establish a comprehensive framework for alternative investment funds, their managers and depositaries, and by achieving the directive's aim of increasing transparency and mitigating systemic risk, ultimately contribute to improved protection of investors.

Esma's advice is in response to a 2010 request originally sent by the Commission to Esma's predecessor, the Committee of European Securities Regulators. An advisory body comprised of EU securities regulators that advised the European Commission from 2001 to 2010 on securities legislation policy issues, Cesr was replaced by Esma at the beginning of this year.

November 16 was the deadline for delivery of Esma's advice to the Commission. The 500-page document takes into account industry feedback received by Esma in response to two consultation papers, published in July and August. The Commission has indicated that it remains open to further input from the industry and other stakeholders before it finalises the rules.

Esma says that while not binding on the Commission, the proposed rules will bring greater clarity on the application of the thresholds that determine the scope of the AIFM Directive, while the provisions regarding operating conditions impose stronger organisational and conduct rules for alternative fund managers, on top of increased reporting requirements to investors and regulators and the rules governing use of leverage.

The advice seeks to clarify the duties of depositaries to alternative investment funds, such as monitoring funds' cash flows, as well as defining the circumstances in which assets held in custody can be deemed to be lost and the consequences. It also fleshes out the framework under which third-country firms and managers will be able access European investors, both before and after the AIFM Directive's marketing 'passport' is due to be extended to non-EU firms and funds after mid-2015.

The advice document covers four broad areas. The first part, covering general provisions for managers, authorisation and operating conditions, clarifies how the asset thresholds determining whether a manager is subject to the directive will operate. It also details how managers should cover risks arising from professional negligence through the holding of additional capital or insurance. Esma notes that many of its rules in areas such as conflicts of interest, recordkeeping and organisational requirements are based on equivalent provisions of the Mifid and Ucits legislative frameworks.

The second part of the advice proposes a framework governing depositaries of alternative funds, include the criteria for assessing whether the prudential regulation and supervision applicable to a depositary established in a third country has the same effect as the provisions of the AIFM Directive.

In response to protests from industry bodies such as the Alternative Investment Management Association (Aima), Esma has dropped the nebulous concept of 'equivalence' of third-country regimes with the directive's provisions. Instead it sets out criteria such as the independence of the financial regulator, the eligibility requirements for organisations seeking to act as a depositary, and the existence of sanctions to punish violations.

Esma says that determination of the circumstances in which a financial instrument held in custody should be considered as lost is crucial in determining whether a depositary is required to return an asset or its value. It proposes that an asset should be considered lost if financial instruments supposedly owned by a fund either cease to exist or are found never to have existed, if the fund has been permanently deprived of its right of ownership over the instruments, or if it is permanently unable to dispose of the instruments directly or indirectly.

The document also aims to clarify what constitutes external events beyond the reasonable ability of the depositary to control or protect against. It also clarifies the reasons that would allow a depositary contractually to discharge its liability to make restitution of the assets.

To assist in preventing the build-up of systemic risk, Esma's advice clarifies the definition of leverage, how it should be calculated and in what circumstances a regulator should be able to impose limits on the leverage used by a particular manager. It confirms the proposal set out in one of the consultation papers to prescribe two different calculation methodologies for leverage, the commitment and gross methods, as well as a further option, the advanced method, which can be used by managers on request. To increase transparency of alternative funds and their managers, Esma sets out the form and content of information to be reported to regulators and investors, and what information should be included in a fund's annual report.

Regarding the regulatory co-operation and exchange of information arrangements required to allow non-EU funds or funds from non-EU managers to be marketed in Europe, Esma proposes the institution of written agreements allowing for exchange of information for both supervisory and enforcement purposes.

Agreements should be signed by the European regulators concerned and the third-country regulator of the manager and/or fund, which could take the form of a multilateral memorandum of understanding centrally negotiated by Esma. The detailed content of the co-operation arrangements would take into account international standards, notably the Iosco Multilateral Memorandum of Understanding on co-operation for enforcement purposes and the Iosco Technical Committee Principles for Supervisory Co-operation.

The AIFM Directive was first proposed by the European Commission in April 2009 and agreed by the European Parliament and EU member states in November 2010. The directive was formally signed on June 8 this year, published in the EU Official Journal on July and came into force on July 21; the deadline for transposition into the national legislation of EU member states is July 22, 2013. The marketing passport provisions may, by decision of the Commission, be extended to non-EU jurisdictions any time after July 22, 2015.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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