AIFMD II Astonishingly an Incredibly Feeble Amending Directive

Fund managers have long waited for another one of our tongue-in-cheek updates on the Alternative Investment Fund Managers Directive (AIFMD). You’ve probably (or hopefully) been waiting with more interest for the proposed changes to AIFMD. Well, the wait is over. And the good news is that the proposed changes are not as bad as some feared they could have been.

The key takeaways are as follows:

• Delegation and substances requirements: There will be tighter rules on delegation, but they are not as bad as they could have been… for now! There will be new substance requirements to ensure EU managers retain people with the right expertise on the ground in Europe to avoid so-called letter-box entities. There will also be new reporting requirements to ensure ESMA obtains data on the extent of delegation and this could result in changes further down the track.
• Loan Originating Funds: There are a raft of new rules and requirements for loan-originating funds.
• Liquidity management: There are new mandatory liquidity management tools to be used by open-ended funds in exceptional circumstances.
• Reporting and disclosure: Apparently we need more!
• Depositaries: Clarity that depositaries can effectively passport in Europe without formally having a passport yet; that's to come.

We take a closer look below.

Background to the proposal

On 25 November 2021, the European Commission published a proposal to amend the AIFMD, along with the Undertakings for the Collective Investment in Transferable Securities Directive and other fund-related directives and regulations. This forms part of a series of proposals published on the same day aimed at delivering several key commitments outlined in the 2020 EU Capital Markets Union Action Plan. The proposals follow an October 2020 European Commission review on the operation of the AIFMD, which has largely concluded that the AIFMD is working well. However, the European Commission and other stakeholders consider that there are areas for improvement. Some of these areas (namely delegation) were discussed in an August 2020 letter from ESMA to the European Commission. As well as delegation, the proposals seek to address issues related to AIFMD concerning the build-up and spill over of risks to the broader financial system, such as the regime governing direct lending by AIFs and the importance of effective liquidity management tools (the European Systemic Risk Board and ESMA recommended harmonisation of the rules on the use of liquidity management tools).

Additional services and functions AIFMs can perform

The proposals introduce additional services that an AIFM will be able to provide, including:

• loan origination (the explanatory text to the legislative proposal states that "this means AIFs can extend loans anywhere in the Union, including cross border");
• the servicing of securitisation special purpose entities;
• benchmark administration; and

• credit servicing, in accordance with the 2021 EU Directive on credit purchasers and credit servicers (see our briefing).

The express reference to enabling AIFMs to lend is positive if it allows AIFMs to passport that service within the single market because it could simplify the structuring of some direct lending funds.

Stricter requirements on delegation and prescribed substance requirements

As suspected following ESMA's letter, the proposals seek to tighten up delegation to avoid a perceived risk that many AIFMs delegate substantial parts of their portfolio management function outside the EU. However, the proposals are not as bad as they could have been given ESMA's concerns.

There is a requirement that EU AIFMs have at least two full-time people in the EU with the necessary skills and expertise to oversee the retained and delegated functions. While this is a new, prescribed requirement, it is common practice in many common fund jurisdictions and should not pose too many obstacles for managers. It is also in line with the UK threshold conditions and the four-eyes principle.

Applications for authorisation will need to provide more information concerning the individuals who are "effectively conducting the business" of the AIFM, including: a detailed description of their role, title and level of seniority; a description of their reporting lines and responsibilities in the AIFM and outside the AIFM; an overview of the time allocated to each responsibility; and a description of the technical and human resources that support their activities. The existing requirements concerning information and arrangements made for delegation and sub-delegation have been enhanced to include a requirement to provide a detailed description of human and technical resources to be used by the AIFM for monitoring and controlling the delegate.

Article 20(1) is to be amended to clarify that delegation arrangements apply to all functions listed in Annex I and to the ancillary services permitted under AIFMD. Language referring to "services", in addition to existing references to "functions" has been introduced in provisions found in Article 20.

The proposals provide that ESMA should receive annual notifications from competent authorities of delegation arrangements where an AIFM delegates more risk or portfolio management to third country entities than it retains. The notifications are to include: information on the AIFM and the AIF concerned; information on the delegate, specifying the delegate’s domicile and whether it is a regulated entity or not; a description of the delegated portfolio management and risk management functions; a description of the retained portfolio management and risk management functions; any other information necessary to analyse the delegation arrangements; a description of the competent authorities’ supervisory activities, including desk-based reviews and on-site inspections and the results of such activities; and any details on the cooperation between the competent authority of the AIFM and the supervisory authority of the delegate. ESMA is to develop technical standards concerning delegation notifications and the standard forms, templates and procedures for the transmission of the delegation notifications. We can, therefore, expect more reporting and that national competent authorities will require managers to including this information in their regular reporting requirements.

AIFMD delegation rules are to also apply to UCITS ManCos.

A depositary passport in practice but not in name

The rules requiring AIFs to appoint a depositary in the AIF's home Member State will be relaxed. This is to address concerns about so-called depositary market concentration in some markets. The European Commission has opted against introducing a depositary passport for now, owing to lack of EU-wide uniform laws in securities and insolvency; however, the proposed Directive includes a review clause concerning aspects of the AIFMD including a prospective depository passport. For now, AIFMs can procure depositary services in other Member States so we reach a similar outcome to a passport in practice.

Third country depositaries in jurisdictions which are identified as high-risk under EU money laundering laws or on the EU list of non-cooperative jurisdictions for tax purposes are not permitted.

It is proposed that use of a central securities depositary (CSD) will be viewed as a delegation (except where the CSD is acting as an issuer CSD, i.e. a CSD proving a notary service or central maintenance service in relation to a securities issue). Under the existing regime, CSDs are not considered delegates of the depositary and the industry believes that depositaries cannot carry out oversight duties effectively without the necessary flow of information. It is also proposed that depositaries cooperate not only with their competent authorities, but also with the competent authorities of the AIF that has appointed it as a depositary and with the competent authorities of the AIFM that manages the AIF.

New rules for debt funds

There are numerous new proposals for loan-originating funds. AIFMs managing AIF granting loans will be required to implement effective policies, procedures and processes for the granting of loans. These will need to be reviewed periodically. The proposals also restrict lending to a single borrower, when this borrower is a financial institution, so as to reduce risk to the financial system.

Under the proposals, an AIF is prohibited from lending to its AIFM or its staff, its depositary or its delegate (how that wasn't a conflict under the existing conflict rules is beyond us, but more law just in case anyone was unsure).

To address loan originations resulting in quick-fire sales of loans to the secondary market, AIFs are to be required to retain an economic interest of five per cent of the notional value of the loans they have granted and sold off. An AIF will be required to adopt a closed-ended structure if the notional value of its originated loans exceeds 60 per cent of its net asset value.

Mandatory liquidity management tools and requirements

The proposals provide that AIFMs managing open-ended AIFs will be able to temporarily suspend the repurchase or redemption of the AIFs units by using one of the liquidity risk management tools set out in points 2 to 4 of Annex V, which sets out a minimum list of liquidity management tools that should be available anywhere in the EU and will be further developed via regulatory technical standards from ESMA. The tools include notice periods, redemptions fees, an anti-dilution levy and swing pricing.

Temporary suspensions will only be permitted in exceptional circumstances where it is justified and in the interests of investors. The AIFM will be expected to implement detailed policies and procedures in relation to the activation and the deactivation of selected liquidity management tools, as well as associated operational and administrative arrangements.

AIFMs will be required to notify the competent authorities about activating or deactivating a liquidity management tools.

Tweaks to the National Private Placement Regime for third country fund marketing

The proposals update existing provisions to require that non-EU AIFMs and non-EU AIFs must not be established in jurisdictions identified as high risk countries under the EU money laundering directive. This is an expansion to the current requirements.

The third country where the non-EU AIF is established would need to have signed an agreement with the home Member State of the authorised AIFM and with other Member States in which the units or shares of the non-EU AIF are intended to be marketed, fully complying with the standards laid down in the OECD Model Tax Convention on Income and on Capital and ensuring an effective exchange of information in tax matters (including any multilateral tax agreements), and they must not be on the EU list of non-cooperative jurisdictions for tax purposes.

More reporting to regulators! Apparently someone does read this stuff

Under the proposals, AIFMs will be required to regularly report to their home Member State competent authorities on all markets, instruments and exposures. This is an expansion to current Annex IV reporting, where AIFMs are required to report on the principal markets and instruments in which they trade, provide information on the main instruments in which they are trading and on the principal exposures and the most important concentrations of each AIF managed. ESMA is to develop technical standards providing revised reporting templates in this regard. Exciting times ahead!

More disclosures – no surprises

There are additional disclosures for AIFMs concerning conditions for using liquidity management tools. AIFMs are to disclose a list of fees and charges that will be applied in connection with the operation of the AIF and that will be borne by the AIFM or its affiliates. It is proposed that, on a quarterly basis, AIFMs disclose all direct and indirect fees and charges that were directly or indirectly charged or allocated to the AIF or to any of its investments; and any parent company, subsidiary or special purpose entity established in relation to the AIF’s investments by the AIFM, the staff of the AIFM or the AIFM’s direct or indirect affiliates.

AIFMD III planned

The proposals provide for ESMA to regularly carry out peer review of supervisory practices on delegation, with a particular focus on preventing the creation of letter-box entities. The Commission is also to review the delegation regime and its implementing measures. The proposals also provide for assessing the possibility of introducing the depositary passport and the functioning of the rules for AIFMD managing loan-originating AIFs.

No mention of the AIFMD third country marketing and management passport though. All very quiet on that front and we are expecting it to remain that way given the proposals were lobbied for by the UK and Europe conceded on the basis most third country firms would choose the UK as their member state of reference, leaving the UK FCA to deal with the supervision of such firms. With Brexit taking this off the table, there is little prospect of a third country passport coming to the force any time soon.