FSA: The Alternative Investment Fund Managers Directive - The road ahead

Speech by Sheila Nicoll

Director of Conduct Policy, the FSA

Alternative Investment Management Association (AIMA) Policy and Regulatory Forum, Brussels

Good morning; thank you to AIMA for inviting me to speak at this forum.

I took the Alternative Investment Fund Managers Directive (AIFMD) under my wing after Dan Waters left the FSA. Dan relished tackling the AIFMD, and together with the UK Treasury we worked hard to ensure an appropriate and proportionate approach was taken. As you are aware, we were very keen to make sure that this approach was based on a sober and objective view of the risks posed by alternative investment funds.

But I don’t want to look back over the last two years – I would like to say that an objective perspective will again be crucial over the next few months. It will be crucial as the European Securities and Markets Authority (ESMA) task forces go about writing their advice to the European Commission on the more detailed ‘subordinate measures’ which will sit under the Directive. I will say more on these task forces later.

In particular today I want to touch on some common themes that I think run through the ESMA task forces. I will also say some words on a few of the detailed policy issues which still need to be addressed.

Timetable

It is worth starting by reminding you of the timetable we are facing; this is how we understand the process will be working over the next year or so.

As you know, political agreement was reached towards the end of 2010. In December 2010 the Commission issued a request for advice to CESR (now ESMA) in relation to the many subordinate measures found within the Directive. There are actually 99 ‘delegated acts’, technical standards and guidelines to develop, so each of the four ESMA task forces has its work cut out.

The Commission recently pushed the deadline for delivery of the advice back from September to November 2011.

The task forces are already in operation. Between now and when they consult on the draft advice in the early summer, they will have had a series of meetings aimed at producing high quality but proportionate advice for the wide range of firms that sit under the AIFMD.

The groups should then pick up their pens again after the consultation process has finished and refine the advice as needed. Due consideration must clearly be given to the responses of the consultation. An open ear is a precondition for setting proportionate regulations.

After due consideration of ESMA’s advice, the Commission will then adopt the subordinate measures envisaged by the Directive either in the form of one or more further Directives, or in the form of one or more Regulations. It is important to note that if the Commission chooses not to adopt the advice provided by ESMA it is required to justify this position.

The legal form of the subordinate measures adopted by the Commission will be very important.

Directives provide the ability for Member States to consider domestic factors and market characteristics during national implementation; on the other hand, they do not provide a maximum level of harmonisation across the European Union (EU) and so can create an un-level playing field.

Regulations, on the other hand, are directly applicable in each Member State, avoid the domestic implementation process – and achieve greater harmonisation – but they are less sensitive to domestic considerations. Regulations also require even more precise and unambiguous legal drafting – which can lengthen the negotiating process. And they don’t always promote effective regulation if national authorities are precluded from explaining what they mean to firms and what the expected outcomes are.

The debate surrounding directives versus regulation is, to me, a hot topic. We have had initial thoughts from the Commission and perhaps the panel will share their views on this later?

When the ESMA advice is turned into Directives or Regulations it will start to be applicable on the implementation date. We await the jurist/linguist hearing which will finalise the text and allow publication in the Official Journal. The running expectation is that the deadline for final implementation of the AIFMD package in each Member State will be the middle of 2013.

Industry input

Before I go on to talk about the issues, as I see them, for the task forces, it is worth pointing out that the ESMA advice is not being produced in a vacuum. Or to be more precise, I hope it is not being produced in a vacuum.

There has been agreement that the task forces engage in ‘targeted engagement’ with the industry, a position I fully endorse. Many of the task forces have set up, or are in the process of setting up, industry workshops. The task force on ‘Scope’, chaired by the Central Bank of Ireland, has already held its workshop, with further workshops proposed by the other task forces.

I will say two things about this engagement,

Firstly, as I said earlier, we must give due consideration to the views of the industry participants we include in the workshops. These groups bring a lot of expertise and we must avoid falling into the trap of not listening, or listening only to those views that back up previously held assertions.

Secondly, we must ensure that these groups are representative of those who will be affected. This is incredibly difficult as the AIFMD doesn’t just affect investment managers but also prime brokers, custodians, depositaries, transfer agents...the list goes on and includes – Independent Fund Administrators, Fund Administrators attached to banks or other services providers, central security depositaries, notaries, accountants in their role as auditors and Markets in Financial Instruments Directive (MiFID) firms that market shares of alternative investment funds (AIF).

Key issues for the task forces

Before I set out the key issues around the ‘subordinate measures’ which need to be drawn up under the Directive, I would just like to highlight three common issues that seem to weave their way through each task force.

Firstly, it is important to acknowledge the new roles and powers of ESMA. One example of this is that ESMA now has the ability to develop binding technical standards which in many cases supplement the delegated powers given to the Commission. Another example is that the Commission no longer provides a ‘mandate’ for assistance as it did when ESMA was CESR, but instead makes a ‘request for advice’. The difference is not just terminology; it reflects the central role ESMA plays in steering the subordinate measure under the Directive.

ESMA will need to consider carefully how to respond to the Commission’s ‘request for advice’. This is particularly so where it either holds the view that no further legislative measures beyond those in the Directive are necessary, or where it concludes that the powers delegated to the Commission are not necessarily appropriate to achieve the outcomes envisaged by the Directive. In these instances it is important for ESMA to make the case that while it has significant technical experts at its disposal and must always strive for an optimal outcome; it does so within the bounds of the terms on which political agreement was reached.

The second of my three themes is in relation to consistency. In many cases there will already be existing ‘Community acquis’ (or, in layman’s terms, existing regulation) on the areas of advice that are being developed by each task force. I am not advocating that ESMA shouldn’t think outside the box on some of these issues. However, it is important to highlight those existing rules in the UCITS Directive, many of which have roots in MIFID, which may be used as a basis for some of the advice. It would seem to me fairly uncontroversial that where these rules relate to the same activities the existing rules should be adopted. Such an approach appears sensible because many future alternative investment fund managers (AIFM) are already subject to the MIFID rules.

It is apparent that while many UCITS firms also manage alternative investment funds the reverse is not true. Many AIFM will just be running AIF. So, whilst existing UCITS managers may be able to apply many of the requirements in the AIFMD quite easily, the same cannot be said for non-UCITS managers. This means that we need to apply some critical thinking and ask ourselves whether a regime designed for retail investors readily applies itself to the professional fund space. Consistency in itself is not a sufficient argument to cut and paste UCITS.

The last theme to touch on, and which is a more of a general point, is that the AIFMD is the first directive to go through the new ESMA process. The way the process is conducted will set a precedent. Specifically, it sets a precedent in:

• the way in which we respond to the request for advice;
• the way we involve industry experts;
• the format of the consultation;
• the way we conduct the impact analysis; and finally
• the extent to which we take on board the comments raised and appropriately respond to them in the feedback statement.

And on this last point I would like to be clear that in certain circumstances there may be no easy answer to give in the advice. We need to give simple answers where we can, but sometimes there is no easy solution and we need to be prepared for some hard work. The UK FSA is prepared for this and I am sure the other panellists are too – including Patrice Bergé-Vincent from the AMF who has the unenviable task of chairing the task force drawing up the Depositary provisions.

Policy issues

I would now like to focus on two of the policy areas which deserve some special thought. I am not going to go into too much technical detail but I would like to highlight some of the key issues which need to be addressed.

Firstly I would like to address the question of scope and specifically the question of who is an AIFM? It remains unclear who will be considered an AIFM. The Directive is unclear for a reason - the reason is that it gives choice; it gives flexibility for the multitude of different legal and operation structures that fall into scope. For example, AIF can either be internally or externally managed. As you will know there is, within different types of funds, a continuum of responsibilities and actions taken by the governing body of the AIF ranging from minimal involvement to day-to-day stock selection.

The Directive does not provide delegated power to the Commission to determine under which circumstances the AIF can be internally managed and when it can be externally managed. This is a sensible outcome. We need a Directive which provides a clear framework under which AIFM are regulated, but the Directive needs to take account of the diverse and global nature of the industry it is seeking to regulate. We therefore can’t, and indeed shouldn’t, get to a place where we say that an AIF can be internally managed if it does x, y and z. The issues in the directive are too numerous for a blunt list of activities to be effective. My view is that the answer to this question lies within the delegation requirements and this may be a point for discussion within the panel later.

I have touched on scope and now I will turn my attention to the second issue I want to discuss, which is the requirement to appoint a depositary.

As I see it, the ESMA task force on depositaries has to deal with not one, not two but three important policy issues.

Firstly it needs to explain when certain financial instruments held by an AIF are lost.

Secondly, it needs to set out how the custody, prime broker, depositary relationship will work as a function of the custody or verification responsibilities of depositaries

And finally, it needs to explain how the relationship between service providers – such as the fund administrator, transfer agent, sub-custodians and depositary – will work as function of the oversight and cash monitoring duties imposed on the depositary.

The outcome of discussions on these policy issues needs to be cast in a manner which caters for the different market participants and the structures employed by AIF of all different types.

Third countries

You will all have noticed that I have not so far discussed the third-country issues. As this audience will know, this was a charged aspect of the negotiations. The final outcome is, in my view, a balanced one which reflects the practical realities of how alternative investment fund management – including its supporting services – inevitably involves markets, jurisdictions and investment across the globe.

As Mark Hoban, the Financial Secretary to the UK Treasury, said in a recent speech to the British Private Equity & Venture Capital Association (BVCA), ‘without third-country access, it would have meant an iron curtain not so much falling across Europe, as encircling it.’

As those of you who have followed the third-country debate closely will know, once the Directive is transposed certain supervisory requirements will need to be met to permit the ongoing private placement of funds. The FSA will need to make sure it has appropriate cooperation arrangements in place with third-country regulators to monitor systemic risk. These arrangements will need to be in line with international standards.

The UK FSA, and its successor bodies, will ensure that the necessary further work is done to determine the framework under which these arrangements will operate.

Looking forward and conclusion

Thank you for your attention this morning. There are three key points I would like you to take away:

• Firstly – consistency between regulations is a necessary but not a sufficient condition to argue for a direct copy across from a retail directive.
• Secondly – we should be fully aware of the operational issues – and I mentioned depositaries and scope earlier – created for firms at level 1 and should strive to ensure an optimal outcome that has a proportional focus. We should vigorously challenge any barriers that are placed in our way to achieving this goal.
• Lastly – we should not miss opportunities to consult. This will inevitably lead to the early identification of previously unknown issues which can be solved before the regulation is enacted.

I think we now turn to the panel session and I am sure that I echo your thoughts by saying that I am keenly anticipating both the questions but also the responses from Patrice Bergé-Vincent, Thomas Neumann and Nicoletta Giusto. I hope we can add valuable insight into the direction of the task forces, whilst responding to any concerns raised.