Speech by Sheila Nicoll, Director of Conduct Policy, PwC Global Alternative Investments Seminar.
Good afternoon ladies and gentlemen and thank you to PwC for its invitation to speak at this forum.
I have been asked to provide my perspective on the development of the Alternative Investment Fund Managers Directive (AIFMD).
This is, of course, very timely since the European Securities and Market Authority (ESMA) has just published, for consultation, its draft advice to the Commission on detailed rules that will sit under the Directive. I propose, therefore, to focus on what I see as the important issues in that consultation. I will then talk about how ESMA is developing proposals for the important third-country aspects of the Directive.
Alternative Investment Fund Managers Directive
The AIFMD was finally published in the European Union’s ‘Official Journal’ on 1 July (2011). Working with the (UK) Treasury, the FSA and its successor organisations, particularly the Financial Conduct Authority (FCA), will need to transpose the Directive by 22 July 2013.
There is a lot of work to do between then and now.
Under the directive, the European Commission needs to develop a significant volume of fairly detailed rules. ESMA has, for the last six months, been working on advice to the Commission and you, and others who are interested, have two months, until 13 September, to comment.
Your input is vital, and I would strongly urge you all to take the time to provide thoughtful and constructive input.
It has been a daunting task, to a tight timetable – ESMA's draft advice stretches to 438 pages. ESMA has tried to be proportionate in its approach, and to take account of the very wide range of subjects and stakeholders covered by, or who have an interest in the AIFMD.
Where there has been strong agreement within ESMA, a single approach has been proposed. In other areas several options have been presented – these reflect the complexity and, in some cases, political sensitivity around some of the issues.
In many cases, the proposed advice has been aligned to existing requirements in, for example, the Undertakings for Collective Investment in Transferable Securities (UCITS) directive or Markets in Financial Instruments Directive (MIFID). But in others, the AIFMD is in new territory, requiring new rules on leverage for example, which I will come to later. Or it covers activities which are distinct from, say, UCITS which has required tailoring of existing rules.
I can’t possibly cover everything in the consultation in 20 minutes, but will focus today on issues which I think are of most interest to this audience.
Depositaries
First, depositaries – a highly sensitive subject which has received a lot of political scrutiny.
Several of the important principles in this area were agreed during the original debate on the Directive, but authority was delegated to the Commission to develop more detailed rules covering some very significant policy issues.
ESMA’s advice joins up many of the dots which had been left unconnected by the original Directive and I would like to highlight a few of the pictures that emerge.
One of the most contentious and sensitive aspects of this part of ESMA's proposed rules is the liability of a depositary to restitute the alternative investment fund (AIF) for lost assets.
ESMA is seeking the input of all stakeholders to achieve a balanced outcome which provides an appropriate level of investor protection without creating systemic risk.
In particular, ESMA is consulting on whether the starting point should be an assumption that the depositary should be liable for the actions of its sub-custodians as if those actions were performed by the depositary itself.
It is important to note that when delegating custody to its sub-custodians, the depositary must follow the comprehensive due diligences procedures which are in the ESMA advice, it then needs to monitor them on an ongoing basis. I therefore find it counterintuitive that the robust requirements set by ESMA do not change the extent to which the depositary is liable for actions within its sub-custodians. Does this mean the depositary will be liable for events outside its reasonable control? Will the punishment fit the crime?
ESMA considers that depositaries must identify and monitor potential loss events if they want to avoid liability for the loss. The advice also says that depositaries, in some cases, must take additional ‘appropriate actions’ but unfortunately it doesn’t then go on to explain what these are. I think practitioners will find it incredibly useful if ESMA explains what these additional actions look like and when they must be taken.
ESMA has considered a number of other aspects of the depositary’s role including its oversight duties and in this regard due diligence and the reliance or otherwise a depositary can place on the controls applied by third parties.
ESMA has also considered the relationship between the depositary and prime broker which is particularly important in the hedge fund area.
Depending on the option selected in relation to the financial instruments that can be held in custody, we could be in a position where the prime broker will be viewed as a sub-custodian to the depositary when holding assets as collateral. This may not be an optimal outcome and it is important that the consultation teases out the full consequences if this were the final result.
In general the depositary section raises as many questions as it answers but I think that is to be expected. I am specifically looking forward to hearing views about what should be considered a loss and whether the internal/external split implicit in the advice is right.
Leverage
Next, leverage – one of the most technical parts of the advice. I think the focus here needs to be on two key phrases: ‘proportional application’ and ‘robust methodology’.
- Proportional application: ESMA’s advice seeks to take account of how the fund and its investors view leverage by providing for an “advanced method”. This allows for tailoring by the manager so as both to meet the disclosure needs of investors and to act as a reasonable benchmark against which maximum leverage limits can be assessed.
- A robust methodology: the advice should help limit the extent to which leverage can be hidden behind layers of derivatives or via complicated hedging and netting relationships. That said, you as practitioners may have wanted it to go further and clarify how borrowings within portfolio company and fund of fund structures should be treated.
Transparency
Next, transparency. One of the main objectives of the Directive is to increase the transparency of AIFM vis-à-vis investors and regulators.
It includes requirements regarding the annual report of the AIF, initial and ongoing disclosure to investors and reporting to competent authorities.
It has been challenging, on the one hand, to achieve harmonisation while, on the other hand, respecting national practices and standards. This has for instance been the case in relation to annual reporting and accounting rules where I think a reasonable compromise has been achieved. The minimum requirements proposed seek to take account of, and work in parallel with, existing national and international requirements without cutting across them.
The one remaining area of likely contention around the annual report is remuneration disclosure.
This is a difficult area but I believe the advice has sought to achieve a proportional response to the requirements of the Level 1 text, and has provided flexibility in the way these disclosures are reflected in the financial statements.
I would encourage debate as to how this will be interpreted or applied in practice.
There are still divergent views around the treatment of tools and arrangements for managing liquidity - including to what extent side pockets and gates can be used in normal circumstances.
The conclusions of the consultation on this could have quite a significant impact on existing practice and disclosure. It is important that you explain existing practice in this area and the implications of changes that the advice may require, so that ESMA can make an informed decision in its final advice to the Commission.
As you may have noticed, ESMA has proposed that all AIFMs should be required to report to the competent authorities on a quarterly basis.
The Commission’s mandate asked ESMA to provide advice on the “appropriate frequency of such reporting, taking account the potential risks posed by specific types of AIFM”. In the response, we would encourage you to consider the extent to which you feel that that mandate has been met, and the practicalities and costs of such reporting in practice.
Risk Management
My next subject is risk management.
Overall this has been a relatively uncontentious area as it draws heavily on existing UCITS requirements.
The one area of contention is around the provision of a non-exhaustive list of specific safeguards AIFM should apply against conflicts of interest to ensure the independent performance of risk management activities.
The debate relates to whether all or certain safeguards should be mandatory. It would be useful to hear, in the responses to the consultation, what the impact of these safeguards would be in practice, particularly for smaller firms, and its likely effect on cost or its potential to create barriers to entry.
Scope
And now to a fundamental question – scope – and more particularly, ‘who is the AIFM’?
The Directive is unclear on this point.
My view is that the answer is to an extent linked to the delegation provisions. The Directive allows managers to delegate functions to third parties but not to the extent that the AIFM becomes a ‘letter box entity’. I believe that ESMA’s advice has added clarity to this area and provides a strong framework within which we can take this work forward
Valuation
I am nearly there and my next contentious issue relates to external valuers.
As you may be aware the Directive requires an independent performance of the valuation function, but this can be done within the AIFM or by an external valuer. The advice makes two clarifications here. Firstly - this ‘valuation function’ refers only to the valuation of individual assets and not the administrative function of calculating the NAV (Net Asset Value). Secondly – there can be more than one external valuer. The implications are that fund administrators that calculate the NAV should not be considered to be ‘external valuers’.
In the interests of clarity it is also important to note that where an AIFM performs the valuation function it can still delegate or indeed separately contract with 3rd parties for the performance of some of the tasks involved, provided it retains responsibility for the valuation function itself.
I think this should provide a workable framework.
Capital
My final area of focus is the prudential framework.
The Directive’s requirements are broadly consistent with that for UCITS management companies – except that there are some additional requirements covering risk arising from professional negligence.
The risks that such policies may be required to cover in relation to fraud go beyond current coverage offered by professional indemnity policies. Generally at the moment such policies will cover fraud by the staff of the AIFM, but the advice also includes frauds by ‘relevant persons’ - this includes directors, partners and delegated parties.
It is therefore important that ESMA understands from the responses whether such extended cover is, or can be made, available, and how much it may cost. It can then take that into account in its final advice to the Commission.
Overall, the proposals developed by ESMA in relation to capital requirements are unlikely to result in significant changes for many fund managers, particularly those already subject to Pillar 2 requirements; however, they could create barriers to entry for smaller fund managers.
In drawing my remarks on the ESMA consultation to a close I want to stress that the ESMA advice is not being produced in a vacuum. ESMA has already undertaken a programme of targeted engagement with certain stakeholders and this consultation provides a further opportunity for stakeholders of all types to provide input. I would encourage you to grasp this opportunity.
Third-country aspects
I want now to turn to the third-country aspects of the AIFMD which govern the way the marketing and management of non-European alternative investment funds and their fund managers will be regulated.
The ESMA consultation does not include proposals around cooperation between European and non-European supervisory authorities.
Given the very tight time constraints to which we are all working, ESMA has given priority to the aspects of its advice where it needs input from the industry, but we recognise that cooperation arrangements between regulators are a pre-requisite for the management and private placement of non-EU based funds in Europe.
So ESMA is committed to a separate consultation on these aspects of its draft advice in the summer so that it can meet the mid-November deadline for delivering its final advice to the Commission.
ESMA’s chairman, Steven Maijoor, has, in particular, acknowledged the importance of ensuring that “an effective and efficient regulatory framework is in place in Europe for the recognition of third country service providers”.
ESMA has, importantly, been asked to take account of relevant international standards, particularly International Organization of Securities Commissions’ (IOSCO) principles and standards relating to the control of potential systemic posed by alternative fund managers. ESMA is now discussing how existing standards need to be tailored to meet the requirements of the AIFMD.
As I have said previously, the UK FSA and its successor bodies, is committed to making sure the work is done to finalise these supervisory cooperation arrangements and that they will be in place by mid July 2013.
Conclusion
Thank you for your attention this afternoon.
In conclusion then, work on the AIFMD has continued at quite a pace since the beginning of the year. Now is the opportunity to spend a couple of months taking stock of where ESMA has got to before it provides its final advice to the European Commission. It is important that the UK and indeed the pan-European industry is part of that stock take and I very much look forward to your thoughtful and constructive contribution to the consultation.
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