- Alternative Investment Fund Managers Directive (AIFMD) — Alternative investment fund — Advertising and marketing and funds — Hedge fund — Supervision
I. Terms of Reference
1. The extraordinary expansion of the EU regulatory framework for investment funds and the creation of a single market for non-UCITS
A. Pre-AIFMD: UCITS, NURS, and unregulated funds
1.01 Since 19891 it has been possible to seek authorization as an ‘undertaking for collective investment in transferable securities’ (UCITS) for EU based, open-ended collective investment arrangements that invest in a diversified portfolio of transferable securities and seek to offer participations to the public.2 Authorization of an investment fund as a UCITS will permit the offering of participations in the UCITS to the public in Member States other than the Member State under the laws of which the UCITS is organized without further authorization by the host Member State.3
1.02 The regulation of collective investment arrangements that are not UCITSs—including investment funds offered to the public in only one Member State, known as non-UCITS (p. 3) retail schemes or ‘NURSs’—traditionally has been left to the Member States’ national initiative. The Member States took different positions in relation to the scope of their national regulatory frameworks for investment funds and otherwise similar schemes received different regulatory treatment under the national frameworks. What was a ‘collective investment fund’ was decided by reference to different criteria and, where arrangements were caught as collective investment funds, national frameworks tended to treat the exclusions or exemptions from the offering of participations in these funds differently. Equally, ‘managing a collective investment scheme’ other than a UCITS fund was not a regulated activity in all jurisdictions.
1.03 This resulted in a diverse collection of regulatory frameworks ranging from the fairly liberal—which seek to regulate only investment funds that are offered to the public, thus leaving certain qualified investors free to invest in unregulated investment funds—to the conservative—which prohibit the offering of any unregulated investment funds in any circumstances. For instance, a closed-ended investment trust was not treated as a ‘collective investment scheme’ in the UK, but would have been an ‘investment institution’ in the Netherlands. Equally, the Netherlands and the UK exempted the offering of (foreign) funds to qualifying investors subject to certain criteria, but Italy and France offered no such exemptions for foreign funds.
B. The AIFMD: a sweeping Directive
1.04 The implementation of the Alternative Investment Fund Managers Directive4 (AIFMD) has introduced maximum (sometimes permitting Member State ‘gold-plating’) harmonizing regulatory standards into the previously diverse landscape. The AIFMD brings the managing of ‘alternative investment funds’ (AIFs) from the EU, and the offering of units, shares, or other participations rights in AIFs to professional investors (ie non-retail investors) based in the EU, within the scope of pan-EU regulatory framework.
1.05 AIFs are very broadly defined as ‘collective investment undertakings’ which are offered to ‘a number of investors’, invest the collective assets ‘in accordance with a defined investment policy’ and do not require authorization as a UCITS.5 The definition purposefully does not limit the catchment area.6 Simply put, the AIFMD captures all arrangements that have some collective investment characteristic and are not a UCITS. The definition ignores whether the arrangement is open-ended or closed-ended, what legal form it has, whether or not the participation rights are listed, and, notwithstanding the name of the Directive,7 what it invests in.8
(p. 4) 1.06 The AIFMD is aimed at the managers of AIFs, referred to in the AIFMD as ‘Alternative Investment Fund Managers’ (AIFMs), rather than the AIFs they manage.9 AIFs may continue to be regulated and supervised at the national level. It is the AIFM’s, not the AIF’s, responsibility to ensure that the management and offering of the AIF complies with the AIFMD. The AIFMD applies to the EU or non-EU manager of an AIF regardless of whether the AIF is an EU AIF or a non-EU AIF, although non-EU AIFs may be exempted from certain provisions, particularly if the non-EU AIF is not marketed in the EU. But EU AIFMs will always need some form of authorization under the AIFMD.
1.07 Subject to de minimis and other exemptions, and an implementation period for non-EU managers and for (EU and non-EU) managers of non-EU AIFs, the AIFMD sets aside all qualified investor, private placement, or similar exclusions or exemptions that operated on the offering of funds that were not authorized to be offered to the public at national level prior to the AIFMD coming into force. Outside the limited de minimis exemptions, there are no options left for operators of non-UCITS investment funds to offer participations within the parameters of these types of regulatory safe havens.
1.08 The implementation of the AIFMD, therefore, amounts to an extraordinary expansion of the EU regulation of the management and offering of non-UCITS collective investment schemes. Had the European legislator wanted to give the Directive a more meaningful name, it should have been called the ‘Professional Investor Fund Manager Directive’ or maybe even the ‘Non-UCITS Fund Manager Directive’.
C. The creation of a single market for management and marketing of AIFs
1.09 One of the aims of the AIFMD is to ensure that, once fully operative, it will create a single market in which EU and non-EU AIFMs authorized by one Member State may also manage AIFs in all other Member States and market their AIFs freely to professional investors in the EEA subject to a harmonized offering regime.10
1.10 The AIFMD makes a distinction between authorization of EU AIFMs and authorization of non-EU AIFMs, and a further distinction between the management and marketing of EU AIFs and the management and marketing of non-EU AIFs. As a result, the regulatory framework has become complex. The table below is designed to assist in the navigation of the AIFMD maze.
Marketing to professional investors
Marketing to professional investors
* Article 66(3) delays implementation of Article 35 and Articles 37–41 until activated by a Commission delegated act made pursuant to Article 67(6). The delegated act must be adopted three months after the European Securities and Markets Authority (ESMA) has given positive advice pursuant to Article 67(1) about extending passporting rights for the marketing of non-EU AIFs by EU AIFMs within the meaning of Article 35 and Articles 37–41. ESMA must give advice by 22 July 2015.
** Article 66(4) provides for termination of Articles 36 and 42 by a Commission delegated act made pursuant to Article 68(6). The delegated act must be adopted three months after ESMA has given positive advice pursuant to Article 68(1) about terminating the national regimes, if any, made under Articles 36 and 42. ESMA’s advice must follow three years after the 22 July 2015 advice relating to extending passporting rights for the marketing of non-EU AIFs by EU AIFMs within the meaning of Article 35 and Articles 37–41. In other words, ESMA must give termination advice by 22 July 2018.
(p. 6) 1.11 Unlike the UCITS Directive, the AIFMD does not seek harmonization of the constitution and operation of the AIF. This was deemed to be ‘disproportionate’.11 In other words, the AIFMD, subject to delayed implementation for non-EU AIFs and non-EU AIFMs, introduces a single market for the managing and marketing of EU and non-EU AIFs by authorized and passported EU and non-EU AIFMs without imposing a fully harmonized operating regime on the AIFs.
1.12 The fact that a Member State may or may not regulate an AIF established in its jurisdiction does not restrict an authorized AIFM’s rights under the AIFMD to market that AIF in another Member State. For example, if an AIFM authorized by the competent regulator in the UK manages an Irish qualifying investor fund (QIF) and seeks to market that QIF in France pursuant to its passporting rights, the French authorities cannot impose additional requirements on the Irish QIF nor the UK AIFM in respect of that QIF.12
2. Private law aspects of the AIFMD
1.13 The AIFMD is regulatory law and therefore, by its very nature, a public law. It prescribes rules for AIFMs, who are persons who engage in activities that are regulated pursuant to the AIFMD. Accordingly, the purpose of the rules is to prescribe general conduct and organizational standards to which the regulated firm must adhere in order to be authorized to conduct its regulated business.
1.14 The purpose of regulatory law is not to create private law rights and liabilities between the regulated firm and third parties, be they clients of the firm or otherwise. Nevertheless, the AIFMD includes provisions that appear to reference private law rights of the AIF and of the investors in the AIF in Article 19(10) (liability of the AIFM for the valuation function), Article 20(3) (liability of the AIFM for a delegated function), and Article 21(12) and (13) (liability of the depositary). In addition, Article 37(13) (jurisdiction clause) appears to imply a mandatory forum choice into any contractual relationship.
1.15 Article 19(10) provides in the first paragraph that ‘AIFMs are responsible for the proper valuation of AIF assets, the calculation of the net asset value and the publication of that net asset value. The AIFM’s liability towards the AIF and its investors shall, therefore, not be affected by the fact that the AIFM has appointed an external valuer’. Similarly, Article 20(3) provides that the ‘AIFM’s liability towards the AIF and its investors shall not be affected by the fact that the AIFM has delegated functions to a third party’, and under Article 21(13) the ‘depositary’s liability shall not be affected by any delegation’.
1.16 These provisions could be read as regulatory requirements on AIFMs and depositories not to seek to avoid responsibility for delegated functions. Indeed, Article 21(6)(e) specifies as one of the conditions for the appointment of the depository that it must ‘by contract be liable to the AIF or to the investors of the AIF, consistently with paragraphs 12 and 13’.
(p. 7) 1.17 If the provisions must be read as regulatory requirements, an AIFM or depository that seeks to contractually exclude liability for the delegated function would be breaching regulatory requirements, but that breach per se would not also invalidate or subvert the contractual arrangement. If the applicable private law recognizes some form of limitation on the ability of a party contractually to exclude liability, it is conceivable that breach of a regulatory requirement would be interpreted by the competent court to constitute a failure of the contractual exclusion to meet the applicable test for, eg, fairness or reasonableness, and therefore, that the attempted exclusion of liability is set aside.
1.18 However, other provisions use much more direct language. The second paragraph of Article 19(10) reads: ‘notwithstanding the first subparagraph and irrespective of any contractual arrangements providing otherwise, the external valuer shall be liable to the AIFM for any losses suffered by the AIFM as a result of the external valuer’s negligence or intentional failure to perform its tasks’. Article 21(12) provides in the first paragraph that the ‘depositary shall be liable to the AIF or to the investors of the AIF, for the loss. . .of financial instruments held in custody’ and in the third paragraph that the ‘depositary shall also be liable to the AIF, or to the investors of the AIF, for all other losses suffered by them as a result of the depositary’s negligent or intentional failure to properly fulfil its obligations pursuant to this Directive’.13
1.19 This liability language is plain in intention and purpose. It purports to create or preserve, as the case may be under the applicable national private law, private rights of action against the AIFM and the depositary for the AIF and its investors. If challenged in the national courts, the European principle of effectiveness, known as effet utile, will probably operate to the effect that contractual arrangements or rules of national private law that seek to exclude, mitigate, or alter any liability of the AIFM or depositary as envisaged by Article 19(10), 20(3), or 21(12) and (13) will be set aside.14
1.20 It is not clear, however, what the nature of these private rights of action is. Is it a statutory right of action? Is it to be implied in the contractual relationship, if any, between the injured parties and the AIFM or the depositary, or does it set a negligence standard that gives separate actions in tort to the injured parties? Further, are the rights of action meant to be independently enforced by investors in the AIF or is it a collective action? And if it is a collective action, is the AIF responsible for enforcement?
1.21 Article 37(13) contains a jurisdiction clause and provides that ‘Any disputes between the [non-EU] AIFM or the AIF and EU investors of the relevant AIF shall be settled in (p. 8) accordance with the law of and subject to the jurisdiction of a Member State’. Again, it is not clear how this provision is intended to work in the context of national civil procedure rules. Are contrary contractual choices of law clauses set aside? What law of which Member State applies? Does this affect conflicts of laws forum selection rules in the context of tortious liability?
3. Policy reasons for the expansion of the EU regulatory framework for investment funds
A. The stated case for the AIFMD
1.23 The first three recitals of the AIFMD aim to make the case for expansion of the scope of the EU regulatory framework for investment funds. Recital (1) notes that managers of AIFs are ‘responsible for the management of a significant amount of invested assets in the Union, account for significant amounts of trading in markets for financial instruments, and can exercise an important influence on markets and companies in which they invest’. Recital (2) asserts that the ‘impact of AIFMs on the markets in which they operate is largely beneficial, but recent financial difficulties have underlined how the activities of AIFMs may also serve to spread or amplify risks through the financial system’; and recital (3) concludes that ‘[r]ecent difficulties in financial markets have underlined that many AIFM strategies are vulnerable to some or several important risks in relation to investors, other market participants and markets’.
The financial crisis has exposed a series of vulnerabilities in the global financial system. It has highlighted how risks crystallising in one sector can be transmitted rapidly around the financial system, with serious repercussions for all financial market participants and for the stability of the underlying markets. . . .The proposed legislation will introduce harmonised requirements for entities engaged in the management and administration of alternative investment funds (AIFM).
1.25 The Commission justifies the need for ‘closer regulatory engagement with this sector’ with a reference to reports produced by the European Parliament16 and the High-Level Group on Financial Supervision chaired by Jacques de Larosière.17 Neither report, however, appears to suggest that there is a need to expand the regulatory framework for investment funds in the EU to the level the AIFMD has ultimately introduced. The reports merely note the need for governments and regulators to gain a better understanding of the level of leverage (p. 9) and the size of the investments made by (specifically) hedge funds and private equity funds. The limited findings of the Rasmussen and De Larosière reports do not appear to provide a proper basis for the Commission’s policy rationale for the introduction of the AIFMD in its final form.
1.26 The Commission further observes in the Explanatory Memorandum that the ‘financial crisis has underlined the extent to which AIFMs are vulnerable to a wide range of risks’ and that these risks are ‘of direct concern to the investors in those funds, but also present a threat to creditors, trading counterparties and to the stability and integrity of European financial markets’.
(a) Macro-prudential (systemic) risks, defined as ‘direct exposure of systemically important banks to the AIFM sector’ and ‘pro-cyclical impact of herding and risk concentrations in particular market segments and deleveraging on the liquidity and stability of financial markets’.
(b) Micro-prudential risks, defined as ‘weakness in internal risk management systems with respect to market risk, counterparty risks, funding liquidity risks and operational risks’.
(c) Investor protection risks, defined as ‘inadequate investor disclosures on investment policy, risk management, internal processes’ and ‘conflicts of interest and failures in fund governance, in particular with respect to remuneration, valuation and administration’.
(d) Market efficiency and integrity risks, defined as the ‘impact of dynamic trading and short selling techniques on market functioning’ and the ‘potential for market abuse in connection with certain techniques, for example short-selling’.
(e) Risks relating to the impact on market for corporate control, defined as ‘lack of transparency when building stakes in listed companies, e.g. through use of stock borrowing, contracts for difference, or concerted action in “activist” strategies’.
(f) Impact on companies controlled by AIFMs, defined as the ‘potential for misalignment of incentives in management of portfolio companies, in particular in relation to the use of debt financing’ and the ‘lack of transparency and public scrutiny of companies subject to buy-outs’.
B. The questionable logic of the arguments for the AIFMD
1.28 Of the risk categories listed by the Commission in the Explanatory Memorandum, only (b) and (c) appear special to the fund industry. Categories (a), (d), (e), and (f) are general matters that concern all market participants, whether or not they are fund vehicles. The question may be asked, therefore, whether the risks cited in categories (a), (d), (e), and (f) can serve properly as (part of) the policy rationale for EU legislation that aims to regulate the fund industry. Prima facie, it would appear not. In this context, it is worth noting that short-selling risks (see category (d)) are specifically addressed in a separate European short-selling regulation applying to all market participants.18
1.29 Other arguments made by the Commission are similarly questionable. The Explanatory Memorandum states that ‘AIFM were not the cause of the crisis’, but that the ‘risks associated (p. 10) with their activities have manifested themselves throughout the AIFM industry over recent months and may in some cases have contributed to market turbulence’. By way of example, the Commission observes that ‘hedge funds have contributed to asset price inflation and the rapid growth of structured credit markets’, and that the ‘abrupt unwinding of large, leveraged positions in response to tightening credit conditions and investor redemption requests has had a pro-cyclical impact on declining markets and may have impaired market liquidity’.19 Forced selling by funds will certainly have increased the pressure on market, thus decreasing liquidity. This would qualify as a category (a) risk. However, forced selling in distressed market conditions is not special to investment funds and it is not clear why operators of AIFs, or indeed the investors in AIFs, ought to be singled out for regulation on this basis. All market participants contribute to asset price inflation.
1.30 Equally, the fact that funds-of-hedge-funds have ‘faced serious liquidity problems’ causing ‘some funds-of-hedge-funds to suspend or otherwise limit redemptions’, as the Commission notes,20 does not constitute a meaningful policy reason for regulation of AIF in the manner proposed. In the event that the markets in which assets comprised in the pool ceases, temporarily or permanently, to be accessible or reliable, the operator of the scheme may need to suspend redemptions and contributions. That is a feature of investment in the particular market, not a feature special to collective investment arrangements. Any participant in that particular market, whether or not an ‘alternative investment fund’, would be faced with a dearth of trading opportunities as well as challenges to obtaining a reliable price.
1.31 While there may be good reasons in relation to particular types of AIFs, notably funds that operate a highly leveraged investment strategy, to seek transparency from the operators of those types of AIFs in relation to the AIFs’ trading positions—as argued in the Rasmussen and De Larosière reports—the policy reasons put forward by the Commission to justify the proposed regulatory intervention in the non-UCITS investment fund industry appear to lack focus. Even if there were special systemic risks associated with AIFs as defined in the AIFMD, for which the Commission has provided no evidence, it remains unclear why such risks justify, for instance, broad-brush strict restitutionary liability for depositaries of AIFs that fail—in a singularly uninformed manner—to recognize the complex legal reality of cross-border custody services.
1.32 It is difficult to avoid the conclusion that the AIFMD is the product of rushed and opportunistic rule-making, driven by the political environment du jour rather than considered and informed policy. Indeed, the name of the Directive is a stark reminder of the (initial) lack of political focus. It wrongly and opportunistically brands the AIFMD as merely designed to regulate private equity funds and hedge funds.21
(p. 11) 1.33 As a result, while the broad notions of regulating (the management of) non-UCITS funds and creating a single market for the offering of these funds to professional investors undoubtedly make good economic policy, the AIFMD presents a chequered landscape that lacks intellectual coherence.
1.34 When it concerns the ability of pension funds, insurance companies, and other financial intermediaries to access the world’s asset managers so as to ensure optimized portfolio selection—which is the best guarantee for optimized risk-return calibration—investors and product providers alike should be able to expect law-making based on careful consideration of broad-based empirical evidence and technically sound and informed analysis. European lawmakers, high-minded in the wake of a financial crisis, did not quite manage to apply the care and diligence required to make responsible law for the financial markets—the life blood of the modern economical cycle for allocation of capital from household savings and investments.
4. Legislative structure
A. The Lamfalussy procedure
1.35 Since the mid-2000s, EU financial services legislation is created at several ‘levels’. This process is known as the ‘Lamfalussy procedure’.22 Level 1 constitutes framework legislation, typically in the form of a directive of the Council and the European Parliament that must be implemented by the Member States through national legislation.
1.36 Level 2 consists of implementing measures that are made by the Commission, referred to as ‘delegated acts’. Delegated acts are typically made in a combination of regulations, which apply directly in the Member States, and directives, which must be implemented through national legislation.
1.37 Level 3 consists of specialist work of various bodies made up of representatives of national regulators. The Level 3 bodies make regulatory guidelines that apply to market participants and national regulators directly, as well as technical standards to assist the Commission in making delegated acts.
1.38 The operative Lamfalussy organizing principle is that certain rules are clarified into further detail at a later stage, thus leaving the setting of main principles at primary legislative level, ie the European Council and the European Parliament, and permitting specialist rules to be made at Level 2 and Level 3 without the need to seek ratification from the Level 1 legislative bodies, although these bodies are typically given the right to object to proposals within a certain period.23
1.39 The original Level 3 bodies were the Committee of European Banking Supervisors (CEBS),24 the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS),25 and the Committee of European Securities Regulators (CESR).26 These committees have recently been abolished and replaced by newly formed ‘European Supervisory Authorities’ (p. 12) (ESAs), operative since 1 January 2011. The ESAs are the European Banking Authority (EBA),27 the European Insurance and Occupational Pensions Authority (EIOPA),28 and the European Securities and Markets Authority (ESMA).29
1.40 The ESAs form part of the newly conceived ‘European System of Financial Supervision’ (ESFS). The ESFS is designed as an integrated network of national and EU supervisory authorities, leaving day-to-day supervision to the national level. It seeks to ‘overcome deficiencies’ in the pan-European regulatory framework and to ‘provide a system that is in line with the objective of a stable and single Union financial market for financial services, linking national supervisors within a strong Union network’.30 Apart from the ESAs, the ESFS comprises the European Systemic Risk Board (ESRB),31 the Joint Committee of the European Supervisory Authorities,32 and the national regulators.33
B. The AIFMD framework
1.41 The AIFMD constitutes Level 1 framework legislation. The AIFMD empowers and instructs the Commission to make further Level 2 rules by way of delegated acts. It concerns: Article 3 (exemptions), Article 4 (definitions), Article 9 (initial capital and own funds), Articles 12 and 14–21 (operating conditions for AIFMs), Articles 22–24 (transparency requirements), Article 25 (leverage), Articles 34–37, 40, 42, and 67–68 (non-EU AIFs and AIFMs), and Article 57 (exchange of information between regulators).34
1.42 To date, the Commission has adopted three regulations to supplement the rules in the AIFMD. The bulk of the Level 2 measures are contained in Regulation No 231/2013 of 19 December 2012 (Implementing Regulation).35 The Implementing Regulation deals with most matters that are delegated to the Commission under the AIFMD, except (p. 13) the opt-in procedure for AIFMs that meet the exemption conditions of Article 3(2)36 and the selection of the Member State of reference for certain non-EU AIFMs.37
1.43 The relevant ESA under the AIFMD is ESMA. Articles 10–14 of the ESMA Regulation empower ESMA to make regulatory technical standards in relation to matters in which the Commission has been given the power to make delegated acts.38
1.44 The regulatory technical standards must be ‘technical’ so as not to ‘imply strategic decisions or policy choices’ and their scope is delineated by the scope of the delegated acts to which they relate.39 ESMA must conduct public consultations and cost/benefit analyses in relation to draft technical standards, except if disproportionate or in matters of urgency.40 The Commission may reject ESMA’s proposed technical standards and ask for variations, and, indeed, has done so in relation to a number of areas in connection with the AIFMD.
1.45 Article 16 of the ESMA Regulation empowers ESMA to make guidelines and recommendations. These apply to national regulators and/or market participants. The objective is to further the consistency, efficiency, and efficacy of the ‘supervisory practices within the European System of Financial Supervision’ (ESFS) and to ensure ‘the common, uniform and consistent application of Union law’.41 Here, too, ESMA must conduct public consultations and cost/benefit analyses in relation to draft guidelines and recommendations, except if disproportionate or in matters of urgency.42
1. Subject matter and scope (Articles 1–2)
A. Subject matter (Articles 1 and 2(1))
1.46 Article 1 sets the scene: the AIFMD creates a regulatory framework for the authorization and regulation of ‘managers of alternative investment funds (AIFMs) which manage and/or market alternative investment funds (AIFs) in the Union’.
1.47 Article 2(1) puts beyond doubt that any connection of an AIFM with the EU, either because the AIFM is based in the EU or, if not, manages an EU AIF or markets an AIF in the EU, will bring the AIFM in scope. Accordingly, EU AIFMs which manage one or more EU or non-EU AIFs, non-EU AIFMs which manage one or more EU AIFs, and non-EU AIFMs which market one or more EU or non-EU AIFs in the EU, subject to applicable exclusions and exemptions, all need authorization under the AIFMD.
(p. 14) 1.48 The AIFMD, therefore, is not directed at AIFs per se.43 It seeks to regulate the operators, or ‘managers’, of AIFs—the AIFMs. Naturally, certain elements of the constitution and operation of AIFs are regulated indirectly by requiring the AIFM as part of its continued authorization to ensure that its AIFs are AIFMD-compliant.
1.49 Unless the AIF is a ‘self-managed’ AIF, so that it is also authorized as the AIFM,44 the compliance of the AIF will not ultimately be within the control of the AIFM. The AIFM will be required to resign as manager to the AIF in the event that the AIF fails to comply with the AIFMD.45
B. Scope: what is an ‘AIF’? (Articles 2(2) and 4(1)(a))
1.51 An ‘AIF’ is defined in Article 4(1)(a) of the AIFMD as a collective investment undertaking, which raises capital from a number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors and which does not require authorization pursuant to the UCITS Directive.46
1.52 Article 2(2) makes it clear that the structure of the arrangement, form (legal structure), or substance (open-ended or closed-ended) is of no consequence to the determination of whether or not an arrangement is an AIF.
1.53 The definition is clearly, and presumably purposefully, broad and inclusive. ESMA has made guidelines on the meaning of AIF,47 but this guidance is of a very general nature and does little to bring more certainty. ESMA does not wish (unintentionally) to narrow the scope of Article 4(1)(a).48
1.54 Accordingly, the only certainty is that UCITSs are not AIFs. All other elements—ie ‘collective investment’, ‘undertaking’, ‘raising capital’, ‘from a number of investors’, ‘with a view to investing’, ‘defined investment policy’, and ‘investing for the benefit of the investors’—are capable of variable interpretations ensuring that unless there is some form of exclusion, any arrangement that has collective investment characteristics is potentially in scope.
1.55 For instance, the notions of ‘collective investment’, ‘investing for the benefit of the investors’, and ‘defined investment policy’ are de facto largely non-descript. At first blush, it may be tempting to conclude that this is about arrangements that enable a number of participants, the investors, to ‘pool’ their assets and have the combined assets managed as a single fund in accordance with a certain investment objective so that they may share equally, pro rata to their participation, in the profits and losses of the pool as well as the cost of operation. However, many commercial arrangements are based on the notion of pooling resources and sharing profits and losses.
1.56 Even determining, for purposes of the definition of AIF, whether an undertaking has a number of investors or only one investor is not straightforward. Except where the undertaking is (p. 15) legally prevented, for example by law or its constitutional instrument, from raising capital from more than one investor, it should be considered an AIF notwithstanding that, de facto, there is only one investor.49 Naturally, if the sole investor is funded by multiple investors, look-through applies.50
1.57 In practice, it will be necessary for providers of investment and other financial products to consider each product offered in the EU carefully to assess whether it is caught by the AIFMD. That means screening against the implementation rules of the Member State in which the AIFM manages the AIF as well as the rules of each Member State in which the AIF may be offered.
C. Exclusions from the definition of AIF (Article 2(3))
1.58 Certain arrangements have been excluded from the definition of AIF by Article 2(3) AIFMD. The most obvious exclusion is the company, ie a business enterprise that participates in commerce in contractual or corporate form and seeks capital funding, privately or publicly, by way of a fixed number of equity participations. Where the enterprise concerns farming, building, manufacturing, or the sale of goods or services, it will not be difficult to identify the factors that distinguish the company from a collective investment arrangement.51 If, however, the company’s enterprise is the purchase and sale of financial investments, for its own account, the matter is less straight forward. Holding companies are therefore excluded from the definition of AIF.52 But the definition of holding company itself leaves grey areas.
1.59 Pension funds also operate collective investment arrangements. A defined benefit scheme disconnects the participants’ entitlements from the actual investment return and may be characterized more properly as a form of insurance. Defined contribution schemes, however, often offer participants a choice of investment options which are each organized and managed as a pool and may in some manner be characterized as investment funds. Most pension schemes would qualify as AIFs but for the exclusion from the definition of AIF.53
1.60 Other exclusions are supranational and national governmental bodies, including central banks and bodies that manage assets meant to fund social security obligations, as well as, helpfully, employee participation and savings schemes.54
1.61 Equally, unit-linked insurance policies, which pay out by reference to the value of a portfolio of investment funds that the policyholder may select during the life of the policy to invest the insurance premiums in, are well within reach of the definition of AIF. Interestingly, Recital (8) of the AIFMD observes that the Directive ‘should not apply to the management of pension funds; employee participation or savings schemes; supranational institutions; national central banks; national, regional and local governments and bodies or institutions which manage funds supporting social security and pension systems; securitisation special purpose entities; or insurance contracts and joint ventures’.55 All these arrangements have been (p. 16) listed as excluded from the definition of ‘AIF’ in Article 2(3), with the exception of insurance contracts. Notwithstanding, presumably, insurance services and insurance contracts are intended to be excluded from the scope of the AIFMD.
D. Grey area: notional pools may or may not be AIFs
1.62 The distinction between financial arrangements that constitute collective investment proper, and other financial arrangements, which operate to pay the participants a share of the profit and loss but are not collective investment, is most clearly obfuscated in the case of (off-balance sheet) asset-backed securitizations and (on-balance sheet) ‘structured debt’ instruments.
1.63 In the case of asset-backed securitizations, a special purpose vehicle will issue debt instruments. The proceeds of the issue will be used to buy a portfolio of assets from the originator, the arranger of the securitization, for example credit card debts or mortgaged loans. The returns of the portfolio of assets are used to fund the payments due under the issued debt instruments. The AIFMD does not aim to capture these arrangements and ‘securitisation special purpose entities’ have been excluded from the definition of AIF.56
1.64 Unlike securitization vehicles, structured debt arrangements are not excluded and may, prima facie, be caught. Structured debt arrangements entail a financial institution that has the benefit of a commercial credit rating to issue debt expressed to pay interest and principal by reference to the return of a notional pool of assets.
1.65 Consequently, all debt holders will share equally in the rise and fall of the reference value. Similarly, total return swap transactions may reference baskets of financial instruments arrangements. If the swap provider writes a number of swaps referencing an identical basket, the swap counterparties will share in the return of that basket. From some perspective, it may be said that these series of bilateral contractual arrangements amount to collective investment and are therefore AIFs. That conclusion, however, would not be right and appropriate in view of the definition of ‘AIF’ in the AIFMD, certainly not if interpreted in the context of the AIFMD’s stated rationale.
1.66 The primary raison d’être for the AIFMD is the management of systemic risk. Structured debt and swap transactions are balance sheet events for the issuer. The proceeds are not used to invest in an actual pool of assets for the benefit of its counterparties. The reference value remains a notional pool and the issuer will typically ensure that it can make payments by entering into swap and other investment transactions that will protect the issuer from any adverse movement in the value of the notional pool.
1.67 It is difficult to see how, in these arrangements—per Article 4(1)(a)(i)—capital has been raised from a number of investors ‘with a view to investing it’. The proceeds of the transactions—‘it’ in the definition of AIF—are not invested but will fund the issuer’s general operations and will be used by the issuer as principal, not as operator of a collective investment scheme. Systemic risk arising from these arrangements should be addressed as a matter of the regulation of the operations of the issuer as a financial institution, for example a credit institution, not as an AIFM.
1.68 The secondary aim of the AIFMD is investor protection. It concerns protection from certain market and other operational risks. In that context, the AIFMD seeks to impose operational (p. 17) requirements on the AIFM that aim to mitigate the potential impact of certain events. In particular, the AIFMD imposes risk and liquidity management and requirements in Articles 15 and 16 and a depositary requirement in Article 21.
1.69 These risk mitigation requirements are not meaningful in the context of a notional pool. Again: the proceeds, ‘it’, are not invested. The AIFMD, therefore, is not the right tool to regulate investment products which are bilateral contracts that determine the product provider’s payment obligations by reference to a notional pool of assets. A better approach is to regulate the governance of these products, and risk mitigation, as a matter of the regulated business of the issuer, ie either in the context of authorization as an investment firm under MiFID or in the context of the authorization as a credit institution under the Banking Directive.57 Indeed, the governance of unit-linked insurance policies is left to be regulated under the Life Insurance Directive.58 Naturally, a level playing field should be preserved in terms of operative conduct of business rules and product restrictions on market access.59
1.70 It may perhaps also be argued in certain circumstances that contracts that pay out by reference to notional pools are not ‘undertakings’ within the meaning of Article 4(1)(a). However, it is not clear what is meant by an ‘undertaking’. Article 2(2) refers to any ‘legal form’, which seems to make clear that the AIF does not need to have a legal personality, but not whether and to what extent an arrangement must have a separate existence of some description to constitute an AIF. Since capital must be raised from ‘a number of investors’ in order for there to be an AIF, arrangements that do not have legal personality should at least be a multi-partite arrangement to be considered as an AIF.
E. Scope: ‘managing’ an AIF (Article 4(1)(w))
1.71 The AIFMD lists the key components of ‘managing an AIF’ in Article 4(1)(w) and Annex I, which together stipulate that ‘managing AIFs’ means performing ‘at least’ the ‘investment management functions’ of ‘portfolio management’ or ‘risk management’ for one or more AIFs.
1.72 The drafting gives rise to confusion because Article 4(1)(w) appears to suggest that to be the AIFM, it is sufficient to be appointed either as the portfolio manager or as the risk manager. (p. 18) The wording in paragraph 1 of Annex I of the AIFMD does not use the word ‘or’, however, and Article 6(5)(d) provides that an AIFM must be appointed by the AIF to perform both functions in order to be authorized under the AIFMD.60
1.73 For a collective investment scheme to run properly, in essence, three different categories of functions must be performed: portfolio management functions (the investment and reinvestment of the assets of the collective investment scheme); administrative functions (the valuation of the assets, pricing of the shares or units, and cancellation and issue of units or shares, including settlement of the transactions with the investors, an activity known as ‘transfer agency’); and marketing and distribution functions.
1.74 In this context, it is instructive to compare the AIFMD’s definition of ‘managing an AIF’ to the UCITS Directive’s definition of ‘managing a UCITS’. Annex II of the UCITS Directive is clear on the point that ‘managing a UCITS’, also referred to as ‘collective portfolio management’, includes all three categories.61 In other words, the person who seeks to ‘manage a UCITS’ must be appointed by that UCITS to perform, and must have assumed responsibility to the UCITS for the performance of, all three categories of functions, together defined as ‘collective portfolio management’ by Annex II of the UCITS Directive.
1.75 The AIFMD takes a different approach. Although Annex I uses the words ‘collective management of an AIF’ and clearly implies that this concept is similar to the concept of ‘collective portfolio management’ used in the UCITS Directive,62 Annex I also implies that, unlike a management company authorized under the UCITS Directive, it is not mandatory for an AIFM to be appointed by the AIF to perform the administrative or marketing functions. Responsibility for investment management functions, ie portfolio management and risk management as defined in Annex I of the AIFMD, is sufficient.
1.76 Portfolio management and risk management are not defined in the AIFMD. Some confusion may therefore arise about the meaning of ‘portfolio management’ in the context of ‘management of a collective investment undertaking’ (be that a UCITS or an AIF).
1.77 It is clear that there is no functional difference between managing a portfolio of investments that belongs to an individual and managing a portfolio of investments that belongs to a collective investment undertaking. In both cases the portfolio manager is responsible for the investment and reinvestment of the portfolio, on a discretionary basis, with a view to pursuing a certain investment objective.
1.78 A person who manages the investment and reinvestment of the portfolio of an AIF is therefore not necessarily the ‘manager’ of that AIF, ie the AIFM. If that were true, all persons who provide MiFID portfolio management services to an AIF would be managing the AIF within the meaning of the AIFMD, and they are not.63 For a person to be the AIFM, there needs to be an additional, collective element. That must logically mean that the AIFM is the person who has assumed responsibility for the overall performance of the various functions listed in Annex I of the AIFMD in the context of the operation of the collective investment scheme.
(p. 19) 1.79 For instance, where it concerns portfolio management, responsibility for portfolio liquidity management in view of expected redemptions and contributions is a collective element in the management of the portfolio that is not present in individual portfolio management. This distinguishes the portfolio management role of an AIFM, or indeed a UCITS management company, from the portfolio management role of a MiFID investment firm. Naturally, the AIFM (or UCITS management company) can delegate the responsibility to a MiFID investment firm.
1.80 Merely advising the AIF is not sufficient, even if that function is accompanied by risk management.64 There must be discretionary investment powers, ie the AIFM must have discretion to make investment decisions within the boundaries of the agreed investment policy and the investment restrictions.
F. Scope: ‘marketing’ an AIF (Article 4(1)(x))
1.81 ‘Marketing’ is defined in Article 4(1)(x) AIFMD as a ‘direct or indirect offering or placement’, made ‘at the initiative of the AIFM’ or ‘on behalf of the AIFM’, to or with investors who are domiciled in the EU or who have a registered office in the EU, ‘of units or shares of an AIF’ managed by the AIFM.
1.82 The offering or placement must be made ‘at the initiative of the AIFM’ or persons in its distribution channel. Accordingly, if the units or shares are purchased at the investor’s initiative, commonly referred to as ‘reverse solicitation’, no ‘marketing’ within the meaning of the AIFMD has occurred. Recital (70) clarifies that the AIFMD is not intended to apply if an EU-based professional investor ‘invests in AIFs on its own initiative, irrespective of where the AIFM and/or the AIF is established’.
1.83 Pension funds and other institutional investors are often assisted by professional consultants who solicit product information from investment managers through so-called ‘requests for proposals’ or ‘RFPs’. It is very likely that investments in AIFs pursuant to these RFPs properly qualify as having been made at the initiative of the investor, rather than the AIFM. Much of this is fact and context bound, of course, and will also depend on national implementation and guidance from the national regulators.
1.84 Given that the offer or placement must be made ‘at the initiative of the AIFM’ or ‘on behalf of the AIFM’, it follows that the AIFM is only responsible for offerings or placements made through a distribution channel controlled by the AIFM. If a person, for example a broker, who is not authorized by or on behalf of the AIFM (eg by way of a distribution agreement or otherwise), offers or places units or shares in an AIF to or with an investor in the EU, the offering or placement does not cause the AIFM to be in breach of the AIFMD.
1.85 That would potentially leave a hole in the regulatory net because an AIF is a collective investment scheme and, therefore, units or shares in an AIF are financial instruments within the meaning of Section C of Annex I to MiFID. Investment firms authorized under MiFID and credit institutions authorized to provide MiFID services would therefore be able to offer or place units in non-compliant AIFs in the EU in accordance with their regulatory permissions.
1.86 The AIFMD deals with the potential gap in Article 6(8), which provides that ‘investment firms’, which ‘directly or indirectly, offer units or shares of AIFs to, or place such units or (p. 20) shares with, investors in the EU, may only do so to the extent the units or shares can be marketed in accordance with’ the AIFMD.65
1.87 In view of recital (9) AIFMD, the term ‘investment firm’ as used in Article 6(8) ought to be interpreted within the meaning of Article 1(1) MiFID, without reference to any exemptions so as to capture all firms that engage in investment services within the meaning of MiFID, regardless of whether or not these firms are based in the EU, and regardless of whether or not they are authorized under MiFID.
1.88 The wording of Article 6(8) suggests that the prohibition on ‘offering’ or ‘placing’ of units by an investment firm is limited to activities that amount to marketing. Therefore, an investment firm should be free to advise a client within the meaning of Article 4(1)(4) of MiFID to purchase units in an AIF,66 even if that AIF could not otherwise be marketed to that client in accordance with the AIFMD. Equally, per the definition of ‘marketing’ in Article 4(1)(x) and recital (70), if the firm executes an order on behalf of but at the initiative of the client,67 the resulting transaction ought not to amount to offering or placing.
2. Exemptions (Article 3)
1.89 Separately from the exclusions in Article 2(3), the AIFMD offers a number of exemptions in Article 3. Group company investment vehicles are exempted and the AIFMD does not apply to the extent that the AIF’s only investors are the AIFM or its group companies, provided these are not themselves AIFs.68
(a) in the case of AIFs that employ leverage, the aggregate value of the long assets of all the leveraged AIFs under common control of the AIFM does not exceed EUR 100 million;69
(b) in the case of AIFs that do not employ leverage and are closed-ended for a period of at least five years, the aggregate value of the long assets of all the AIFs under common control of the AIFM does not exceed EUR 500 million.70
1.91 The Commission has made Level 2 rules in relation to the calculation, monitoring, and reporting of the assets under management by an AIFM who seeks to avail of the materiality threshold exemptions.71 In summary: annually, the AIFM must calculate the aggregate value of all the assets held in each AIF it manages under common control, including those portfolios delegated to third parties, but UCITS portfolios, portfolios delegated to the AIFM by third parties, and cross-investments between the AIFs or their sub-funds, are excluded.72
1.92 The assets must be valued in accordance with the rules that apply to the AIF per its constitutive documents and the laws of its place of organization.73 Derivative instruments, however, including (p. 21) instruments with embedded derivatives such as convertible bonds, must be valued in accordance with the ‘conversion methodology’ set out in the Commission’s Implementing Regulation.74
1.93 AIFMs who have the benefit of the materiality threshold exemption are not fully exempted from the AIFMD: the AIFM must register with its national regulator and regularly provide information about its AIFs, the investment strategies, and the holdings and the principal activities, as well as monitor the value of the assets under management and notify its regulator immediately in the event that the AIFM fails to continue to qualify for the exemption due to a breach of the applicable threshold.75 Breaches that are expected to be temporary may not disqualify the AIFM if the AIFM is able to provide reasonable justification for its assessment that the breach is temporary in nature.76 However, breaches that are likely to continue for longer than three months are not considered to be temporary in nature.77
3. Determination of AIFM (Article 5(1))
A. Appointment to manage an AIF
1.94 Article 5(1) of the AIFMD directs the Member States to ensure that each AIF ‘shall have a single AIFM, which shall be responsible for ensuring compliance with [the AIFMD]’. To be the AIFM, a person must ‘manage the AIF’.
1.95 As discussed in paragraph 1.75, Article 4(1)(w), in conjunction with Annex I, implies that, unlike a management company authorized under the UCITS Directive, it is not mandatory for an AIFM to be appointed by the AIF to perform the administrative or marketing functions. Responsibility for investment management functions, ie portfolio management and risk management as defined in Annex I of the AIFMD, is sufficient.
1.96 The Directive’s splitting of ‘investment management functions’ (portfolio management and risk management) from other collective management functions reconciles with the fact that the AIFMD does not regulate AIFs directly. Unless an AIF is ‘self-managed’, so that it is also authorized as the AIFM,78 the compliance of the AIF will not ultimately be within the control of the ‘external’ AIFM. Instead, the AIFMD requires the AIFM, rather than each AIF, to ensure that the AIFs under its purview comply with the Directive.79 The AIFM will be required to resign as manager of the AIF in the event that the AIF fails to comply with the AIFMD.80
B. Internally managed versus externally managed AIFs
1.98 Article 5(1) permits the AIFM to be either a person which is appointed separately by or on behalf of the AIF to manage the AIF (‘external AIFM’), or to be the AIF itself, if its legal (p. 22) form permits a governance structure that allows for self-management of the AIF (‘internal management’) by a governing body of the AIF and the governing body has not decided to appoint an external AIFM.81
1.99 The distinction between the self-managed, or ‘internally managed’, AIF and an AIF that is ‘externally managed’, ie has appointed an AIFMD management company, is of particular consequence for the capital requirements imposed by Article 9.
1.100 In practice, investment funds are structured in one of four forms: in corporate form as a company with variable capital; in contractual form as a partnership operated by a (usually incorporated) general partner; in contractual form as a common fund held by a depositary company and managed by a management company; or in the form of a (unit) trust operated by a (usually incorporated) trustee. Only the company with variable capital has a governance structure that permits self-management through its governing bodies, the board of directors, and/or shareholders.
1.101 AIFs that exist in contractual or trust form do not normally have independent governing bodies. They are managed through their general partner, management company, or trustee who, therefore, would in the first instance qualify as the AIFM. However, nothing in the AIFMD suggests that authorization as an internally managed AIF of a trust or contractual common fund is not permitted if the constitutive documents of the AIF establish a board or other governing body that is charged with the Annex I investment management functions. For purposes of Article 9, it is conceivable that the capital requirement of EUR 300,000 would be contributed to the trust or contractual common fund by the sponsor of the AIF by way of subordinated units or shares that are only redeemable if all ordinary unit or shareholders have been paid in full.
4. Types of AIFM and AIFs
A. Open-ended and closed-ended AIFs
1.102 Application of Article 16 (liquidity management), Article 19 (valuation), and Article 61 (transitional provisions) of the AIFMD differs depending on whether the AIFM’s AIFs are open-ended or closed-ended.
1.103 Open-ended collective investment funds do not normally have a fixed term, and permit investors to make contributions and request redemptions at certain times during the life of the fund. The number of units or shares issued to an investor in return for contributions to the fund and the amount payable to the investor by the fund upon cancellation of units of shares following a redemption request are based on the price of the unit or share on the day of the contribution or redemption (known as the ‘dealing day’). The price is calculated by dividing the net asset value of the fund—ie the assets minus the liabilities as determined based on prevailing market prices and in accordance with the rules applicable to the fund under its constitutive documents and the law of its place of organization—by the number of outstanding units or shares on the dealing day. The contribution, or the redemption amount, as the case may be, is payable upon the contribution or redemption becoming binding on the investor and the fund.
1.104 Closed-ended collective investment funds have a fixed term and do not permit additional contributions of privately offered closed-ended funds after the fund has closed following the capital-raising cycle. During the capital-raising period, each investor agrees on the amount of (p. 23) capital it will commit to the fund. Once the aggregate of the investors’ capital commitments reaches a certain threshold determined by the manager of the fund, the capital-raising cycle ends and the fund is said to be ‘closed’. The next phase is the investment phase, in which the manager will seek out investment opportunities. The investment will, apart from bank borrowing, be funded by ‘drawing down’ capital commitments, or, later in the life of the fund, by the proceeds from the sale of earlier investments. This will continue until the manager has invested the entire committed capital. In the final phase, the manager will sell the investments of the fund one by one and return capital, plus or minus the return on the particular investment, to the investors.
1.105 Accordingly, open-ended and (privately offered) closed-ended funds have fundamentally different modi operandi. Open-ended funds accept contributions and will permit investors to take their capital out on a continuous, all be it not always high frequency, basis. The share of the investor in the pool is valued based on prevailing market prices that will be obtained from public sources. Closed-ended funds are not open for continuous contributions and redemptions and are perhaps best described as a series of collective investments in individual assets that are funded by the investor and lenders at the time of purchase. Capital is only returned once the investment is sold. Thus, the values of the capital contributions to, and the redemptions from, open-ended funds are determined based on estimated prices, notwithstanding the fact that the manager will normally have to sell fund assets to meet the redemption request. The values of the capital draw-downs and return from closed-ended funds, on the other hand, are based on actual prices.
1.106 Different operational processes have different implications for the liquidity profile and valuation of the fund. The manager of an open-ended fund is concerned with meeting redemption requests out of the portfolio and ensuring that the valuation of the redeemed units is accurate and fair to the remaining investors; the redeeming investor should not be over- nor underpaid. The manager of the closed-ended fund, on the other hand, returns the proceeds of the actual divestment to all investors once the asset has been successfully sold. Liquidity does not play a role in that process and the valuation is a mere calculus event based on the actually achieved price, not an estimation based on a collection of prevailing market values.
1.107 Naturally, the ability to operate an open-ended fund depends on the availability of reliable market prices, as well as relatively liquid markets for the assets in which the fund invests so that the manager may sell assets to meet the redemption requests. If the assets are less liquid, the manager must limit the frequency of the dealing days. Some funds that invest in illiquid hedge fund strategies operate with annual or even less frequent dealing days. At some point, it is tempting to conclude that the fund cannot be said to be open-ended.
1.108 Indeed, this is what ESMA, after consultation, wrote into its initial draft ‘regulatory technical standards’ (RTS) relating to ‘types of AIFM’.82 Recital (3) of ESMA’s initial draft RTS observes that the distinction between open-ended and closed-ended funds should be determined based on ‘an appropriate threshold for the frequency of redemption opportunities offered to AIF investors given the particular relevance thereof to the rules on liquidity management and valuation procedures’ and that given ‘current market practice, it is appropriate to consider as open-ended those AIFs which offer redemption frequencies of at least yearly’.
(p. 24) 1.109 As demonstrated, however, exactly because of the fundamental difference between valuation of investor interests in open-ended and closed-ended funds, the redemption opportunity, no matter how infrequent, would appear to be the wrong determinant. Rather, what matters is whether contributions and redemptions are driven by the manager’s investment opportunity and consequently by funding needs or liquidation proceeds of actual investment transactions.
1.110 The Commission concurs. In a letter dated 4 July 2013, the Commission wrote to ESMA that it has ‘serious doubts’ whether the frequency of the ability to redeem is a criterion that can be used to distinguish between open-ended and closed-ended funds. The Commission observed that Articles 16(1) and 19(3) of the AIFMD, in conjunction, denote a closed-ended fund as a fund which carries out valuations ‘in case of an increase or decrease of the capital by the relevant AIF’, and concludes that in case of a closed-ended fund, the ‘valuation and calculation frequency is therefore linked solely to increases or decreases of its capital’.
1.111 ESMA disagreed with the Commission’s response to its initial draft RTS for several reasons, mostly based on the practical implications of the liquidity and valuation rules for funds that have a low dealing frequency, ie less than once a year.83 Notwithstanding, ESMA submitted re-drafted RTS to the Commission ‘in order to ensure a timely implementation of the AIFMD provisions and move the process forward’.84
1.112 Article 1(2) of the re-drafted RTS provides that an open-ended AIF is an ‘AIF the shares or units of which are, at the request of any of its shareholders or unit holders, repurchased or redeemed prior to the commencement of its liquidation phase or wind-down’. Under Article 1(3) of the re-drafted RTS, a closed-ended AIF is an AIF that is not an open-ended AIF within the meaning of Article 1(1).
1.113 This approach—to base the distinction on whether the fund returns capital to investors after a sale of investment rather than at the request of the investor—is in line with what the market will in practice deem to be the difference between open-ended and closed-ended funds.85
B. Leveraged and unleveraged AIFs
1.114 In addition to the distinction between internally and externally managed AIFs, and between open-ended or closed-ended AIFs, the application of the AIFMD may differ depending on whether the AIF is considered to be (substantially) leveraged or unleveraged. This affects the application of Article 5(2) (exemptions) and Article 16 (liquidity management). Separately, AIFMs managing leveraged AIFs are subject to special duties under Article 25 (AIFMs managing leveraged AIFs).
1.115 The dictionary definition of ‘leverage’ describes it as the mechanical advantage gained by the use of a lever. A lever permits the use of the benefit of momentum so that less force is required to lift an object than if the object were lifted directly. In the context of investment, leverage denotes the momentum that is experienced when the market exposure of the investment of own funds is increased through the use of financial levers, ie financial transactions that result in the ability to make profits, or incur losses, from market movements of certain defined investments without investing own funds equal to the principal value of those investments at the time of the transaction.
(p. 25) 1.116 Leveraged exposure can be achieved in different ways. The most straightforward is to invest borrowed money. If the lender is prepared to provide an unsecured loan, the investor does not need own funds and has maximum momentum. More commonly, the lender will require the purchased investment as collateral and require the investor to invest own funds in addition to the borrowed funds, thus creating a buffer in the value of the collateral and protecting the lender against adverse market movements.
1.117 A common way to achieve leveraged market exposure is to enter into a forward contract or future. For instance, the purchaser of an index future will typically be required to provide only 10% of collateral value against the purchased value. EUR 10.00 thus permits the conclusion of a forward contract that gives EUR 100.00 market exposure. Similarly, someone who writes a put or a call option on an index may only have to provide collateral to the tune of 10% of the value to which the put or call relates. The buyer of the option is in a slightly different position, as only the premium is due and the option will naturally only be exercised if it is in the money.
1.118 Swap agreements can also provide leverage. For instance, an unfunded total return swap will permit the purchaser against the payment of a periodic fee calculated as a rate, for example LIBOR plus 0.30%, applied on the value of the reference asset, known as the ‘notional value’, to gain market exposure to virtually any asset class, limited only by the requirement to collateralize the future payments due to the provider of the total return swap.
1.119 A more complex and common set of transactions that give leveraged exposure is called ‘shorting’. The investor sells EUR 100.00 of certain financial instruments that are not actually owned and borrows the instruments from a third party to satisfy the delivery obligation. The proceeds of the short sale, plus any top-up with own funds as may be required by the lender, are provided as collateral for the securities loan. If the lender permits it, the short-seller may also choose to use the proceeds to buy different financial instruments and provide those as collateral instead of the cash proceeds of the short transaction, in which case the short-seller is said to have both a ‘long’ and a ‘short’ exposure to the market.
C. Determining whether an AIF is leveraged
1.120 The term ‘leverage’ is defined in Article 4(1)(v) of the AIFMD as ‘any method by which the AIFM increases the exposure of an AIF it manages whether through borrowing of cash or securities, or leverage embedded in derivative positions or by any other means’. This broad definition captures the numerous ways in which any market participant, collective investment fund, or otherwise, can seek to gain exposure to certain investments without investing own funds to the value of those investments.86
1.121 As instructed in Article 4(1)(3), the Commission has duly provided rules on the measurement and calculation of leverage in Articles 6–11 of the Implementing Regulation. Article 6(1) of the Implementing Regulation provides that leverage of an AIF shall be expressed as the ratio between its exposure and its net asset value.
1.122 It is important to note that it concerns the exposure of the AIF and not the exposure of issuers of instruments in which the AIF is invested. While investments with embedded derivatives, for example convertible bonds, are captured, investment in a leveraged issuer is not a leveraged transaction for the AIF. This matters in the context of closed-ended funds, which invest, for example, in private equity or real estate, as they tend to make investments through (p. 26) portfolio companies for tax and ring-fencing reasons. Portfolio companies typically obtain bank loans to fund their investments. The AIF would become exposed, however, if it agreed to guarantee any of the loans made to the portfolio companies.87
1.123 In addition, calculation of exposure excludes ‘any borrowings that are temporary in nature and fully covered by capital commitments from investors’,88 permitting the avoidance of settlement failures through temporary bridging facilities without tipping the AIF into a leveraged AIF regime.
1.124 The exposure must be calculated in two ways: using the gross methodology and using the commitment methodology.89 Gross exposure is the ‘sum of the absolute values of all positions’ of the AIF,90 but excludes cash and cash equivalents and unused cash borrowings.91 Positions are to be valued in accordance with the rules set out in the AIF’s constitutive documents and the laws under which the AIF is organized,92 but derivative instruments are valued using the conversion methodology set out in Annex I and II of the Implementing Regulation.93 Positions funded through the reinvestment of cash borrowings are to be valued at the higher of the value of the cash borrowing or the position funded with the proceeds of the borrowing.94 Repurchase and securities lending agreements are valued in accordance with paragraphs (3) and (10) to (13) of Annex I.95
1.125 The commitment methodology also starts with the sum of the absolute values of all positions of the AIF.96 However, all cash and cash borrowings are included. Again, positions are to be valued in accordance with the rules set out in the AIF’s constitutive documents and the laws under which the AIF is organized.97 Derivative instruments are to be valued using the conversion methodology set out in Annex I and II,98 except that total return swaps written by the AIF are not included,99 forward contract or futures purchased by the AIF if fully covered with cash positions are not included,100 and foreign exchange forward contracts, if used for currency hedging purposes, are not included.101 Positions funded through cash borrowings are to be valued at the higher of the value of the cash borrowing or the position funded with the proceeds of the borrowing.102 Repurchase and securities lending agreements are valued in accordance with paragraphs 3 and 10–13 of Annex I of the Implementing Regulation.103 Next, opposite positions must be netted where applicable104 and qualifying hedging arrangements must be taken into account.105
(p. 27) 1.126 The rationale put forward for the use of these two methodologies is that the combination is the best basis for ‘an objective overview of the leverage used’.106 The idea is that the gross method provides the overall exposure while the commitment method ‘gives insight in the hedging and netting techniques used’.107
1.127 There is something to be said for that, as the gross calculation adds up all positions, minus cash, regardless of whether the position is long or short, thus showing the absolute value of the market exposure, treating cash as nil exposure. The commitment method shows the relative value of the market exposure, including cash, but neutralizing all positions that may be properly regarded as hedged or netted. If the commitment exposure is equal to the net asset value (NAV), the AIF can be said to be not leveraged as it has not increased its market exposure beyond the value of its own funds. Notwithstanding, the gross exposure may still show whether or not the AIFM extensively employs derivatives for hedging and market exposure purposes.
1.128 As noted, Article 6(1) of the Implementing Regulation provides that the leverage of an AIF ‘shall be expressed as the ratio between the exposure of the AIF and its net asset value’. It does not clarify what the position is if the ratio is 1 based on the commitment exposure, suggesting that the AIF is not leveraged, but greater than 1 if based on the gross exposure. This could happen if the AIF uses derivatives to hedge positions, for example foreign exchange forward contracts (‘fx forwards’), and gain fully funded market exposure.
1.129 The AIF is considered to be ‘substantially leveraged’ if the ratio of the commitment exposure to NAV exceeds 3.108 In that case, Article 24(4) of the AIFMD imposes special reporting duties.
1. Overview: EU AIFMs and non-EU AIFMs
A. Jurisdiction of a Member State
1.130 Under Article 1(1), the AIFMD’s objective is to ensure that it is prohibited to ‘manage an AIF’ in the EU without prior authorization. In practical terms, this means that each Member State must ensure that ‘managing an AIF’ is a regulated activity that requires a licence or some other form of authorization if it is carried out in that Member State.
1.131 An activity is carried out in a Member State if the AIFM is domiciled in the Member State or a foreign AIFM manages an AIF that is domiciled in that Member State. The foreign AIFM may seek to establish a branch or representative office.
1.132 In the case of a domestic AIFM, authorization from the home Member State is required pursuant to Article 6(1) of the AIFMD. Subject to conditions, an exemption from compliance with Articles 21 (depositary) and 22 (disclosure requirements) applies by virtue of Article 34 to the extent that the domestic AIFM manages non-EU AIFs which are not marketed in the EU.
(p. 28) 1.133 In the case of a non-domestic EU AIFM, that AIFM may rely on its home state authorization to provide management services cross-border into another Member State under Article 33. An EU AIFM may also establish a branch in another Member State.
1.134 Non-EU AIFMs that manage an EU AIF will be required to be authorized by their Member State of reference pursuant to Article 37. Non-EU AIFMs may rely on such authorizations to provide management services cross-border into another Member State under Article 41.
1.135 A non-EU AIFM that is managing a non-EU AIF, logically, is not ‘managing an AIF in the EU’. However, if the non-EU AIFM wishes to market its non-EU AIF in one or more Member States, it would need authorization to manage the AIF from its Member State of reference under Article 37.
1.136 Articles 37 and 41 of the Directive will not come into force until July 2015.109 It is not immediately clear from the text of the AIFMD what the position is in relation to authorization of non-EU AIFMs ad interim. On the face of Article 6(1), which refers to AIFMs without distinction between EU AIFMs and non-EU AIFMs, it would appear that until Article 37 comes into force, Member States have to treat non-EU AIFMs that manage domestic AIFs as domestic AIFMs. However, given that Article 42 permits marketing of both EU and non-EU AIFs managed by non-EU AIFMs subject to a special (partly national) regime, the better interpretation is that the authorization of non-EU AIFMs remains subject to national authorization regimes until Article 37 comes into force. Indeed, that appears to be the position most Member States are taking.
B. Scope of authorization
1.138 Authorization to manage an AIF includes portfolio management and risk management, and may include non-core AIFMD administrative services (valuation and transfer agency) and marketing.110
1.139 In addition, under Annex I, paragraph 2(c) of the AIFMD, authorization for non-core services may include authority to engage in ‘activities related to the assets of AIFs’. These are defined as: services necessary to meet the fiduciary duties of the AIFM, facilities management, real estate administration activities, advice to undertakings on capital structure, industrial strategy and related matters, advice and services relating to mergers, and the purchase of undertakings and other services connected to the management of the AIF and the companies and other assets in which it has invested. These are all activities that are usual in the context of closed-ended funds that invest in real estate, private equity, and infrastructure projects.
C. MiFID services to an AIF are not in scope of the AIFMD prohibition
1.140 Individual portfolio management by investment firms or credit institutions of portfolios owned by collective investment funds or collective pension schemes is the norm rather than the exception. Typically, an MiFID portfolio manager is appointed as a delegated manager (p. 29) by the fund if it is self-managed, or by the management company of the fund if it is managed externally, to manage the fund’s assets.111
1.141 Article 6(8) of the AIFMD provides that investment firms authorized under MiFID and credit institutions authorized under the Banking Directive do not require authorization under the AIFMD to provide MiFID investment services, such as individual portfolio management, to AIFs. Similarly, investment firms established in a third country, which, under the applicable national law may provide investment services in respect of AIFs, do not require separate AIFMD authorization.112
D. UCITS management company
1.143 UCITS management companies authorized under the UCITS Directive must also be authorized under the AIFMD if they wish to manage and market AIFs or take up any other activities as an AIFM.113 However, the competent authorities do not require UCITS companies to provide information or documents which the UCITS management company already provided when applying for authorization under the UCITS Directive (provided that such information or documents remain up to date).114
E. MiFID services by an AIFM
1.144 Member States have the option of authorizing an external AIFM to carry out certain MiFID services. The authorization would concern the core business of ‘individual’ portfolio management,115 and may include the non-core businesses of investment advice,116 safe-keeping, and administration in relation to shares or units of collective investment undertakings,117 and reception and transmission of orders in relation to financial instruments.118
(p. 30) 1.145 AIFMs authorized to carry out MiFID services must comply, inter alia, with the MiFID initial capital requirements, organizational requirements, and conduct of business obligations.119 Accordingly, the AIFM will have to meet both MiFID and AIFMD initial capital requirements, organizational requirements, and the conduct of business obligations.120
1.146 There are some restrictions. AIFMs may not be authorized for MiFID business only.121 Further, the MiFID authorization must at least include portfolio management to permit authorization for the non-core MiFID business.122 This makes sense, as the core business of an AIFM should be management of the AIF. In addition, the AIFM is not authorized only to perform the non-core AIFMD services.123 Finally, AIFMs are not authorized to provide the AIFMD core service of collective portfolio management without also providing the AIFMD core service of risk management, or vice versa.124 Both these restrictions may be explained by the fact that the core business of an AIFM should always be collective portfolio and risk management. However, these restrictions do not prevent an AIFM from delegating collective portfolio and risk management in accordance with the AIFMD.125
2. Authorization and passporting of EU AIFMs
A. Authorization of EU AIFMs (Article 6)
1.147 A Member State will require an AIFM domiciled in its territory and which manages one or more AIFs, regardless of the location of its AIFs and regardless of whether its AIFs are marketed in the EU, to be authorized by the Member State’s national regulator. In these circumstances, the Member State is the ‘home Member State’ of the AIFM.126
B. Exemptions for EU AIFMs from Articles 21 and 22 where non-EU AIFs are not marketed in the EU (Article 34)
1.148 To facilitate the domestic EU management industry that provides services outside the EU, Article 34(1) of the AIFMD provides for a partial exemption for EU AIFMs that manage non-EU AIFs not marketed in the EU.
1.149 The EU AIFM is exempted from compliance with Articles 21 (depositary) and 22 (disclosure requirements) in respect of those AIFs if it complies with all other requirements, and (p. 31) appropriate cooperation arrangements are in place between the national EU regulator and the supervisory authorities of the third country where the non-EU AIF is established.
1.150 The purpose of the cooperation agreements is ‘to ensure at least an efficient exchange of information that allows competent authorities of the home Member State of the AIFM to carry out their duties’ under the AIFMD.127
C. Passporting by EU AIFMs of management authorization (Article 33)
1.151 Member States must ensure that an EU AIFM authorized by another Member State may manage EU AIFs established in their territory either on a cross-border basis or by establishing a branch, provided that the AIFM is authorized by the other Member State to manage that type of AIF.128
1.152 An AIFM intending to manage EU AIFs established in another Member State for the first time must notify its national regulator of the Member State in which it intends to manage AIFs directly, or establish a branch,129 and provide a ‘programme of operations’ stating in particular the services which it intends to perform and identifying the AIFs it intends to manage.130
1.153 If the AIFM intends to establish a branch, it must provide additional information on: the organizational structure of the branch;131 the address in the home Member State of the AIF from which documents may be obtained;132 and the names and contact details of the persons responsible for the management of the branch.133 ,134
1.154 The competent authorities of the home Member State of the AIFM must, within one month of receiving the notification in the case of direct management, or within two months in the case of establishment of a branch, transmit the complete notification file to the competent (p. 32) authorities of the host Member State of the AIFM. Such transmission must occur only if the AIFM’s management of the AIF complies, and will continue to comply, with the AIFMD and the AIFM otherwise complies with the AIFMD.135
1.155 The competent authorities of the AIFM’s home Member State must enclose a statement to the effect that the AIFM is authorized by that state.136 The competent authorities of the home Member State must immediately notify the AIFM about the transmission.137
1.156 Upon receipt of the transmission notification the AIFM may start to provide its services in its host Member State.138 The host Member State of the AIFM must not impose any additional requirements on the AIFM in respect of the matters covered by the AIFMD.139
1.157 In the event of a change to any of the information communicated in the notification file, an AIFM must give written notice of that change to the competent authorities of its home Member State at least one month before implementing planned changes, or immediately after an unplanned change has occurred.140
1.158 If, pursuant to a planned change, the AIFM’s management of the AIF would no longer comply with the AIFMD, or the AIFM would otherwise no longer comply with the AIFMD, the competent authorities of the AIFM’s home Member State must inform the AIFM without undue delay that it is not to implement the change.141
1.159 If a planned change is implemented notwithstanding the above in paragraphs 1.157 and 1.158, or if an unplanned change has taken place pursuant to which the AIFM’s management of the AIF would no longer comply with the AIFMD or the AIFM otherwise would no longer comply with the AIFMD, the competent authorities of the AIFM’s home Member State must take all due measures in accordance with Article 46.142
1.160 If the changes are acceptable because they do not affect the compliance of the AIFM’s management of the AIF with the AIFMD, or the compliance by the AIFM with the AIFMD otherwise, the competent authorities of the AIFM’s home Member State must, without undue delay, inform the competent authorities of the AIFM’s host Member States of those changes.143
3. Authorization and passporting of non-EU AIFMs
A. Authorization of non-EU AIFMs (Article 37)
1.161 Article 37(5) and (8) of the AIFMD provides that the non-EU AIFM must apply for authorization to its Member State of reference and follow the procedures and comply with the conditions set out in Articles 6–11, subject to certain amendments set out in Article 37(8).144
(p. 33) 1.162 Article 37(4) sets out the rules for determining the Member State of reference of a non-EU AIFM that seeks authorization to manage one or more EU AIFs or to manage a non-EU AIF marketed in the EU. There are three reference points, set out in this table.
1.163 If the non-EU AIFM ticks box 1, it is not marketing the EU AIF in the EU and the home Member State of the AIF is the Member State of reference where the EU AIF is established. If it concerns multiple AIFs in multiple Member States, the Member State of reference is either the Member State where most of the AIFs are established or the Member State where the largest amount of assets is being managed.145