Jeremy C. Jennings-Mares
In this alert, we provide an update on EU regulatory issues that are relevant to all managers of alternative investment funds, both for European and non-European funds. This includes the effect of a possible no-deal Brexit, details on the review by the European Commission of the operation of the AIFM Directive and information on upcoming new EU legislation on the cross-border distribution of investment funds.
AIFMD and Brexit
As part of its preparations for a possible no-deal Brexit, the UK Treasury, on 21 February 2019, published the Alternative Investment Fund Managers (Amendment etc.) (EU Exit) Regulations 2019, which will amend the UK’s Alternative Investment Fund Managers Regulations 2013 in such circumstances.
The aim of these regulations is to ensure that the UK’s legislation implementing the Alternative Investment Fund Managers Directive (Directive 2011/61/EU) (“AIFMD”) will function properly in the event of a no-deal Brexit. These regulations amend references to the EEA passporting system (which will cease to be applicable to UK managers (“AIFMs”) of alternative investment funds (“AIFs”) in such a scenario) and they replace references to the European Union with references to the UK and replace references to the European Commission and the European Securities and Markets Authority ("ESMA") with references to the UK Treasury and the Financial Conduct Authority (“FCA”), respectively. They also remove any obligation for the UK authorities to share information and co-operate with EU authorities without a guarantee of reciprocity.
In terms of specific changes:
The European Commission considers changes to AIFMD
On 10 January 2019, the European Commission published a report prepared by KPMG, in relation to the operation of the AIFMD.
The report was commissioned by the European Commission pursuant to its obligations under Article 69 of AIFMD, to start a review on the application and scope of AIFMD, including analysing its impact on investors, AIFs and AIFMs (defined below), within the EU and outside the EU, and the degree to which the objectives of AIFMD have been achieved. Following its mandate, KPMG conducted a general survey, addressed to AIFMD stakeholders, such as AIFMs, investors, distributors, depositories, asset managers, regulators and investment advisers, as well as industry representative bodies. KPMG received 478 “useable” responses, the majority of which were given on behalf of institutions. KPMG made the following findings, pursuant to the survey and various interviews with market participants.
AIFMD has played a major role in helping to create an internal market for AIFs and a harmonised regulatory and supervisory framework for AIFMs. However, some of AIFMD’s provisions (or alternatively the detail or application of certain provisions) have not contributed to the achievement of these aims and may even, in some cases, be contrary to those aims.
A high percentage of survey respondents considered that AIFMD is not applied consistently between member states, although most of these consider that only a small number of areas needed further harmonisation in order to prevent arbitrage between different countries’ rules and to ensure a common level playing field.
A number of member states apply additional provisions to the authorisation of sub-threshold AIFMs, which can include requiring full authorisation, in the case of some member states. This differentiation is expressly permitted by AIFMD.
Respondents and interviewees noted that not all the data required by AIFMD’s reporting requirements to be reported to national competent authorities (“NCA”) may be essential. In other cases it can be insufficient and there are also duplicative provisions. In addition, some of the reporting obligations overlap with other EU legislative reporting requirements. Although the details of the regulatory reporting requirements are contained in AIFMD’s delegated regulation (which is directly applicable in all EU member states and therefore provides no national discretion), the AIFM’s home member state NCA can stipulate the method of data delivery and can also require additional information from time to time. As a result, respondents considered that differences in national interpretation and filing procedures increased their costs.
Having said that, many respondents and interviewees emphasised the need for the Commission, before making amendments to the reporting requirements, to recognise the significant irrecoverable costs already incurred by AIFMs, NCAs and ESMA in implementing reporting systems and urged that the issue of reporting should be looked at, at the same time, for both asset and fund managers.
Respondents and interviewees requested the harmonisation of calculation methodologies for leverage, as between AIFMD, the Undertakings for Collective Investments in Transferable Securities (“UCITS”) directive and other relevant legislation. However, given the ongoing work by the International Organization of Securities Commissions (“IOSCO”) on common leverage measures, it will be most efficient for the industry for changes to the EU requirements to be proposed only after completion of IOSCO’s work and to be introduced simultaneously for UCITs funds and AIFs.
One issue that is considered by respondents to have hampered the effectiveness of AIFMD for some asset classes relates to the choice in AIFMD’s valuation rules between internal valuation or external valuation and the different national interpretations of the extent of the liability of external valuers.
The remuneration requirements of AIFMD were some of the most hotly-negotiated provisions during the legislative phase, due to the fact that many major non-EU jurisdictions do not impose similar restrictions on AIFMs and, therefore, this potentially leads to competitive disadvantages for EU firms. Respondents also felt that the rules on remuneration favour less complex business models and create a disadvantage for more complex participants. It was also noted that investors in many respects do not receive transparent and consistent information, which can vary according to the domicile of the reporting entities within the EU. For instance, each AIF may disclose the total amount of remuneration paid by the AIFM to its staff (compared to on an AIF-by-AIF basis), which provides very little transparency for investors where the AIFM manages many AIFs.
In addition, carried interest and partner remuneration are often only partially incorporated in the remuneration figures and are therefore disclosed by AIFMs on an inconsistent basis. This lack of a level playing field can expose market participants in those jurisdictions with a stringent AIFMD implementation policy to unfair competition.
Variations in Regulatory Fees
Approximately half of the respondents expressed concerns about the variations in fees paid to NCAs as part of the marketing passport notification process or under the national private placement regimes (“NPPRs”). Some interviewees believe that this factor, together with the divergence of marketing requirements between different EU member states, results in foreign-domiciled AIFs being at a competitive disadvantage to domestic funds.
In relation to such variations, the proposal by the European Commission on cross-border distributions of funds was generally considered a positive development since it aims to increase transparency about regulatory fees by providing ESMA with greater supervisory powers and setting out some high-level common principles on how regulatory fees should be determined.
A large percentage of respondents expressed concerns about AIFMD’s investor disclosure requirement, and, in particular, the inconsistent application of the requirements between different jurisdictions, including the additional disclosure requirements imposed by some member states that can hamper investors who are selecting the most relevant information for their own monitoring purposes, which undermines the investor protection goals of AIFMD.
Other Issues in the Report
Further clarity was requested by many respondents on the interaction between AIFMD and the legislative package consisting of Directive 2014/65/EU and MiFIR (“MiFID II”), particularly in the case where the AIFM also provides MiFID services. In addition, there is confusion as to the interplay between AIFMD and NPPRs, which may have slightly different definitions (depending upon the EU jurisdiction) of what constitutes a professional or semi-professional investor or client, consequently giving rise to differing marketing requirements.
Many respondents noted the difficulties caused by so-called “gold-plating” of the AIFMD requirements by different member states, leading to a lack of harmonisation. In particular, differing custody standards and interpretations were targeted, such as in relation to the segregation of assets, use of custody records and liability of the central securities depositary in a custody chain. These differing standards prevent depositary groups from operating a common model throughout the EU.
In addition, respondents pointed out the lack of harmonised rules hindering the marketing of AIFs across borders because of issues such as the difference in definition of an AIF between different member states and differences in interpretation of “marketing” and the passporting requirements. As an example, there are significant differences in the extent to which (permissible) “pre-marketing” can take place in different member states before full “marketing” is deemed to be taking place.
At the moment, the AIFMD marketing passport is not available to non-EU AIFMs. AIFMD envisages that, if it becomes available to non-EU AIFMs, the current system of non-EU AIFMs using each member state’s NPPR will eventually be abolished. The European Commission expressed the view in the report that, from an investor’s point of view, it is clearly of EU added value that NPPRs should be permitted to continue to operate in order to maximise investor choice. Many respondents to the survey also indicated that NPPRs should not be abolished, even once the marketing passport has been extended to non-EU AIFMs, and should co-exist with the marketing passport. This last fact comes as no surprise, given that many non-EU AIFMs, who currently use the NPPRs, will find it impractical to use the marketing passport in its current form, due to the small scale and geographical scope of their EU marketing efforts and, in some cases, domestic structural hurdles to their compliance with the requirements necessary for authorisation in the EU.
The European Commission may now propose amending legislation that it considers necessary in respect of AIFMD. The Commission’s review is required to take due account of developments at the international level and of discussions held with non-EU countries and international organisations. After finalising its review, the European Commission is obliged to submit a report to the European Parliament and the Council of the EU without undue delay (the European Commission has indicated that it will report to the European Parliament and the Council in 2020).
One would hope that, within the same timeframe, the European Commission will be able to make a decision as to whether to extend the benefit of the EU marketing passport to non-EU AIFMs from all, or certain, non-EU countries, since several years have now passed since ESMA produced its advice on several non-EU countries in this regard. If it does finally decide to extend the passport, it will also need to decide, in due course, whether to retain or abolish the NPPRs, which will continue to be important to many non-EU AIFMs after the extension of the passport.
The Cross-Border Distribution of Investment Funds
As part of its Capital Markets Union (“CMU”) initiative, the European Commission made proposals in March 2018 for a new directive and regulation in relation to the cross-border distribution of collective investment funds. The legislative proposals will amend both AIFMD and the UCITS Directive. The key proposals that will affect AIFs and AIFMs are discussed below.
AIFMD contains the following definition of “marketing” in the context of shares or units of an AIF: “a direct or indirect offering or placement, at the initiative of the AIFM or on behalf of the AIFM, of units or shares of an AIF it manages to or with investors domiciled, or with a registered office, in the Union”.
An AIFM engaging in marketing under the definition above is required to have at least pre-notified the relevant competent authority in the member state of the marketing or, in some cases, to be authorised in that member state. Promotional activities that fall short of the above definition of marketing, or that can be regarded as merely a precursor to marketing, are not prohibited by AIFMD, and different member states have different approaches to these “pre-marketing” activities.
In the UK, the FCA has issued helpful guidance as to the dividing line between AIFMD marketing and pre-marketing, but most other EU regulators have not issued such guidance and it has become apparent that many EU regulators take a very different stance to the FCA on the question of where the dividing line should be drawn. The inconsistent approach by different EU regulators makes it very difficult in practice for an AIFM to simultaneously gauge levels of investor interest in a potential fund across multiple EU jurisdictions.
As a result, the European Commission has proposed in its draft directive a new definition of “pre-marketing” for the AIFMD. Pre-marketing is proposed to be defined as:
a direct or indirect provision of information on investment strategies or investment ideas by an AIFM or on its behalf to professional investors domiciled or registered in the [EU] in order to test their interest in an AIF which is not yet established.
The European Commission’s proposed concept of pre-marketing is that each EEA member state should permit an authorised EU AIFM (N.B. not a non-EU AIFM) to engage in pre-marketing activities, without any prior notification to competent authorities, so long as the pre-marketing relates to an investment idea or strategy at a time when no actual AIF has already been established for such idea or strategy. In addition, investors should be unable to subscribe to the units of the AIF during the course of pre-marketing because the fund does not exist at that point, and no offering documents, whether draft or final, should be distributed to potential investors during the pre-marketing.
If, following the pre-marketing activities, the AIFM intends to offer for subscription units of an AIF that has features similar to the idea or strategy that has been pre-marketed, then the appropriate marketing notification procedures for a full AIFMD “marketing” should be observed, and the AIFM would not be able to classify such offer and subscription as “reverse solicitation” (to which AIFMD would not apply).
In addition to the proposed principles of pre-marketing, the proposed directive also sets out some negative conditions for pre-marketing.
The European Commission’s proposed new Article 30a of AIFMD states that EU member states must ensure that an authorised EU AIFM may engage in pre-marketing in the EU, except where the information presented to potential professional investors:
This “pre-marketing” proposal has attracted a great deal of criticism. Many commentators have interpreted this new concept as an exhaustive definition of pre-marketing (though it remains to be seen whether all individual member states adopt this interpretation when implementing the directive into their national laws). They have interpreted the proposals as meaning that any promotional activities by an EU AIFM that do not meet the above conditions should be regarded as “marketing” and therefore must be subject to the required marketing notification. Such a narrow definition would effectively restrict the ability of EU AIFMs to gauge the level of investor interest in a potential fund or a new fund by bringing forward the time at which “full” marketing is deemed to occur and notification is required. Compare this to the current FCA-stated position that it will not regard the use of draft AIF documentation as “marketing” (so long as such documents cannot be used by a potential investor to invest in the AIF) because the AIFM cannot apply for permission to market an AIF under Article 31 of AIFMD until the documents required to be submitted with each application are in final form.
The pre-marketing definition proposed by the European Commission is much narrower than the FCA’s policy position and is too narrow to be of much practical help to AIFMs trying to gauge investor interest. This therefore actually runs counter to the stated aim of the draft directive of eliminating regulatory barriers to the cross-border distribution of funds.
In addition, given that this definition applies only to EU AIFMs, then if it is interpreted by member states as an exclusive definition of permissible pre-marketing, it could allow non-EU AIFMs to conduct certain pre-marketing without the notification requirement that would apply to EU AIFMs in respect of the same pre-marketing activity. This is inconsistent with the CMU’s aim of deepening and broadening EU capital markets.
Help seems to be at hand in the form of the legislative amendments proposed by the Council of the EU and the European Parliament. They propose that the pre-marketing definition can apply to an AIF that has already been established and that draft offering documents and draft constitutional documents may be used for pre-marketing, so long as the promotion does not amount to an offer or placement of AIF shares/units, and no subscription documents (whether draft or final) are presented to potential investors. Where draft offering documents are provided, they cannot contain sufficient information to allow investors to make an investment decision, and each document must also clearly state that it does not constitute an offer or invitation to subscribe for AIF units and that the information in the document should not be relied upon because it is not complete and may be subject to change. AIFMs must ensure that investors do not acquire AIF units through such pre-marketing, and that investors contacted at the pre-marketing stage may only acquire units in the resulting AIF under marketing permitted under Article 31 or Article 32 of AIFMD. Any such acquisition within 18 months of the commencement of pre-marketing shall be considered to be the result of "full" marketing, and therefore subject to Article 31 or Article 32 procedures.
In addition, the procedure file of the European Parliament, to be considered at its plenary session of 15 April 2019 to 18 April 2019, provides that the harmonised pre-marketing rules should not disadvantage an EU AIFM, compared to a non-EU AIFM.
Discontinuation of Marketing of AIFs
The draft directive also introduces proposed uniform conditions under which an authorised EU AIFM, having notified the competent authority of its home member state that it intends to market an EU AIF in another member state, may formally discontinue such marketing in such other member state (“host member state”). The conditions to be met for such discontinuance are that:
As soon as the competent authority of the home member state has notified the AIFM that the above information has been transmitted to the competent authority in the host member state, the AIFM must immediately cease all marketing activities in that member state. However, it remains obliged to observe the annual report and investor disclosure obligations in Articles 22 and 23 of AIFMD in respect of all investors who remain invested in the AIF.
Facilities for Retail Investors
The draft directive also provides that an AIFM must establish, in each EEA member state where it intends to market an AIF to retail investors, facilities to perform certain tasks, such as processing subscriptions, payments and redemption orders from investors, providing certain information to investors and making available to investors information such as the fund rules or instruments of incorporation and the AIF’s latest annual report.
The directive is intended to be applied by each EEA member state no later than two years after its entry into force.
Requirements for Marketing Communications
The draft regulation provides that marketing communications to potential AIF investors must be identifiable as such, that AIFMs must present the risks and rewards of such an investment in an equally prominent manner and that they must ensure that all information contained in marketing communications is fair, clear and not misleading.
The marketing communications must also ensure that no information in any marketing communication contradicts the information required to be disclosed to investors under Article 23 of AIFMD, or (if applicable) contained in a prospectus pursuant to the New Prospectus Regulation (Regulation (EU) 2017/1129), or diminishes its significance. The marketing communication must also indicate how and where investors can obtain a copy of the New Prospectus Regulation prospectus (if applicable).
These provisions are intended to apply as from two years after the entry into force of the regulation, except for the provisions as to non-contradiction of Article 23 AIFMD, which are intended to apply as from the date of entry into force of the regulation.
Publication of National Marketing Requirements
As from the date falling two years after the entry into force of the regulation, the national competent authority of each member state will be obliged to publish, and maintain on its website, a central database containing all applicable national laws and regulations governing the marketing of AIFs and summaries thereof in a language that is “customary in the sphere of international finance”. Notification of these laws and regulations would also have to be sent to ESMA, in order for ESMA to maintain its own central database containing these details for each member state.
Verification of Marketing Communications
The draft regulation provides that, where a member state permits the marketing of AIFs to its retail investors, its national competent authority may require systematic notification of the marketing communications intended to be sent to the retail investors, in order to verify compliance with the provisions of the draft regulation. However, such systematic notification would not be a prior condition to the marketing of the AIF.
If the competent authority requests any amendments to a marketing notification, that request must be sent to the AIFM within 10 business days after the business day following its receipt of the systematic notification.
Fees and Charges
The draft regulation provides that fees or charges levied by competent authorities must be proportionate to the expenditure incurred in the authorisation/registration process and the performance of their supervisory and investigatory powers under AIFM.
By no later than the date falling six months after the entry into force of the regulation, the competent authorities must publish their fees and charges, or the methodology therefor, on a central database in a language that is “customary in the sphere of international finance”. They must also send such details to ESMA, who would, by no later than 30 months after the entry into force of the regulation, publish such details on its own interactive database on its website. ESMA is also required, by the same date, to make available on its website an interactive tool that allows users to perform online calculations.
ESMA Central Database of AIFMs and AIFs
By no later than the date falling 30 months after the entry into force of the regulation, ESMA would also be required to maintain on its website a central database of all AIFMs, and all AIFs marketed by each AIFM, as well as the member states in which those funds are marketed.
Date of Application and Current Status
Certain parts of the regulation are expected to be applicable immediately upon its entry into force; whereas other parts of the regulation (as indicated above) are intended to become applicable between six months and 30 months after that date, and the directive will have to be transposed into the national laws of each EU member state within two years of its entry into force.
On 5 February 2019, the Council of the EU and the European Parliament announced that they had reached preliminary agreement on the draft legislation, and the European Parliament is due to consider it in its 15 April 2019 to 18 April 2019 plenary session.
 S.I. 2019/328, available at http://www.legislation.gov.uk/uksi/2019/328/pdfs/uksi_20190328_en.pdf.
 An AIFM is “sub-threshold” if it directly, or indirectly through a company with which it is linked by common management or control or by substantive direct or indirect holding, manages portfolios of AIFs with an aggregate volume of assets under management that either does not exceed EUR100 million, including any assets acquired through the use of leverage, or does not exceed EUR500 million in circumstances where the portfolio of AIFs consists of AIFs that are unleveraged and have no redemption rights exercisable during a period of five years following the date of initial investment in each AIF.
 See “The Cross-Border Distribution of Investment Funds” section of this publication.
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