Aifmd level 2 measures december 2012 cummings final
www.cummingslaw.comA IntroductionOn 19 December 2012, the EuropeanCommission published the draft level 2delegated Regulation (the “Level 2 Measures”)that it has adopted, which provides detailon the implementation of the AlternativeInvestment Fund Managers Directive (AIFMD).The two main objectives of the AIFMD are:(i) to provide a clear and consistentframework for the regulation andsupervision of AIFM in the EU; and(ii) to ensure a high level of investorprotection in the EU.The Level 2 Measures aim to achieve thesecore objectives by creating a single rulebookfor all AIFMs to ensure a level playing fieldand dealing with the following issues:• a common approach to calculatingAUM and leverage;• a common approach on an AIF’slevel of additional own funds andlevel of PI insurance required byAIFMs (operational continuity);• general operating conditions for AIFMs,including general principles, conflictsof interest, risk management, liquiditymanagement, investment in securitisationpositions, organisational requirements,valuation and delegation of AIFM functions;• a common approach on the scope of custodyand on the depositaries’ liability to returnfinancial instruments lost in custody;• a common approach to transparencyof AIFMs towards investors andsupervisory authorities;• a common approach to co-operationwith third countries; and• a common approach to an AIF’sreporting frequency and exchange ofinformation on the potential systemicconsequences of AIFM activity.B Who is an AIFM and what isan AIF and what must they do?The AIFMD will apply to EU-based fundmanagers, wherever their funds are based, andnon-EU-based managers who either manageor market one or more AIFs in the EU.An AIFM is anyone who, at a minimum, eitherperforms portfolio management servicesor risk management services for an AIF andan AIF means virtually any fund, regardlessof structure, jurisdiction or investmentstrategy, other than a UCITS fund.The AIFM may delegate its portfolio managementor risk management duties if it wishes but notto the extent that it becomes a mere “letter-box entity”, and accordingly may not do so to a“substantial margin”. It must also manage therisks attaching to the delegation, and remainsresponsible to investors for the activitiesdelegated t. The effect of these provisions is that,even where portfolio management activities aredelegated in their entirety, an AIFM must havesufficient resource and expertise to supervise andmanage the risks of the activities delegated. TheLevel 2 Measures give detailed requirements forthe delegation process and delegation contractsand delegation is discussed in more detail below.Where the AIFM carries out both riskmanagement and portfolio management, it mustmaintain a separation between the two and havesatisfactory hierarchical arrangements in place.The AIFM will be required to carry out its dutiesin accordance with the rules of the AIFMDand general operating conditions. Pleasesee below, where more details are given.AIFMs must also comply with capitaladequacy requirements by holding a certainamount of own funds, either in cash or byinsurance policy or a combination of thetwo. More details are given below.There is an exemption for managers who manageleveraged assets of below €100m (a small hedgeAIFMD: Level 2 Measures.www.cummingslaw.com
www.cummingslaw.comfund) and those who manage unleveraged assetsof below €500m where there are no redemptionrights within five years of initial investment inthe AIFs (a private equity fund). Please seebelow for the methods of calculating leverage.However, even exempt managers are subjectto the AIFMD and in the UK managers willhave to register with the FSA and provideinformation on their investment strategies, themain instruments in which they are trading andtheir principal exposures and concentrations.They will also have to notify the authorities ifthey no longer fall below the relevant thresholdwithin 30 days of exceeding the threshold.C What about the AIF andits other service providers?While the AIFM will need to consider theimplications of the AIFMD, so will certain keyservice providers, most notably administrators,depositaries and prime brokers, whosecontractual documentation and roles aresignificantly impacted. Please see below for asummary of the rules affecting depositaries.D What action is needed now?Please see our Checklist for Managers.To summarise briefly, AIFMs needto liaise with their lawyers to:• keep track of the FSA’s response and issueof application forms and then complete andsubmit the forms when they are available;• decide who will conduct risk managementand portfolio management, and how;• review and negotiate administrationand prime/clearing brokerageagreements to meet depositary rules;• update offering memoranda andall marketing documentation;• put in place internal andcompliance procedures; and• put in place reporting procedures.E Summary of the mainLevel 2 MeasuresCalculation of assets under management(Arts 2 – 5)In accordance with Article 2 of the AIFMD, theAIFM has to calculate total AUM by determiningthe value of all assets it manages, withoutdeducting liabilities, and valuing all financialderivative instruments at the value of anequivalent position in the underlying assets (soas to reflect the AIF’’s exposure to those assets).This calculation must be made at leastannually, using the calculation methodologyset out in the Level 2 Measures, and must becommunicated to the competent authorities.AIFMs are then required to monitor AUMon an on-going basis and action must betaken when thresholds laid down in theAIFMD are occasionally breached.Calculation of leverage (Arts 6 – 11)The AIFMD defines leverage as any methodby which the AIFM increases exposure of anAIF it manages, whether through borrowingor leverage, and in order to ensure uniformcompliance when calculating leverage.The Level 2 Measures provide twomethods for calculation:(i) the “gross” method; and(ii) the “commitment” method.Although additional and optional methods maybe adopted on the basis of technical advicedeveloped by ESMA, the gross and commitmentmethods remain obligatory for all AIFMs. Bothof these methods are set out in detail in theLevel 2 Measures (Arts 7 and 8 respectively), butgenerally, the gross method indicates the overallexposure of the AIF and the commitment methodprovides information on hedging and netting,the intention being to allow regulators andinvestors to gain a complete picture of the AIF.
www.cummingslaw.comOnly AIFMs using “substantial” leverage arerequired to make certain information availableto the competent authorities. “Substantial”means where the exposure of an AIFexceeds three times the net asset value ascalculated using the commitment method.Additional own funds and PI insurance(Arts 12 – 15)The AIFMD requires AIFMs to hold appropriateadditional own funds or PI insurance to coverpotential liability risks arising from professionalnegligence, such as a breach of legal orregulatory obligations, confidentiality or fiduciaryduties, improper valuation of assets, operationalprocedural failures or misrepresentation.The Level 2 Measures specify theappropriateness of cover: additional ownfunds should represent at least 0.01% of thevalue of portfolios of AIFs managed and PIinsurance should cover an individual claim ofat lease 0.7% of the value of portfolios of AIFsmanaged and 0.9% of the value of portfolios ofAIFs managed for claims in aggregate per year.The AIFM shall be obliged to implementeffective internal risk management policiesand procedures to monitor the professionalliability risks to which the AIFM is or could beexposed, which must be subject to at leastannual review, and to monitor the value ofportfolios managed on an on-going basis.General Operating Conditions (Arts 16 – 82)Articles 12 – 20 of the AIFMD require AIFMs tooperate under certain harmonised conditionsand the Level 2 Measures clarify and expand indetail the duties and obligations of AIFMs, andalso specify the criteria to be used by competentauthorities to assess the manner in whichAIFMs operate, in respect of the following:• general principles and conflictsof interest (Arts 16 – 37);• risk management (Arts 38 – 45);• liquidity management (Arts 46 – 49);• investment in securitisationpositions (Arts 50 – 56);• organisational requirements (Arts 57 – 66);• valuation (Arts 67 – 74); and• delegation of AIFM functions (Arts 75 – 82).Turning in brief to some of these points:The Level 2 Measures lay down rules fora conflict of interests policy which AIFMsshould implement, a risk managementsystem to be established and applied, anappropriate liquidity management systemto be adopted, policies and procedures forthe valuation of assets to be establishedand maintained and a well-documentedorganisational structure to be established forthe proper management of AIFs, includingadministrative and accounting proceduresand adequate internal control mechanisms.The AIFM must ensure that the governingbody, the senior management and, whererelevant, the supervisory function, areresponsible for the AIFM’s complyingwith its obligations under the AIFMD.The Level 2 Measures have considerablyexpanded upon delegation of AIFM functionsand provided clarification upon the issue ofthe “letter-box entity”, which generated muchdiscussion during the drafting stage. Article75 does permit AIFMs to delegate functions,but AIFMs are expected to show “objectivereasons” for the delegation and are notallowed to delegate in such a way as to altertheir obligations or circumvent liabilities.Article 82 prohibits a manager from becominga mere “letter-box entity” i.e. an AIFM isprohibited from delegating to an extent thatexceeds by a “substantial margin” the investmentmanagement function performed by the AIFMitself, but it will also be regarded as a letter-boxentity if it no longer has the necessary resourcesor expertise to supervise the activities it hasdelegated, or has no power to take decisions inkey areas, or no contractual rights to inquire of,inspect, gain access to or instruct its delegates.
www.cummingslaw.comFurthermore, AIFMs will also need to lookat where they delegate, as there are certainrestrictions on delegating to delegates incountries which do not have cooperationagreements with the relevant EU Member State.Depositaries (Arts 83 – 102)The Level 2 Measures contain detailed provisionsabout the obligations and rights of depositaries,taking into account that their core functionis the protection of the AIF’s investors.AIFMs are obliged under the AIFMD to ensurethat each AIF which they manage appoints adepositary and the Level 2 Measures containlengthy provisions which include establishingthe criteria for monitoring the cash flows ofan AIF, the scope of financial instrumentsto be held in custody, general oversightduties and duties regarding subscriptionand redemptions and valuation of assets,delegation of custody and liability for the lossof a financial instrument held in custody.There is an on-going onus upon the AIFM toensure that the depositary is provided with allrelevant information it needs to comply withits obligations and to have a clear overviewof all the AIF’s cash flows, as the depositaryis required to carry out effective and propermonitoring in this respect. Article 88 sets outthe scope of custody and to ensure a highstandard of investor protection, all financialinstruments which can be registered in a financialinstruments account and which belong to an AIFmust be held in custody (including those assetsprovided to a collateral taker as collateral.As regards loss of assets in custody, articles100-102 ensure that the depositary is liablefor the return of an instrument if the loss iscaused by events in the operational sphereof the depositary or its sub-custodian,such as insolvency on the part of thesub-custodian (subject to any permittedcontract of discharge of liability).Transparency of AIFMs (Arts 103 – 110)The extensive disclosure requirements laid out inthe Level 2 Measures cover disclosures in annualreports, disclosures to investors generally andperiodic disclosures to competent authorities.Disclosures in the annual reports impose anumber of extra disclosure requirements,such as the need to disclose remunerationand carried interest, as well as materialchanges over the previous year.Periodic disclosures of various matters also needto be made to investors, for example specialliquidity measures, such as side pockets or gates,changes in maximum leverage levels and the riskprofile and risk management systems employedby the AIFM. These matters need to be disclosedat the outset in the offering document, and,at a minimum, also in the annual report andin any other periodic reporting to investors.There is also a significant list of matters whichare required to be disclosed periodically -whether quarterly, semi-annually or annually,depending on the size of the AIFM - to thecompetent authorities. These include theprincipal assets traded, with sectoral andgeographic breakdowns, where they are tradedand any principal exposures or concentrations,the risk profile of the AIFs, special liquidityarrangements such as gates, side pockets etc.and the results of the periodic stress testswhich the AIFMD requires AIFMs to carry out.Co-operation with third countries(Arts 113 – 115)The AIFMD requires co-operationarrangements to be established betweenEuropean competent authorities andsupervisory authorities from the country oforigin of a non-EU AIFM or a non-EU AIF.Some aspects of these arrangements arespecified in the Level 2 Measures in orderto design a common framework to facilitatethe establishment of such co-operationarrangements with third countries. These
www.cummingslaw.comarrangements must establish such mechanisms,instruments and procedures as are requiredto enable third country competent authoritiesto assist the EU to enforce EU legislationand national implementing legislation whichis breached by a third country entity.The Level 2 Measures also require thearrangements to include a data protectionsafeguard in line with the AIFMD. Where thirdcountries are unable to sign such co-operationagreements meeting the minimum requirements,there will be restrictions on marketing, managingand delegation in relation to such third country.Exchange of information relating to potentialsystemic consequences (Art 116)Article 116 specifies the exchange of informationbetween the competent authorities of theMember States, European Securities andMarkets Authority and the European SystematicRisk Board which is required under the AIFMDfor the purpose of identifying potentialsystemic consequences of AIFM activity.F Next StepsThe Level 2 Measures are subject to a threemonth scrutiny period by the EuropeanParliament and the Council of the EUand will enter into force, providing thatneither co-legislator objects, on the 20thday following publication of the Regulationin the Official Journal of the EU (OJ).The Level 2 Measures have significantramifications for many AIFMs who eitheroperate in the EU or manage any AIF in, ormarket one into, the EU and AIFMs shouldnow be actively reviewing what they needto do in order to become compliant with therequirements of the AIFMD, whether in termsof their actual operations, and the divisionof functions within those operations, or theirdocumentation and disclosure arrangements.Should you wish to discuss any of the pointsraised in the above in more detail, please contactClaire at Claire.Cummings@cummingslaw.com
42 Brook Street, London W1K 5DB +44 20 7585 1406 | Neuhofstrasse 3d, CH-6340 Baar +41 41 544 5549Regulated by the Solicitors Regulation AuthorityThis document is for general guidance only. It does not constitute adviceJanuary 2013