On 18 August 2020, European Securities and Markets Authority (ESMA) wrote a letter to the European Commission (Commission) in the context of the forthcoming AIFMD review.  ESMA provides 19 recommendations across a range of key issues as part of its advice to the Commission. These recommendations extend beyond AIFMD to touch on a range of matters for UCITS.

The Commission is expected to issue a public consultation in the coming weeks on the AIFMD review.  ESMA’s policy positions will be influential in informing the Commission’s approach but it remains to be seen how these recommendations will be incorporated into the consultation. We are at the start rather than the end of the process.  The feedback by asset managers, industry bodies and relevant stakeholders to the consultation will play an important role in shaping the outcome, with legislative amendments anticipated later in 2021 at the earliest.  

Delegation and substance

ESMA returns to the hot button issue of substance and delegation in the letter. The key points are discussed below. ESMA’s tone here is not entirely new and chimes with the expectations set out in its Brexit Opinion from July 2017. It is not surprising that ESMA wants to ensure those policy positions and expectations are fed into the Commission’s AIFMD review. For AIFMs and UCITS Management Companies (FMCs) authorised in recent times by the Central Bank of Ireland, there will be familiarity with how those supervisory expectations translate in terms of resourcing and substance (e.g. the 3 full-time equivalents base-line requirement around headcount resource).  

The letter suggests an overall ratcheting up by ESMA on substance and delegation, with more focus to be applied on models involving third country service providers. Brexit plays a role, with ESMA anticipating the potential for increased delegation to the UK given its position as an asset management hub. ESMA observes in the letter that: 

• FMCs routinely delegate collective portfolio management functions (as set out in AIFMD and the UCITS Directive) to third parties. Portfolio management functions are often largely or entirely delegated to third parties within or outside the FMC’s group and/or to third country providers. Functions retained may often just involve control functions (notably risk management).
• Extensive delegation arrangements may result in the majority of human and technical resources (e.g. IT systems) for the day-to-day operations of the FMC and its funds sitting with one or more third parties, who may be outside of the EU.  Most/all staff may not be directly employed by the authorised FMC. These models may result in a substantial portion of the FMC’s management fees flowing out to the delegates, which is an important indicator of extensive delegation arrangements. 
• There is passing mention that delegation arrangements can bring benefits, such as business model efficiencies and access to external expertise. However, the emphasis is on the potential for increased operational and supervisory risks. If the appropriate degree of substance is not achieved, ESMA questions whether the relevant funds can still be effectively managed by the licensed FMC.
• Delegation of collective portfolio management functions to non-EU entities is seen as generating the potential for regulatory arbitrage. ESMA suggests legislative amendments so that the management of the AIF/UCITS is subject to the regulatory standards set out in the AIFMD and UCITS framework, irrespective of the regulatory licence or location of the delegate. We would observe that this is not a new risk.  In practice, mitigating actions include (i) the contractual arrangements with the delegate and (ii) the oversight, monitoring and control framework imposed on the delegate. Indeed, the regulatory regime applicable to certain investment managers often elevates the standard of regulatory protection for funds. Delegation to investment managers authorised under MiFID, including UK investment managers, provides the fund client with stricter protections on best execution and inducements (mostly notably the prohibition around research). 

In light of the above, ESMA is suggesting the Commission consider amendments to Article 82 of the AIFMD Level 2 Regulation (letter box rule) with matching changes for the UCITS Directive:

• Clarifications in the overall drafting of Article 82 so that it is more clearly expressed.   
• The addition of clear quantitative criteria to complement the current qualitative criteria in Article 82(1)(d) (i.e. an AIFM may be a letter box entity where it delegates performance of investment management functions to an extent that exceeds by a substantial margin the investment functions performed by the AIFM).
• Potentially including a list of core or critical functions that must always be performed internally and may not be delegated to third parties.

Use of seconded staff

Noting the increasing incidence of group or consulting staff being seconded into FMCs (often with secondees located outside the domicile of the FMC), clarification is sought on how these arrangements tie in with substance and delegation rules. 

List of collective portfolio management functions and distinction from ‘supporting tasks’

ESMA notes that group entities within or outside of the EU often provide ‘supporting tasks’ to the authorised FMC, as opposed to the listed range of collective portfolio management functions. There are diverging approaches by NCAs on whether certain supporting tasks should be considered collective portfolio management functions and therefore subject to the full rigour of the delegation rules. 

White-label service providers

ESMA draws attention to “fund managers that provide a platform to business partners by setting up funds at the initiative of the latter and typically delegating investment management functions to those initiators/business partners or appointing them as investment advisers or informally following their guidance/instructions”. In ESMA’s view there are embedded conflicts of interest in these models which pose risks for investor protection.  ESMA appears to apprehend that white-label service providers may fail to prioritise their duties to the fund if it involves challenging the sponsor and risking their own commercial interests. ESMA considers that specific measures should be included in the AIFMD and UCITS Directive to address this issue.  It might be said that this concern is better addressed through the existing supervisory toolkit of NCAs since there is already an adequate array of rules on conflicts and duties to investors etc. 

Other Notable Recommendations 

Harmonisation Measures for the AIFMD and UCITS Directive

ESMA recommends carrying over certain more granular requirements in AIFMD to the UCITS framework to achieve a harmonised approach (e.g. risk management, liquidity management and delegation requirements). 

In addition, ESMA recommends that UCITS reporting should be amended to align appropriately with AIFMD reporting.  

Liquidity Management Tools (LMTs)

In ESMA’s view, the Commission should amend the AIFMD to include LMTs outlined in the ESRB 2017 Recommendation on liquidity and leverage risks in investment funds.  The availability of LMTs should also be included in the UCITS Directive (noting that some of the tools will not be suitable or necessary for all types of funds, e.g. side pockets).

Legislative Clarifications 

ESMA suggests that the Commission should clarify some interpretative issues where there has been diverging approaches by NCAs: 

• Clarifying the permissible activities of FMCs.  Differing approaches have been taken as to whether an FMC performing delegated investment management to another FMC in respect of an AIF/UCITS is providing collective portfolio management or discretionary portfolio management (the latter requiring MiFID top-up permissions).
• Level playing field style amendments to ensure that when FMCs are providing MiFID top-up services, such services are aligned with the regulatory standards for MiFID investment firms providing the same services. 
• In light of MiFID II and MiFIR, a house keeping update for the MiFID cross-referencing in Article 6(6) of AIFMD and Article 6(4). ESMA flags some uncertainty on the full extent of the MiFID II rules which should be applied to FMC MiFID top-up activities.  

ESMA has mentioned the need to clarify certain key definitions in the AIFMD, such as the definition of an AIF.

Clarification is also suggested to more comprehensively set out home/host state roles and responsibilities in the context of AIFMs who have exercised passporting rights.  

Reverse Solicitation 

ESMA suggests considering greater clarity on the definition of reverse solicitation given divergent approaches by Member States.  Although, at the same time, ESMA acknowledges that the AIFMD review may not be the most appropriate context given the definition and rules for this concept in light of the evaluation clause under the Regulation on facilitating cross-border distribution of collective investment undertakings.

Loan Origination 

ESMA suggests considering a specific framework for loan origination within the AIFMD.  It refers to its 2016 Opinion in this regard as a starting point, which bears some resemblance to the Central Bank of Ireland’s L-QIAIF regime. ESMA appears to see product level rules for loan funds as supportive of the CMU agenda and assisting in post pandemic recovery. Although, we would query if that would bear out in practice. There has been exponential growth in EU private debt AIFs in recent times, but predominantly in unregulated AIFs rather than through regulated products (such as the L-QIAIF). 

ESMA notes that the ELTIF review is also an opportunity to consider the product characteristics of loan origination funds.

Leverage 

ESMA recommends updates to the AIFMD leverage rules to align with IOSCO’s December 2019 recommendations for a framework assessing leverage in investment funds. 

Depositary

ESMA notes that there has long been a discussion in the EU on the merit of a depositary passport and suggests an assessment of the benefits and risks of such a passport.

Semi-professional investors 

ESMA does not believe that the AIFMD marketing passport should extend to “semi-professional investors”.

External Valuer Liability

ESMA suggests a “gross negligence” as opposed to “negligence” liability standard for external valuers. 

AIFMD Reporting Regime and data use  

Annex II of the letter contains proposals around the AIFMD reporting regime. 

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