Alternative Investment Fund Managers Directive (“AIFMD”), Level 2 Measures - The Wait Is Over ppt

The Level 2 Measures provide that a delegation in the circumstances listed below, will cause an AIFM to be considered to be a letter-box entity: a The AIFM no longer retains the necessa

Alternative Investment Fund

Managers Directive (“AIFMD”),

Level 2 Measures - The Wait Is Over

With the deadline for implementation only 6 months away, the European Commission has finally adopted the AIFMD Delegated Regulations (the “Level 2 Measures”) Originally due to be published in July 2012, the adoption of the Level 2 Measures was delayed due to high level political debate surrounding, in particular, the issues of delegation and the depositary regime Despite the long wait, with the exception of the delegation rules, the Level 2 Measures do not significantly differ from the initial draft texts that were issued over the past 3 months In the case of the delegation rules, a compromise qualitative test was introduced in addition to the controversial quantitative proposals The Level 2 Measures provide the funds’ industry with much needed guidance and clarity and will allow asset managers to start the implementation process.

The Level 2 Measures were adopted in the form of a regulation on 19 December 2012 and are subject to a three month scrutiny period by the European Parliament and Council The European Parliament and Council are unlikely to raise any objections as they only have the right to object to the entire Level 2 Measures and cannot propose further amendments Regulations are directly effective and do not require implementation locally in the member states of the European Union (“EU”) The Commission chose this method of implementation to ensure a harmonised application of the AIFMD rules and to create a single rulebook throughout the EU This will be of benefit to asset managers, particularly those with operations in more than one EU member state Subject to no objections being raised by the European Parliament and Council, the Level 2 Measures will come into effect on 22 July 2013

As a global law firm, Walkers has been advising clients through our international offices on the implementation of AIFMD in the context of both off and on-shore fund jurisdictions, namely, the Cayman Islands, Jersey, the British Virgin Islands and Ireland We highlight below the key aspects of the Level 2 Measures and their impact on alternative fund managers (“AIFMs”) and the funds they manage (“AIFs”) whether they are European based or simply distribute their funds in the EU

1 DELEGATION ARRANGEMENTS

One of the most controversial issues contained in the initial drafts of the Level 2 Measures relates to the delegation of functions to third parties This is not permitted if the delegation results in an AIFM becoming a “letter-box entity”

The Level 2 Measures provide that a delegation in the circumstances listed below, will cause an AIFM to be considered to be a letter-box entity:

(a) The AIFM no longer retains the necessary expertise and resources to supervise the delegated functions effectively and manage the risks associated with the delegation;

(b) The AIFM no longer has the power to take decisions in key areas which fall under the responsibility of senior management or to perform senior management functions;

14 January 2013

(c) The AIFM does not have or loses the right to inspect, obtain information from, have access or give instructions to its delegates; or

(d) Where the AIFM delegates the performance of its investment management functions to an extent that exceeds, by a substantial margin, the investment management functions performed by the AIFM itself

However in addition to the quantitative tests listed above, when considering whether an AIFM should be considered to be a letter-box entity, the Level 2 Measures also provide for a qualitative test that local regulators must also consider when assessing the delegation framework, which includes consideration

of the following criteria:

(a) The AIF’s assets and the importance of the assets delegated to the AIF’s risk/return profile;

(b) The importance of the assets under delegation to achieving the AIF’s investment objectives;

(c) The geographical and sectoral spread of the AIF’s investments;

(d) The risk profile of the AIF;

(e) The AIF’s investment strategies;

(f) The types of tasks delegated versus those that are retained; and

(g) The configuration of delegates and their sub-delegates, their geographical sphere of operation and their corporate structure including whether the delegation is conferred on an entity belonging to the same corporate group as the AIFM

This compromise is a positive development and indicates that the delegation model currently adopted in Ireland will meet these criteria It is worth noting that under the Irish delegation model, funds can be established as self-managed investment companies, which can then delegate the relevant management functions to third parties, including the investment manager The fund itself will be considered to be the AIFM (and not the investment manager) and will have to comply with the requirements of the AIFMD

The Commission will monitor the application of these rules in two years and may outline further changes if it deems necessary The European Securities and Markets Authority (“ESMA”) may issue guidelines to ensure a consistent assessment of the delegation regime across the EU

2 THE DEPOSITARY REGIME

The Level 2 Measures outline the controversial issue of depositary liability for the loss of a financial instrument held in custody

All assets which are capable of being physically delivered to the depositary and also those that are not where they are transferable securities that can be registered or held in an account directly or indirectly in the name of the depositary, must be held in a custody account The proposed approach deviates from the proposals originally put forward by ESMA to the extent that assets are not excluded from the scope of the regime even if they are subject to a security interest collateral arrangement

Custody of collateralised assets can be achieved in 3 ways:

(a) The collateral taker is appointed custodian over the collateralised assets;

(b) The depositary appoints a sub-custodian that acts for the collateral taker; or

(c) The collateralised assets remain with the depositary and are kept in favour of the collateral taker

A full title transfer of the collateralised assets is not deemed to be held in custody and is therefore not subject to the above requirements

The ‘loss of a financial instrument held in custody’ is deemed to have taken place in three situations:

(a) where the ownership right is not valid as it has either ceased or never existed;

(b) where the financial instrument exists but the AIF has definitively lost its ownership right; or

(c) where the AIF has the ownership right but cannot dispose of it on a permanent basis

Depositary liability will not be triggered if the depositary can prove that an external event beyond its reasonable control caused the loss of the assets in its custody, eg, natural events, acts of government, war, riots or major upheavals Fraud, accounting errors, operational failure and failure to segregate assets held in custody by the depositary or by a third party to whom custody has been delegated, would not meet these criteria

The Level 2 Measures permit a contractual discharge of depositary liability, however, this discharge may not be used to circumvent the provisions of AIFMD and there must be an ‘objective reason’ to avail of the discharge The depositary needs to demonstrate that it had no other option but to delegate its custody duties to a third party In particular, this shall be the case if the law of the third country requires that certain financial instruments are held in custody by a local entity and local entities that satisfy the delegation criteria of the AIFMD do not exist or the AIFM insists on maintaining an investment in a particular jurisdiction despite warnings by the depositary as to the increased risk this presents

In terms of cash-monitoring duties, the depositary is required to perform daily reconciliations of all the AIF’s cash flows on an ex-post basis or in the case of infrequent cash flows, as and when such cash flows occur The depositary will also be required to identify significant cash-flows that are inconsistent with the AIF’s normal activity

In terms of safe-keeping duties and ownership verification the Level 2 Measures require the depositary to apply a ‘look-though basis’ to assets held by financial or legal structures controlled directly or indirectly by the AIF/AIFM, but exempts Fund of Funds and Master-Feeder structures provided that they have a depositary The Level 2 Measures detail the reporting requirements for Prime Brokers to the depositary, describe the oversight functions, describe the due diligence process for the selection of delegates including the monitoring of the segregation obligation and set out the contractual particulars for the appointment of a depositary In the case of appointment of a third country depositary, the Level 2 Measures list the criteria for assessing whether they are subject to ‘prudential regulation and supervision’

3 THIRD COUNTRY REQUIREMENTS

The Level 2 Measures summarise some of the requirements of the co-operation agreements required to be entered into between third country regulators and regulators in EU Member States (as agreed with ESMA) to permit AIFMs from such third countries to avail of local private placement regimes in the EU from

22 July 2013 In this regard, the Level 2 provisions clarify the scope, form and objectives of the co-operation arrangements, require co-operation arrangements

to provide for “such mechanisms, instruments and procedures as are necessary” for EU regulators to perform their duties under AIFMD and require co- operation arrangements to include data protection safeguards as anticipated by AIFMD These provisions are not thought to be problematic for offshore jurisdictions, although they will doubtless require careful constitutional analysis by onshore third countries Offshore regulators are engaging pro-actively with ESMA and EU regulators with a view to signing the required co-operation agreements as soon as possible and before 22 July 2013 We set out below under the heading “Implementation” how each jurisdiction is progressing in this regard

4 CALCULATION OF ASSETS UNDER MANAGEMENT

As a threshold exemption exists for AIFMs with assets under management (“AUM”) of €100 million or less, the Level 2 Measures set out how AUM must

be calculated to avail of this exemption (€500 million or less if closed-ended for 5 years and no leverage is employed) The AIFM must aggregate the value

of all the assets that they manage without deducting liabilities Financial derivative instruments must be included in the AUM calculations and their valuation

is determined by reference to the underlying assets Therefore the AUM of each AIFM is not based on the net asset value of each AIF that it manages, but rather the combined value of its AUM It is worth noting that if establishing a self-managed investment company in Ireland, as the fund itself will be deemed

to be the AIFM, only that fund’s assets will be counted in the AUM calculation and not the combined AUM of any other funds managed by the investment manager

To avoid double counting, holdings in other AIFs are excluded from the calculation as well as any UCITS managed by the AIFM The AIFM will be required to monitor the AUM on an ongoing basis and should the AUM exceed thresholds for more than 3 months, the AIFM must submit an application for full authorisation to its competent authority within 30 days

5 LEVERAGE

Leverage must be calculated using both the gross and the commitment methods The gross method gives the overall exposure and the commitment method gives insight into the hedging and netting techniques used by an AIFM

AIFs that employ leverage on a substantial basis, ie, where exposure exceeds three times the AIFs net asset value (based on the commitment calculation), will trigger additional reporting requirements to the AIFM’s local competent authorities Local regulators also have the power to impose higher leverage limits

or other restrictions on the AIFM

6 VALUATION PROVISIONS

The Level 2 Measures provide that AIFMs must put in place written valuation policies and procedures for each of the AIFs that they manage, which should

be reviewed at least annually The valuation policies should set out the competence and independence of the personnel carrying out the valuation Valuations can be performed by the AIFM itself, provided that it performs valuations functionally independently from the portfolio management function

The AIFM must ensure that each AIF values its assets at least as often as it deals and in the case of illiquid assets, at least annually The AIFM must also ensure that remedial measures are in place in the event of a valuation error

7 RISK MANAGEMENT

The AIFM will need to have an adequately documented risk management policy covering all risks faced by the AIFs and will need to set quantitative and/or qualitative risk limits for each AIF covering market, credit, liquidity, counterparty and operational risks Risk measurement includes requirements for back- testing, stress testing and scenario analyses and the rules also require remedial action for breaches of limits The risk management systems should be subject

to an annual review by senior management

The Level 2 Measures outline the role and responsibilities of the AIFMs permanent risk management function (which can be performed by a third party) and defines the conditions to be satisfied in order to ensure the functional and hierarchical separation of risk management, which includes a requirement that personnel in risk management should not be supervised by the head of operating units, including portfolio management and that they should not perform activities within the operating units The basis for calculating their remuneration should be independent of the performance of the operating units

8 LIQUIDITY MANAGEMENT

The Level 2 Measures specify that all AIFMs must maintain an appropriate level of liquidity taking into account investor profile, size of investments and redemption terms The AIFM will need to monitor the liquidity risk of the AIF portfolios and set liquidity limits where appropriate to be monitored on an on- going basis There are requirements for the AIFM to regularly conduct a range of stress tests under normal and exceptional liquidity conditions

9 ORGANISATIONAL REQUIREMENTS

General business organisational requirements, including administration procedures and internal controls designed to secure compliance with decisions and procedures, including requirements for a separate and independent compliance function and internal audit function are set out in the Level 2 Measures These requirements allow for proportionality in terms of the nature, scale and complexity of their business

10 ADDITIONAL OWN FUNDS & PROFESSIONAL INDEMNITY INSURANCE

with the AUM calculations set out above This amount can be reduced by local regulators to 0.008% if on a three year review period, they believe this provides adequate protection to investors

Alternatively, a professional indemnity insurance with a coverage of 0.9% of AUM for aggregate claims per year and 0.7% of AUM per individual claims can

be put in place

IMPLEMENTATION

EU domiciled AIFMs promoting EU domiciled AIFs will be required to comply in full with AIFMD from 22 July 2013 (although there is an optional grace period

of one year to comply for existing AIFMs authorised before 22 July 2013), from which date they will have access to a pan-EU passport to market their funds

to professional investors across the EU

Although the EU marketing passport will not be available to EU AIFMs with offshore AIFs or to non-EU AIFMs until July 2015, from 22 July 2013 they will

be able to market their units under local private placement regimes, subject to the cooperation agreements referred to above being put in place Offshore regulators are engaging pro-actively with ESMA and EU regulators with a view to signing the required co-operation agreements as soon as possible and before

22 July 2013 From July 2015, offshore funds and their managers will be able to avail of the EU marketing passport subject to full compliance with the terms

of AIFMD and the cooperation agreements being put in place

We set out below how the implementation process is being implemented in Ireland, the Cayman Islands, Jersey and the British Virgin Islands

IRELAND

As an EU member state, from 22 July 2013, Irish alternative funds, known as QIFs, will be able to avail of the AIFMD passport to distribute their funds to professional investors across the EU As regulated funds, the QIF product is already materially AIFMD compliant and we do not envisage significant amendments will be required to this model for it to avail of the AIFMD passport and comply with AIFMD

Due to the delegation model available in Ireland, funds can be established as self-managed investment companies, which can then delegate the relevant management functions to third parties, including the investment manager This means that the QIF itself, will be considered to be the AIFM and will have to comply with the requirements of AIFMD and not the investment manager, which reduces the regulatory burden for investment managers

CAYMAN ISLANDS

The Cayman Islands Monetary Authority (“CIMA”) is at an advanced stage of preparing for the implementation of AIFMD It is actively engaging with ESMA

to settle the terms of a template co-operation arrangement which can be entered into separately between CIMA and relevant regulators in EU member states CIMA is also consulting with Cayman Islands fund industry participants and making a number of recommendations to the Cayman Islands Government including proposed amendments to the relevant Cayman statues to accommodate the requirements of AIFMD

JERSEY

The Jersey Financial Services Commission has been working closely with industry and the relevant regulators in EU member states and have entered into detailed discussions with ESMA Jersey has already passed appropriate legislation (due to come into force in April 2013) which will ensure that Jersey is able to sign the cooperation agreements and therefore ensure that funds domiciled in Jersey will be able to avail themselves of the private placement regimes in July

2013 Work has now commenced on the requirements for full passporting for Jersey funds in 2015

BRITISH VIRGIN ISLANDS

The British Virgin Islands Financial Services Commission (“FSC”) has been in discussions with ESMA regarding the terms of a template co-operation arrangement

In preparing for the implementation of AIFMD, the FSC has established an industry focus group to ensure that the implementation measures properly accommodate the BVI funds industry requirements

For further information please contact your usual contact in our Investment Funds team or one of the following from each of our global offices:

Paul Farrell

Partner - Ireland

T: +353 1 470 6669

E: paul.farrell@walkersglobal.com

Tim Buckley

Partner - Dubai

T: +971 4 363 7908

E: tim.buckley@walkersglobal.com

Jonathan Heaney

Partner - Jersey

T: +44 (0)1534 700 786

E: jonathan.heaney@walkersglobal.com

Denise Wong

Partner - Hong Kong

T: +852 2596 3303

E: denise.wong@walkersglobal.com

Ingrid Pierce Global Managing Partner - Cayman Islands T: +1 345 814 4667

E: ingrid.pierce@walkersglobal.com

Thomas Granger Partner - Singapore T: +65 6603 1694 E: thomas.granger@walkersglobal.com

Marianne Rajic Partner - British Virgin Islands T: +1 284 852 2202

E: marianne.rajic@walkersglobal.com

Hughie Wong Partner - London T: +44 (0)20 7220 4982 E: hughie.wong@walkersglobal.com

Disclaimer

The information contained in this advisory is necessarily brief and general in nature and does not constitute legal or taxation advice Appropriate legal or other professional advice should