Having done the easy bit and set up their funds, the UK's alternative investment fund managers must now tackle the hard part – the EU's Alternative Investment Fund Managers Directive. With the new law coming into effect this summer, Stephenson Harwood's James Tinworth explains how they can do this

The EU's Alternative Investment Fund Managers Directive (AIFMD) will hugely affect the management and marketing of alternative investment funds (AIFs) within the European Economic Area (EEA). (For the purpose of this article, AIFs are, broadly speaking, any investment fund that is not a Undertakings for Collective Investment in Transferable Securities (UCITS) fund.)

EEA states are required to have implemented the AIFMD into their national law by 22 July. Notwithstanding the fact that the original draft of the directive was released in April 2009, there are still several material issues that remain unresolved. And UK managers of AIFs could be in for a white-knuckle ride over the next four months or so.

The European Commission published the much delayed – and leaked – 'Level 2′ measures in the form of a draft regulation on 19 December 2012. There is technically a three-month period in which the EU Council or European Parliament can object to the measures, but they must be rejected in full. This is not expected to happen.

The European Securities and Markets Authority (ESMA) published its final guidelines on sound remuneration policies under the AIFMD on 11 February this year. There are two other open ESMA consultations on the definition of an AIF and whether they are open or closed-ended. But attention is now primarily focused on the implementation of the AIFMD by the EEA states.

In the UK, we have had one consultation paper from the Financial Services Authority (FSA) and one from the Treasury. We are expecting a second consultation from both bodies. However, the final legislation and rules may not be available until June.

A complicated matter

One would hope that it would be easy to identify an AIF manager in an AIF structure. This task is complicated, however, by five aspects of the AIFMD: 

1) Each AIF managed within the scope of the AIFMD has a single AIF manager; 

2) The AIFMD defines 'managing AIFs' as performing at least 'portfolio management' or 'risk management' functions for one or more AIFs; 

3) An AIF itself could be the AIF manager; 

4) If an AIF manager delegates its functions to the extent that it becomes a 'letterbox entity', then it can no longer be considered to be the AIF manager of the relevant AIF; and

5) There may, or may not, be a different test to determine the single AIF manager of a non-EEA AIF managed by a non-EEA AIF manager.

The Level 2 measures set out the 'letterbox entity' test. As a regulation, it will automatically become part of English law without the UK having to pass any implementing legislation. The wording of the final test, however, gives the UK a degree of flexibility when it comes to implementing details of the test into English law.

Specifically, the Level 2 measures provide that an AIF manager shall be deemed a letterbox entity  if, among other things, "the AIF manager delegates the performance of investment management functions to an extent that exceeds by a substantial margin the investment management functions performed by the AIF manager itself". 

The way in which the UK will interpret "investment management functions" and "a substantial margin" is obviously critical.

It is fundamentally important to identify the AIF manager because:

a) The AIFMD applies to the AIF manager, not the AIF; 

b) A UK fund manager that is a UK AIF manager may have to be authorised under the AIFMD;

c) Where there is more than one potential AIF manager, the question of whether the AIF manager is an 'EEA AIF manager' or a 'non-EEA AIF manager' could significantly impact on the extent to which the AIF can be managed and/or marketed in the EEA; and

d) Different transitional provisions may apply to different AIF managers.

It is particularly important for investment trusts and other closed-ended listed funds to be able to determine whether they can be their own AIF manager, especially given the UK's proposed regime for 'small AIF managers'. But do we even know what 'marketing' means? 

Clarity over marketing

Another fundamental aspect of the AIFMD that is not yet clear is how the EEA states will implement the AIFMD's definition of 'marketing', which the AIFMD defines as a direct or indirect offering or placement at the initiative of the AIF manager or on behalf of the AIF manager of units or shares of an AIF it manages.

It is clear that there must be some element of active approach to investors, meaning passive marketing (where the approach is at the initiative of the investor, – reverse solicitation, as it is sometimes referred to) is likely to be out of scope. But this will require confirmation by each EEA state.

There is a particular need for confirmation that making AIF shares available on a public exchange does not fall within the definition of 'marketing' under the AIFMD. Again, this will require confirmation by each EEA state.  

When does a UK AIFM have to comply with the AIFMD? Article 61(1) of the AIFMD states: "AIF managers performing activities under this Directive before 22 July 2013 shall take all necessary measures to comply with national law stemming from this Directive and shall submit an application for authorisation within one year of that date."

This badly drafted provision does not make it clear whether the words "within one year of that date" applies to both requirements. Unsurprisingly, different EEA states are interpreting this Article in different ways. 

The UK is taking the approach that the one-year transitional period applies to both requirements. Other EEA states and, almost certainly, the European Commission are of the view that the one-year transitional period only applies to authorisation of the AIF manager, but that an AIF manager must take all necessary measures to comply with national law stemming from the AIFMD from 22 July.

Even if the UK sticks to its guns, a UK AIF manager may find that it has to become authorised for it to continue to market its AIFs into other EEA states. 

Given that the FSA has stated it does not expect to begin accepting applications either for authorisation or for a variation of permission from prospective UK AIF managers before 23 July (and may then take up to six months to accept applications), this could be a major issue. 

Remuneration 

The AIFMD's remuneration requirements (including mandatory deferral/retention of variable remuneration payable to certain individuals at an AIF manager) were always going to be a key concern to fund managers. 

Technically, the FSA does not have to follow the ESMA guidelines. But there will be considerable political and other pressures on it to do so.

There is hopefully enough flexibility in the wording of the final guidelines, however, for the FSA to interpret ESMA's wording in a pragmatic way as far as it relates to such key issues as the disapplication of certain remuneration provisions (including those relating to deferral/retention) and the circumstances in which dividends paid to an AIF manager's shareholders or profit allocations to members of AIF managers structured as LLPs are not classed as "remuneration".

It may be more difficult for the FSA to take the same approach to other guidelines – such as the provision that requires either the entities to which portfolio management or risk management activities have been delegated by an AIF manager to be subject to remuneration requirements that are "equally as effective" as the AIFMD's, or that appropriate contractual arrangements are put in place to ensure that there is no circumvention of the remuneration rules. 

It is not clear whether UCITS or Markets in Financial Instruments Directive (MIFID) firms would be subject to equally effective remuneration requirements and there is potentially a very significant issue for UK AIF managers who want to delegate these activities to a non-EEA entity.

As a last resort option, the FSA could decline to follow ESMA's guidelines (and be named and shamed as a consequence). We may find out shortly whether it is prepared to do this.

Things to consider

Amid all this, there are many issues to consider. As a brief selection, the UK's proposed regime for 'small authorised UK AIF managers' needs clarification; the UK's gold-plated approach to 'depositary-lite' under Article 36 of the AIFMD needs review; it is not certain that the required co-operation agreements with third countries will be in place in time; and the interaction between the application of the AIFMD, the UCITS directive and MIFID to EEA AIF managers appears to need far more thought at an EU level.

Particular consideration should be given to the possibility that an AIF manager may not be able to passport all its services around the EEA under the AIFMD.

Final legislation and rules in the UK may not be available until June. UK managers may have to start to comply with them in July. They should be conducting their initial AIFMD analysis now.

That means closely monitoring, and reacting to, the proposals made by the FSA and the Treasury over the next few months, as well as the implementation of the AIFMD into those EEA states in which their funds are – or are likely to be – marketed. 

James Tinworth (pictured) is a partner at Stephenson Harwood.