MiFID and AIFMD Compared Abigail Bell Richard Frase Richard Heffner 12 February 2013 © 2013 Dechert LLP MiFID and AIFMD Compared Agenda • Authorisation and exemptions • Permitted services • Marketing • Organisation and Conduct of Business • Delegation • Financial resources and insurance • Remuneration Authorisation, Services and Marketing AIFM Authorisation (AIFMD arts 6-11; MiFID arts 5-10) Similar application process – New activity of collective portfolio management (carved out of MiFID concept of “portfolio management”). – AIFMD requires detailed information on each AIF, investment strategy, depositary, delegation arrangements, remuneration policies. – EU wide public register of AIFMs. MiFID firm must have head office in EU state where it is authorised (art 5(4)) AIFM can be outside EU and use “state of reference” Changes in scope of authorisation MiFID: Notification under FSA Principle 11 and authorisation terms; no MiFID equivalent AIFMD article 10: Formal requirement to notify material changes to FSA. Includes new fund launches, changes to investment strategy etc. Formal right to restrict or reject the change within 1 month Same ability to withdraw authorisation in both MiFID and AIFMD Exemptions MiFID Range of different exemptions Collective investment undertakings are excluded from MiFID (art 2(1)(h)) Group exemption for services provided exclusively to parents and subsidiaries (art 2(1)(b)) AIFMD Exemptions are AIF specific 100 million AIF AUM de minimis regime Family office Group exemption for AIFs whose sole investors are parents or subsidiaries (recital (16)) Permitted services MiFID Core Services AIFMD Core services Reception and transmission of orders Execution of orders on behalf of clients Dealing on own account Portfolio management Investment advice Underwriting and/or placing on a firm commitment basis Placing without a firm commitment basis Operation of Multilateral Trading Facilities Acting as an AIFM Portfolio management MiFID Ancillary services AIFMD Ancillary services Safekeeping and administration (becomes a core service under MiFID 2) Granting credits or loans to carry transactions Advice to undertakings on capital structure, industrial strategy and related matters; advice and services relating to mergers and the purchase of undertakings Foreign exchange services connected to the provision of investment services Investment research and financial analysis or other forms of general recommendation Services related to underwriting Core and ancillary MiFID services relating to the underlying of certain derivatives connected to the provision of such services Investment advice Reception and transmission of orders Safekeeping and administration for shares or collective investment undertakings Marketing & Passporting MiFID Marketing is not a MiFID regulated activity. UK rules on financial promotion apply. Placing and receiving and transmitting orders have some impact. AIFM EU standardised marketing regime (both passported and unpassported) Difference between marketing and financial promotion MiFID firms can market AIF units only if the AIF can be marketed in accordance with AIFMD (art 6(8)) An AIF can be listed only if the AIFM is compliant (recital 60) Passporting (MiFID 31-32; AIFMD arts 32-42) MiFID allows passport for all services on cross-border or branch basis AIFMD passport focuses on marketing and managing of AIFs on branch or cross-border basis (article 33) Operating conditions applicable to the firm 8 © 2013 Dechert LLP General Principles (Article 12 of AIFMD) Member States shall ensure that AIFMs: • Act honestly, with due skill, care and diligence (existing obligation under Principle 2 of the FSA’s Principles of Business) • Act in the best interests of the AIF and the integrity of the market (existing obligation under Principle 6 of the FSA’s Principles for Business, but a higher standard and additional responsibility to maintain the integrity of the market) • Have and employ effectively the necessary resources and procedures (existing obligation under Principle 4 of the FSA’s Principles for Business) • Take all reasonable steps to avoid conflicts of interests and, where they cannot be avoided, identify, manage and monitor and disclose these conflicts (existing obligation under Principle 8 of the FSA’s Principles of Business and Articles 13(3) and 18 of MiFID) • Comply with all regulatory requirements applicable to the conduct of their business (existing obligation under Principle 5 of the FSA’s Principles for Business and Article 13(2) of MiFID). • Treat all AIF investors fairly (existing obligation under Principle 6 of the FSA’s Principles for Business) Action Point: Any preferential treatment must be disclosed in the AIF’s constitutional documents . Conduct of Business Obligations (Articles 18-19 of the Regulations) • Due diligence requirements are new. • Some of these apply only in respect of AIFM which manage AIFs investing in limited liquidity assets. • Impact on due diligence conducted by AIFMs on the AIFs they manage. • Requirement to establish a business plan consistent with the duration of the AIF and market conditions. • Must have in place in diligence policies and procedures that take into account the nature, scale and complexity of the AIF’s assets. • Ongoing responsibility for updating business plan to account for changes in investment, strategy or market conditions and regularly reviewing and updating due diligence policies and procedures. • Will be required to retain records of activities for at least 5 years. Action Point: Records will need to be kept of the AIFM’s analysis of investment opportunities. Conduct of Business Obligations (Article 20 of the Regulations) Counterparty selection: • Under CASS 6.3, where a firm arranges the registration of safe custody assets deposited with a third party, it must exercise all due skill, care and diligence in the selection and appointment of the third party. • Principle 10 of the FSA’s Principles for Business requires a firm to arrange “adequate protection” for its client’s assets when responsible for them. • Under Article 20 of the Regulations, when selecting and appointing counterparties and prime brokers, AIFMs must exercise due skill, care and diligence before entering into an agreement and on an ongoing basis thereafter taking into account the full range and quality of their services. • Under AIFMD therefore, this obligation is extended beyond custodians to derivatives and securities lending counterparties and will apply on a continuing basis. Fair Treatment of Investors (Article 12 of AIFMD; Articles 23 and 57 of the Regulations) • Principle 6 of the FSA’s Principles for Business: “A firm must pay due regard to the interests of its customers and treat them fairly”. • Position under AIFMD: No investor should obtain preferential treatment having an overall material disadvantage to other investors BUT treatment differentiating between investors is permitted provided that it is properly disclosed e.g. preferential fees for seed investors. Inducements (Article 24 of the Regulations) • A firm cannot pay or be paid any fee or commission or provide or be provided with any nonmonetary benefit other than: - a fee, commission or non-monetary benefit paid or provided to or by the AIF or a person on behalf of the AIF; - a fee, commission or non-monetary benefit paid or provided to or by a third party or a person acting on behalf of a third party where: (1) the existence, nature and amount of the fee, commission or benefit or, where the amount cannot be ascertained, the method of calculating that amount is clearly disclosed to the investors in the AIF in a manner that is comprehensive, accurate and understandable, prior to the provision of the relevant service; (2) the payment of the fee or commission, or the provision of the non-monetary benefit are designed to enhance the quality of the relevant service and not impair compliance with the AIFM’s duly to act in the best interests of the AIF its manages or the investors in the AIF. - proper fees which enable or are necessary for the provision of the relevant services and do not give rise to conflicts with the AIFM’s duties. Key Point: No material change from current position under COBS 2.3. Risk Management Article 13(5) of MiFID: “An investment firm shall have sound administrative and accounting procedures, internal control mechanisms, effective procedures for risk assessment and effective control and safeguard arrangements for information processing systems.” Risk Management (cont.) SYSC 7.1.6: A common platform firm must, where appropriate and proportionate, establish and maintain a risk management function that operates independently and carries out the following tasks: – Establish, implement and maintain adequate risk management policies and procedures which identify the risks relating to the firm’s activities, processes and systems and set the level of risk tolerated by the firm. – Adopt effective arrangements, processes and mechanisms to manage the risk relating to the firm’s activities, processes, and systems, in light of that level of risk tolerance. – Monitor: 1. the adequacy and effectiveness of the firms risk management policies and procedures. 2. the firm’s level of compliance with the arrangement, processes and mechanisms adopted; and 3. the adequacy and effectiveness of measures taken to address any deficiencies therein. Risk Management (cont.) • Post AIFMD, an AIFM will be required to : – functionally and hierarchically separate the functions of risk management from the operating units, including portfolio management; and – (to the extent it has not already done so) implement adequate risk management systems to identify, measure, manage and monitor all risks relevant to each AIF investment strategy. • Note that the test under Level 2 as to whether these functions are independent is quite onerous. • The FSA has indicated that it would review this separation in line with the principle of proportionality. • The AIFM must review its systems at least once per annum. Risk Management (cont.) • Where it is considered disproportionate for the risk management function to be functionally and hierarchically separate, the FSA will take the following into account when considering the safeguards to ensure independence of the risk management function: – use of data that is reliable and subject to a degree of appropriate control; – risk management staff compensated in accordance with the performance of the risk management function and independent of the performance of the business areas; – independent decision making; and – the segregation of competing duties. • The FSA may also take into account the existence of a review of the risk management function by an independent third party or by the internal audit function. Risk Limits The AIFM will be subject to an additional obligation to establish and implement quantitive and/or qualitative risk limits for each AIF that it manages covering: – Market risks – Credit risks – Liquidity risks – Counterparty risks – Operational risks. Must be aligned with the AIF’s risk profile as disclosed to investors and take into account the AIF’s strategies and assets and the national rules applicable to the AIF. Operating conditions applicable to the AIF 8 © 2013 Dechert LLP MiFID Custody v AIFM Depositary • MiFID: No duty to appoint or supervise client’s custodian. • Principle 10 of the FSA’s Principles of Business: “A firm must arrange adequate protection for its client’s assets when it is responsible for them”. • CASS 6.3 imposes duties on firms which control the appointment of a custodian. • Article 12 of AIFMD prescribes duties on the AIFM regarding the appointment of a depositary for each AIF. Liquidity Management (Article 16 of AIFMD and Articles 46-49 of the Regulations) • For each AIF which is not a closed-ended unleveraged AIF, AIFMs must: – employ an appropriate liquidity management system, and – adopt procedures enabling them to monitor the AIF’s liquidity risk and to ensure that the liquidity profile of the AIF’s investments comply with its underlying obligations. • AIFMs must also ensure for each AIF they manage the investment strategy, liquidity profile and redemption policy are consistent. This will be the case where investors have the ability to redeem in a manner consistent with the fair treatment of AIF investors and in accordance with the AIF’s redemption policy and obligations. • AIFM must also have regard to the impact of redemptions on underlying prices or spreads of the AIF’s individual assets. • Not directly addressed in MiFID; indirect responsibility under the FSA’s Principles for Business. Liquidity Management (cont.) Note in particular the requirement for AIFMs to: • monitor compliance by AIFs with the risk limits set by the AIFM and determine a course of action where these limits have been or are likely to be exceeded; and • regularly conduct stress tests to assess the liquidity risk of each AIF under their management. The AIFM must conduct an annual review of its liquidity management policies and procedures and update them as necessary. Action Point: For AIFs investing in less liquid assets, AIFMs should consider prior to launch the liquidity profile of the AIF, the appropriate redemption schedule and the use of liquidity management tools to assist in managing redemptions (e.g. hard and soft locks/gates etc). Valuations (Article 19 of AIFMD; Articles 67-74 of the Regulations) • Likely to require a substantial reallocation of responsibility as between the AIF’s service providers and its governing body. • AIFMs required to take responsibility for the proper valuation of AIF assets and calculation of the NAV. • An external valuer may be appointed in which case the external valuer will be liable to the AIFM for losses arising from its negligence or intentional failure. • Third parties may be unwilling to take on this responsibility meaning that the AIFM will have to perform this function internally. Conflicts of Interest • Current rules set out in SYSC 10.1. • The rules on conflicts contained in AIFMD are broadly similar but some points to note: – Potential conflicts must be considered in terms of investors in the AIF not just in terms of the AIF itself. – Conflicts policy needs to reference activities carried out by delegates, subdelegates, external valuers and counterparties, not just those of the AIFM itself. – A requirement for AIFM managing open-ended AIFs to identify, manage and monitor for conflicts between redeeming and continuing investors and conflicts between the AIFM’s incentive to invest in illiquid assets and the AIF’s redemption policy. – The AIFM must develop strategies for determining when and how to exercise any voting rights held in the AIF portfolios it manages. This follows the UCITS approach but is not contained in MiFID. Delegation AIFM level 1 Requirements for prudent delegation track UCITS AIFM level 2 Quantitative/qualitative restrictions on delegation MiFID 1 Outsourcing of critical or important functions MiFID 2 Restrictions on permitted delegates (will catch delegation by AIFMs) A firm may receive services at its own exclusive initiative (MiFID 2 recital 74, MiFIR article 36(4)) Otherwise, for retail client business (and professional client business?) (MiFID 2 article 41): • the sub-manager must establish a branch in the EU (not just a representative office) • the branch must be authorised by its EU state • the sub-manager must be authorised in its 3rd country • the 3rd country must meet equivalence and reciprocity requirements • the authorised branch gets a MiFID passport (article 44) Regulatory Capital & Remuneration 8 © 2013 Dechert LLP Current Requirements • MiFID regime – FSA prudential categories – Hedge Fund Manager – BIPRU limited licence / 50K firm – Private Equity / Venture Capital (advisory only) – Exempt CAD firm • BIPRU limited licence / 50K firm – capital requirement highest of: – €50,000 – Fixed Overheads Requirement (FOR) - 25% of annual fixed overheads – Sum of market risk and credit risk capital requirements – Individual Capital Adequacy Assessment Process (ICAAP) • Exempt CAD firm – capital requirement (at firm’s option) of: – €50,000; or – insurance (min €1 million each claim / €1.5 million all claims); or – combination of capital and insurance (subject to £5,000 capital floor) AIFMD Requirements • FSA’s proposed prudential categorisation of AIFMs – Collective Portfolio Management Firm (CPM firm) – IPRU(INV) Chapter 7 – Collective Portfolio Management Investment Firm (CPMI firm) – GENPRU & BIPRU • Based on whether AIFM has extended “MiFID” permissions – CPM firm – collective portfolio management only – CPMI firm – collective portfolio management, PLUS additional permissions for any of: • client-by-client discretionary portfolio management (managed accounts) • investment advice • reception and transmission of orders (not available for UCITS investment firm) • custody of CIS units AIFMD Requirements - 2 CPM firm – AIFMD requirements only • capital requirement is higher of: – €125,000, plus 0.02% of AUM over €250 million (subject to €10 million cap) – Fixed Overheads Requirement (FOR) – 25% of annual fixed overheads • Plus: additional own funds OR professional indemnity insurance • Plus: liquid assets requirement CPMI firm – AIFMD requirements + CAD • capital requirement is higher of: – CPM capital requirement (as above) – BIPRU limited licence firm capital requirements Additional Own Funds / PI Cover • To cover Professional Liability Risks – defined in Level 2 Regulation as: – • “risks of loss or damage caused by a relevant person through the negligent performance of activities for which the AIFM has legal responsibility” Alternative 1 – Additional Own Funds – must be at least 0.01% of the value of AIF portfolios under management – limited home state discretion to reduce to 0.008% (but FCA not expected to exercise) • Alternative 2 – PI Cover – Required terms: • must cover “Professional Liability Risks” defined in Level 2 Regulation • coverage limits of at least: each claim: 0.7% of the value of the AIF portfolios under management all claims: 0.9% of the value of the AIF portfolios under management • initial term at least 1 year • cancellation notice at least 90 days – Any agreed excess – fully covered by additional own funds – Policy exclusions – FSA expects to be covered by adequate own funds AIFMD Liquid Assets Requirement AIFM own funds and any additional own funds must be: • “invested in liquid assets or assets readily convertible into cash in the short term and shall not include speculative positions” • per FSA, “readily convertible into cash” means capable of being realised for cash within 1 month • Does not apply to €125,000 base requirement MiFID firms – CRD IV proposals • Directive and Regulation not final – implementation delayed – was due 1 Jan 2013 – now 1 Jan 2014? • CAD investment firms – BIPRU Limited License / 50K firms – Base capital requirement remains €50,000 – New calculation basis for variable capital requirement • New requirements based on Total Risk Exposure Amount – For BIPRU limited licence category, calculated as higher of: • sum of credit risk capital and market risk capital requirements • 12.5 x 25% of fixed annual expenditure CRD IV proposals - 2 • Three new requirements (% of total risk exposure amount): – Common Equity Tier 1 capital ratio: 4.5% – Tier 1 capital ratio: 6% – Total capital ratio: 8% (Common Equity Tier 1 and Tier 1 rates phased in over 1st, 2nd and 3rd years) • Plus, as Common Equity Tier 1 capital (phased in over 4th, 5th & 6th years): – Capital Conservation Buffer – additional 2.5% of total risk exposure amount – Countercyclical Capital Buffer ? – between 0% to 2.5% of total risk exposure amount – Possible exemption for SME investment firms • Once phased in, potential increase in regulatory capital requirements – Min total capital requirement = 10.5% ratio = 32.8% of annual fixed overheads Remuneration • AIFMD requirements similar to CRD III (current FSA Rem Code) – • BUT limited basis to apply proportionality Possible new AIFMD requirements for MiFID firms currently in Proportionality Level 3 – To pay at least 50% of variable remuneration in units / shares of AIFs managed or equivalent non-cash (subject to AIF legal structure) • but not if AIFs represent less than 50% of portfolios managed by the firm – To defer at least 40% of variable remuneration (or 60%, for very high remuneration) for at least 3 to 5 years (unless AIF life cycle shorter) – To adjust variable remuneration to reflect the financial situation of the AIFM and the performance of the business unit, the AIF and the individual concerned – To set an appropriate balance between fixed and variable remuneration Dechert LLP Definitive advice Practical guidance Powerful advocacy dechert.com Almaty • Austin • Beijing • Boston • Brussels • Charlotte • Chicago • Dubai • Dublin • Frankfurt • Hartford Hong Kong • London • Los Angeles • Luxembourg • Moscow • Munich • New York • Orange County • Paris Philadelphia • Princeton • San Francisco • Silicon Valley • Tbilisi • Washington, D.C. Dechert practices as a limited liability partnership or limited liability company other than in Almaty, Dublin, Hong Kong, Luxembourg and Tbilisi.