Including updates on AIFMD and IOSCO principles on asset-backed securities and complex financial products


ESMA consults on AIFMD key concepts

The devil is in the detail and the European Securities and Markets Authority (ESMA) is starting to flesh-out some of the key concepts within the Alternative Investment Funds Management Directive (AIFMD).

In a discussion paper published on 23 February, ESMA sets out its thinking on some key parameters on the Directive’s scope and outlines how the new regime may interact with other key pieces of EU legislation.

ESMA clarifies that an alternative investment fund manager (AIFM) must be capable of providing both portfolio management and risk management functions to obtain an AIFM authorisation but that performing either of these functions for an alternative investment fund (AIF) constitutes ‘management’, bringing the AIFM within scope of the AIFMD. As with other functions, an AIFM may choose to delegate these two functions either in whole or in part-- but not to such an extent that it becomes a quasi ‘letter-box entity’ with little actual managerial oversight of the fund. The AIFM would still be responsible and liable for the portfolio and risk management functions delegated to third parties.

Article 2 of AIFMD sets out a broad definition of AIF, ensuring that many fund structures previously free from regulatory oversight will be captured under AIFMD. It outlines that alternate investment funds (AIFs) can be open or closed ended, can take any legal form and can be admitted to trading on a regulated market. The definition does not limit AIFs in terms of asset classes in which they can invest. However, given the wide range of funds existing within the European Union (EU), the definition still sets obstacles for supervisors in establishing which funds should be subject to AIFMD.

Given these challenges, ESMA carried out a mapping exercise to establish the types of AIFs which currently exist in the EU. The exercise identified 6 categories in total, including: various types of non-UCITS funds, private equity funds that invest in unlisted equities and real estate funds. The mapping exercise did not produce a definitive list of funds to which AIFMD will apply: instead, ESMA is proposing that, in the identification process, supervisors should assess each fund based on whether it possesses certain characteristics, including:
  • Raising capital: an AIF must involve ‘some kind of communication by way of business’ between the investor and the fund manager. Vehicles raising capital on a non-commercial basis should not be considered an AIF since the investment is not intended to deliver an investment return or profit. However, the absence of capital raising would not automatically preclude an entity from being an AIF, particularly if it was established through in specie transfer of assets rather than through asset purchase.
  • Collective investment: an AIF must be a collective investment undertaking which pools together capital raised for investors. Its aim should be to generate a return for its investors through the sale of its investments rather than an entity acting for its own account and whose purpose is to manage underlying assets to generate value during the life of the undertaking.
  • Defined investment policy: all investments should be made in accordance with the AIF’s pre-defined investment policy. ESMA offers an indicative list of criteria that should be considered in determining whether an entity follows a defined investment policy, including: having a fixed investment policy after an investor's commitment is binding (though this can change at a later date if investors are notified); a policy which is set out in the fund documents; and the policy contains a set of guidelines that it will invest in certain assets, pursue certain strategies, and invest in certain geographical areas.
  • Number of investors: an entity cannot be an AIF if its fund rules restrict investment to a single investor, unless that investor acts on behalf of others (such as a nominee or a feeder fund).
  • Ownership and control of assets: investors in AIFs should generally not be the registered holders of the underlying assets and should have ownership through shares/units in the AIF or beneficial ownership based on their investment in the AIF. Investors should also not have day-to-day control or discretion over the underlying assets.
ESMA believes that an assessment made against such characteristics should make it easier to establish a harmonised application of AIFMD and prevent the build-up of risk in any one AIF which has atypical features and previously would have eluded regulatory oversight.

ESMA also proposes to establish additional criteria in due course so that the AIFMD applies consistently and uniformly to AIFs, including: defining ‘open-ended’ for AIFMD purposes (i.e. can invest or divest without limitation at least annually) and what constitutes an AIF of ‘significant size’ for the purposes of the remuneration requirements.

One interesting section in the discussion paper focuses on the appointment of the AIFM. The guidance states there are ‘no provisions in the Directive which impose conditions or criteria on the AIF for the appointment or selection of the AIFM’. Therefore, the AIF is free to appoint any legal person as AIFM provided this entity is authorised under the AIFMD.

ESMA asks stakeholders whether it would be beneficial – or possible – to provide more clarity on which funds automatically fall outside the scope of AIFMD. However, it displays a clear reticence to be tied too closely by pre-determined definitions, for example, of holding company, joint venture or insurance contract, noting that given the dynamism and resourcefulness of the industry, tight definitions would make circumvention a real possibility/probability. Any additional clarity provided on such definitions is likely to be broad-brushed enough to leave plenty of wriggle room for supervisors.

The final section of the paper deals with the interaction of AIFMD with other pieces of EU legislation. The guidance states that an AIFM may act as a management company for UCITS provided that the alternative investment fund manager is ‘authorised in accordance with UCITS Directive for that activity’. Firms authorised under the Markets in Financial Instruments Directive (MiFID) or the Banking Consolidation Directive can continue to provide investment services such as individual portfolio management to AIFs on a delegated basis without needing to be authorised as an AIFM.

The discussion paper closes for comments on 23 March 2012 and responses will provide input to a consultation paper which ESMA plans to issue in the second quarter of 2012 setting out its complete proposals for the draft regulatory technical standards (RTS) required under Article 4(4) of the Directive. Following consultation, ESMA will finalise the draft RTS and submit them to the European Commission for endorsement by the end of 2012.

Only 18-pages in length, this discussion paper is just the starting point towards more detailed regulatory technical standards on AIFMD. Many outstanding issues are still to be addressed, so considerable uncertainty remains. It is important, though, that industry fully engages in this process. The RTS will supplement details to be supplied by the delegated acts to be issued by the European Commission, following ESMA’s advice in November last year. The delegated acts have not yet been issued (although anticipated at the end of February). This latest discussion paper begins to clarify some essential questions around the potential impact of existing operational structures and activities but there is a long way to go. We still need many more of those devilish details.


IOSCO outlines disclosure principles for asset-backed securities

The ongoing financial crisis can trace its roots to asset-back securities (ABS) in the form of pooled US subprime mortgages produced under the ‘originate-to-distribute’ model which proliferated during the 2000s. They were perceived to be a vital source of funding for the US economy and proved very popular with institutional and retail investors alike. At its height in 2006, approximately $1.6 trillion (two-thirds of which related to mortgage-back securities) of ABS were issued which financed well over half of all mortgages in the US, according to figures from SIFMA and Citi. The growth in ABS was less pronounced in Europe but still significant and a source of systemic concern, with around €500 billion worth of ABS issued in 2006, according to the European Securitisation Forum.

However, these securities, cloaked in a veil of complexity, were poorly understood by supervisors, rating agencies and investors alike. The central premise that real estate-backed investments were safe (given historical trends) came under closer scrutiny from 2007 as house prices in the US started to fall and the folly of separating those who give out loans from those who provide the underlying funds, became ever clearer. Impairments on subprime loans started to increase, the value of the associated ABS, the securitisation market collapsed and a credit crunch ensued.

Since the crisis, governments have called for greater transparency and disclosure across financial markets, including ABS disclosure.

The International Organisation of Securities Commissions (IOSCO) published ‘Principles for Public Offerings and Listings of Asset-Backed Securities’ in April 2010. In Europe, the Capital Requirements Directive (CRD) II--Europe’s immediate response to the 2008 financial crisis--enhanced disclosure rules around ABS by requiring credit institutions to provide investors with all materially relevant data on the credit quality and performance of the individual underlying exposures, cash flows and collateral supporting a securitisation exposure. Moreover, regional central banks-- like the Bank of England which have accepted ABS as collateral eligible for its liquidity insurance operations since 2007--have beefed-up their disclosure requirements as part of its eligibility criteria on collateral (the European Central Bank is currently formalising similar standards).

However, not all types of ABS issued are captured under these regulatory frameworks. For example, CRD II disclosure requirement only apply to credit institutions. IOSCO’s 2010 principles do not explicitly address continuous reporting disclosure mandates or requirements to disclose material developments.

Clearly, some uniform standards which are internationally accepted as disclosure benchmarks would be useful and may mitigate risks in certain parts of the ABS market and result in better outcomes for investors.

On 20 February, IOSCO identified 11 draft Principles which it considers essential to enhancing investor protection, including:
  • ensuring that information is disclosed in a simple, clear and fair manner
  • publishing performance information on the asset pool on a periodic basis
  • disclosing sufficient information on material events (such as legal proceedings, updated information on parties involved with the ABS, affiliations with related parties, asset impairment information, repurchase and replace activity) when they take place
  • ensuring that all investors and market participants have equal (and simultaneous) access to disclosures.
The Principles are designed to offer guidance to securities regulators who are developing or reviewing their regulatory regimes for ongoing disclosure of ABS. They are expected to be adopted by regulators to varying degrees in different jurisdictions, depending on the characteristics of the issuing entity or of the securities involved. IOSCO recognises that adopting these principles globally will be difficult, given differences in legal frameworks across jurisdictions.

The consultation period on these principles closes on 21 May 2012, after which IOSCO will publish finalised Principles later this year. Much of the requirements are based on common sense, but should be given consideration by industry. Clearly, these requirements will cost financial institutions in some regions money to implement and will add to the sizable reporting requirements they will face in the next few years.


IOSCO consults on suitability requirements for complex financial products

More disclosure requirements for financial institutions are envisaged by IOSCO, as it consults on suitability requirements related to selling complex financial products to retail and non-retail clients. The consultation outlines fundamental principles relating to the role of the intermediary in the distribution process and is open for comments until 21 May 2012.

There are 9 principles in total, which can be summarised as follows:
  • General requirements: intermediaries should act ‘honestly, fairly and professionally’ and take ‘reasonable steps’ to manage conflicts of interest (i.e. disclosure) that arise in the distribution of complex financial products.
  • Classification: intermediaries should put in place appropriate policies and procedures to identify retail and non-retail clients.
  • Suitability of advice: intermediaries should take ‘reasonable steps’ to ensure that recommendations made to a customer on buying a financial product are based on reasonable assessment that the structure/risk-reward profile of the financial product is consistent with the customer’s risk appetite and capacity for loss.
  • Sufficient knowledge: an intermediary should have sufficient information to have a reasonable basis for any recommendation, advice or exercise of investment discretion for a customer in connection with the distribution of a complex financial product.
  • Disclosure requirements: investors should receive or have access to material information to evaluate the nature of the financial product.
  • Compliance functions: intermediaries should establish a compliance function and develop appropriate internal policies and procedures that support compliance with suitability obligations, including when developing or selecting new complex financial products for customers.
  • Incentives: firms should have appropriate policies and controls to eliminate any incentives for staff to recommend unsuitable complex financial products.
  • Execution-only selling: in cases where no management advice or recommendation is given by an intermediary in the distribution of complex financial product, the regulatory system should have adequate controls to protect customers.
  • Supervisory regime: supervisors should examine the selling of complex products carefully examined and take appropriate enforcement action where necessary.
IOSCO does not suggest that retail and certain types of non-retail clients should necessarily be treated any differently, although in some jurisdictions certain suitability obligations may be differentiated or waived depending on the client’s classification. In these countries, IOSCO actually warns supervisors on the dangers of adopting overly broad presumption or definition of non-retail investor that could lead to inappropriate advice to some kinds of non-retail clients who are not as ‘sophisticated’ as others (e.g. municipalities and local authorities).

The consultation was informed by a survey which IOSCO conducted last year on G20 members’ current regulatory frameworks in this area. The findings are presented in the Annex of the document and provide some interesting insights on the distribution of complex financial products across different countries.

Differences are not just limited to Anglo-Saxon/ EU versus the rest of the world, but are more rich and complex even for countries within the EU. Overall, IOSCO notes ‘significant’ differences in G20 members’ suitability regimes, particularly in relation to the scope of application (especially when it comes to the definition of ‘suitable’), the steps to be complied with and the relevant factors embedded in the suitability determination. Also, the internal controls and organisational requirements that the market intermediary is required to put in place to help ensure compliance with suitability requirements are significantly different across the countries sampled. Enforcement regimes are also diverse, together with the ‘consequences arising when the market intermediary assesses that the product is unsuitable to the client’.

Harmonising rules on the distribution of complex products will be difficult, given the close association between customer protection rules and domestic legislative frameworks. In the EU several proposals are afoot to further harmonise the distribution of complex products. Enhanced powers by the European Supervisory Authorities to intervene and ban certain products on a temporary basis in all Member States are important. Moreover, the propagation of the single rule book encompassing the Markets in Financial Instruments Regulation and the forthcoming Packaged Retail Investment Products legislative proposals--which we expect in Q2 2012--should help promote the idea of having a fully functioning single market for complex products across the EU where customers are offered equal protection.