AIFMD - summary of Level 2 measures and proposed UK implementation


The Regulation is subject to a three month scrutiny period by the European Parliament and the Council of the EU and will enter into force, providing that neither co-legislator objects, on 22 July 2013, alongside the AIFMD. While the AIFMD allows for certain flexibility in implementation by EU legislators and regulators, the Regulation is directly applicable, meaning there is no room for manoeuvre by Member States and the provisions contained in the Regulation will apply as specified. The Regulation expands on many of the requirements in the AIFMD, with particular focus on certain areas which required further clarity, such as in respect of delegation and depositaries.

This note considers the following areas under the Regulation, with more detail provided on the areas that we consider to be of most importance:

- Calculation of AUM / leverage / own funds and professional indemnity insurance;

- Operating conditions and organisational requirements;

- Valuation;

- Delegation;

- Depositary issues; and

- Transparency / exchange of information / rules regarding third countries.

The Regulation will further increase the pressure on asset management firms and EU national regulators in the race to ensure compliance with the AIFMD by the time of its entry into force, in July 2013. While the Regulation is considerably shorter than the draft recommendations provided by ESMA to the Commission at the end of 2011, the Commission has failed to take into account certain of ESMA’s recommendations in key areas which could lead to further difficulty. The rules contained in the AIFMD and now the Regulation are onerous in places, and could lead to significant restructuring within the industry. Many of the requirements to be put in place serve little or no benefit to investors. Of greater concern perhaps is the fact that a number of areas are still unclear, as we highlight below in this note. There looks certain to be a period of upheaval while fund managers grapple with the provisions to be implemented.


The AIFMD applies a basic catch-all approach and covers a wide variety of Alternative Investment Fund Managers (“AIFMs”) that engage in EU-related management or marketing activities, subject to certain specific exemptions. An AIFM is defined as any legal person whose regular business is managing one or more alternative investment funds (“AIF”), with an AIF defined as a non-UCITS collective investment undertaking of any legal form which raises capital from a number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors. The Commission’s stated aim with the AIFMD was to create ‘a single rulebook that ensures a level playing field among AIFMs in the Union’.

It has been recognised that a substantial number of AIFMs are already authorised as management companies under the undertakings for collective investment in transferable securities regime (“UCITS”) or are operating under the Markets in Financial Instruments Directive (“MiFID”) regime. An approach which is consistent with existing regulatory standards was therefore sought to prevent different or overlapping regulatory standards. However, in places the AIFMD and the Regulation have gone further than the existing regimes, most notably in respect of the provisions on delegation and requirements on depositaries.

The AIFMD (the broad ‘Level 1’ Directive) made provision for a detailed set of implementing measures (the ‘Level 2’ measures) to be produced covering a wide range of topics, including: calculation of the assets under management; clarification of certain operating conditions for AIFMs; the delegation of AIFM functions; and clarification of a depositary’s duties and liability.

The draft Regulation follows from the final advice sent by ESMA on 16 November 2011 to the Commission on possible implementing measures under the AIFMD. The advice was prompted by a request for technical assistance from the Commission, focussing on four key aspects: general provisions, authorisation and operating conditions; depositary functions; transparency requirements and leverage; and supervision, as well as two public consultations. However, industry concerns have not been sufficiently dealt with by the Regulation and now it is up to regulators to try and make sense of the requirements and determine a pragmatic way of implementing them within national law (although as
already stated, any power is considerably limited by the fact the Regulation is directly applicable to Member States). The Regulation does not deal with certain areas of the AIFMD such as scope, authorisation of AIFMs, management and marketing of AIFs in the EU including in relation to third countries and the availability of the passport, and transitional provisions.

There is still a significant amount of material to be published before the AIFMD comes into force. Most notably ESMA is still developing detailed level 3 guidance on many of the aspects covered within the Regulation, such as the exchange of information between regulators and the creation of a common register of AIFMs within the EU. ESMA recently released (on 19 December 2012) two further consultation papers; on types of AIFMs and key concepts of the AIFMD (which focuses on the definition of an AIF).

From a UK perspective, the FSA released their first consultation paper on the implementation of the AIFMD within the UK regulatory framework, CP 12/32, in November 2012, and it intends to release a second consultation paper later in February 2013 as well as publishing its responses to the first consultation. The FSA has indicated that one policy statement will be published relating to both consultation papers in June 2013. This means that UK firms will be subject to a short and strict timetable in order to understand and assimilate this information to ensure compliance with the totality of
AIFMD implementation ahead of the ‘live’ date of 22 July 2013. You can find our note on UK implementation of AIFMD here.

Calculation of AUM / leverage / own funds and professional indemnity insurance

Calculation of assets under management

Article 3 of the AIFMD deals with circumstances under which AIFMs may be exempt from the obligation to obtain authorisation because the assets held by AIFs they manage are below certain thresholds (although AIFMs whose AUM are below these thresholds can choose to opt in to the AIFMD). The threshold is €100 million; this includes any assets acquired through the use of leverage. If, however, assets under management (“AUM”) are both unleveraged and have no redemption rights exercisable for five years after initial investment in each AIF (i.e. closed ended, unleveraged funds), then the threshold is €500 million.

The Regulation sets out how the calculation of total AUM should be made; it requires the AIFM to identify all AIFs and for each AIF identify and value the portfolio of assets, including all assets acquired through leverage, and then aggregate the values and determine whether the total falls within one of the thresholds for exemption (Article 2). This calculation should be made at least annually on a ‘threshold calculation date’ to be determined by the AIFM. Assets where management has been delegated by the AIFM can count towards the threshold, but assets do count where they are managed by the AIFM under delegation from another manager. The AIFM is permitted to exclude from the calculation any UCITS and any cross holdings (i.e. investments by an AIF in other AIFs managed by the same AIFM, given that, on a look-through basis, there is only one set of underlying assets to be included in the calculation). Any
derivatives must be valued at an equivalent position in the underlying assets. The Commission explained in the preliminary wording to the Regulation that valuing derivatives ‘as if the underlying assets were acquired by the fund represents a key policy choice as this method of valuation best reflects the AIF’s exposure to those assets.’ The Commission has chosen to omit the provisions suggested by ESMA in its advice that foreign exchange and interest rate hedging positions should be excluded from the calculation. Potentially this could result in some AIFMs failing to stay within one of the thresholds.

Where the AIFM falls under one of the thresholds and is exempt from the AIFMD, registration with the regulator is still required and as part of this, information on the calculation of AUM should be provided to the regulator along with the offering document for each AIF or extract or general description of its investment strategy (Article 5).

For AIFMs seeking to stay below the thresholds and avoid authorisation, they must monitor on an on-going basis their total AUM, and the proximity of the total to the thresholds and anticipated subscription and redemption activity should inform the frequency of calculation to see if they will stay within the thresholds (Article 3). Under Article 4 the AIFM must identify any breaches of the relevant thresholds and determine whether such breach is of a temporary nature. Any breach requires notification to the regulator. However, if the breach is not temporary (which will be automatic if it is likely to continue for at least 3 months), application for authorisation as an AIFM under the AIFMD within 30 days is required.
This 30 day time requirement provides a bit more breathing space, as the original advice provided by ESMA to the Commission suggested that immediate authorisation should be required in such circumstances.

Calculation of Leverage

Leverage is defined under the AIFMD as any method by which the AIFM increases the exposure of an AIF it manages whether through borrowing of cash or securities, or leverage embedded in derivative positions, or by any other means. The Regulation (at Articles 6-11) obliges AIFMs to calculate leverage by two methods: the gross method (which gives the overall exposure) and the commitment method (which gives insight into the hedging and netting techniques used – this method is established and recognised in the asset management sector). The Commission believes that by combining the two methods it provides an objective overview and a good insight into the investment strategies and
exposure of AIFs to assist with the monitoring of systemic risks. For private equity funds, leverage that exists at the level of acquired companies generally does not need to be included in the calculation.

Additional own funds and professional indemnity insurance

The AIFMD provides that AIFMs should have one of the following to cover potential professional liability risks arising from their professional negligence: additional own funds; or professional indemnity insurance (PII) (Article 9(7)). The Regulation includes (at Article 12) a list of risks to be covered by own funds or PII, which include the risk of acts, errors or omissions resulting in a breach of legal and regulatory obligations or fiduciary duties, the risk of a failure to establish, implement and maintain appropriate procedures to prevent fraud, and the risk of business disruption or system failures. Additionally, ESMA suggested in its advice to the Commission that the AIFM should also account for the risk of any negligent valuation performed by an appointed external valuer, and this has been carried through to the Regulation.

In line with the requirement to have effective operational risk management policies and procedures in place, certain qualitative requirements have been set out at Article 13 in order to address professional liability risks. These include implementing documented policies and procedures subject to review at least yearly, and the setting up of a historical loss database to record among other data any professional liability risks that have materialised.

Quantitative limits have been set for the amount of additional own funds to be provided and PII cover. The AIFM shall provide additional own funds covering liability risks arising from professional negligence at least equal to 0.01% of the value of the portfolios of AIFs managed. Regulators may authorise the AIFM to provide a lower amount of own funds, subject to an absolute minimum of 0.008%. AIFMs that obtain PII should have cover equal to 0.9% of AUM for claims in aggregate per year and 0.7% of AUM per individual claim. These limits are considered by the Commission ‘appropriate to protect investors from damage resulting from any professional failure of the AIFM’ but inclusion of the limits means the
Commission has departed from ESMA’s recommendation of including caps, which could lead to AIFMs with very large AUM finding difficulties in obtaining cost effective professional indemnity insurance. The Regulation also does not allow for a combination of own funds and PII, which is another departure from ESMA’s recommendation.

Operating conditions and organisational requirements

The operating conditions and organisational requirements build on the requirements in the AIFMD (at Articles 12 -18). The Regulation makes it clear that AIFMs must adhere to an overarching set of principles or high level standards of care when operating their business. These high level requirements conform in general to the existing requirements on MiFID investment firms and UCITS management companies, and as such the majority will not be new to firms or groups currently under MiFID and/or UCITS. For example, Article 17 requires that AIFMs must apply policies and procedures to ensure that they are acting in the best interests of the AIF or the investors as well as the integrity of the market. This duty also explicitly extends to not charging “undue costs”. Linked to this is the expectation that AIFMs are to conduct high standards of due diligence and exercise due skill and care when monitoring investments (Article 18), investing in assets of limited liquidity (Article 19) and appointing counterparties and prime brokers (Article 20). The requirements relating to prime brokers will be new to most AIFMs.

The Regulation recognises that conflicts of interest may arise in practice despite attempts to avoid them. The focus of the provisions is to require AIFMs to quickly identify, appropriately monitor and effectively manage them in a way which limits the impact they may have on the interests of the AIF or investors. The procedures AIFMs put in place need to be “appropriate to the size and organisation of the AIFM and the nature, scale and complexity of the business” (Article 31). Where the risk of damage to the AIF or investor’s interests cannot be sufficiently managed, the Regulation requires an AIFM follow a specific procedure to provide information to those impacted prior to the business being conducted.

The Regulation also requires the establishment and application of a number of systems by AIFMs. The primary focus is upon risk and liquidity management. In relation to risk management, firms must establish and maintain a permanent risk management function which, on an ongoing basis, identifies measures, manages and monitors all risks relevant to each AIF’s investment strategy and ensures these are communicated to investors and the AIFMs senior management. The risk management function must also be ‘functionally and hierarchically separated’ from the operating units, including the portfolio management function and conditions must be fulfilled to satisfy such separation (Article 42).

The management procedures should provide sufficient tools to protect against a broad range of risks and set quantitative and qualitative limits on such risks as market, credit and counterparty risks (Article 44). Such a function must be regularly reviewed and altered if found to be lacking (Article 41). The liquidity management system must ensure that the AIFM maintains a level of liquidity in the AIF appropriate to its underlying obligations based upon an assessment of the relative liquidity of the AIF’s assets in the market. This also requires the AIFM to adequately monitor the liquidity levels within an AIF and ensure that there are sufficient tools at their disposal to cope with both liquid and illiquid assets
in line with both liquidity limits set and redemption requests (Article 48).

The Regulation also provides a number of general principles for the organisational structure an AIFM should adopt. The overriding intention is for an AIFM to create a clear organisational structure with definitive allocations of responsibility and established reporting lines (Article 57). Linked to this is the need for an AIFM’s governing body, senior management and supervisory functions to have access to sufficient information regarding each AIFs activities and the ability to effectively oversee the establishment and implementation of the policies/systems required by the Regulation (Article 60).


The Regulation imposes on AIFMs requirements as to the procedures they apply when both valuing assets within the AIF’s portfolio and calculating the net asset value of an AIF (Articles 67-74). The rules are kept at a high level to allow for the varying requirements that AIFM will be subject to in different jurisdictions. AIFMs are required to have in place written policies and procedures which ensure a sound, transparent, comprehensive and appropriately documented valuation process. A written policy is required for each AIF the AIFM manages, and it must be reviewed on an ongoing basis. AIFM’s must not invest in any type of asset for the first time before identifying an appropriate valuation methodology for that particular type of asset. If an external valuer is used, there must be an appropriate information exchange process in place and the external valuer must be able to provide professional guarantees as to their competence. If the valuation is carried out in-house, there must be documented safeguards in place to ensure the functional independence of the valuation task.

Where a valuation model is used, its main features must be explained and justified in the valuation policy, and before being used the model should be approved by the senior management of the AIFM as well as being validated with a person of sufficient expertise who has not been involved in the design of the model. AIFMs must ensure that the valuation polices and procedures are applied consistently, and that they are reviewed periodically and at least every year.


One of the most controversial components of the Regulation is in relation to delegation. The provisions on delegation are contained at Articles 75-82, and build on the requirements at Article 20 of the AIFMD.

Delegation by the AIFM is allowed under the AIFMD, provided the relevant regulator is notified and the conditions at Article 20(1)(a)–(f) are met. The conditions include, among others, that:

- the AIFM must be able to justify its entire delegation structure on objective reasons;

- where the delegation concerns portfolio or risk management, it must be conferred only on entities which are authorised or registered for the purpose of asset management and subject to supervision or prior approval by the relevant EU regulator (in addition, where delegation is conferred on a third country entity, cooperation arrangements must be in place); and

- delegation must not prevent the effectiveness of the AIFM’s supervision and the AIFM must be in a position to monitor effectively at any time the delegated activity. Delegation must not prevent the AIFM from acting, or the AIF from being managed, in the best interests of its investors.

Additionally, the AIFM’s liability towards the AIF and its investors is not affected by any delegation (or any subdelegation) and the AIFM must not delegate its functions to the extent it becomes a letter-box entity (Article 20(3)).

General principles

Article 75 sets out some general principles on delegation, which expand on the conditions found at Article 20 of the AIFMD. These are as follows:

- the delegation structure does not allow circumvention of the AIFM’s responsibilities or liability and the AIFM’s obligations towards the AIF and investors are not altered as a result of delegation;

- the conditions with which the AIFM must comply under the AIFMD are not undermined;

- the delegation arrangement must take the form of a written agreement containing provisions on: the AIFM’s right of information, inspection, admittance and access to books and premises; and the AIFM’s instruction, termination and monitoring rights. The AIFM must also ensure its consent is obtained to any sub-delegation (further detail on sub-delegation is contained at Article 81) and that the delegate protects any confidential information relating to the AIFM, the AIF and investors;

- the AIFM must ensure the delegate carries out the delegated functions effectively and in compliance with applicable law and regulatory requirements and the delegate must disclose to the AIFM anything that would materially impact this. The AIFM must establish procedures to review the services provided on an ongoing basis and must ensure the delegate establishes, implements and maintains a plan for disaster recovery and periodic testing of backup facilities;

- continuity and quality of delegation must be maintained in the event of termination of delegation; and

- where it concerns portfolio management, the delegation is in accordance with the investment policy of the AIF.

Objective reasons

Following the above, Article 76 of the Regulation provides that the AIFM must provide the relevant regulatory authority with a ‘detailed description, explanation and evidence’ of the objective reasons of delegation. Certain criteria will be considered in determining whether there are objective reasons, including: optimising of business functions and processes; cost saving; expertise of the delegate in administration or in specific markets or investments; and access of the delegate to global trading capabilities. The level of detail a regulator will accept and whether any requests for further evidence will be made as permitted by Article 76(2) remains to be seen.

Article 77 sets out key features of the delegate, requiring delegates to have sufficient resources and an appropriate structure in place and requiring persons who effectively conduct the business of the delegate to have sufficient experience, knowledge and expertise and to be of sufficiently good repute.

Delegation of portfolio or risk management

Article 78 sets out the types of entities deemed to be authorised or registered as required under the AIFMD, with reference to the applicable EU legislation (including UCITS and MiFID) and, in respect of third country entities, those authorised or registered for the purpose of asset management and effectively supervised by a competent authority (i.e. the third country is broadly equivalent in its regulatory regime to the EU). Further, where delegation is conferred on a third country entity, provisions allowing the relevant regulatory authorities to conduct certain supervisory activities are
listed at Article 78(3) and must be included in written cooperation arrangements (Article 79 highlights when delegation shall be deemed to prevent the effective supervision of the AIFM).

Article 78(3) therefore creates obligations on EU regulators to ensure that such provisions are contained in third country cooperation agreements, with no flexibility or recognition that some provisions may not always be fulfilled (e.g. it will not always be the case that requests for information or access can be granted by a third country). It also departs from ESMA’s advice to the Commission, that a request for relevant information under Article 78(3)(b)(i) should only be for information necessary to enable appropriate supervision of delegation, rather than to enable supervision of the entire AIFMD.

Conflicts of interest
Detail on the minimum criteria to assess when determining whether a delegation conflicts with the interests of the AIFM or investors in the AIF is provided at Article 80(1). This builds on the requirement at Article 20(2)(b) of the AIFMD that no delegation shall be made in the event of a conflict. Identifying and managing conflicts will not be new to the majority of fund managers, however comprehensive scrutiny and assessment of each of the criteria listed at Article 80(1) will be required as well as ensuring Article 80(3) is fulfilled, i.e. that the AIFM ensures any delegate takes all reasonable steps to identify, manage and monitor potential conflicts of interest that may arise between itself and the AIFM, the AIF or investors and has appropriate procedures in place, and that the AIFM ensures any potential conflicts and mitigating measures are disclosed by the delegate and in turn the AIFM discloses these to the AIF and investors. The notion of functional and hierarchical separation is referred to at Article 80(2), where it refers to conditions for fulfilling the separation of the portfolio and risk management function from other potentially conflicting tasks (it is also mentioned under Article 42 in relation to the risk management function).

Letter-box entity

Article 82 is perhaps the most problematic for a number of fund managers. As mentioned above, the term letter-box entity has been carried through from the AIFMD, which in turn referenced the term as used in UCITS; however it is given a restrictive and more onerous meaning in the Regulation. The recommendations from ESMA in its advice to the Commission were that the AIFM would be deemed a letter-box entity and would no longer be considered to be the manager of the AIF where:

- the AIFM no longer retains the necessary expertise and resources to supervise the delegated tasks effectively and manage the risks associated with the delegation; and

- the AIFM no longer has the power to take decisions in key areas which fall under the responsibility of the senior management or no longer has the power to perform senior management functions in particular in relation to the implementation of the general investment policy and investment strategies.

Although these provisions have been retained in the Regulation, the Commission significantly amended the scope of the term letter-box entity, by also including the following additional criteria:

- the AIFM loses its contractual rights to inquire, inspect, have access or give instructions to its delegates or the exercise of such rights becomes impossible in practice; and

- the AIFM delegates the performance of investment management functions to an extent that exceeds by a substantial margin the investment management functions performed by the AIFM itself.

This latter provision effectively introduces a quantitative test, making it difficult for the AIFM to assess how to delegate investment management functions and making full delegation potentially unworkable. It remains to be seen what ‘a substantial margin’ may constitute.

Further qualitative criteria are listed at Article 82(1)(d)(i)-(vii), which should also be taken into account by regulators when assessing the extent of delegation. These are:

- the types of assets the AIF is invested in, and the importance of the assets managed under delegation for the risk and return profile of the AIF;

- the importance of the assets under delegation for achieving the investment goals of the AIF; the geographical and sectoral spread of the AIF's investments;

- the risk profile of the AIF; the type of investment strategies;

- the types of tasks delegated in relation to those retained; and

- 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.

Presumably the qualitative test will inform the decision on the quantitative test, which perhaps lessens slightly the full force of the quantitative test.

In the preliminary text to the Regulation, it states that the AIFM must at least keep the decision making functions which are its primary business role, and therefore it has to perform at least the functions related to either risk or portfolio management (which together are considered the investment management functions as listed at Annex I of the AIFMD). The Commission’s reasoning appears to be that ‘the ability to manage and control the AIF would not be ensured if the AIFM was not closely involved in the decision-making of its delegates’ (at 3.2.6 of the preliminary text to the Regulation).

The Regulation goes further than the AIFMD therefore by requiring the AIFM to actively engage in the decision making process of its delegate(s). This potentially defeats the point of many existing delegation arrangements and will be problematic for the structure of many existing funds, where the delegate, particularly in the case of investment management where the AIFM is the manager or operator of the fund, is often given full responsibility to make investment decisions on behalf of the fund. This will potentially lead to either: a re-designation of the AIFM as a different entity (such as the investment manager, although this may not be feasible where the investment manager is a third party and provides such investment services to a number of funds); or the AIFM as manager or operator of the fund taking more active involvement in the way investment management of the fund is run. In theory, significant restructuring may be required by funds and fund managers across Europe, with little or no added advantage of increased investor protection. In practice, the extent to which these new tests will alter existing delegation structures remains to be seen – some EU jurisdictions have already implied that they will continue to permit “full delegation” models.

A firm currently authorised by UCITS IV that requires authorisation as an AIFM under the AIFMD (and therefore will have a dual authorisation) will not as an AIFM be able to delegate to the same extent as it could where it was singly authorised under UCITS (as authorisation under UCITS IV allows a firm to manage AIFs alongside UCITS funds). This may impact the benefit of becoming authorised under both UCITS and the AIFMD. Article 82 is to be assessed after two years by the Commission and so may not continue in the same strict vein subsequent to that. ESMA is also permitted to issue guidelines to ensure consistency in assessment by regulators of delegation structures across the EU.

Depositary issues

The Regulation provides lengthy rules in relation to the services carried out by depositaries and the standards they must meet. The requirements are more detailed and extensive than those proposed in ESMA’s advice to the Commission, with the onerous provisions regarding depositary liability in particular likely to have a significant impact on the costs associated with accessing depositary services.

Appointment of the depositary

The Regulation specifies a long list of particulars which the contract under which the depositary is appointed is required to include (Article 83). Some of the particulars reflect what would generally be included in such an agreement in any event, covering issues such as a description of the services to be provided, the safe-keeping and oversight functions, information exchange, the depositary’s escalation procedures and how the AIFM is able to review the depositary’s performance. The confidentiality provisions in the contract must not impair the relevant regulatory authority’s ability to access relevant documents. The contract is also required to state that the depositary’s liability is not affected by any
delegation of its functions unless its liability is properly discharged in accordance with the AIFMD. While the contract requirements are extensive, there is at least no requirement for a separate contract for each AIF; the Regulation allows there to be one framework contract which lists the AIFs to which it applies.

Monitoring of cash-flows

Depositaries are required to ensure “effective and proper” monitoring (as opposed to the “proper monitoring” suggested by ESMA) of the AIF’s cash flows (Article 85). This monitoring will need to ensure there are adequate procedures to reconcile all cash flow movements on a daily basis (or when they occur in the case of infrequent movements) and ensure there are procedures to identify significant cash flows “at the close of business day”. This is more burdensome than ESMA’s suggestion that the requirement refer to a “timely basis”, but a welcome change from the draft Regulation which required significant cash flows to be identified “immediately”. In relation to the provisions on proper booking of the AIF’s cash, the Regulation goes beyond the ESMA proposal that non-EU accounts must be with a “bank or credit institution”; instead, the accounts are required to be with entities that are subject to prudential regulation and supervision which “have the same effect” as EU law. This may greatly restrict the countries in which AIF cash can be placed.


Contrary to ESMA’s advice, as a result of the Regulation depositaries are to be closely connected to the subscription process, given the obligation on the AIFM to ensure that, at the close of each business day on which subscription payments are received, the depositary is provided with information about the payments and any information necessary to ensure such payments are booked in cash accounts (Article 87).

Safekeeping duties

The custody duties of a depositary will apply to transferable securities, money market instruments and units of collective investment undertakings (provided they are capable of being registered or held in an account in the depositary’s name). The Regulation has not incorporated ESMA’s suggestions regarding collateral, meaning that collateral may need to be treated as being in custody, in contrast to current practice for OTC derivatives which are title transferred. Given that the liability provisions bite in relation to all assets that are in scope, it will be crucial to properly identify which assets must be held in custody. For assets in custody, depositaries are required to meet the high standard of “ensuring”: proper registration, regular reconciliations with sub-custodians, accurate records and segregated accounts, the exercise of due care, assessment and monitoring of relevant custody risks, adequate organisation arrangements to minimise risk, and the verification of ownership rights over the assets (Article 89). These duties will apply on a look-through basis to the underlying assets held by financial or legal structures controlled directly or indirectly by the AIF or AIFM on its behalf; this would appear to extend to assets held by entities that are not AIFs. However these duties will not apply to fund of funds or master-feeder structures if the underlying funds have a separate depositary).

Oversight duties

The depositary is required to carry out a risk assessment of the AIF’s strategy and the AIFM’s organisation at the outset of its appointment in order that it may devise appropriate oversight procedures which it must then update regularly (Article 92). The AIFM must at the outset and on an ongoing basis provide the depositary with “all relevant information” it needs to comply with its duties under the AIFMD. The AIFM is required to ensure that the depositary can visit the premises and inspect the books of not only the AIFM, but also any service provider appointed by the AIFM or AIF (such
as administrators).

The depositary is required to ensure that the AIF, AIFM or other appointed entity implements and applies (meaning this will need to be checked regularly) appropriate procedures for reconciling subscription or redemption orders with the monies received or paid out, and checking that a corresponding number of shares or units are issued or cancelled (Article 93). The depositary must also regularly verify that there are appropriate procedures in place to value assets in accordance with the requirements in the AIFMD as well as the AIF’s own rules (Article 93).

Due diligence on delegates

The Regulation expands on the obligations in the AIFMD for depositaries to carry out an appropriate due diligence process when selecting and monitoring a delegate (including sub-custodians). The depositary must exercise due skill, care and diligence in ensuring that any delegation provides an “adequate” standard of protection of the assets. Various minimum standards are listed, including assessing the applicable regulatory and legal framework, and assessing whether the third party’s internal controls, financial strength, reputation and operational and technological capabilities are appropriate (Article 98). There are requirements to carry out ongoing monitoring of the delegate to ensure continued compliance. In particular, depositaries must ensure a “high standard” of care, prudence and diligence. This is a strengthening of the “reasonable” standard proposed by ESMA.

The depositary is also required to ensure that any third parties to whom safekeeping functions are delegated segregates the assets of the depositary’s AIF clients from its own assets, assets of other clients, assets of the depositary and nonAIF clients of the depositary (Article 99).

Liability of depositaries

Article 21 of the AIFMD imposes liability on depositaries for its own failure or negligence, or in the case of a loss of a financial instrument held in custody by itself or a third party to whom it has delegated custodial duties.

Loss of financial instruments held in custody

Under the Regulation, assets held in custody shall be considered “lost” if: a stated right of ownership of AIF is demonstrated not to be valid because it either ceased to exist or never existed; the AIF has been “definitively” deprived of its right of ownership; and the AIF is definitively unable to dispose of the asset (Article 100). An AIF will not be considered to be definitively deprived of its right of ownership of an instrument if it is substituted by or converted into another financial instrument. The requirement to notify investors immediately of any loss is not subject to any materiality threshold.

Where a sub-custodian becomes insolvent, the AIFM is required to monitor the insolvency proceedings closely to ascertain when the assets should be considered lost, which, if not before, will be deemed to be at the end of the proceedings.

Discharge of liability

In limited circumstances, a prudent depositary may be able to discharge its liability for any loss of assets held by it (or a sub-custodian) in custody (Article 101). In order to do so three conditions must be met:

- The event which led to the loss was not the result of the act or omission of the depositary or third party (such “external” events may include market closure);

- The depositary could not reasonably have prevented the event happening, despite taking all reasonable industry-standard precautions;

- Despite rigorous and comprehensive due diligence, the depositary could not have prevented the loss. This condition will be deemed to be fulfilled if the depositary ensures that it and any sub-custodian have established adequate processes to identify and monitor any external events which could lead to loss and, if any significant risks are identified, informed the AIFM of such risks and taken appropriate mitigating action.

The Regulation lists certain typical force majeure events which may be deemed to be “external” and enable the depositary’s liability to be discharged - war, riots, other major upheaval, acts of nature or changes in the law affecting the assets. The provision is drafted in such a way that the list of events is exhaustive, meaning that there will be no scope to argue that any other events not listed could be automatically be deemed to be “external”.

Objective reasons for contractual discharge of liability

Under Article 21(13) of the AIFMD, a depositary may discharge itself of liability if it has contractually transferred liability to a sub-custodian, provided the AIF (or the AIFM acting on its behalf) has expressly agreed in a contract that such a transfer of liability is allowed and the objective reason for doing so. Fulfilling the requirement of having an “objective reason” will not be straightforward. The Regulation provides that objective reasons must be limited to “precise and concrete” circumstances relating to a certain activity and be consistent with the depositary’s policies and decisions (Article 102). While this may be a high standard to meet, the drafting has at least been watered down from the draft
Regulation, which had also required the reason to be based on objective factors that are “sufficient, consistent, coherent and justifiable”.

The Regulation deems there to be an objective reason where a depositary can demonstrate that it had no other option but to delegate its custodial duties. This will be the case where the laws of a third country require assets to be held in custody by a local entity, or where the AIFM insists on maintaining an investment in a certain country contrary to warnings form the depositary about the risks it would entail. The final wording of this provision is a welcome improvement for depositaries on that in the previous draft, which included cumulative criteria that ESMA had criticised on the basis that it contradicted the AIFMD and made it impossible to discharge liability.

Transparency / exchange of information / rules regarding third countries


One of the main objectives of the AIFMD is to increase the awareness of both investors and supervisory authorities of the risks which may be associated with a particular AIFM and any related AIFs. The Regulation seeks to do this by increasing the transparency of an AIFM through setting the content, format and frequency of information released by the AIFM. The Commission have stated that they have attempted to do this in line with recognised practices and existing standards in an attempt to limit the burden this may cause. The overriding requirement is that information be regularly provided to investors in a “clear and understandable way” (Article 109) which allows them to compare with both previous disclosures and other disclosures in the market.

Exchange of information

When reporting to a regulator an AIFM is expected to provide information concerning its main instruments, markets of operation and the degree of diversification it currently has (Article 110). This latter point makes a clear link to one of the key objectives of the AIFMD to increase market stability and reduce risk for investors. When a regulator receives information on AIFs and AIFMs, it is obliged to share such information with other EU regulators where doing so will assist with effective monitoring of the global AIF market and responding to the potential stability and functionality issues
arising from activities within the markets (Article 116). The Commission is seeking to create a co-ordinated approach to the regulation of AIFMs so as to ensure that all European markets have access to sufficient information so as to protect against disorder and risks to long-term development.

Rules regarding third countries

As with the provisions requiring exchanges of information within the EU the rules regarding cooperation arrangements with third countries are recognition of the fact that AIFs operate on a global market. The Commission has instructed competent national authorities to enter into formal written cooperation agreements with third countries, formalising the nsharing of information in both supervision and enforcement. The Commission goes further by requiring that each agreement have a specific clause requiring that information received by an EU body be capable of being shared with ESMA or the ERSB (Article 113). Cooperation arrangements with third countries will need to establish the mechanisms,
instruments and procedures required for: enabling EU competent authorities to have access to all information necessary for the performance of their duties under the AIFMD; enabling on-site inspections to be carried out where required; and requiring the third country competent authority to assist the EU competent authorities where necessary to enforce EU legislation and national implementing legislation breached by an entity established in that third country (Article 114). As outlined above in relation to the provisions on cooperation arrangements in respect of delegation, these provisions impose significant obligations on EU regulators to drive a hard bargain with third country regulators, and it remains to be seen whether the full extent of these provisions will actually be carried through into any actual cooperation arrangements.


The Regulation is largely as expected from the previous leaked drafts that were circulating last year. It places a fairly substantial burden on AIFMs, particularly those that are small, niche, purely non-UCITS fund managers who do not fall within the scope of an exemption. Certain rules will have a significant impact across the fund management industry, particularly in relation to delegation and depositaries. However in part this is offset by increased harmonisation, particularly with the availability of the passport (for EU AIFMs in respect of EU AIFs). It will require a great effort from national legislators and regulators as well as the industry to ensure that the AIFMD and the Regulation can be complied
with from 22 July 2013. Practically speaking, this date is looking increasingly unrealistic, and hopefully national regulators (which in the UK’s case, will for the most part be the new FCA) will take the shortened deadline into account when assessing compliance.