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Introduction

The European Securities and Markets Authority (ESMA); the successor of CESR, has been assigned with the mandate of providing the European Commission with proposals regarding the AIFMD implementing measures (i.e. implementing acts and delegated acts). ESMA has published a Consultation Paper (CP) containing its draft proposals which shall be finalised in the light of the feedback received and be subsequently submitted to the European Commission by 16 November 2011.

The present article undertakes the task to present a summary of key issues dealt with in the CP regarding the AIFMD authorisation thresholds and the depositary’s appointment, tasks and liability regime. It is motivated by the fact that the AIFMD is itself the result of a series of constantly modified draft texts, the monitoring and presentation of which has led to the understanding of the finally adopted provisions. In addition, the implementing measures form part of the AIFMD framework.

Authorisation thresholds and related issues

The AIFMD subjects to authorisation AIFMs managing AIFs whose assets under management (AuM) in aggregate exceed 100.000.000 EUR including leverage or 500.000.000 EUR without leverage and with a lock-up period of five years. AIFMs below these thresholds are subject to registration requirements, while AIFMs managing ‘fully invested’ or ‘fully subscribed’ AIFs according to Article 61 of the AIFMD are exempted from authorisation.

According to the CP, it is the responsibility of the AIFM to establish whether it must obtain an authorisation or be subject to registration. Inversely, an AIFM authorised under the AIFMD and falling below these thresholds will have to notify its competent authority thereof, in order to become de-authorised.

Establishing that the AIFM is below/above the thresholds requires the AIFM to:

• Identify the AIFs for which it is the AIFM under the AIFMD (e.g. no UCITS, no family offices, no sovereign wealth funds)

• Value at least annually and monitor on an ongoing basis (no ‘single snap shot’ approach) the AuM, in order to establish whether the AuM exceed the thresholds. When using an external valuer, the CP lays down that this term does not include the price provider, whereas there can be more than one external valuers, for ensuring proper valuation of all assets. In such a case, a process for exchange of information between AIFM and external valuer(s) has to be in place. Valuation methodologies have to be applied consistently for all assets within an AIF and across all AIFs having the same AIFM. When calculating the total value of AuM:
  1. The latest available NAV has to be used. NAV must be calculated within 12 months from threshold calculation date. This date has to be chosen with regard to NAV calculation time and frequency and be applied consistently, unless a deviation is justified.
  2. Cross-holdings between AIFs managed by the same AIFM (i.e. Umbrella cross-investments for internally/externally managed AIFs as well as Funds of Funds- involving only AIFs- investments for externally managed AIFs), are excluded from the calculation, because there is only one set of underlying assets on a look-through basis. Yet, assets acquired through leverage must be included in the calculation. When AIFMs also (i.e. not only) manage ‘fully subscribed’ and/or ‘fully invested’ AIFs, then such AIFs have to be included in the threshold calculation/
  3. The AIFM must, following calculation, monitor the total value of AuM on an ongoing basis. Monitoring AuM does not have the meaning of recalculation but to assess whether the thresholds may be exceeded. Factors for assessment include, apart from the latest NAV, subscription and redemption activity, capital draw downs and distributions (where applicable), the type of AIFs managed and the classes of assets invested, as well as the time until the next annual calculation. Monitoring may lead to the conclusion that recalculation is necessary.
• Notify the competent authorities if thresholds are exceeded, and demonstrate (if no immediate authorisation is intended) that the excess is of temporary nature (i.e. will not exceed 3 months). This assessment shall be based on anticipated subscription and redemption activity, capital draw downs and distributions (where applicable). Anticipated market movements shall not be taken into consideration. At the end of this three month period, a recalculation of the AuM has to take place. If the excess persists, authorisation has to be sought within 30 calendar days.

The appointment of the depositary, tasks and liability regime

The appointment of the depositary of an AIF has to be evidenced by means of a written agreement. The CP takes as a base, the model agreement between the UCITS management company and the UCITS depositary by adding and amending items. Items relating to contracting capacity, description of eligible assets, right of reuse of entrusted assets, cash-accounts opened at third parties and escalation procedure have been added. Items relating to the termination of the agreement, to liability and transfer of liability and flow of information have been amended.

Regarding the AIF depositary’s tasks, these are extended, compared to the UCITS depositary tasks (safe-keeping and compliance oversight), with the additional obligation to ensure the AIF’s cash flows are properly monitored.

• As to the safe-keeping tasks, certain types of financial instruments are subject to custody, whereas those assets not being subject to custody qualify as ‘other assets’ and are subject to ownership verification and record-keeping by the depositary:
  1. Financial instruments (e.g. transferable securities, money market instruments, units of collective investment schemes and financial instruments which can be physically delivered to the depositary) that the depositary is in a position to control and, if necessary, retrieve are subject to custody with financial instruments provided as collateral being excluded.
  2. ‘Other assets’ (e.g. cash deposits, all financial contracts, physical assets not qualifying as financial instruments or not physically deliverable to the depositary, all financial instruments provided as collateral under a title transfer collateral arrangement and certain financial instruments not physically deliverable to the depositary) are subject to ownership verification and record-keeping. Ownership verification requires the depositary to make sure it receives satisfactory information on the AIF’s ownership over the asset. Record-keeping comprises either the depositary to register the AIF’s assets in its name or to know at any moment where the assets are and ensure its ability to provide at any time a comprehensive and up-to-date inventory of the AIF’s assets. Complying with such an obligation requires the AIFM to ensure the depositary has access to information by third parties.
• As to the compliance oversight tasks of the depositary, the CP undertakes to provide clarification on those tasks. As far as it concerns the general requirements of those tasks, the depositary should assess, upon its appointment, the risks associated with the nature, scale and complexity of the AIF and set-up appropriate procedures. It should also perform verifications of procedures, which are under the responsibility of the AIF, the AIFM or a third party, manage conflicts of interest and set-up and implement an escalation procedure, when detecting a potential irregularity.

• Regarding cash-flow monitoring, this has the meaning of full overview of all cash movements of the AIF. The AIFM shall among others ensure that the depositary has access to all information related to cash accounts, existing and new, opened at third parties outside the depositary. The depositary shall ensure that subscription monies have been received by verifying relevant information at AIF’s register level and that segregated cash accounts (containing not only subscription proceeds but all cash belonging to the AIF) have only been opened with certain bank entities.

The CP’s concept as to the depositary’s liability regime is to ensure on the one side a high level of the investor protection, while refraining from placing the entire responsibility on the depositary.

• The CP deals among others with the meaning of the term ‘loss’ of financial instruments held in custody by the depositary itself or a sub-custodian.
  1. ‘Loss’ is distinct from the decrease in value stemming from investment decisions or from any intentional transfer to a third party (e.g. collateral to the prime broker) by the AIF or the AIFM acting on behalf of the AIF. The occurrence of ‘loss’, has to be determined by the AIFM. It could lead to court proceedings for resolving complex disputes, since triggers the depositary’s obligation to return financial instruments of identical type or corresponding amount.
  2. ‘Loss’ refers to loss of beneficial ownership, when distinct from legal ownership, and takes place a) where it is uncovered that the ownership right of the AIF is unfounded because it ceases to exist or never existed (e.g. accounting error, fraudulent conduct), b) where the AIF has been permanently deprived of its ownership right over the financial instruments without them having been replaced, or c) where the AIF is permanently unable to directly or indirectly dispose of them.
  3. In case of insolvency of the sub-custodian, financial instruments will be considered as ‘lost’ when one of the three conditions exposed under ii above is met with certainty, at the end of the insolvency proceedings at the latest. For instance, assets properly segregated, would not be considered as ‘lost’, since they can be recovered, the question being when. Inversely, where the sub-custodian fails to implement segregation rules or where such rules are not given effect because of local law or where a percentage of the assets are lost because of business disruption due to insolvency, then a loss may take place.
• Although the depositary’s liability shall not be affected by delegation, the depositary can contractually discharge its liability all along the custody chain by transferring it to the sub-custodian(s), if an objective reason is given. In the CP two options for determining when an objective reason is given are proposed:

  1. According to the first option an objective reason is given when legal requirements in the targeted country for investments require the appointment of a specific sub-custodian or when the delegation of custody tasks to the sub-custodian is in the best interest of the AIF.

  2. According to the second option an objective reason for discharge will be given when the AIF/AIFM on behalf of the AIF and the depositary have contractually agreed that the depositary can discharge its responsibility.

• When the loss is due to an external event beyond the depositary’s control and despite its reasonable efforts, the depositary is exempted from liability for the loss. Yet the burden of proof lies with the depositary. In order for the exemption to apply, this event has to be cumulatively:

  1. ‘External’ (e.g. market closure, technical failure at Central Security Depositary or any other settlement system, local law does not give effect to asset segregation rules) within the sense that the loss did not occur as an act or omission of the depositary or its sub-custodians to meet its/their obligations (e.g. accounting error, operational failure, fraud within the depositary’s/sub-custodian’s network).
  2. ‘Beyond the depositary’s reasonable control’ within the sense that reasonable efforts could not have prevented the loss (e.g. the loss is a result of Acts of State or Acts of God).
  3. “The depositary could not have prevented the loss despite comprehensive and rigorous due diligences”. Such diligences require a) structure and expertise from the depositary’s side, in order to timely identify and monitor external events beyond its reasonable control potentially resulting to a loss, b) review of the risk significance of such external events, and c) appropriate action-taking (e.g. inform the AIFM that the only appropriate action is to dispose of the financial instruments or even notify competent authorities asking for authorisation to transfer liability to a sub-custodian or terminating the contract) upon the occurrence of external events presenting a significant risk. The ultimate recourse of the depositary should be the termination of the respective contract, provided the AIF is given a period of time to find another depositary in accordance with national law.

Conclusion

The present text undertook the task to present the current state of things concerning two major issues of the AIFMD (authorisation thresholds and depositary), with the aim of illustrating the ‘road-map’ rationale towards the final proposal. When the final proposal is submitted, a summary of the key aspects of the final proposal will take place.

Christos holds a BA in Economics and Accounting (Joint Honours) and is a Fellow member of the Institute of Chartered Accountants in England and Wales (ICAEW), and of the Institute of Certified Public Accountants of Cyprus. He also holds the CF qualification of the ICAEW. He joined KPMG in 1994 and became a partner in 1999. He is currently the Service Line Leader of the Funds Unit of KPMG Cyprus.

KPMG in Cyprus traces its origins back in 1948. It comprises more than 750 people, including 37 board members, working from 6 offices throughout the island.