On 18 August 2020, ESMA wrote to the European Commission with a list of improvements it wanted to see made as part of the current AIFMD review process. ESMA’s letter is wide ranging but the topic generating most interest are ESMA’s recommendations on delegation/substance.
My working assumption when reading ESMA’s letter is that where it raises a topic and recommends that clarification or specific requirements would be advisable (e.g. white-labelling), what is actually meant is that ESMA has doubts about the practice and would like to see it limited or prohibited. On this basis, it seems to me that ESMA’s views the ideal fund manco as one which is a captive fund manco only managing group investment funds and which has all functions performed in-house by staff physically located in its home Member State.
But EU fund mancos already make use of extensive delegation arrangements, often to firms located outside the EU. Logically, this will only get increase post-Brexit so, from ESMA’s perspective, something must be done about it!
So here are two easy solutions to ESMA’s delegation/substance problem:
Both AIFMD and UCITS say that a fund manco’s liability is not affected by delegation by the fund manco of any functions to third parties. So regardless of whatever delegation arrangements a fund manco puts in place and howsoever the delegate is regulated (if at all), the fund manco remains liable. Viewed in this light, delegation is not really an issue after all because the fund manco is always on the hook. Instead of trying to limit delegation artificially and superimpose AIFMD/UCITS on delegates, ESMA should focus on the fund mancos – to what extent does a fund manco intend to delegate and how does it intend to oversee and manage the risks associated with these arrangements? The more a fund manco intends to delegate, the more a regulator should expect or demand of the fund manco in terms of ongoing due diligence and intrusive delegate oversight. Regulators should also expect to see evidence from fund mancos that they have defended the interests of investors by beating up on delegates who deliver below-par performance (and I’m not just talking about investment performance). Capital is important here too. Does the fund manco have the capital or insurance to cover its potential liability if something goes wrong? The first recommendation in ESMA’s letter is about increased harmonisation between the AIFMD and UCITS regimes. AIFMD requires AIFMs to carry PI insurance but UCITS does not. Maybe that’s an area for harmonisation if ESMA chooses to focus on fund mancos rather than delegates?
Solution 2 is even easier – turn on the AIFMD third country regime and include similar provisions in a harmonised UCITS Directive. ESMA is concerned about regulatory arbitrage and the difficulty for EU regulators of supervising delegate firms in third countries. But the horse has already bolted on this second concern. AIFMD contains extensive provisions on how firms in third countries can be regulated and supervised by a ‘Member State of Reference within the EU. These provisions have never been turned on but EMSA did provide advice to the European Commission in July 2016 that there are ‘no significant obstacles impeding the application of the AIFMD passport to Canada, Guernsey, Japan, Jersey and Switzerland. So instead of creating some arbitrary limit on delegation or trying to extend AIFMD and UCITS to delegates located in third countries, why not simply turn on the AIFMD third country regime and let AIFMs in those countries submit for authorisation and supervision by an EU regulator? Then these firms could manage and market AIFs within the EU subject to the full rigours of the AIFMD regime. And for good measure, why not extend this regime into a newly harmonised UCITS Directive so that fund mancos in third countries be authorised as UCITS mancos and manage EU-domiciled UCITS?
Who are these solutions good for?
These two solutions are good for investors. They look to balance the benefits of delegation (increased choice, access to expertise and operational efficiency) with consumer protection (e.g. third country fund mancos are directly subject to the entirety of the AIFMD and UCITS regimes and subject to authorisation and supervision by an EU-base regulator). If an investment fund can be run more efficiently by delegating functions instead of performing them in-house, and compliance risk can be managed, then why force EU investors into less-efficient, more costly investment funds? How does that aid consumer protection and value for money?
Who are these solutions tough for?
These solutions are tough for EU financial regulators. For example, how does the French AMF actually supervise an AIFM operating out of San Francisco? What happens if the supervisors from the French AMF bang of the office door in San Francisco demanding access but the security guard won’t let them in? What rights of entry, search and seizure does the AMF have under Californian or US law?
But despite these obvious difficulties, the third country regime is already written into the AIFMD (albeit they have not been commenced). This means that EU regulators will simply have to find ways to supervise AIFMs located in third countries.
Who are these solutions bad for?
Let’s face it, these solutions could be bad for EU asset managers, who will face more competition, and bad for the coffers of EU Member States, as fund manco fees are paid to firms located outside the EU and, with it, the majority of the tax take for income tax, etc. (Was this ESMA’s real concern when it referred to extensive delegation arrangements causing ‘a large amount of the management fees generated by the authorised AIFM or UCITS management company are paid to delegates’?)
The European Parliament and European Commission might be concerned with protecting the EU asset management industry and increasing the tax take in Member States but this is not within ESMA’s remit. ESMA’s mandate is ‘safeguarding the stability of the European Union's financial system by enhancing the protection of investors and promoting stable and orderly financial markets’. In pursuing this mandate, the above solutions work. The solutions don’t work, however, if ESMA’s focus is elsewhere. What’s my money on? I’m betting on quantitative restrictions on delegation.