As discussed in our previous blog, ESMA has written to the European Commission ahead of the EU executive’s review of the AIFMD regulation. Although ESMA has recommended a raft of potential changes, one area that appears to be garnering particular attention, is the issue of delegation and substance.
Looking specifically at ESMA’s comments on delegation, they have identified several areas of concern outlined below:
Extent of delegation
It has been observed by ESMA that AIFMs and UCITS management companies delegate to a large extent the collective portfolio management functions and only perform some control functions internally. Moreover, in light of the withdrawal of the UK from the EU, ESMA foresees delegation of portfolio management functions to non-EU entities will likely increase further.
Whilst ESMA accepts that the extensive use of delegation arrangements may increase efficiencies and ensure access to external expertise, they may also increase operational and supervisory risks. In turn, ESMA believes this raises questions as to whether those AIFs and UCITS can still be effectively managed by the licensed AIFM or UCITS management companies.
To address this, ESMA considers further legal clarifications are required on the maximum extent of delegation to ensure supervisory convergence and ensure authorised AIFMs and UCITS management companies maintain sufficient substance in the EU.
Specifically, ESMA recommends the Commission reconsider and/or complement the qualitative criteria set in Article 82(1)(d), with clear quantitative criteria or provide a list of core or critical functions that must always be performed internally and may not be delegated to third parties. ESMA also suggests such considerations should be matched in the UCITS Directive as well.
Applicable regime in case of delegation and regulatory arbitrage
ESMA has put forward that in order to avoid regulatory arbitrage and protect EU investors, legislative amendments should ensure that the management of AIFs and UCITS is subject to the regulatory standards set out in the AIFMD and UCITS frameworks, irrespective of the regulatory licence or location of the delegate.
Use of seconded staff
Furthermore, ESMA has also observed an increasing use of secondment arrangements where staff from professional services firms/consultancies or group entities are seconded to the AIFM or UCITS management company on a temporary basis.
Due to many of the seconded staff operating outside of the EU, ESMA would like further legislative clarifications as to whether those secondment arrangements are in line with the substance and delegation rules set out in the AIFMD and UCITS frameworks.
List of collective portfolio management functions and distinction from ‘supporting tasks’
ESMA has concerns that in the absence of clear legal definitions or an exhaustive list of collective portfolio management functions set out in Annex I of the AIFMD and Annex II of the UCITS Directive, it is often difficult for NCAs to assess whether the ‘supporting tasks’ provided by the group entities are subject to the delegation rules set out in the AIFMD and UCITS Directive or not.
To address this issue, ESMA has recommended implementing legislative clarifications in line with the interpretation supported by ESMA in Section VIII of its Q&As on the application of the AIFMD. This would resolve uncertainties and ensure that the collective portfolio management functions set out in Annex I of the AIFMD are performed in compliance with the AIFMD rules.
White-label service providers
Finally, ESMA has requested more specific requirements on white-label service providers (i.e. managers that provide a platform to business partners by setting up funds at the initiative of the latter and typically delegating investment management functions to those initiators/business partners or appointing them as investment advisers or informally following their guidance/instructions.) due to the NCAs having doubts as to whether such business models are in line with the AIFMD and UCITS regimes.
What’s Next?
The above recommendations are not surprising given ESMA’s communications since the Brexit vote, including their opinion published in 2017 on the supervisory convergence in the area of investment management in the context of Brexit. All eyes will now turn to the EU Commission to see how they address and incorporate ESMA recommendation during the AIFMD review.
Should the above recommendations be incorporated in the soon to be expected AIFMD consultation, do not be surprised of a unfavourable reaction, as this may be seen as an attack on the well-established fund structures utilised in a number of jurisdictions in Europe, in particular, in Ireland and Luxembourg.
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