At the end of September 2017, the European Commission published its 283-page Review of the European Supervisory Authorities1 (ESAs). It is concerned with a desire to ensure that the regulation of financial markets keeps up with their continuing integration, and also recognises Brexit as being a trigger for the need to strengthen and centralise supervisory arrangements in the EU27.
The Review document included a proposal from the Commission to amend the Regulations establishing each of the three ESAs to equip them with additional powers to achieve its objective of converging not only regulatory, but also supervisory practices in the EU, through the promotion of an EU supervisory culture. The Commission is clear about its intentions:
“ESAs should particularly focus on situations that may lead to a circumvention of the rules and monitor financial institutions or financial market participants that intend to make an extensive use of outsourcing, delegation and risk transfer in third countries with the intention of benefitting from the EU passport while essentially performing substantial activities or functions outside the Union.”
The Commission’s concern is that, without additionally converging NCAs’ supervisory practices as well as their regulatory ones, the door would remain open for abuses of Union rules.
The fund management industry is concerned about this new mandate for the relevant ESA (ESMA in this case) to monitor firms that intend to make use of delegation or outsourcing to third countries and to review such delegation arrangements. In the current draft, ESMA would have a new power to review delegation arrangements that were previously under the sole supervisory control of each national competent authority.
How concerned should UK or third country-based managers be about these proposals? And what can managers do now to mitigate their impact?
Both the UCITS and AIFMD regimes allow for the delegation of portfolio management from a UCITS ManCo or AIFM to a different entity, whether such entity is in the EU or a third country, and the rules governing both regimes recognise the need for substance to remain at the level of the European management entity to prevent them from being considered to be merely letter-box entities.
These delegation regimes have allowed UCITS and, more recently, AIFs to become hugely successful products. Taking UCITS alone, there are now more than 29,000 funds representing over €8 trillion of assets2 from investors worldwide. They have attracted many of the best managers from outside the EU to launch such vehicles with a delegated management structure. At the same time, a huge number of managers inside the EU also manage funds on a delegated basis, with estimates that up to 90% of the fund assets in the EU are managed on a delegated basis3 and a large portion of these are managed from London. The UK is also currently the single largest domicile for AIFMs, with 26% of all AIFMs being in the UK4.
As a consequence of Brexit, a huge proportion of EU fund assets will become managed on a delegated basis from a third country, and these arrangements are likely to become subject to ESMA’s enhanced oversight; whether on an intra-group risk transfer basis or delegated from a third party ManCo or AIFM.
Delegation is currently only subject to the oversight of NCAs, and with competition between the various EU fund jurisdictions, there is evidence to suggest that certain NCAs are more permissive than others in their interpretation of what constitutes a letter-box entity, such as the extent to which some jurisdictions allow the outsourcing of conducting officers. While the Commission has expressed concern about regulatory arbitrage of delegation arrangements, it has never actually supported such statements with evidence of any abuses. Nevertheless, Brexit can be seen as a trigger for the Commission to demonstrate the need for it to strengthen and centralise supervisory arrangements in the EU27.
The Commission’s proposals include changes to the regulation establishing ESMA5, chiefly for it to have a new power to monitor firms that intend to make extensive use of delegation or outsourcing to third countries. These are included within a new Article 31a regarding “Coordination on delegation and outsourcing of activities as well as of risk transfers”.
The industry’s concerns relate to the requirement that, where a firm intends to delegate a material part of its activities or any of the key functions or the risk transfer of a material part of its activities to a third country, its NCA would have to notify ESMA of its intention to authorise or register that entity, providing sufficient detail to enable ESMA to make an assessment, thus shifting the ultimate oversight of such arrangements from the NCAs to ESMA.
The original draft of Article 31a included a 20-working day approval period from where NCAs would have to wait for ESMA to issue an opinion on the validity of the delegation arrangements before permitting a third country delegation, but this requirement has since been removed.
Whilst the current amended proposal means that NCAs won’t now have to wait for this opinion to approve arrangements, ESMA may still issue opinions on arrangements. It may also issue recommendations to the relevant NCA to review a decision or withdraw an existing authorisation. Strictly speaking, an NCA could choose not to follow such opinions or recommendations, which would follow the EU’s comply or explain principle, but ESMA would then make this public.
Furthermore, ManCos and AIFMs would also be required to notify their relevant NCA when they intend to outsource, delegate or risk transfer a material part of their activities or any of their key functions to another group entity or their own branch established in a third country. Each NCA would then have to inform ESMA of such notifications on a semi-annual basis.
Finally, there are a number of other proposals, including an extension of ESMAs product intervention powers, which currently only extend to MiFID firms and CRD-authorised credit institutions; this would amend MiFIR to explicitly extend these powers to cover ManCos and AIFMs.
It is worth noting that there are currently no proposed changes to the specific rules around delegation that are currently set-out in the consolidated UCITS Directives and AIFMD and their implementing measures. This was reflected in the recent comments of Steven Maijoor, the chairman of EMSA, when recently addressing the German Investment Funds Association (BVI) and confirmed that ESMA was not “looking to question, undermine or put in doubt the delegation model” and he also recognised that “the flexibility to organise centres of excellence in different jurisdictions has contributed to the industry’s success”. However, in a following meeting in Brussels, he reiterated that ESMA needed to address the risk of letter-box entities.
Likelihood of Implementation in this Form? What Happens Next?
The Commission will now consider industry feedback on the proposals and make any necessary amendments before they are considered by both the European Parliament and the Council of Ministers before finally progressing to trilogue negotiations between all three parties. This is likely to take some time, especially given the controversy around extending ESMA’s powers and the potential risks to the global competitiveness of European funds, especially at a time where Asia, a traditional market for UCITS, is looking at its own fund harmonisation regimes.
It is also worth noting that a political divide has emerged in Brussels over plans to give greater powers to the ESAs, and whether supervisory power should sit at a European level, or at a national one. Such a divide could slow down any legislative process, as could the Brexit negotiations. In any event, given that the underlying rules on delegation remain unchanged by the proposals, there are practical steps that managers can take now to mitigate the risk of their delegation or risk transfer arrangements being questioned or withdrawn.
Practical Steps for Managers
The specific rules on delegation under UCITS and AIFMD will remain unchanged by the proposals. However, despite the comments of the ESMA chairman, the proposals highlight the Commission’s focus on delegation and risk transfers to third countries and its concern that these are implemented within the rules. From ESMA’s perspective, the key concern has and will remain to be around the substance of a management entity, rather than its onward delegation outside the EU.
All market participants who are either using or intending to use this model should take the opportunity to shore-up their arrangements to ensure that they are not only in compliance with the applicable provisions of AIFMD or UCITS, but also that they are capable of demonstrating this.
While the UCITS and AIFMD rules are drafted in such a way as to apply to the ManCo or AIFM, rather than the delegate, clearly the portfolio management firm looking to delegate should undertake a rigorous selection and due diligence process on the manager it wishes to partner with to ensure that it will be able to comply with the rules.
Portfolio Managers under a Third Party Delegation Model
Delegates should assess their arrangements, the capacity of their partners and the robustness of their oversight processes by actively engaging with their fund boards or GPs to ensure that such oversight is taking place, not just looking at the manager’s activities regarding your fund, but its activities as a whole. It should be considered good governance to keep these arrangements under ongoing review.
Points for consideration should include:
- Are they equipped with the necessary expertise and dedicated resources (number and quality of staff) to supervise delegation to you, and manage risks associated with the delegation?
- How well capitalised and insured are they? Are they subject to any litigation?
- What is the level of their understanding of your investment strategies, risk profile, asset classes, geographical and sectoral spread?
- What arrangements are in place to deal with staffing changes, particularly around conducting officer functions? Notification requirements, back-ups etc? How well incentivised are conducting officers not to leave?
- Are all necessary aspects of the delegation model sufficiently documented in policies and procedures? Are these actually followed, for example, what would you do if they gave you instructions?
- What is their overall risk appetite to take on delegates with differing strategies?
- How are your arrangements ring-fenced from those of the ManCo’s/AIFM’s other delegates? And how equipped are they to deal with other strategies of delegates? What happens in the event of a regulatory breach caused by another delegate?
- Does the management agreement include sufficient protections for the fund to take remedial action before an event occurs? By law, their agreement with you should confer flexible termination rights against you, but what about the fund having flexible termination rights against them?
This should be a straightforward process, but one that needs to be approached honestly and objectively in order to stress test your delegation model against the legal requirements. It should be a co-operative process, and you should also ensure that you provide all necessary information to your ManCo or AIFM in a timely manner to allow it to discharge its regulatory obligations.
If any of your questions result in there being that the manager’s regulatory oversight is not in compliance, or there are significant commercial concerns, this should raise a governance issue for the fund’s board or GP. As such, these concerns should be escalated to them with any recommendations in a timely manner. At this stage, it may be necessary for the fund to take advice on the best course of action.
Portfolio Managers under an Intra-group Risk Transfer Delegation Model
Portfolio managers often consider the point at which they have a critical mass of assets and/or vehicles to establish their own ManCo or AIFM. These arrangements will be subject to similar disclosure and oversight rules for the risk transfer to a third country, but have the advantage of a tailored approach, more transparency into - and control of - the activities of the management entity (and its staff) and avoiding the risk of contagion between your activities and those of other portfolio managers to whom the management entity has also delegated.
The rules on delegation remain relevant, as is the need to correctly document the risk transfer. You may also need to consider the additional legal issues associated with bringing such activities in-house, such as the process to receive NCA approval for their new management entity and employment law matters.
If the new disclosure and monitoring rules come into force in substantively the same form as proposed by the Commission, ManCos and AIFMs should be prepared to re-submit delegation information on to their NCA and be prepared for any additional information requests.
Finally, market participants launching new funds should ensure that they provide good quality information to their NCA so that compliance with the rules on delegation can be clearly demonstrated with a view to avoiding any subsequent disclosure requests from ESMA. As always when engaging with NCAs, preparation and transparency are key.
The Commission’s proposals have raised a number of concerns from third country fund managers, as well as those inside Europe, who see this as a wider threat to the ongoing success of European funds on a universal level. While Brexit was stated as a reason behind the proposed changes, the potential for harm extends globally.
The Commission has since made a marginal concession on one of the less workable aspects of the proposals by removing the requirement for NCAs to wait for approval from ESMA before allowing third country delegations. However, at the time of writing, the majority of the proposed changes remain, including ESMA’s ultimate power to recommend that a delegation right is withdrawn.
Regardless of how the final rules look, this should be taken as a shot across the bow for many portfolio managers who are relying on a delegation model to focus on the substance of their arrangements.
Delegation will continue to be a permitted business model, but there is no doubt that Brexit has put third country delegation and risk transfer arrangements on the Commission’s radar. The consequences of a management entity being deemed to be a letter-box entity could be terminal, so one cannot under-emphasise the need to ensure that arrangements are compliant and kept under review.
_This article has also been published in the issue 133 of the Hedge Fund Journal.
1. https://ec.europa.eu/info/law/better-regulation/ initiatives/com-2017-536_en
4. https://www.esma.europa.eu/sites/default/files/ library/esma50-165-538_report_on_trends_risks_ and_vulnerabilities_no.1_2018.pdf#page=40
5. https://eur-lex.europa.eu/legal-content/EN/ TXT/?uri=celex%3A32010R1095