More than four years have passed since the Commission issued a proposal for an Alternative Investment Fund Managers Directive (‘AIFMD’), which formed part of the EU policy response to the financial crisis of 2007-2008.
The world of EU securities regulation and supervision has changed considerably since then. The Lisbon Treaty came into force and changed the law-making process for delegated acts to be adopted by the Commission. The European Institutions implemented a significant revamp of the European regulatory framework by widening the scope of regulation and the extent of detail of substantive law applicable to securities markets. The European Securities and Markets Authority (‘ESMA’) became operative with strong powers to make regulation in the form of technical standards and with the tools to force supervisory convergence at national level. ESMA was also vested with a de facto pan-European supervisory role for credit rating agencies and trade repositories and has the function of coordinating colleges of supervisors for central counterparties.
The significant regulatory and supervisory response to the financial crisis and the subsequent euro-crisis changed the dynamic of financial regulation and supervision of securities business in the EU, including that applicable to alternative investment fund management.
The AIFMD regulates the activity of all fund managers (‘AIFM’) which manage alternative investment funds (‘AIF’) being all those collective investment schemes that do not qualify as UCITS schemes.
Malta is a jurisdiction of choice for international financial services, particularly in the funds sector with over 600 international funds, 60 fund managers and 27 fund administrators established in Malta. The scope of the Directive is wide and, as a consequence, it captures a significant majority of the Malta industry. The implementation of the Directive has been carried out by the Malta Financial Services Authority (‘MFSA’), Malta’s single regulator and supervisor for financial services.
Section 1: AIFMD Legislative Process
The Commission’s proposal for the regulation of the alternative investment funds industry was published in April 2009. It immediately became the subject of controversy, particularly with the hedge funds industry in London threatening to move outside the EU. The Commission’s proposal required greater transparency, restrictions on leverage and a higher degree of capital held by fund managers. This specific regulation was required in order to fulfil EU policy-makers’ commitment to apply harmonised EU regulation in fields of finance which were largely unregulated before the financial crisis. However, the Commission’s proposal came under scrutiny as having been prepared in haste and without proper consultation. In particular, it tried to apply a one size fits all regime to an industry which is characterised by very different types of players. The same points were raised by Member States during the meetings of the Council of the European Union and by MEPs at the European Parliament.
Along the way, the various issues of concern raised during the initial stages of the debate were tackled through revisions to the Commission’s proposal. Other concerns were, however, triggered during this process. This was the case of the depositary passport, which was Malta’s main issue during the debate on the level 1 text.
The Commission’s proposal required the appointment of the depositary by the AIF having the role of safekeeping the assets of the fund and monitoring the activity of the fund manager. The proposal required the depositary to be a credit institution in the EU, thereby allowing free movement in the field of depositary services. As a consequence of discussions in Council and at the specific request of a number of Member States, the text was amended to include a requirement that the depositary had to be established in the same Member State of the AIF. This created an issue for a number of Member States where the depositary industry was not yet fully developed, as the lack of competition from external depositaries would most likely result in inefficiencies and higher charges applied by the local depositary business. Moreover, it was Malta’s view that the restriction on the free movement of depositaries would have a serious impact on the development and growth of the funds industry in the affected Member States.
Malta made the point that a depositary passport was necessary to complete the internal market for the funds industry and that the mechanisms for such a passport to operate had already been established, particularly given the extent of existing harmonisation of the requirements applicable to credit institutions and investment firms in the EU. In Malta’s view the extent of harmonisation of the activity of depositaries should have allowed a framework for mutual recognition between Member States to operate effectively in this field. However, the majority of Member States in Council were, at that stage, not yet convinced about the desirability of mutual recognition in the field of depositary services, particularly given the alleged importance of proximity of supervision of the depositary by the financial supervisor of the AIF. Malta further argued that unless a full depositary passport was allowed, Member States should as a minimum be granted the option to permit EEA credit institutions and investment firms to get access to their market and provide depositary services within their territory. This was a pragmatic solution to address the depositary passport challenge during the stage of the AIFMD legislative process.
Ultimately, the requests made by Malta and other Member States having a similar view resulted in a compromise whereby a transitional provision for a period of four years was included in the AIFMD. This transitional provision gives Member States the discretion to allow AIFs established on their territory to appoint depositaries in other Member States. This discretion is however restricted to the appointment of depositaries that are authorised as credit institutions in their home Member State. Furthermore, the text of the Directive was amended to include a recital which invites the European Commission to put forward an appropriate horizontal legislative proposal which inter alia governs the right of a depositary in one Member State to provide services in other Member States. The overall intention of these amendments being that of giving Member States, where the depositary industry is not yet fully developed, sufficient time to allow their depositary industry to grow, while at the same time giving the European Commission the time to put the depositary passport back on its legislative agenda. This has already materialised in the case of UCITS funds with the publication of the 2012 UCITS VI Consultation.
At level 2 of the AIFMD legislative process, the major issue of contention emerged from the requirements which regulate the delegation by an AIFM to a sub-manager, specifically the requirements on letter-box entities. The version of the AIFMD Delegated Regulation issued in March 2012 inter alia stipulated a quantitative test whereby, in the event that the totality of the individual tasks delegated by the AIFM substantially exceeded the tasks carried out by itself, the AIFM was to be considered as a letter-box entity. This meant that the fund manager would no longer be considered an AIFM for the purposes of the Directive. This provision raised significant concerns within the hedge fund industry, particularly given the accepted market practice for fund managers to make the high-level policy decisions directly while delegating the day-to-day stock picking and risk management of the portfolio to another firm in the EU or a third country. This accepted market practice allowed the realisation of a certain degree of economies of scale.
The proposed rule on letter-box entity meant that the AIFM would have to undertake much of the previously delegated activity directly. This would have made the prevailing delegation model unworkable for an AIFM and would have resulted in a significant amount of restructuring within the industry, with the cost being passed on to investors. This was Malta’s most significant concern at this stage of the AIFMD legislative process. Malta, together with other Member States, argued in favour of a more workable solution with regard to the letter-box entity requirements. Ultimately, the Commission moved away from the quantitative determination of a letter-box entity, by replacing the proposed rule with an approach which requires the assessment of compliance of the delegation structure with an established set of qualitative criteria. However, this meant that the mechanism for assessing the delegation arrangements would most likely result in different interpretations of the relevant requirements at national level and, as a consequence, in a fragmented approach to the supervision of AIFM delegation structures and in opportunities for supervisory arbitrage.
In an attempt to resolve the risks resulting from an uneven approach to the interpretation of the requirements on letter-box entities, the Commission Delegated Regulation stipulates that ESMA may issue guidelines to ensure a consistent assessment of delegation structures across the Union. Unfortunately, while ESMA has carried out a sterling job on AIFMD at Level III, above all in negotiating MOUs with over 40 third country competent authorities for the purpose of the Directive and in establishing a consistent approach to the application of the reporting by AIFM and the implementation of the requirements on remuneration, it has yet to initiate work in the field of delegation by AIFM. This is a key area for convergence if the intended harmonisation objectives of the Directive are to be achieved in practice.
The Transposition and Implementation of AIFMD by Malta
As the AIFMD has an impact on a significant majority of fund management companies and collective investment schemes established in Malta, the implementation of the Directive became a top priority on the Authority’s regulatory agenda. To address the implementation challenge, the Authority set-up an Implementation Working Committee, which was inter alia responsible for suggesting amendments to the local legislative framework for the purpose of the AIFMD. The Committee had three main objectives: [i] carrying out the correct transposition and implementation of the AIFMD and subsidiary legislation; [ii] ensuring a smooth transition from the existing regime for the regulation of Non-UCITS fund managers, which was largely based on MiFID, to the AIFMD regime; and [iii] ensuring that certain features of the regime, such as the framework for the regulation of professional investor funds, would be retained.
The Implementation process resulted in: various changes being implemented to the Investment Services Act which is Malta’s primary legislation that regulates the activity of investment services licence holders and collectives investment schemes; the publication of four new legal notices which regulate the passporting by AIFM, the marketing of AIFs, and the activity of third country operators; and significant changes to the structure and content of the MFSA’s Investment Services Rules which regulate the activity of investment services licence holders in Malta.
From a services provider perspective, the Investment Services Rules for Investment Services Providers were restructured to reflect the European framework for securities business, ie, MiFID, UCITS and the AIFMD.
Article 3 of the AIFMD provides an exemption for small fund managers and lays the foundations for a de minimis regime, however, Malta decided to exercise the discretion to regulate de minimis fund managers through an existing licensing process rather than registration, as it considered that it is in the best interest of fund managers to be licensed particularly when dealing with potential investors. Moreover, it is the MFSA’s policy that only persons who are assessed as being fit and proper to provide financial services and subject to proper investor protection regulation (including anti-money laundering and funding of terrorism regulation) should be allowed to establish a financial activity in Malta. These decisions are reflected in the published Rulebook.
Malta also decided to introduce a depositary-lite regime. The AIFMD contemplates the possible provision of services by a depositary-lite in the case of third country funds and EU AIFs, which have no redemption rights exercisable during a period of five years from the date of the initial investment and which, in accordance with their core investment policy, generally do not invest in assets that must be held in custody.
Malta’s depositary-lite allows entities such as recognised fund administrators and investment firms that are subject to an initial capital requirement of €125,000 to apply for an authorisation to provide restricted depositary services. This is an area which is experiencing significant interest from the industry and should facilitate the process for private equity and venture capital type funds to be established in Malta.
The following diagram depicts the structure of the Investment Services Rulebook pre and post the implementation of the AIFMD:
Diagram – Structure of MFSA Rulebook – Pre and Post Implementation of AIFMD
The green boxes depict the new sections of the Investment Services Rules introduced as a consequence of AIFMD implementation. The changes also include those which were implemented to the Rulebook applicable to collective investment schemes. Although the AIFMD regulates the activity of the fund manager, Malta opted to continue exercising its discretion to regulate the fund. As a consequence, an AIF Rulebook was drawn up and adopted by the MFSA. This new Rulebook provides Maltese/EU AIFMs with a regulatory framework that allows them to establish AIFMD-compliant funds for marketing to professional investors in Malta or across the EU. Moreover, the AIF Rulebook transposes the Directive for the purpose of self-managed AIFs, which in terms of the AIFMD are the AIFM and must ensure compliance with the Directive.
From a practical implementation point of view, the biggest challenge faced by the Authority was that of ensuring a proper understanding of the AIFMD by the industry and the internal preparation for re-authorisation of all existing fund managers.
In terms of the Directive, all existing fund managers are required to take the necessary measures to comply with the Directive and are also required to submit an application for authorisation as an AIFM to their national competent authorities by the 22 July 2014. To address these practical challenges the Authority organised a number of information sessions for the industry and prepared self-assessment questionnaires to be completed and submitted by existing fund managers for authorisation as an AIFM. In order to be in a position to process all relevant applications for re-authorisation, the Authority applied a provisional earlier deadline, 31 March 2014, for the submission of the relevant self-assessment questionnaires by existing fund managers.
The Authority has issued guidance on the setting up of an AIFM in Malta and launched a question and answer facility on its website, which allows the industry to raise queries with the MFSA relating to the practical implementation of the Directive. The industry has found this facility very useful. The Authority has already replied to over 70 queries.
This paper examines the implementation process of the AIFMD from Malta’s point of view. At every stage of the process, Malta, like other Member States, faced a number of challenges and issues, which would have had an impact on its reputation as a jurisdiction of choice for international financial services. Malta took the necessary steps to ensure that these issues would be properly addressed. During the negotiations in the Council of the European Union, Malta argued in favour of an internal market for depositaries. As part of the discussions on the Delegated Act, Malta was in favour of a more workable solution with regard to delegation arrangements by an AIFM. At transposition stage, the de minimis requirements, the depositary-lite arrangements and the establishment of an AIF rulebook were the main topics of internal debate. With regard to practical implementation, making sure that the industry was well informed and prepared for AIFMD was the main challenge addressed by the Authority.
The Malta process analysed in this paper demonstrates a pragmatic approach to the AFIMD. However, the implementation of AIFMD is not yet complete and monitoring supervision of compliance with AIFMD would, at this stage, appear to be the final test for the MFSA in this area of regulation. Various mechanisms may be applied to address this final challenge. Requesting regular reporting on the stages of implementation appears to be a sensible solution in order to obtain the required information which would allow the prioritisation of supervisory activity. This will be followed up by on-site inspections focusing on assessing the extent of proper implementation of the AIFMD by the industry and/or regulatory meetings to examine the implementation from a governance perspective. Nonetheless, whichever supervisory mechanisms are in the end implemented, the MFSA will most certainly continue to apply the same pragmatic approach to the AIFMD as it has applied during the process so far.
 A copy of the MFSA Investment Services Rules may be downloaded from the Authority’s web-site: http://www.mfsa.com.mt/pages/viewcontent.aspx?id=506
Christopher P Buttigieg
Mr Buttigieg is a Deputy Director within the Securities and Markets Supervision Unit of the Malta Financial Services Authority and an assistant lecturer in the Banking and Finance Department of the University of Malta. The author would like to thank Professor Joseph V. Bannister, MFSA Chairman, Dr David Fabri, MFSA Director Legal and International Relations and Mr Jonathan Sammut, MFSA Securities and Markets Supervision Unit for their comments and suggestions on the paper. The views expressed in the paper are solely those of the author at the time of writing and do not engage the MFSA.