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EUROPE’S AIFMD: THE LATEST IMPLICATIONS FOR UK FUND MANAGEMENT FIRMS
Paul Ellerman and Bradley Richardson
Herbert Smith Freehills
6 November 2013
The UK’s Financial Conduct Authority has published a ‘consultation document’ to resolve many of the outstanding issues surrounding the implementation in the UK of the remuneration rules introduced by the European Union’s Alternative Investment Fund Managers Directive (AIFMD). Paul Ellerman and Bradley Richardson of Herbert Smith Freehills explain why it is likely to be helpful to fund management firms. The policies that they discuss have their analogues in all the international financial centres of the EU. The ’s “AIFM Remuneration Code”, a collection of rules
that the regulator will finalise after the period of consultation ends.
THE RULES IN SUMMARY
The AIFM Remuneration Code does four things:
‘Malus’ provisions are a mechanism to enable firms to reduce the
amount of deferred, but not yet paid, bonuses when certain events
occur (including a significant downturn in performance or a material
failure of risk management), whereas ‘clawback’ provisions
would apply in similar circumstances but so as to require the repayment
of bonus amounts that have already been paid.
TIMING IS THE KEY
An important subject that firms have been considering is the ’s
time-line for required compliance with the AIFM Remuneration
Code. The consultation paper makes it clear that each firm will
only have to subject its remuneration regime to the new rules in respect
of the first full ‘performance period’ (which in many cases will
mean the firm’s financial year) commencing after the firm obtains
authorisation as an AIFM. Thus, when a firm has a calendar-year
performance period and waits to become authorised until 22 July
2014 (the ‘long-stop date’ that the directive imposes for authorisation),
the first performance period caught by the rules will be 1st
January to 31st December 2015. This would mean that the first bonus
payments to be subject to the rules would be those paid in the
first quarter of 2016.
Although the before the regulator will change
(‘vary’) its ‘permissions’ and authorise it (with the new ‘permission’
of ‘managing an AIF’) must include a confirmation that the new remuneration
policy is in place. It must also enclose a summary of that
policy (although the policy will have a delayed start date).
PROPORTIONALITY: ABLE TO OVERRIDE IMPORTANT REQUIREMENTS The ‘proportionality principle’ states that firms only need to comply
with the rules in a manner befitting their size, organisation and
complexity. How will this apply in respect of the onerous Pay-Out
Process Rules?
The is taking a very helpful approach to fund management
firms in its proposals, although the process that they will have to go
through is more involved than one might have expected. It is also
more complex than the equivalent process under the existing CRD
Remuneration Code.
Each firm will have to undertake a two-stage analysis. Firstly, it will
have to compare its total assets under management (AuM) with set
thresholds. The nature of the alternative investment funds in the
portfolio – whether or not they are leveraged and whether they are
open-ended or closed-ended – will dictate the threshold that applies.
Although the consultation paper does provide detail on
this point, but this is because guidance has already come from the
European Securities and Markets Authority (ESMA) and the has
promised to comply with it.
WHEN FUND FIRMS DELEGATE JOBS TO OTHERS
Those ESMA guidelines also introduced the principle that whenever
an AIFM delegates the management of a portfolio and/or risk management,
either to a different entity in its own group or to a ‘thirdparty’
(external) investment manager, the AIFM must ensure:
INSTRUMENTS AS A MEANS OF PAYMENT
The consultation paper again takes a pragmatic approach in respect of the requirement to ensure that the ‘variable remuneration’ of the senior managers of the AIFM in question and those staff members who have a material impact on the risk profile of either the AIFM or the funds under management (collectively referred to in the UK as ‘code staff’) is paid in part in the form of ‘instruments’. These are units in the funds for which the individual is responsible, or equivalent interests.
Firstly, the requirement to use instruments is subject to the legal structure of the fund in question. The follows the directive in this respect and states that wherever it is impractical to pay remuneration in the form of fund units or equivalent interests due to the legal structure of the fund, the fund manager need not. The regulator says it may be impractical to use fund units:
There are issues that a fund management firm might have to bear in mind when seeking to rely on this guidance. It would have to undertake analysis to decide whether or not it would be impractical to pay remuneration in instruments on a fund-by-fund basis. Even if it could not pay remuneration in the form of actual fund units, it would instead have to use equivalent instruments (such as synthetic units), unless it could also show that it would be impractical to do so.
Whenever a fund management firm does disapply this requirement, the recommends that it should still consider paying part of ‘variable remuneration’ in the form of shares in itself or its parent company, or in an index of the funds under management. This is, however, only a recommendation and even if the firm does do so it will have complete flexibility in determining what proportion of remuneration will be paid in this way (normally, at least 50% of both the upfront and deferred components of ‘variable’ remuneration must be paid in instruments).
Secondly, even when it is possible for a fund manager to pay remuneration in the form of shares in the funds under management, the will permit the use of shares in the management firm or its parent company, or of units in an index of the funds under management. This approach could be justified for senior managers whose jobs relate to the whole firm and not to any specific fund. Similarly, the payment of remuneration in the form of fund units may create a conflict of interest for people in risk and compliance jobs in respect of those funds, and so shares in the fund firm might be more appropriate.
Any firm that has a portfolio that is less than 50% alternative investment funds (by net asset value) should also take account of the ESMA guidelines that govern the proportion of ‘variable’ remuneration that must be paid in instruments. Whereas normally 50% of ‘variable’ remuneration must be paid in instruments, if AIFs account for less than half of the total portfolio that minimum 50% requirement can be reduced to a proportion that reflects the proportion of AIFs in the portfolio.
WHICH REMUNERATION IS SUBJECT TO THE RULES?
When a staff member’s role solely relates to the management of AIFs, as in the case of a portfolio manager, it is clear how the rules apply because they govern the whole of his remuneration. However, other staff may do jobs that relate partly to AIFs and partly to “non-” business – which includes managing Undertakings for Collective Investment in Transferable Securities (UCITS). In this case, the will permit owner-managed partnerships to exclude a part of the partnership drawings (those that represent a commercial return on the capital invested by the partners) from the ambit of the rules. Although this guidance is helpful, it is not clear if it applies to limited-liability partnerships that can be seen as ‘subsidiaries’ of wider groups by virtue of having corporate members and other partnerships will also still have to issues to deal with in formulating effective and tax-efficient deferral arrangements.
DISCLOSURE – WHAT SHOULD HAPPEN AND WHEN
The biggest outstanding issue not addressed by the consultation paper is that of the directive’s disclosure-related requirements. Each fund management firm will have to include ‘remuneration disclosure’ in the annual report of each AIF and provide it to investors (but not the public). In summary, an AIFM will have to disclose the remuneration of its entire staff membership, split by fixed and variable pay, and a single total remuneration figure for each of its senior managers and every other member of its ‘code staff’ (i.e. every important risk-taker).
The crucial outstanding question is about timing – the will issue guidelines on these subjects and resolve the uncertainties that firms are facing.
Paul Ellerman is a partner and Bradley Richardson is a senior associate in the Herbert Smith Freehills LLP Remuneration and Incentives group. Paul can be reached at +44 20 7466 2728 and paul.ellerman@hsf.com; Bradley at bradley.richardson@hsf.com and +44 20 7466 7483.