Alternative Investment Management Association Representing the global hedge fund industry
While you may have been following the progress of the Alternative Investment Fund Management Directive (AIFMD or “the Directive”) since publication of the first draft in April 2009, we felt it both timely and important to examine this Directive further and provide a brief background and comment specifically on the professional indemnity insurance (PII) implications.
The stated aims of the Directive include establishing a harmonised European Union (EU) framework for monitoring and supervising the risks that alternative investment funds (AIF) and their alternative investment fund managers (AIFM’s) could pose to financial stability, investors, counterparties and other financial market participants.
It applies to any entity wishing to manage or market AIF’s to EU professional investors.
The Directive covers a wide variety of AIF’s and their managers AIFM’s ranging from hedge funds to funds investing in illiquid assets (real estate, private equity, infrastructure, commodities or goods such as wine or art) and covers all possible investment strategies and legal forms of AIFMs and AIFs.
With the Directive, all collective investment funds in the EU will fall into one of two categories, they are either UCITS (undertakings for collective investment in transferable securities) or AIFs. The Directive does not, however, cover existing UCITS funds.
To operate in the EU, all AIFM’s with assets under management (AUM) exceeding EUR100 million (or EUR500 million for closed ended unleveraged funds, which are effectively, funds investing in illiquid assets e.g. private equity, real estate and similar funds) must obtain initial authorisation from their member state regulators (FSA or the FCA as its replacement in the UK). AIFM’s whose AUM do not reach these thresholds may also opt in.
It is therefore expected that the Directive will apply to a significant number of UK-based firms and non-EEA AIFMs will be affected if they are marketing the fund in the EU. For an EU based AIFM managing a non EU AIF  the full directive requirements will apply (barring certain depositary rules and reporting requirements if not marketing in the EU).
On 19 December 2012, the European Commission, the European Parliament and Council adopted the AIFMD Level 2 regulation. Formal entry into force of the Regulation is therefore expected sometime in March or April 2013.
The implementation date of the Directive is 22 July 2013. However under current FSA proposals, existing UK AIFM’s operating at July 2013 have a year’s transition period and will need to comply by July 2014. It should be noted however that firms wishing to market to EU investors from July 2013 may need to be an authorised firm.
Insurance and capital requirements
The Directive requires AIFMs to hold appropriate additional own funds or (emphasis added) professional indemnity insurance to cover potential liability risks arising from professional negligence. Potential professional liability includes damage or loss caused by persons who are directly performing activities for which the AIFM has legal responsibility, such as the AIFM’s directors, officers or staff, and persons performing activities under a delegation arrangement with the AIFM. The liability of the AIFM will not be affected by delegation or sub-delegation and the AIFM should provide adequate coverage for professional risks related to such third parties for whom it is legally liable.
Limits of indemnity for PII
PII limits of indemnity are deemed appropriate to protect investors from damage resulting from any professional risks of the AIFM at the following levels:
Conversely, an AIFM’s additional own funds to cover professional liability risks are considered to be appropriate if they represent at least 0.01% (0.008% where the FSA deems appropriate based upon risk profile and capital adequacy) of the value of AUM.
The rationale for the lower value of additional own funds is that coverage through PII is by nature more uncertain than coverage provided through additional own funds, therefore different percentages should apply to the two different instruments used for covering professional liability risk.
Whilst the rationale is understood, it is questionable whether it is appropriate to deal with such uncertainty via the amount available to cover losses arising from professional liability risks.
Certainly the adequacy of the additional own funds amount appears low to achieve the objective of protecting investors and paying for professional liability losses when compared to the limit of indemnity required under the Regulation or indeed the PII limit of indemnity already purchased by many AIFM. For example, one insurer’s own assessment relating to the hedge fund sector based on their predominantly EU based customer portfolio indicates that the average limit of indemnity of their insured firms when compared to AUM is 2.39%.
Bearing in mind the additional own funds amount is a one off capital charge, whereas the PII will be subject to payment of an annual premium and an annual aggregate limit of indemnity (albeit such limit being higher than the capital requirement and therefore, in theory, greater protection) it will be interesting to see which option is chosen.
Many investment managers already purchase PII and it is, in our view, unlikely they will cancel existing PII to rely on additional own funds. Reasons for the PII approach are likely to include investor pressure, existing good corporate governance and operational risk management, maintaining existing insurance cover or simply a preference for (and comfort with) an insurance solution to cover such operational risks over relying on (smaller) capital amounts.
However, there are practical implications to adopting the PII approach and existing PII policies must be amended to comply with the Directive.
As we know, the Directive includes a provision that requires the AIFM to hold either (further) additional own funds or PII to cover professional liability risks. Such risks are outlined in the Directive, which also states that they should arise out of negligence and for which the AIFM is legally responsible.Cover provided by a PII policy is based on a legal liability existing with the party seeking compensation and most policies available already cover risks that go beyond the scope of ‘negligent’ activities.Therefore, although some further policy amendments will be required to ensure compliance with the Directive, an AIFM who chooses the insurance route should at least find this section of the Directive relatively easy to deal with.
However, could there be a more fundamental conflict between what the Directive requires and the practice amongst some alternative investment managers who agree a higher ‘gross negligence’ standard with the fund via contractual terms?Whilst it is not specifically stated that legal liability cannot be avoided in this way, the focus on avoiding conflicts of interest in the Directive, together with the FSA’s recent public comments relating to its concerns in this area, perhaps indicates that the regulator will be concerned if parts of the Directive relating to professional liability can be seemingly circumvented by the AIFM contracting out of its responsibilities for negligence.
Does this indicate that contractual legal responsibilities toward the fund are an area likely to require review by alternative investment fund managers? Their recent “Dear CEO” letter related to conflicts of interest between asset managers and their customer’s highlights the FSA’s interest in this area. The document published in November 2012 noted concern that some firms, mostly hedge fund managers, relied on clauses to remove liability for the cost of errors and omissions other than in the case of ‘gross negligence’. Drivers are not only regulatory but also come from investor demands. We have noted an increased focus by investors relating to responsibility of the investment fund manager for ‘negligent’ trade errors in particular and therefore similar interest from insured investment fund managers regarding their PII policy response.