We now have ESMA’s technical advice to the European Commission on possible implementing measures for the Alternative Investment Fund Manager’s Directive but there is still plenty of work needed to understand what it all means.
I was particularly interested in how ESMA has approached the requirements for the manager to maintain a form of capital adequacy – whether through the maintenance of own funds or professional indemnity cover to meet the risks arising from professional negligence.
US based hedge fund managers have not needed to worry about the capitalisation of their businesses or for maintaining professional indemnity cover for these risks although some do as a matter of good practice. Others take the view that the size of claims given the assets they manage would make any insurance unrealistic and to the extent they were able to obtain a policy the costs and the deductibles would make it difficult to justify. In the UK investment managers need to be authorised by the Financial Services Authority and need to have adequate capital. This has generally been measured by most managers on the basis of their three month fixed operating costs as being the basis for maintaining a minimum capital requirement.
ESMA appears to be approaching the issue differently for managers authorised under the AIFMD allowing a combination of own funds and professional indemnity insurance to address professional liability risk for liability arising from professional negligence.
Managers need to understand what this means for them.
The basic quantitative rule for the “additional own funds requirement” for liability risk is equal to 0.01% of the value of the portfolios of alternative investment funds managed by the manager. This would be calculated at the end of each year. Member States will be permitted to lower the requirement to 0.008% provided that the manager can demonstrate based on its historical loss data over a minimum of three years that liability risk as defined is adequately captured. Member States can also raise the own fund requirement if they are not sufficient to capture liability risk arising from professional negligence.
The risks it is intended to cover are divided into two main groups:
- (a) Risks in relation to investors, products and business practice
- (b) Risks in relation to business disruption, system failures and process management
An alternative to maintaining own funds is to take out and maintain a professional indemnity insurance policy that meets certain requirements and with a minimum cover of the higher of :
- 0.75% of the amount by which the value of the portfolio of the manager exceeds €250 million up to a maximum of €20 million or
- €2 million
The minimum coverage of the insurance for all claims in aggregate per year must be at least equal to the higher of:
- 1% of the amount by which the value of the portfolio exceeds €250 million up to a maximum of €25 million or
- €2.5 million
Own funds can be combined with professional indemnity cover to meet the requirements set out provided that the value of assets covered by the managers own funds is not less than 10% and the minimum limits for the insurance cover will apply after adjusting them on a pro rata basis.
But it is not just European managers that need to start addressing these requirements, other managers looking to distribute products into Europe need to start thinking about the impact of these regulations and how it may affect them going forward.
©Jaitly LLP