AIFM DIRECTIVE: ESMA CONSULTATION PAPER

AIFM DIRECTIVE: ESMA CONSULTATION PAPER On 13th July ESMA published its consultation on the implementation measures for the Alternative Investment Fund Managers Directive (AIFMD). The AIFM Directive aims at establishing common requirements governing the authorisation and supervision of Alternative Investment Fund Managers (AIFMs) in order to provide a coherent approach to the related risks and their impact on investors and markets in the European Union. The Directive is designed to cover AIFMs managing all types of funds that are not covered by the UCITS Directive 2009/65/EC. It is not intended to regulate Alternative Investment Funds (AIFs) themselves. The Directive outlines: Operating conditions for AIFMs (including duty of care, remuneration, conflict of interest management, initial capital and own funds, risk management and liquidity management). Organisational requirements (valuation of assets, delegation to third parties, appointment of depositary). Transparency requirements (annual reports, disclosure to investors, reporting obligations to competent authorities). AIFMs managing specific types of AIFs (leveraged funds, funds acquiring non-listed companies including asset stripping rules). Marketing arrangements rules. In a speech by Sheila Nicoll, Director of Conduct Policy at the FSA 1 she highlighted the big issues in regards to the consultation document as being depositaries, leverage, transparency, risk management, valuation and capital/prudential framework. Lockton Comment: As insurance brokers, we would like to take the opportunity to respond and comment on: Risk management & formal risk management frameworks including commenting on Box 6 where ESMA has provided a description of potential professional negligence risks. Our views on how Professional Indemnity insurance (PII) can be used to cover against potential liability risks arising from professional negligence. This includes outlining the steps AIFMs would need to go through and commentary on Box 9 in the ESMA consultation paper p33. ESMA Consultation Question Q9 and Q15. Our thoughts to consider for 2013 PII insurance placements. 1 http://www.fsa.gov.uk/pages/library/communication/speeches/2011/0721_sn.shtml

Risk Management - Private Equity and formal risk management frameworks The Directive clearly places operational risk management framework as an important tool to ensure consistency of approach and clear identification of the risks faced and created by the AIFM and its investors. This requirement is in line with other regulated sectors of the financial industry and it is of no surprise that the overall approach taken to the draft advice on general operating conditions has been to align the requirements as much as possible with the existing provisions in the UCITS Directive and Markets in Financial Instruments Directive (MiFID) 2 Part of the common requirements is the requirement of Internal Capital Adequacy Asset Protection (ICAAP). Article 9, Initial Capital and own funds 3 of the AIFM Directive requires: That Member States shall require that an AIFM which is an internally managed AIF has an Initial capital of at least EUR300,000 and where the value of the portfolios of AIFs managed by the AIFM exceeds EUR250million, the AIFM shall provide an additional amount of own funds. That additional amount of own funds shall be equal to 0,02 % of the amount by which the value of the portfolios of the AIFM exceeds EUR 250million but the required total of the initial capital and the additional amount shall not, however, exceed EUR10million. Using Professional Indemnity insurance (PII) to cover against potential liability risks arising from professional negligence. Article 9, section 7 of the AIFM Directive goes on to states: To cover potential professional liability risks resulting from activities AIFMs may carry out pursuant to this Directive, both internally managed AIFs and external AIFMs shall either: a) have additional own funds which are appropriate to cover potential liability risks arising from professional negligence; or b) hold a professional indemnity insurance against liability arising from professional negligence which is appropriate to the risks covered. Lockton comment: The steps under the AIFM directive for using PII to cover professional negligence liability risks include: Step 1: Step 2: Step 3: Step 4: Step5: Risk Identification: to specify the risks which must be covered (an important output from the risk management framework) Confirm additional amount of own funds required for ICAAP to cover potential professional liability risks resulting from activities AIFMs may carry out pursuant to this Directive To work out whether the AIFM wants to use their own funds or buy PII to cover potential professional liability risks resulting from activities AIFMs may carry out pursuant to the Directive To validate that the PII insurance is fit for purpose or if not, confirm appropriateness of the additional own funds To have a procedure in place to update PII in line with ongoing adjustments. 2 Introduction and background point 7. General operating conditions pg 9 ESMA Consultation paper 3 Article 9, section 1 & 3

Step 1: Risk Identification The Directive wants to ensure that the risks associated with each investment position of the AIF and their overall effect on the AIF s portfolio can be accurately identified, measured and monitored at any time through stress testing procedures 4. This concerns mainly due diligence requirements and implementing the appropriate risk management systems. Part of the appropriate risk management system requires the implementation of appropriate internal control mechanisms for operational risks and this should include the identification of professional liability risk. ESMA has provided a description of potential risks in Box 6 5 : 1. The AIFM must be able to cover the potential liabilities arising from professional negligence. 2. The potential liabilities risks to be covered are the risk of losses arising from the activities of the AIFM for which the AIFM has legal responsibility. Those particularly a) Risks in relation to fraud Losses due to dishonest, fraudulent or malicious acts by relevant persons. b) Risks in relation to investors, products, and business practices: Losses arising from a negligent failure to meet a professional obligation to specific investors and clients. Those risks particularly include i. negligent loss of documents evidencing title of assets of the AIF ii. misrepresentations and misleading statements made to the AIF or its investors by the AIFM or relevant persons iii. negligent acts, errors or omissions by the AIFM resulting in a breach of: a. obligations according to law and regulatory framework b. duty of skill and care to the AIF when carrying out its professional activities c. obligations of confidentiality d. AIF rules or instruments of incorporation e. terms of its appointment by the AIF iv. improper valuation of assets and calculation of unit/share prices c) Risks in relation to business disruption, system failures, process management: Losses arising from negligent failure resulting in or not adequate prohibiting the disruption of business or system failures, from failed transaction processing or process management 4 Article 15, 3(b) 5 Pg 33 ESMA Consultation paper

Lockton Comment: In relation to Box 6: 1 The most frequently alleged liability arising from investors resulting from professional negligence include: Breach of fiduciary duty Breach of contract Securities fraud In addition, professional service risks for private equity firms include allegations of breach of duty of skill and care to the portfolio companies and/or their creditors. 2 In reference to 2(a): Exposure to Third Party Fraud can be insured The insurance will have to recognise that the AIF is a third party Fraud committed by key persons is generally not insured except for defence cost and more commonly under a Directors and Officers policy. First party fraud would normally be covered under a crime policy. In reference to 2(b): Losses arising from a negligent failure to meet a professional obligation to specific investors and clients in relation to investors, products, and business practices can be insured In reference to 2(b)(i): Negligent loss of documents is often included under a crime policy or a PI policy. Care would need to be taken to explicitly include this cover under the PII. Note: cover for loss of documents is often covered by way of a carve-back to the property damage exclusion. In reference to 2(b)(ii): Where misrepresentation and/or misleading statements made to the AIF or its investors are made by a relevant person(s) - consideration needs to be given as to the document the misrepresentations or misleading statements were made in cover for this risk is often covered under a prospectus liability extension under a Directors and Officers policy (where the relevant person would be legally liable for the misrepresentation or misleading statement). Care would need to be given in regards to allocation clauses in the insurance policy and confirmation cover is granted under the PII policy. In reference to 2(c): Exposure to losses arising from negligence failure resulting in or not adequately prohibiting the disrupting of business or system failures, from failed transaction processing or process management can be insured. Consultation Questions asked by ESMA: Q9: The risk to be covered according to paragraph 2 (b)(iv) of Box 6 (the improper valuation) would also include valuation performed by an appointed external valuer. Do you consider this as feasible and practicable? We would assume it is common market practice to have valuations signed-off by an auditor however it is unclear whether this would be deemed an appointed external valuer. However, if a claim for negligence against the AIFM involved improper valuation preformed by an appointed external valuer, then the insurer will reserve their rights to subrogate against the external valuer in the name of the AIFM.

Step 2: Calculation on amount required to cover potential professional liability risks resulting from activities AIFMs may carry out pursuant to this Directive ESMA has been requested to advise on methods for calculating the respective amounts of additional own funds or the coverage of the professional indemnity insurance. Suggestions received from interested parties on how to calculate the amount required to cover potential professional liability risks included using the Insurance Mediation Directive 6 or Article 7 of Directive 2006/49/EC 7, however, ESMA has decided to use neither as a starting point because none of these provisions include a calculation method but rather set fixed amounts in figures. ESMA has suggested 8 : On the calculation of additional own funds, the advice provides two options: the first is based on the variable assets under management (AuM), while the second also takes into account the variable income. The second option is therefore partially based on the approach taken in Annex X Directive Part 3 2006/48/EC i.e. the Basic Indicator Approach, and includes the assumption that liability risks may not only rise with the value of the AIF s portfolios but also with the income of the AIFM. Accordingly, the additional own funds should be calculated as: Option 1: 0.0001 X AuM Option 2: 0.000015 x AuM + 0.02 x relevant net income Step 3: To work out whether you want to use your own funds or buy PII to cover potential professional liability risks resulting from activities AIFMs may carry out pursuant to this Directive Insurance has proved itself as an effective risk transfer mechanism. In fact, it could be argued, that the insurance industry historically has played its part of being an important stabilizer to the global financial system and economy especially where risk is transmitted to the insurance sector from another financial sector or when assisting economies recover from natural disasters (such as hurricanes, earthquakes and of late tsunamis) via indemnification of individual policyholders. Many EU Directives and other regulatory authorities require Professional indemnity insurance to safeguard financial stability so it is a valid and recognised method to replace capital adequacy requirements. 6 Insurance Mediation Directive: Insurance and reinsurance intermediaries shall hold professional indemnity insurance covering the whole territory of the Community or some other comparable guarantee against liability arising from professional negligence, for at least EUR 1000000 applying to each claim and in aggregate EUR 1,500,000 per year for all claims 7 Article 7 of Directive 2006/49/EC: Coverage for the firms referred to in Article 3(1)(b)(iii) shall take one of the following forms: (a) initial capital of EUR 50 000; (b) professional indemnity insurance covering the whole territory of the Community or some other comparable guarantee against liability arising from professional negligence, representing at least EUR 1 000 000 applying to each claim and in aggregate EUR 1 500 000 per year for all claims; or (c) a combination of initial capital and professional indemnity insurance in a form resulting in a level of coverage equivalent to that referred to in points (a) or (b). 8 P37 ESMA consultation paper

Step 4: To validate that the PII insurance is fit for purpose or if not, confirm appropriateness of the additional own funds Your insurance broker can assist in validating the insurance and confirme this via the Statement of Demands and Needs statement letter 9 provided to the insured. The process is threefold: 1 PII policy complies with the stipulated requirements. 2 PII coverage limit complies with the stipulated amounts (per claim and in the aggregate). 3 PII policy is reviewed at least once a year or in the event of a change which affects compliance. ESMA stipulates in Box 9, that the PII insurance must comply with the following terms: 1 As an alternative to the requirements in Box 8 paragraph 1 regarding additional funds, the AIFM may take out and maintain at all times professional indemnity insurance complying with the following requirements: a) Must have an initial term of no less than one year; b) Must be wide enough in cover to include the liabilities of the AIFM and relevant persons 10 ; (care needs to be given to definition of relevant person (c)) c) There are no exclusions regarding liability risks listed in Box 1; d) Any defined excess is covered by own funds e) The insurance is taken out by a regulated firm which has sufficient financial strength with regard to claims paying ability f) The insurance is provided by a third party entity The amount of coverage has two requirements: 2 COVERAGE OF THE INSURANCE PER CLAIM The minimum should at least be the higher of either: a) 0.75% of the amount by which the value of the portfolios of the AIFM exceeds 250million up to a maximum of 20million b) 2million 9 Required by the FSA as part of being a UK regulated insurance intermediary given to the customer (the AIFM) prior to the conclusion of the contract detailing the underlying reasons for any advice given to the customer on the policy. 10 relevant person means any of the following: a) A director, partner or equivalent, or a manager of the AIFM b) An employee of the AIFM, as well as any other natural person whose services are placed at the disposal and under the control of the AIFM and who is involved in the services of collective portfolio management by the AIFM c) A natural or legal person who is directly involved in the provision of services to the AIFM under a delegation arrangement to third parties for the purpose of the provision of collective portfolio management by the AIFM.

3 INSURANCE FOR CLAIMS IN THE AGGREGATE PER YEAR The minimum should at least equal the maximum of: a) 1% of the amount by which the value of the portfolio of the AIFM exceeds 250million, up to a maximum of 25million b) 2.5million c) The amount calculated for the additional own funds amount (Box 8) 4 The AIFM should review the policy and its compliance with the requirements at least once a year and in the event of any change which affects compliance of the policy with the requirements. Lockton Comment: In relation to Box 9: 1 In consideration of 1(b): cover for the relevant persons should only be extended to where the liabilities attach to the AIFM - especially where the legal person is a third party appointed by the AIFM or AIF for the purpose of the provision of collective portfolio management by the AIFM (refer to definition of relevant person c)) In consideration of 1(c) - We would recommend 1(c) be deleted considering the following: Exclusions re those liability risks listed in Box 1 is this meant to be Box 6? All insurance policies have exclusions so care would need to be given to defined the risks in Box 6 to make sure the insurance policy could be deemed as meeting the requirements. In the UK, cover for loss arising from fraud or dishonesty of an Insured Person (where a judgment has been established against them) is not able to be insured. There are also crimes which are uninsurable by law. It is worth noting most insurance policies will state that headings are descriptive only, therefore: exclusionary conditions are not always found in the exclusion section of the policy wording they can be found in a definition or conditions. In consideration of 1(e): the market practice for insurer security rating is: A-

Consultation Questions asked by ESMA: Q15: Would you consider it more appropriate to set lower minimum amounts for single claims, but higher amounts for claims in aggregate per year for AIFs with many investors (e.g. requiring paragraph 2 of Box 9 only for AIFs with fewer than 30 investors)? Where there are more than 30 investors, the amount in paragraph 3 (b) would be increased e.g. to 3.5 m, while for more than 100 investors, the amount in paragraph 3 (b)would be increased e.g. to 4 m. Firstly, let s consider whether there is a need for a requirement to set a limit per claim and also for claims in aggregate per year. Currently in the UK, most AIFM s PI insurance is based on each and every claim (eec) and in the aggregate basis. So for example, a policy with a limit of liability of say, 5million, can be exhausted by either having one claim of 5mil, or as many claims up to the value of 5million. Cover is not available for unlimited small claims. From our experience, the claim notification risk profile of AIFMs tends to be low frequency and low severity however it is worth noting that: 1 Notification of circumstances that potentially may lead to a claims have increased significantly following the financial crisis. 2 Unrelated claims are not common for AIFMs - one allegation of a wrongful act which would include a professional negligence claim, would typically cause several claim notifications from different investors. All insurance policies include the definition of a claim whereby related or continuous or repeated or causally connected wrongful acts are deemed to be a single wrongful act/claim. The impact this has is to change the potential nature of one individual claim (being made up of many claimants) from being one of low impact to one of high severity and potentially catastrophic for the AIFM. Secondly, we do not think it logical to have number of investors as the criteria for set amounts required. Numbers of investors into the fund, in our experience, have little impact to the risk and increase of exposure to professional indemnity claims. This categorisation is simply not required as a factor. We would recommend deleting section 2 and incorporating this in 3 to read per claim and in the aggregate

Step 5: To have a procedure in place to update PII in line with ongoing adjustments An annual review of the PII programme (or immediately in the event of a change which affects compliance) should be included in the risk management framework. Conclusion: Thoughts to consider for 2013 policy placements: Ensure that your policy covers the risks know your policy. Consider ring fencing the limit to allow transparency in allocating the cost of the insurance as a fund expense (discuss this with LPs). Investigate what PII are similar PE firms buying at the moment? Consider whether you need to change what you buy to use PII as a supplement for capital adequacy replacement. Understand how PII relates to your indemnification provision in the LPA or equivalent? Please contact Danyalle Brinsmead for further clarification or questions concerning this document. Contact details: Danyalle Brinsmead Phone: 0207 933 2155 Mobile: 07920 288 903 Email: Danyalle.Brinsmead@uk.lockton.com Disclaimer: The information provided in this document is intended for use as a guideline and is not intended as, nor does it constitute, legal or professional advice.