By James Tinworth (pictured), partner in the hedge funds practice, Stephenson Harwood – On 28 June 2012, ESMA released a consultation paper on its guidelines on sound remuneration policies under the AIFMD. ESMA will consider all comments received by 27 September 2012.
In 2009, the combination of the release of the first draft of the AIFMD and the confirmation that the top income tax rate would be increased from 40p to 50p prompted many existing and prospective hedge fund managers to question the attractiveness of London (or any other city in the EU) as the base for their management business. Whilst there was no exodus, it is undeniable that the popularity of non-EU, tax-favourable jurisdictions, like Switzerland, dramatically increased.
The concern is that, in 2013, the final AIFMD will prompt hedge fund managers to ask this question again. The AIFMD’s remuneration requirements will be a very significant factor when answering this question, particularly for smaller hedge fund managers.
How do the ESMA guidelines fit into the AIFMD?
Article 13 of the AIFMD provides that EU Member States shall require AIFMs to have remuneration policies and practices for relevant categories of staff (described below) that are “consistent with and promote sound and effective risk management and do not encourage risk-taking which is inconsistent with the risk profiles, rules or instruments of incorporation of the AIFs they manage”. AIFMs shall determine the remuneration policies and practices in accordance with Annex II of the AIFMD.
The AIFMD requires ESMA to ensure the existence of guidelines on sound remuneration policies which comply with Annex II of the AIFMD.
Whose remuneration will be affected?
Those “identified staff” whose professional activities have a material impact on the risk profiles of the AIFM or of the AIFs it manages. Such staff would include (unless it can be demonstrated that they have no material impact on the risk profiles of the AIFM or of the AIFs it manages):
- members of the “governing body” of the AIFM1 (e.g. the directors, the CEO and partners);
- “senior management”2;
- “control functions”3;
- staff responsible for heading portfolio management, administration, marketing or human resources;
- “risk takers”4; and
- any other employees/persons receiving total remuneration that takes them into the same “remuneration bracket”5 as “senior management” and “risk takers”.
Does it apply to carried interest?
Yes. The AIFMD’s remuneration requirements shall apply to remuneration of any type paid by the AIFM, to any amount paid directly by the AIF itself, including carried interest6, and to any transfer of units or shares of the AIF.
What’s the worst that can happen?
There are many requirements, although the headlines are that:
- Fixed and variable components of total remuneration payable to “identified staff” should be appropriately balanced and the fixed component should represent a sufficiently high proportion of the total remuneration to allow the operation of a fully flexible policy on variable remuneration components (including the possibility to pay no variable remuneration component).
- A “substantial portion”, and in any event at least 40% (60% where the remuneration is “of a particularly high amount”7), of the variable remuneration component of any remuneration payable to “identified staff” should be deferred over a period which is appropriate in view of the “life cycle”8 and redemption policy of the relevant fund and should be correctly aligned with the nature of the risks of that fund. The deferral period should be at least three to five years unless the “life cycle” of the relevant fund is shorter. For example, if GBP150,000 of variable remuneration were payable to an identified staff member, at least GBP60,000 would have to be deferred for at least three years and GBP90,000 could be paid out.
- A “substantial portion”, and in any event at least 50% of (a) the deferred part of this variable remuneration and (b) the part of this variable remuneration that is to be paid upfront should consist of units or shares of the relevant AIF(s). Continuing the example: GBP90,000 would be paid out (consisting of GBP45,000 in cash and GBP45,000 in AIF shares) and GBP60,000 would be deferred for at least three years (consisting of GBP30,000 in cash and GBP30,000 in AIF shares).
- The deferred part of this variable remuneration should vest no faster than on a pro-rata basis. The identified staff member in our example would get the deferred GBP60,000 in three instalments: GBP20,000 after the first year, GBP20,000 after the second year and GBP20,000 after the third year.
- Any part of this variable remuneration that consists of units or shares of the relevant AIF(s) must be subject to an appropriate retention policy designed to align incentives with the interests of the AIFM and the AIFs it manages and the investors of such AIFs. Subject to the next requirement, any AIF shares received by the identified staff member in our example would be subject to a “retention period”, during which the staff member would not be able to sell (or, presumably, redeem) them.
- The amount of this variable remuneration that is actually paid out, including any deferred part, should be subject to an adjustment mechanism (which should include malus or clawback arrangements9). ESMA refers to this mechanism as “ex post risk adjustment”.
The cumulative effects of the above requirements on the identified staff member in our example are that (all things being equal):
- at the end of Year One, he will be paid GBP45,000 in cash. He will get GBP45,000 in AIF shares but won’t be able to redeem them for a retention period of, say, one year.
- at the end of Year Two, he will be paid GBP10,000 in cash and can redeem his GBP45,000 of AIF shares. He will get another GBP10,000 in AIF shares but won’t be able to redeem them for one year.
- at the end of Year Three, he will be paid GBP10,000 in cash and can redeem his GBP10,000 of AIF shares. He will get another GBP10,000 in AIF shares but won’t be able to redeem them for one year.
- at the end of Year Four, he will be paid GBP10,000 in cash and can redeem his GBP10,000 of AIF shares. He will get another GBP10,000 in AIF shares but won’t be able to redeem them for one year.
- at the end of Year Five, can redeem his GBP10,000 of AIF shares.
Leaving aside numerous commercial and practical issues, won’t this cause a tax issue for the identified staff?
Yes. In respect of Year One, the identified staff member in our example would get a tax bill in respect of the full GBP150,000. For a higher rate tax payer in the UK, this bill would be for GBP60,000, which is GBP15,000 more than the variable remuneration that he actually receives in cash.
AIFMs will therefore need to ensure careful treatment of identified staff and that the related structuring is put in place.
What is the proportionality principle?
The AIFMD provides that AIFMs should comply with the remuneration requirements in a way and to the extent that is appropriate to their size, the size of AIFs they manage (including any assets acquired through the use of leverage), their internal organisation and the nature, scope and complexity of their activities.
As a result, ESMA was required to take this proportionality principle into account when drafting its guidelines. The ESMA guidance provides (on a non-exhaustive basis) that:
- The size criterion can relate to the value of the AIFM capital and to the value of the assets under management (including any assets acquired through the use of leverage) of the AIFs that the AIFM manages; liabilities or risks exposure of the AIFM and of the AIFs that it manages; as well as the number of staff, branches or subsidiaries of an AIFM.
- The internal organisation criterion can relate to the legal structure of the AIFM or the AIFs it manages, the complexity of the internal governance structure of the AIFM and the listing on regulated markets of the AIFM or the AIFs it manages.
- In considering the nature, scope and complexity of the activities criterion, the underlying risk profiles of the business activities that are carried out should be taken into account10.
The ESMA guidance also provides that the proportionality principle can also operate within an AIFM for some of the specific requirements. This means that some AIFMs, either for the total of their identified staff or for some categories within their identified staff, can tailor the six headline requirements described above.
Can the proportionality principle disapply some or all of the AIFMD’s remuneration requirements?
No (as things stand). The key difference between ESMA’s draft guidelines and the CEBS guidelines (which were in relation to remuneration policies and practices under the Capital Requirements Directive) is that the CEBS guidelines provided that the application of the proportionality principle may lead to the neutralisation (disapplication) of some requirements. Whilst ESMA’s draft guidelines do provide that “not all AIFMs should have to give substance to the remuneration requirements in the same way and to the same extent”, “[some] AIFMs can meet the [remuneration] requirements of the AIFMD in a simpler or less burdensome way” and that requirements “may be applied in a tailored manner”, they do not provide for neutralisation.
In fact, the ESMA guidelines explicitly state that any tailored application of the requirements “should not be understood as allowing an AIFM to disregard any of the requirements of Annex II of the AIFMD”. It remains to be seen whether the final version of the ESMA guidelines will provide for neutralisation.
When it comes to implement the AIFMD, does the UK have to follow the final ESMA guidelines?
EU law requires competent authorities and financial market participants “to make every effort to comply with [ESMA’s] guidelines and recommendations”. The FSA (or its successor, the FCA) could inform ESMA that it does not intend to comply with the final ESMA guidelines, stating its reasons. ESMA will publish that fact and may publish the FSA’s reasons. ESMA will also inform the European Parliament, the EU Council and the EU Commission and outline how it “intends to ensure that the [FSA] follow its recommendations and guidelines in the future”.
The short answer, therefore, is “no, the FSA does not”, although there will be considerable political and other pressures on the FSA to do so. If the final version of the ESMA guidelines do not provide for neutralisation of the requirements, then it is difficult to see how the FSA’s rules could do so.
What about the exemption for smaller fund managers?
According to the AIFMD, a smaller AIFM does not have to be authorised as an AIFM under the AIFMD where it can rely on one of the exemptions in Article 3(2) (i.e. (i) AIFMs who manage AIFs whose assets under management (including any assets acquired through leverage) do not exceed EUR100 million or (ii) AIFMs who manage AIFs that are unleveraged and have no redemption rights exercisable during a period of 5 years following the date of initial investment and whose assets under management do not exceed €500 million). Such an AIFM can instead be “registered” with its regulator and may only be required to comply with Article 3(3) and avoid, amongst other things, the AIFMD’s remuneration requirements.
It is important to note, however, that the AIFMD’s exemption for such “registered AIFMs” is “without prejudice to any stricter rules adopted by Member States”. The UK authorities have stated that they are considering two options – full application of the AIFMD to smaller AIFMs or the application of “a lighter regime selectively, differentiating between AIFM” – and have indicated that they are minded to choose the latter option. In the UK therefore smaller AIFMs could be subject to registration only, selective application of AIFMD authorisation requirements or full AIFMD authorisation.
So smaller managers in the UK may, or may not, have to comply with the AIFM remuneration requirements?
There won’t be clarity on this until later in the year.
Are there any structures that would avoid the requirements?
Whilst there are structures available that can minimise the adverse tax consequences for identified staff, the AIFMD expressly states that variable remuneration must not be paid to identified staff “through vehicles or methods that facilitate the avoidance of” the remuneration requirements of the AIFMD.
1 ESMA defines this as the component of the governance structure with ultimate jurisdiction and power of direction. In corporate structures this is usually the board of directors but in other structures may be an equivalent body. The governing body is distinct from senior management, whom it directs, but some or all members of senior management may comprise the management body which may also contain nonexecutive members.
2 ESMA defines “senior management” as the person or persons who effectively conduct the business of an AIFM.
3 ESMA defines “control functions” as staff (other than senior management) responsible for risk management, compliance, internal audit and similar functions within an AIFM (e.g. the CFO to the extent that he/she is responsible for the preparation of the financial statements).
4 i.e. staff members, whose professional activities – either individually or collectively, as members of a group (e.g. a unit or part of a department) – can exert material influence on the AIFM’s risk profile or on an AIF it manages, including persons capable of entering into contracts/positions and taking decisions that materially affect the risk positions of the AIFM or of an AIF it manages. Such staff can include, for instance, sales persons, individual traders and specific trading desks.
5 ESMA defines “remuneration bracket” the range of the total remuneration of each of the staff members in the senior manager and risk taker categories – from the highest paid to the lowest paid in these categories.
6 The AIFMD defines “carried interest” as a share in the profits of the AIF accrued to the AIFM as compensation for the management of the AIF and excluding any share in the profits of the AIF accrued to the AIFM as a return on any investment by the AIFM into the AIF.
7 Not defined in the AIFMD or the ESMA guidelines.
8 ESMA does not define what a fund’s “life cycle” is but does provide that if the life cycle of an AIF is, for instance, one year, the minimum deferral period may be one year.
9 ESMA defines “malus” as an “arrangement that permits the AIFM to prevent vesting of all or part of the amount of a deferred remuneration award in relation to risk outcomes or performances of the AIFM as a whole, the business unit, the AIF and, where possible, the staff member” and “clawback” as a “contractual agreement in which the staff member agrees to return ownership of an amount of remuneration to the AIFM under certain circumstances. This can be applied to both upfront and deferred variable remuneration”.
10 Relevant elements can be: (i) the type of authorised activity (investment management functions listed in point 1 of Annex I of the AIFMD only or also the additional functions listed in point 2 of Annex I of the AIFMD and/or the additional services listed in Article 6(4) of the AIFMD); (ii) the type of investment policies and strategies of the AIFs the AIFM manages; (iii) the national or cross-border nature of the business activities (AIFM managing and/or marketing AIFs in one or more EU or non-EU jurisdictions); and (iv) the additional management of UCITS.