As July draws ever-closer and we approach the final AIFMD deadline, the alternative investment fund management (AIFM) industry continues to make the most of its period of transition. Since the directive was passed last year, the investment community has undergone a period of significant change, as managers and directors adjust their offerings to align them with the new regulatory measures.

As the legislation is still not in force, the full effect of the AIFMD remains to be seen, with asset and hedge fund managers divided on the directive’s likely effect. However, the number of managers that have successfully obtained, or are currently applying for, AIFM authorisation, suggests that the industry is prepared for considerable change. At its most basic, the AIFMD hopes to reduce systemic risk and give investors more protection against sharp practice than before, while the European Union hopes to create a more level playing field. It will become clear over time whether these goals are achievable, but we can be certain that firms will find themselves in a new environment once the deadline passes in July. An increase in regulation, and the guidelines that precede it, brings many considerations to the fore, and will have implications for the hedge fund sector.

At each hedge fund, compliance and risk management staff must analyse their entire operation from a regulatory, legal, compliance, operational and commercial perspective. With the emphasis on change and understanding, as well as implementation, it is apparent that compliance and risk management is set to have a key role in the restructuring of AIFMs.

Insurance requirements: malpractice in the spotlight?

Perhaps one important aspect of the AIFMD that has not been very widely addressed is the change to insurance requirements. This is an aspect of regulation the directive addresses in detail, with clear and specific instructions for AIFMs which mandate insurance.

The changes put forward by the AIFMD require managers to hold appropriate additional 'own funds' or professional indemnity insurance. This is primarily to cover the risk that liability will arise from professional negligence. Professional liability can be an all-encompassing term, however. As far as an AIFM is concerned, it 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 most significant insurance change outlined in the directive, as far as compliance and risk management people are concerned, is featured in articles 12 and 15. Article 12 states that AIFMs must hold 'own funds' or professional indemnity insurance to cover their professional liabilities. The liability of the AIFM in question 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. Article 12 goes on to suggest the types of risk that should be covered as the result of various activities the AIFMs may carry out, including the following:

• loss of documents evidencing title of assets of the AIF;

• misrepresentations or misleading statements made to the AIF or its investors;

• acts, errors or omissions resulting in a breach of legal and regulatory obligations;

• duty of skill and care towards the AIF and its investors;

• fiduciary duties;

• obligations of confidentiality;

• AIF rules or instruments of incorporation;

• terms of appointment of the AIFM by the AIF;

• failure to establish, implement and maintain appropriate procedures to prevent dishonest, fraudulent or malicious acts;

• improperly carried-out valuations of assets or calculations of unit/share prices; and

• losses arising from business disruption, system failures and failures in the processing of transactions or the management of processes.

Under Article 15 the cover is required to have an initial term of one year at a minimum, with a notice period for cancellation by insurers of not less than 90 days. It is worth noting that some smaller AIFs are exempt from such requirements under the AIFMD. These are AIFs with assets under management (including debt or 'leverage') that do not exceed €100 million, or do not exceed €500 million when the portfolio is not 'leveraged'. Smaller AIFs also need have no redemption rights during a period of five years following the date of initial investment to be exempted.

Potentially disruptive issues

At a superficial level, there is a conflict between what the AIFMD requires and the practice amongst some alternative investment managers of agreeing to a higher ‘gross negligence’ standard with the fund in the terms of their contracts. This is something compliance and risk management folk should bear in mind.

There is not a specific stipulation in the AIFMD that suggests that legal liability cannot be avoided in this way. However, the regulation indicates that the European Commission will be concerned if the AIFM can bypass some of the rules by contracting out of its responsibilities for negligence. This is particularly likely in view of the FCA’s recent public comments about the reservations it has about negligence clauses.

This does not necessarily mean that contractual responsibilities toward funds are an area likely to require review by alternative investment fund managers. However, there is potential for conflicts of interest between asset managers and their fund-customers.

The changes brought on by the directive will not only be regulatory, but also come from investor demands. Already, investors seem to be paying more and more attention to the responsibility of investment fund managers for ‘negligent’ trade errors. This has led insured investment fund managers to take a greater interest in the ways in which their PII policies might respond.

Options for the future

The outlined changes leave UK managers with two primary options:

• Buy Professional Indemnity Insurance (PII). This will amount to 0.7% of the total asset value of the AIF for individual claims, and 0.9% of the total asset value of the AIF in aggregate per year.

• Hold additional 'own funds' to cover losses. In February this year the FCA provided 'guidance' which described how to value assets under management (AuM) and announced that it would permit AIFMs to value derivatives positions at market value for the purposes of determining their capital requirements under the directive.

Potential solutions

There is no blanket solution, given the huge variances in size and scale between AIFMs. Purely from a compliance perspective, it seems clear that a combination of both options is the best way to reduce overall risk, as well as being a much sounder strategy from a financial perspective. It is debatable whether the AIFMD’s capital allocation approach is an appropriate direct replacement for insurance and it is fair to say that investors are unlikely to consider it so.

A large percentage of investment managers already purchase PII. It is very unlikely that such managers will cancel existing PII to rely on additional own funds alone. One of the main driving forces behind PII, is often pressure from investors who demand a ‘safety net’ and the type of assurance that additional own funds simply cannot offer. The purchase is also popular amongst corporate governance and operational risk departments, which may have a preference for an insurance policy to cover operational risks. These risks include an over-reliance on capital amounts.

The logic behind using a lower value of additional own funds is that coverage through PII is widely viewed as less certain than coverage provided through additional own funds. For obvious reasons, this is of particular concern to compliance departments. Because of this, different percentages should apply to the two different instruments used for covering professional liability risk. Although this is an understandable position to take, it is questionable whether it is a feasible long-term strategy, given the levels of uncertainty, particularly the amount of funds that must be available to cover losses resulting from professional liability risks.

It is apparent that the adequacy of the 'additional own funds' approach is questionable, especially when one is trying to achieve the objective of protecting investors and paying for professional liability losses and particularly when compared with the limit of indemnity required under the AIFMD, or indeed the PII limit of indemnity that many AIFMs already purchase. For example, one insurer’s own assessment relating to the hedge fund sector, which it has based on its predominantly EU-based customer portfolio, indicates that the average limit of indemnity of their insured firms when compared with assets under management is 2.39%.

As it stands, the 'own funds' requirements outlined in the AIFMD may not offer investors the necessary levels of protection, particularly when smaller firms serve them. Compliance departments in the UK will have to reconsider whether the appointed AIFM is protecting investors from sharp practice well enough, or if further investment is necessary. Professional indemnity risk transfer products will no doubt form part of this consideration, either alongside the 'own funds' they hold or in place of them.

Although it will be necessary for AIFMs to make further policy amendments to comply totally, an AIFM who chooses the insurance route should at least find this section of the AIFMD relatively easy to grasp and implement across the business.

The use of 'own funds' may initially seem appealing from a compliance and risk management perspective when the firm in question is large enough to cover the costs and produce the necessary capital. However, as at smaller firms, this will not be enough by itself. Larger firms that wish to use 'own funds' for compliance purposes will still benefit from the additional security of PII. This can also contribute to a strong risk management strategy built on a combination of the two options. An insurance programme purchased in accordance with perceived risk exposure as opposed to a strict adherence to prescriptive limits is likely to be the most practical approach.

Baronsmead, whose senior partner is Robert Kelly, has offices in the City of London and can be reached on +44 (0) 20 7529 2305.