The impact of the IFD & IFR on AIFMs & UCITS ManCos

Most provisions of Regulation (EU) 2019/2033 (the “Investment Firm Regulation” or “IFR”) and Directive (EU) 2019/2034 (the “Investment Firm Directive” or “IFD”) will be applicable as from 16 June 2021 onwards. The IFD and IFR amend the own capital requirements that are applicable to alternative investment fund managers (“AIFMs”) and UCITS management companies (“UCITS ManCos”), as well as, fund managers that provide “MiFID II add-on services”. This contribution discusses the applicability of the IFD and IFR to both AIFMs and UCITS ManCos.

1.????Background

On 5 December 2019, the IFD and IFR were published in the Official Journal of the European Union and entered into force on 25 December 2019. The IFD and IFR regulate the prudential requirements applicable to investment firms authorized under Directive 2014/65/EU, as amended (“MiFID II”). On 26 June 2021, the IFD is required to be implemented by all Member States, including Luxembourg. To enable consistency with the IFD implementation, most provisions of the IFR will also be applicable by 26 June 2021.

The IFD/IFR prudential framework introduces a new approach to classify investment firms and a different prudential regime will be applied to each class. The existing prudential regime under Regulation (EU) No. 575/2013, as amended, (“CRR II”) and Directive 2013/36/EU, as amended, (“CRD V”) largely focuses on the prudential supervision of credit institutions and addresses only, to a limited extent, the specific characteristics of investment firms. The IFD and IFR replace the prudential regime that is currently applicable to (certain types of) investment firms under CRR II and CRD V and seeks to establish a prudential framework for investment firms that is more proportionate, simple, risk-sensitive, and appropriate to the size and nature of investment firms.?

The IFD and IFR both affect the own funds requirements imposed on AIFMs and UCITS ManCos, as well as, those AIFMs and UCITS ManCos that also provide MiFID II “add-on” services. Before addressing this, the new prudential requirements for investment firms and the scope of the IFD and IFR will be discussed.

2.????The ?IFD & IFR versus CRR II & CRD V

The current CRR II and CRD V requirements applicable to investment firms are designed to address common risks faced by credit institutions. Accordingly, the existing requirements are largely calibrated to preserve the lending capacity of credit institutions through economic cycles and to protect depositors and taxpayers from possible failure, and are not designed to address all of the different risk profiles of investment firms. Investment firms, however, do not have large portfolios of retail and corporate loans and do not take deposits. The likelihood that their failure can have detrimental impacts on overall financial stability is lower than in the case of credit institutions, but investment firms, nevertheless, pose a risk which is necessary to be addressed by means of a robust framework. Furthermore, many investment firms in the EU are small and “non-interconnected”. The risks faced and posed by most investment firms are, thus, substantially different to the risks faced and posed by credit institutions and such differences are intended to be clearly reflected in the prudential framework under the IFR and IFD.

3.????Investment firms classification and prudential framework under the IFD & IFR ?

The IFD and IFR lay down provisions on the specific risks posed to different types of investment firms concerning internal governance, remuneration policies, concentration risk, capital requirements, liquidity requirements and reporting requirements.?

One of the most prominent changes introduced by this regime, is the creation of three categories of investment firms.

Under the IFD and IFR, “Category 1” investment firms are large, systemically relevant investment firms that show similiarities with systemically relevant credit institutions, except that they do not meet the criteria to qualify as a credit institution (i.e. they do not hold deposits or other repayable funds). Under the amended definitions of “credit institutions” and “investment firms”, as introduced by the IFD, this type of investment firm is now “relabelled” as a credit institution in its own right and will continue to be subject to the CRR II and CRD V regimes. The IFD and IFR, furthermore, defines two separate subcategories of “Category 1” investment firms.

“Category 1a” investment firms are engaged in ‘high-risk activities’, such as dealing on own account, underwriting financial instruments or placing financing instruments on a firm commitment basis. The total value of the consolidated assets of this type of investment firm is less than EUR 30 billion, but more than EUR 15 billion. If the total value of the consolidated assets is less than EUR 15 billion, but more than EUR 5 billion, the national regulator has the discretionary power to subject such an investment firm to the CRR II regime, if – in short - it deems the investment firm to be “systemically relevant”. This category of investment firms is, therefore, not requalified as a credit institution under the CRR, but is through a mutatis mutandis clause in the IFD/IFR subject to the full rules of CRR II. In addition, only a few rules of the IFR/IFD regime apply to this category.

“Category 1b” investment firms that, by virtue of their size and importance or their membership of a group, will remain subject to a number of obligations stemming from the CRR II and CRD V framework, however, without being treated as credit institutions in their own right. These investment firms also perform high-risk activities, but choose to be subject to the prudential regime of the CRR II/CRD V instead of the new IFR/IFD regime. In short, this option exists if an investment firm is a subsidiary and is already included in the supervision of another financial intermediary, such as a credit institution, financial holding or mixed financial holding on a consolidated basis. If an investment firm wishes to make use of this option, it must submit an application to the CSSF. This category of investment firms does not qualify as a credit institution under CRR II either, but with the consent of the CSSF, it will be subject to the prudential regime of the CRR II via a mutatis mutandis clause in the IFR.

“Category 2” investment firms represent the traditional investment firm, which will be fully subject to the new IFR and IFD regime. For Category 2 to apply, however, investment firms must prove that (i) it is not a Category 1 (or 1a or 1b) investment firm, and (ii) it exceeds one of the thresholds to qualify as a Category 3 investment firm.

Finally, “Category 3” investment firms are small, non-interconnected firms that will benefit from certain exemptions to ensure the proportionality of the rules applicable to them. To that end, each investment firm that does not fall in Category 1 (or 1a or 1b), will have to calculate the K-factors to assess whether it falls in Category 2 or Category 3. A simplified prudential regime applies to Category 3 investment firms and the provisions on governance, remuneration, transparency, risk management and prudential reports are not, or to a lesser extent,?applicable this type of investment firm.

In this respect, it has to be noted that MiFID II remains applicable to all categories of investment firms.

4.????Direct applicability IFR & IFD to AIFMs & UCITS ManCos

Article 2(1) IFD and Article 1(1) IFR determine that the prudential requirements laid down in both frameworks only directly apply to “investment firms” that are authorized pursuant to MiFID II. The IFD nor the IFR explicitly clarify whether they are (fully) applicable to AIFMs and UCITS ManCos providing “MiFID II add-on services”. Recent European initiatives contain explicit references with respect to the applicability of their initiatives to AIFMs and UCITS ManCos providing “MiFID II add-on services”. This is, for example, the case with Article 1(1) Commission Delegated Directive (EU) 2017/593. Furthermore, Recital 39 IFD refers to specific cross-references in Directive 2011/61/EU, as amended (the “AIFMD”), and Directive 2009/65/EC, as amended (the “UCITSD”), to CRR II and CRD V that will no longer apply to investment firms from the date of application of the IFR and should be construed as references to the corresponding provisions in the IFD and IFR. In addition, Article 60 and 61 IFD makes an explicit reference to those provisions of the IFD that seek to amend the AIFMD and UCITSD. Taken from this, the European legislator did not seem to have had as its intention to directly apply the IFD and IFR to AIFMs and UCITS ManCos, nor to those that provide “MiFID II add-on services”.

Given the unclarities with respect to the scope of the IFR and IFD, it is, however, likely to be a matter of the IFD implementation of the individual Member States as to whether and to what extent they wish to apply IFR/IFD requirements to AIFMs and UCITS Mancos with top-up permissions. The current Luxembourg IFD implementation draft bill, for example, does not directly apply the IFD/IFR to AIFMs and UCITS ManCos, nor to those that provide “MiFID II add-on services”. On the contrary, the Dutch IFD implementation (draft) bill extends certain rules, including solvency, liquidity and organizational requirements, to AIFMs and UCITS ManCos with a “MiFID II top-up”. There seems, thus, to be a level non-playing field with respect to the direct applicability of the IFR/IFD prudential requirements to AIFMs and UCITS ManCos (with a “MiFID II top-up”).

5.????New “Fixed Overheads Requirements” for Fund Managers

Although the IFD and the IFR seem not to be directly applicable to AIFMs nor UCITS ManCos, Article 60 and 61 IFD replace the own funds requirements that are being laid down in Article 7(1)(a)(iii) UCITSD and Article 9(5) AIFMD.

This amendment implies that the own fund requirements of both UCITS ManCos and AIFMs must at no time be less than the amount prescribed in Article 13 IFR. In accordance with Article 13 IFR, the “fixed overheads requirements” amount to, at least, one quarter of the fixed overheads of the preceding year. Following an EBA report published in September 2017, this requirement is introduced as “it aims to ensure that investment firms hold capital to help them fail in a more orderly manner, providing adequate financial resources to support winding-down of the firm”.

On the basis of Article 9(5) AIFMD and Article 7(1) UCITSD, there is currently, however, already a “fixed overheads requirement” applicable to AIFMs and UCITS ManCos. The amendments in this respect are, however, the updated cross-references to Article 13 IFR and the clarification that the “fixed overheads” have to be calculated in accordance with the figures resulting from the applicable accounting framework.

6.????Prudential Requirements applicable to Fund Managers that provide MiFID II “Add-on” services

Although the IFR and the IFD are not applicable to (Luxembourg) AIFM and UCITS ManCos, nor to those providing “MiFID add-on services”, the IFD has indirect implications for the latter type of fund managers.

In particular, Recital 39 IFD refers to specific cross-references in the AIFMD and UCITSD to CRR II and CRD V that will no longer apply to investment firms from the date of application of the IFR and IFR should be construed as references to the corresponding provisions in the IFD and IFR.

In other words, the specific cross-references made to CRD V and CRR II to, inter alia, the UCITSD and the AIFMD, which will no longer apply to investment firms as of the entry into force of the IFD and IFR, will apply as references to the corresponding provisions in the IFD and IFR. More specifically, the changes to the cross-references are elaborated in Title VII IFD. For example, Article 64(2) IFD amends Article 15 MiFID II, which contains a reference to Article 9 IFD. Article 9 IFD reflects Article 28 CRD V and Article 29 CRD V and provides that, depending on the type of investment firm, the initial capital shall be EUR 750,000, EUR 150,000 or EUR 75,000.

The IFD, thus, indirectly impacts AIFMs and UCITS ManCos providing “MiFID II add-on services”.

7.????Conclusion

The Luxembourg IFD implementation draft bill seems to point in the direction that the IFD/IFR will not be applied to AIFMs and UCITS ManCos, nor to those that provide “MiFID II add-on services”. The IFD and IFR will, however, modestly affect the own funds requirements imposed on (Luxembourg) AIFMs and UCITS ManCos by clarifying how “fixed overheads” have to be calculated. Furthermore, the IFR and IFR clarifies that the previous CRD V and CRR II cross-references in the UCITSD and AIFMD applicable to AIFMs and UCITS ManCos providing “MiFID II add-on services” now apply as references to the corresponding provisions in the IFD and IFR.

Despite not being directly applicable, it is, however, possible that IFR and IFD could be a source of inspiration for future changes to the prudential requirements applicable to AIFMs and UCITS Mancos (with and without MiFID II top-up permissions).