AIFMD regulations have created a liability problem for valuers, with repercussions for investors, writes Melville Rodrigues
Recent encouraging developments suggest that the UK will soon amend the regulation that applies to alternative investment fund managers. In October, Ashley Alder, chair of the Financial Conduct Authority (FCA), will be 鈥渃onsulting on amending鈥� the Alternative Investment Fund Managers Director (AIFMD) regime and 鈥渞e-evaluating the AIFMD rules for non-UCITS retail funds next year鈥�.
The then Parliamentary Secretary for the Treasury, Baroness Joanna Penn, : 鈥淥n the AIFMD specifically, work has already started on plans for reform, with a discussion paper issued by the FCA in February.鈥� She said the government was 鈥渨orking closely with the FCA to explore what changes can be made to AIFMD to make it more streamlined and tailored to UK markets. I assure all noble Lords that that work is being taken forward with urgency.鈥�
Reform of the UK AIFMD regime provides an opportunity to solve a serious problem regarding fund valuation. Helpfully, the FCA has already recognised this issue. In its on the Long-Term Asset Fund, the FCA indicated that:
- the independent (external) valuation of illiquid and hard-to-value assets provides important protection to consumers;
- the FCA would like the market for external valuers to work better;
- while the liability standard derives from UK AIFMD and the FCA is therefore unable to change it at this stage, the FCA is working with the Treasury to consider the function of the external valuer.
UK fund valuer problem and solution
Let me explain the problem in more detail. While the policy intent of the UK AIFMD regime is the protection of investors, the current UK AIFMD Regulation 24(5) wording (see box below) in fact achieves the opposite.
The wording of the UK AIFMD regulations
鈥淚rrespective of any contractual arrangements that provide otherwise, an external valuer is liable to the AIFM of an AIF in respect of which the external valuer is appointed for any losses suffered by the AIFM as a result of the external valuer鈥檚 negligence or intentional failure to perform its tasks.鈥�
The regulation overrides any contractual limit on liability agreed between the fund manager 鈥� known as the alternative investment fund manager (AIFM) 鈥� and the valuer. As such, the regulation means that there is effectively no cap on the external valuer鈥檚 liability for losses suffered by the AIFM as a result of the valuer鈥檚 negligence in performing its tasks as valuer. This simply does not work in practice.
The unlimited liability imposed by the regulation means that few, if any, professional valuers can or will accept appointment as external valuers by an AIFM. In addition to their commercial concerns, there is the fact that most reputable valuers in the UK are required by their professional bodies to have professional indemnity insurance, and this insurance will generally not be available unless a liability cap is in place.
This has a negative consequence for fund investors. It means they are forced to rely on the AIFM鈥檚 internal valuation and are denied the benefit of independent determination of asset value by an external valuer. This runs counter to long-established principles of investor protection and good corporate governance.
I have led an industry initiative to solve the problem. As part of this initiative, I have conferred with a range of industry stakeholders, including contacts at valuation firms, UK fund managers, pension funds and other institutional indirect investors, industry associations, law firms and senior counsel.
Following this initiative, I propose the following solution. This approach will make uncapped liability the default position, but will allow AIFMs and valuers to disapply this position where they wish to do so (subject to certain requirements). Under this solution, if the AIFM were to both appoint an external valuer and agree to limit the external valuer鈥檚 liability, the UK AIFMD provision requiring uncapped liability would not apply and the external valuer would only be liable to the given agreed limit (provided with a qualification that the relevant limit on liability were reasonable and proportionate to value of the AIF assets).
This solution will provide flexibility to AIFMs and external valuers who wish to use it, but will otherwise leave the relevant provision essentially unchanged. As such, AIFMs and external valuers who wish to proceed under the current approach will still be able to do so (see box below).
Proposed change to wording of Regulation 24(5)
(a) Where the AIFM of an AIF and the external valuer agree to limit liability of the external valuer for losses suffered by the AIFM as a result of the external valuer鈥檚 negligence in performing its tasks (provided the limit of liability agreed is reasonable and proportionate to value of the AIF assets), the external valuer shall only be liable to that limit; and
(b) Subject to Regulation 24(5)(a) and irrespective of any other contractual arrangements, an external valuer is liable to the AIFM of an AIF in respect of which the external valuer is appointed for any losses suffered by the AIFM as a result of the external valuer鈥檚 negligence or intentional failure to perform its tasks.
* Amended wording in italics
Let鈥檚 look forward to the FCA consultation this year and hope that an industry response will persuade the FCA and Treasury to solve the fund valuer problem.
The EU dimension
I hope that reform of the UK regulation may in time prompt a similar reform in relation to the equivalent EU AIFMD provision (Article 19(10) EU AIFMD), which imposes uncapped liability in respect of external valuers operating in an EU context. I recognise, however, that this will take more time.
Unfortunately, as things stand, the proposed EU AIFMD II reforms do not extend to the EU AIFMD provision Article 19(10). However, in its response to the preceding review of EU AIFMD, the that there was a problem with external valuer liability. The EU could tackle the issue with a solution along the lines being proposed here.
