Critically examine the fiduciary principle as applied to the management of the Alternative Investment

Funds (AIFs) by the Alternative Investment Funds Managers (AIFMs) in the European Union?

This essay seeks to critically analyze the fiduciary principle as applied by the Alternative Investment
Funds Managers (AIFMs) to the management of Alternative Investment Funds(AIF) in European
Union. The essay will critically focus on the application of fiduciary principle within the European
Union. The analysis will be based on the information that is gathered from various sources which will
be mentioned subsequently. The essay initially will focus on defining key terms which requires
discussion for a general understanding; in particular Alternative Investment Fund (AIF), Alternative
Investment Fund Managers (AIFMs), Fiduciary duty/principle and certain legislative provisions
primarily the Alternative Investment Fund Managers Directive that regulate the domain of Alternative
Investment Funds Managers in European Union.

Europe has a developed and prosperous private equity industry. There are at least 2,000 private equity
firms in Europe-with about 600 billion euros in assets under management (AUM)1. The European
industry invested about 50 billion euros in almost 6,000 companies in 20162. The European economy
needs risk capital so that the businesses can innovate, evolve and get bigger.

An Alternative Investment Fund (AIF) is any “collective investment undertaking” that raises capital
from a number of investors, with a view to investing it in accordance with a defied investment policy
for the benefit of those investors3, but which does not require authorization under the Undertakings for
collective investment in transferable securities (UCTIS)4 regime. The phrase “collective investment
undertaking” in particular is not explained, but the Directive provides that an entity may be an AIF
whether it’s open or close-ended, and whether it is constituted under trust law, contract law or under
any statue.

Every entity in the world is managed by trained professionals, one can call them managers or directors.
The AIFs are managed by the Alternative Investment Fund Managers (AIFMs) who are responsible for
the management of a significant amount of invested assets in the Union, account for significant amount
of trading in markets for financial instruments and can exercise an important influence on markets and
companies in which they invest (recital 1)5. As per Article 46, AIFMs means legal persons whose regular
business is managing one or more AIFs. The impact of AIFMs on the market in which they operate is
largely beneficial, but recent financial strains have highlighted how the activities of AIFMs may also
serve to escalate and supplement risks through the financial system. Uncoordinated national responses,
be it due to the Great Recession or lack of regularization, makes the efficient management of the risk
strenuous hence generating loss of confidence in the market. To avoid that, a collective need for
governing the authorization and supervision of AIFMs was imperative; to provide a logical approach
to the related risks and their impact on investors and markets in the Union.

The Alternative Investment Fund Managers Directive 2011/61/EU (AIFMD) is the first EU-Level
framework for direct regulation of the alternative investment sector. The AIFMD reflects the notion
that Alternative Investment Fund Managers (AIFMs) -whilst “largely beneficial”- may […] spread or
amplify risk” (recital 2) through financial system, and it proposes (Recital 4) to provide an internal

1 Assets under management as defined by Invest Europe are the total amount of capital managed from Europe. It includes the
total amount of funds available to fund managers for future investments plus the amount of funds already invested (at cost)
and not yet divested. Fees already paid to managers are excluded, but not excluded accumulated management fees.
2 Invest Europe “2016 European Private Equity Activity. Statistics on Fundraising, Investments & Divestments”,

<https://www.investeurope.eu/media/651727/invest-europe-2016-european-private-equity-activity-final.pdf.> accessed 11
April 2018
3 DIRECTIVE EU 61/2011 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 8 June 2011on Alternative

Investment Fund Managers and amending Directives EC 41/2003 and EC 65/2009 and Regulations (EC) No 1060/2009 and
(EU) No 1095/2010, art 4 < https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex%3A32011L0061> accessed 11
April 2018
4 Directive (EC) 65/2009
5 Directive (EU) 61/2011
6 Directive (EU) 61/2011, art 4 s(1)(b)
market for AIFMs and a harmonized and stringent regulatory and supervisory framework for AIFMs’
activities. The Directive applies, in general, to managers of alternative investment funds, that is, to any
legal person whose regular business is managing one or more alternative investment fund. It provides
regulatory oversight of AIFMs which covers private equity managers, hedge funds managers, real estate
managers and other AIFs managers. In a nutshell, the AIFMD imposes a number of requirements on
AIF Managers particularly in the fields of ‘authorization7 and marketing’, ‘transparency requirements8’,
‘capital obligation9/adequacy;’ and ‘organization10 and governance’. The purpose is to fortify the
protection imparted to investors into AIFs.

The equity investment chain will best serve the interest of savers and companies if relationships along
it are based on the concept of stewardship11. Stewardship demands confidence based on trust in the
agent with whom money has been placed, and respect by that agent should be defined in ways that
establish and reinforce trust and respect12. Stewardship is incompatible with conflict of interest. The
relationship of the principle-agent13, trustee-beneficiary14, solicitor-client15, mortgagee-mortgagor16,
company directors-company17, partners and co-partners to name a few, is a special kind of overarching
fiduciary relationship. At the core of the fiduciary relationship lies a particular conception of loyalty.
In certain cases where a person is empowered to make decisions on behalf of another, equity will seek
to ensure that these decisions are not taken in conflict of interest. The decision maker, the ‘fiduciary
must act only in the interest of the person on whose behalf he makes those decisions and must not allow
self-interest, or the interest of third parties, to govern his relationship in any way that would conflict
with the principal’s best interest18.

The term “fiduciary duty” has been used in a board sense to cover various duties a fiduciary owes.
However, the courts have now taken a stringent view against using the term in this way. It has now
been recognized that fiduciaries will owe both fiduciary and non-fiduciary duties. Only those duties
that are peculiar to fiduciaries are properly termed as fiduciary duty19. Lord Justice Millett in Bristol
and West Building Society v Mothew noted:
“The expression “fiduciary duty” is properly confined to those duties which are peculiar to fiduciaries
and the breach of which attracts legal consequences differing from those consequent upon the breach
of other duties. Unless the expression is so limited it is lacking in practical utility”20.

Professor kay21 is of the view that everyone operating in financial market should apply fiduciary
standards in their dealings with each other whenever they are exercising discretion over the investments
of others or give financial investment advice. His opinioned that the clients interest put first, that conflict
of interest should be avoided, and that the direct and indirect costs of services provided should be
reasonable and disclosed.’22 He further stressed that the fiduciary relationships should be independent
of the nature if client and should not be capable of being overridden contractually. The principles
suggested by Prof. kay differ from the approach that the courts have taken in classifying what relations
falls under the domain of fiduciary principle. Many investment intermediaries have the potential to owe

7 Directive (EU) 61/2011, ch II art 6

8 Ibid ch IV art 22
9 Ibid art 9
10 Ibid section 2, art 18
11 The Kay Review of UK Equity Markets and Long-Term Decision Making, Final Report July 2012, ch 9 para 9.1

<http://www.ecgi.org/conferences/eu_actionplan2013/documents/kay_review_final_report.pdf > accessed 12 April2018

12 ibid para 9.1
13 De Busshe v Alt (1878) 8 Ch D 286; Kirkham v Peel (1880) 43 LT 171; Lamb v Evans [1893] 1 Ch 218
14 Price v Blakemore (1843) 6 Beav 507
15 McMaster v Bryne [1952] 1 All ER 1362; Conway v Ratiu [2005] EWCA Civ 1302
16 Farrars v Farrars Ltd (1888) 40 Ch D 395
17 Sinclair v Brougham [1914] AC 398; Item Software (UK) Ltd v Fassihi [2004] EWCA 1244
18 J E Penner, The Law of Trusts (8th edn, Oxford University Press 2012), page 19
19 Bristol and West Building Society v Mothew [1998] Ch 1 [16]; Breen v Williams (1996) 186 CLR 74 [137]
20 Bristol and West Building Society v Mothew [1998] Ch 1 [16]
21
J Kay, The Kay Review of UK Equity Markets and Long-Term Decision Making, Final Report (July 2012)
22 Ibid page 65
fiduciary duties and it depend on the functions they perform and the nature of client-intermediary
relationship. As per Daly v Sydney Stock Exchange Ltd23, those who provide financial investment or
related advice may owe fiduciary duties. Likewise; investment managers play a pivotal role in
institutional market and retail market and hence there is clear basis for them to owe fiduciary duties to
their clients. It was said that:
“It would be unusual for an investment manager acquiring and managing a portfolio of investments
under a formal management agreement not to owe duties of care and duties of a fiduciary nature to the
other party to the agreement.”24

The AIFMs handling the investments in the AIF are in a fiduciary relationship with the investors who
have invested in the AIFs. The principle that governs their fiduciary relationship is that of loyalty and
prudence; “the duty of loyalty”25. As even mentioned under Chapter III of the AIFMD26, it’s the duty of
the member states to ensure that at all times, AIFMs act honestly, with due skill, care and diligence and
fairly in conducting their activities. They are required to act in best interests of the AIFs or the investors
of the AIFs they manage and the integrity of the market27. They have to employ effectively the resources
and procedures that are necessary for the proper performance of their business activities28. Take all
reasonable steps to avoid conflict of interest and, when they cannot be avoided, to identify, manage and
monitor and, where applicable, disclose, those conflicts of interest in order to prevent them from
adversely affecting the interests of the AIFs and their investors and to ensure that the AIFs they manage
are fairly treated29 and treat all AIF investors fairly.

Critically examining the principle, one is of the view that it rests on the notion that their lies a legitimate
expectation that the fiduciary will carry out the trust judiciously and without a hinge of disloyalty. The
fiduciary principal says aloud that an undertaking acting on behalf on another has first and foremost
bound itself in a way to protect and advance the interest of another. This is perhaps the most evident
feature of the fiduciary office for Equity. The distinguishing duty of a fiduciary as governed by the
major principle is the duty of loyalty30. As Lord Justice Millett noted in Bristol and West Building
Society v Mothew:
“The principal is entitled to the single-minded loyalty of his fiduciary. This core liability has several
facets. A fiduciary must act in good faith; he must not make a profit out of his trust; he must not place
himself in a position where his duty and his interest may conflict; he may not act for his own benefit or
the benefit of a third person without the informed consent of his principal.”31

In the 1992 Consultation paper; the duty of loyalty was divided into four categories however one will
be considering the main theme of the paper here with respect to one primary category that highlights
the major fiduciary principal which AIFMs observe and apply to the management of the AIFs; as also
provided by the Directive32; “no conflict rule”33.

Analyzing the no conflict rule, one observes that a fiduciary must shun away from where there is a
conflict between his duty and his interest i.e. a duty-interest conflict. It further demands that also where
there is a conflict of interest between duties owed to multiple principals i.e. a duty-duty conflict, the
fiduciary should prudently handle the conflicting duties without giving precedence to one over the other.
By conflict it means the confrontation between a fiduciary’s non-fiduciary duties to their principal and
their personal interest or a conflict between a fiduciary’s non-fiduciary duties to one principal and their

23 Daly v Sydney Stock Exchange Ltd (1986) 160 CLR 371

24 Diamantides v JP Morgan Chase Bank [2005] EWCA Civ 1612 [27]
25 Ibid [18]
26 Directive (EU) 61/2011, ch III art 12 s (1)
27 Ibid s (1)(b)
28 Ibid s (1)(c)
29 Ibid s (1)(d)
30 Fiduciary Duties and Regulatory Rules (1992) Law Commission Consultation Paper No 124 para 2.4.1, in The Law

Commission, ‘Fiduciary Duties of Investment Intermediaries’ (2014

31 Bristol & West Building Society v Mothew [1998] Ch 1 [18]
32
Directive (EU) 61/2011, art 14
33 The Law Commission, ‘Fiduciary Duties of Investment Intermediaries’ (2014), page 41, para 3.30
non-fiduciary duties to another principal. A corollary of this rule is the no- profit rule that dictates that
a fiduciary must not make an unsanctioned profit by reason of the fiduciary office. As under the
obligations of the Directive, the member states are required to ensure that all AIFMs to take reasonable
steps to identify conflicts of interest that arise in the course of managing AIFs between the AIFM
including its managers, employees or any other person directly or indirectly linked to AIFM by control.
The member state is under obligation to ensure that there is no rising of any conflict of interest between
the AIF or the investors in that AIF34. AIFMs shall maintain and operate effective organizational and
administrative arrangements with a view to taking all reasonable steps designed to identify, prevent,
manage and monitor conflicts of interest in order to prevent them from adversely affecting the interests
of the AIFs and their investors35. AIFMs shall segregate, within their own operating environment, tasks
and responsibilities which may be regarded as incompatible with each other or which may potentially
generate systematic conflicts of interest. AIFMs shall assess whether their operating conditions may
involve any other material conflicts of interest and disclose them to the investors of the AIFs 36. Where
organizational arrangements made by the AIFM to identify, prevent, manage and monitor conflicts of
interest are not sufficient to ensure, with reasonable confidence, that risks of damage to investors’
interests will be prevented, the AIFM shall clearly disclose the general nature or sources of conflicts of
interest to the investors before undertaking business on their behalf, and develop appropriate policies
and procedures.37

There is a difference between the view taken up Professor Kay, setting out his aspirations in
Recommendations of the Kay Review, and that of the courts which tend to take a restrictive view.
Professor Kay observes that fiduciary standards should be independent of client classification and
should apply across the board whenever the investments fund dealers are exercising discretion over
investments of others no matter in what way; which is also reflective of the Government’s policy that
regulates equity markets. The courts on the other hand are reluctant to uphold every ordinary
commercial relationship bound by fiduciary principles. They tend to rely more on regulatory authority’s
regimes and where the intermediaries are bound by regulatory requirements such as the IFA’s duty of
care towards client38; the courts do incorporate and acknowledge that. Secondly, Prof. kay noted that
fiduciary duties should not be contractually overridden whereas the courts oblige contractual terms and
will rely on what contractual terms says about the duty owed by one party to the other39. Further, the
kay review suggests that the intermediary’s legal responsibilities should extend to the final consumer
and shouldn’t be just limited to the client. The courts again have parted themselves from the view as
they are reluctant in establishing duty of care beyond the immediate client40.
The existing state of law that governs the entire relationship of fund managers and their investors is in
a chrysalis. In June 2011, the Secretary of State for Business, Innovation and Skills asked Prof. kay to
review activity in UK equity markets and its impact on the long-term performance and governance of
companies. The review concluded that the problem of the UK equity market is short-termism and one
of the major reason is the decline of trust in the investment chain market 41. The current system is very
different from the one recommended by Prof. Kay. Judges can only decide cases relying on the
principles they are bound by. Courts only develop rules when encountered by a problem or else it’s
stare decisis. Courts can only provide financial redress, but the disruption caused in the market adds
cost and risk.

The purpose of having this entire principle to govern the overall domain of the Alternative Investment
Funds is to protect the investor. The protection from dishonest, unscrupulous and unprincipled
intentions of those managers who are bestowed with the authority to manage their life earnings. Europe
after the second world war was devastated and torn apart. The idea of establishing a customs union was

34 Directive (EU) 61/2011, art 14 s (1)

35 Ibid art 14
36 Ibid
37 Directive (EU) 61/2011, art 14 s (2)
38Rubenstein v HSBC Bank [2011] EWHC 2304.
39
The Law Commission, ‘Fiduciary Duties of Investment Intermediaries’ (2014), page 205, para 10.79
40
Caparo Industries plc v Dickman [1990] 2 AC 605
41
The Kay Review of UK Equity Markets and Long-Term Decision Making, Final Report (July 2012), page 9
primarily to achieve and bolster the rehabilitation process. The global world order has changed now.
The reasons for having such principles to govern the domain of asset management in alternative funds
to is protect the interest of the investor and to maintain his trust in the market. The fiduciary principle
that governs the conduct of AIFMs aims to build trust in the market and AIFMD provides confidence
building measures. The domestic governments and the EU must ensure that the principles as set out by
AIFMD should be incorporated and implemented in letter and spirit to get rid of problems that are
widening the trust deficit in the market.

CONCLUSION

An uncontrolled arena will result in unfettered corrupt practices which will lead to devastation of an
entire financial market resulting in a loss of confidence in the market thus affecting the Union. The laws
in operation, AIFMD in particular controls the way in fiduciaries utilize their powers. The purpose is
to ensure that nobody must exceed the scope of their power and must not exercise a power for an
improper purpose. Where they owe fiduciary duties, fiduciaries in the investment chain must avoid
conflicts and unauthorized profits by virtue of their fiduciary position. The law requires participants to
exercise reasonable care and skill. All participants in the equity investment chain should act according
to the principles of stewardship, based on respect for those whose funds are invested or managed, and
trust in those by whom the funds are invested or managed42. Relationships based and bolstered on trust
are everywhere more effective than trading transactions between anonymous agents as they promote
high performance of companies and securing good returns to savers; hence attracting more and more
investors because of the entrench and established confidence the market provides. Fund managers can
contribute more to the performance of business (and in consequence to overall returns to their savers).
It’s imperative that all players in the investment chain should observe fiduciary standards in their
relationships with their customers. Fiduciary standards ensure that the client’s interests are put first,
conflict of interest is avoided, and direct or indirect costs of services provided should be reasonable and
disclosed. These standards should not require, nor even permit, the agent to depart from generally
prevailing standards of decent behavior. Regulatory authorities at EU and domestic level should apply
fiduciary standards to all relationships in the investment chain which involve discretion over the
investments of others, or advice on investment decisions. These obligations should be independent of
the classification of the client and should not be capable of being contractually overridden43.

42 The kay review of UK Equity Markets and Long-Term Decision Making, Final Report July 2012, Principle 1, page 12
43 Ibid, Recommendation 7, page 13
Bibliography

Primary Sources

Cases

Bristol and West Building Society v Mothew [1998] Ch 1 [16]

De Busshe v Alt (1878) 8 Ch D 286

Kirkham v Peel (1880) 43 LT 171

Daly v Sydney Stock Exchange Ltd (1986) 160 CLR 371

Diamantides v JP Morgan Chase Bank [2005] EWCA Civ 1612

Breen v Williams (1996) 186 CLR 74 [137]

Lamb v Evans [1893] 1 Ch 218

Caparo Industries plc v Dickman [1990] 2 AC 605

Price v Blakemore (1843) 6 Beav 507

McMaster v Bryne [1952] 1 All ER 1362;

Conway v Ratiu [2005] EWCA Civ 1302

Rubenstein v HSBC Bank [2011] EWHC 2304.

Farrars v Farrars Ltd (1888) 40 Ch D 395

Sinclair v Brougham [1914] AC 398;

Item Software (UK) Ltd v Fassihi [2004] EWCA 1244

EU Legislation

DIRECTIVE EU 61/2011 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 8 June 2011 on
Alternative Investment Fund Managers and amending Directives EC 41/2003 and EC 65/2009 and Regulations
(EC) No 1060/2009 and (EU) No 1095/2010
< https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex%3A32011L0061> accessed 14 April 2018

Secondary Sources

Books

Penner J E, The Law of Trusts (8th edn, Oxford University Press 2012) 19

Command Papers and Law Commission Reports

Invest Europe: ‘2016 European Private Equity Activity. Statistics on Fundraising, Investments & Divestments’
<https://www.investeurope.eu/media/651727/invest-europe-2016-e’uropean-private-equity-activity-final.pdf.>
accessed 11 April 2018
Europe Economics: ‘Evaluation of the Alternative Investment Fund Managers Directive’
<https://www.investeurope.eu/media/698210/Europe-Economics-Final-Report-On-AIFMD-Dec-2017.pdf>
Accessed 12 April 2018

SLAUGHTER AND MAY: ‘The Alternative Investment Fund Managers Directive: A tolerable compromise?’
<https://www.slaughterandmay.com/media/1490545/the-alternative-investment-fund-managers-directive-a-
tolerable-compromise.pdf > accessed 11 April 2018

The Kay Review of UK Equity Markets and Long-Term Decision Making, Final Report July 2012, ch 9 para 9.1
<http://www.ecgi.org/conferences/eu_actionplan2013/documents/kay_review_final_report.pdf >
accessed 14 April 2018

The Law Commission: ‘Fiduciary Duties of Investment Intermediaries’ (2014) Ordered by the House of
Commons, available at:
<https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/325508/41342_HC_368_LC350
_accessible.pdf>
accessed 14 April 2018