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Steven Maijoor, chairman, Esma

Industry battles to cope with tsunami of new rules

So massive is the wall of regulation rushing toward the investment industry as a whole that regulators themselves are struggling to keep up. In February the European Securities and Markets Authority published its latest contribution to fleshing out the European Union’s Alternative Investment Fund Managers Directive, a discussion paper on key concepts of the directive designed to help it draw up technical standards.

Sometime between now and July 22, 2013, Esma and the European Commission will have to finalise not only these technical standards and other guidance on how to interpret the directive but the so-called Level 2 measures, pieces of legislation and regulation that should set out detailed implementation rules for a law whose vagueness and lack of clarity in certain areas reflects its chequered drafting and approval history.
In the meantime industry members and European bodies will be grappling with other legislative measures, including the second Markets in Financial Instruments Directive (MiFID II), which will have an impact on the investment management sector, perhaps in particular affecting the eligibility of investors in Ucits that follow alternative investment strategies.
Discussions on MiFID II are examining whether the revised directive should remove the automatic assumption that all Ucits are non-complex products. The implication for Ucits funds deemed to be complex is that they would no longer be eligible for execution-only sales and that potential investors would need to meet an appropriateness test. This might have implications for the distribution of Ucits not only in Europe but in growing markets across Asia, Latin America and the Middle East.
Cost of inadequate supervision
“More and more complex products, such as those involving hedge fund strategies, are entering the Ucits framework,” Esma chairman Steven Maijoor (pictured) told delegates to the spring conference organised by the Association of the Luxembourg Fund Industry in March. “The issue of whether Ucits are complex or non-complex needs to be addressed from the investor side. Are we really certain that internally-complex products are simple to investors under all scenarios?”
During an at times lively discussion Maijoor was challenged by Claude Kremer, chairman of the European Funds and Asset Management Association (Efama), on whether overregulation might drive business out of Europe. “We are in favour of adequate regulation, but not all regulation is adequate and appropriate,” Kremer declared.
Maijoor’s riposte: “Most regulatory reform is focusing on the banking industry. Will it kill banks? Light-touch regulation already did that to some banks.” He added: “There is a short-term cost to the industry, regulators and finance ministries, who are all parts of the chain, but the cost of not having the right kind of supervision is enormous. If we really think regulation is needed for investor protection, there can never be an argument for lower standards. Lower regulation may bring a short-term benefit over one, two or even five years, but in the long term there will be a price to be paid.”
The fund industry has to worry not only about measures that affect it directly but legislation whose indirect effects could be just as significant. For example, the EU’s revised Taxation of Savings Directive, should member states reach agreement on it, will potentially bring many more types of fund, as well as different types of non-individual investor, within the scope of exchange of tax information arrangements, although this is something the industry has already been coping with for several years.
The Solvency II Directive, governing capital requirements for institutions such as insurance companies and pension schemes, will not impact the fund industry directly but could affect the extent to which such institutions can invest in hedge funds. There’s also the proposed EU Financial Transactions Tax, although the industry is doing all it can to fend that measure off, arguing that in the absence of agreement on co-ordinated application of comparable measures worldwide, it will simply cause fragmentation of global markets.
According to Alfi director-general Camille Thommes, had such a tax been in force last year, it would have cost the Ucits industry no less than EUR38bn – EUR15bn on subscriptions and redemptions and EUR23bn on the purchase and sale of securities. “That is assuming an annual portfolio turnover of 1, but turnover within money market funds, which invest in short-term instruments so have to reinvest much more often, is 6.5 times. The Financial Transactions Tax would kill the money-market fund industry.”
Perhaps it will not come to that. Luxembourg is lined up with countries including the UK and Sweden in opposing the tax within the EU Council, although the union’s political heavyweights, Germany and France, are its strongest backers. Alfi and other fund industry bodies hope that the Commission will succeed in finding alternative possibilities less damaging to broad swathes of Europe’s financial industry.
Ongoing debate on Fatca compliance
All this is before considering the consequences of regulatory and other measures emanating from the United States but with extraterritorial effect. The highest-profile measure on the horizon is the Foreign Accounts Tax Compliance Act, or Fatca, which will oblige foreign financial institutions to report income received by US citizens or residents to the Internal Revenue Service on pain of seeing a 30 per cent withholding tax levied on their US-source income.
In February the US unveiled details of how Fatca is intended to function. It also announced an agreement in principle with the UK, France, Germany, Italy and Spain that would allow banks and other financial firms in those countries to report on investments by US persons to their home government rather than to the IRS. This would circumvent any restrictions on communication of client information and possibly simplify the reporting process.
Although Luxembourg and Ireland, as Europe’s leading fund jurisdictions, have also expressed interest in similar deals, KPMG Luxembourg partner Georges Bock says the advantages are perhaps not quite as evident as they first appeared, since countries going down this route will have to adopt some form of Fatca legislation into their national law.
In addition, investment groups with operations in multiple countries would have to strike agreements with the national tax authorities in all those countries. In the end, dealing with the IRS alone might be simpler. But for all the ongoing discussions about how compliance might be eased, industry members accept that there is no likelihood of Fatca going away.
Less widely reported than the Fatca discussions are the efforts being made by organisations such as Efama to persuade the US authorities to make changes in the way the Volcker Rule, designed to curb proprietary trading and sponsorship of alternative funds by federally-protected banks, would apply to asset managers and others elsewhere in the world.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, under whose aegis the Volcker Rule was introduced, also requires non-US hedge fund managers with 15 or more US investors to register with the Securities and Exchange Commission, in many cases on top of being regulated at home.
At least hedge fund regulation and oversight by the SEC appears relatively straightforward, if burdensome; Europe’s AIFM Directive is something else altogether. It’s now nearly three years since the first draft of the legislation was published by the Commission, in April 2009; it took a further 19 months, until November 2010, for the European Parliament and EU Council (the member states) to iron out a compromise on a number of contentious issues and agree the final shape of the text; and it was not until June last year that a legally and linguistically revised version could be translated into the EU’s official languages and formally signed. It was published in the EU Official Journal on July 1, 2011 and came into force on July 21.
Adding detail to the AIFMD framework
Passage of the primary legislation is only the first stage of implementation, however, for a European law that is harmonising for the first time the activities of alternative fund managers operating or marketing their products within Europe. In addition, to facilitate winning approval from the EU’s legislative bodies it skated over some awkward topics, including the modalities of how non-EU managers and funds could obtain access to the post-AIFM Directive European market, with vague language that could somehow be firmed up later.
That job is down to the Commission and Esma, and the latter body – the Committee of European Securities Regulators given institutional form at the beginning of 2011 – has won at least grudging praise from industry members that initially feared an instinctive distrust of alternative funds as a species and a readiness to embrace regulation for its own sake.
Practitioners generally give the authority good marks for listening to their concerns, but the task for industry members and regulators alike to prepare for the implementation of the directive not much more than a year away remains herculean. An important step was achieved last November when Esma sent its advice on level 2 measures, a numbing 500 pages, to the Commission for consideration.
The proposed rules – drawn up in response to a 2010 request originally sent to Esma’s predecessor, Cesr – took into account industry feedback received by Esma in response to two consultation papers, published last July and August. However, the Commission indicated in November that it remained open to further input from the industry and other stakeholders before it finalised the rules in the second quarter of this year – ironic in the light of the complete lack of consultation before the original proposal was unveiled three years ago.
A key aspect of Esma’s advice covers an issue widely viewed as inadequately dealt with in the primary legislation: seeking to clarify the duties of depositaries to alternative investment funds, such as monitoring funds’ cash flows, defining what kind of assets need to be held in custody and which do not, and as a corollary defining the circumstances in which assets held in custody can be deemed to be lost and the consequences thereof for custodians and investors. This appears to be the principal area in which the Commission is thought likely to produce final rules more stringent than those proposed by Esma.
Co-ordination with MiFID and Ucits rules
The advice also adds detail to the framework under which third-country firms and managers will be able access European investors, both before and after the AIFM Directive’s marketing ‘passport’ is due to be extended to non-EU firms and funds in or after mid-2015. But questions about the central issue of how co-operation between EU regulators and their counterparts outside the union should be formalised and details of what it should entail still need further work.
The first part of the advice, covering general provisions for managers, authorisation and operating conditions, clarifies how the asset thresholds determining whether a manager is subject to the directive will operate, and how managers should cover risks arising from professional negligence through the holding of additional capital or insurance. In many cases rules in areas such as conflicts of interest, recordkeeping and organisational requirements are based on equivalent provisions of the MiFID and Ucits legislative frameworks.
The second part of the advice proposes a framework governing depositaries of alternative funds, include the criteria for assessing whether the prudential regulation and supervision applicable to a depositary established in a third country has the same effect as the provisions of the directive.
In response to protests from industry bodies such as the Alternative Investment Management Association (Aima), Esma dropped the nebulous concept of ‘equivalence’ of third-country regimes with the directive’s provisions, which had already been discarded during the process of finalising the primary legislation, in favour determining whether measures in such jurisdictions have “the same effect” as those within the EU. It has also proposed criteria such as the independence of the financial regulator, eligibility requirements for organisations seeking to act as a depositary, and the existence of sanctions to punish violations.
A particularly thorny issue is defining the circumstances under which a financial instrument held in custody should be considered as lost and determining whether a depositary is required to return an asset or its value. Esma has proposed that an asset should be considered lost if financial instruments supposedly owned by a fund either cease to exist or are found never to have existed, if the fund has been permanently deprived of its ownership rights over the instruments, or if it is permanently unable to dispose of the instruments.
The document also aims to clarify what constitutes external events beyond the reasonable ability of the depositary to control or protect against, and the reasons that would justify allowing a depositary contractually to discharge its liability to make restitution of the assets.
A central focus of the directive is preventing or mitigating systemic risk. Esma’s advice clarifies the definition of leverage, how it should be calculated and whether a regulator should be able to impose leverage limits on a particular manager, prescribing two standard calculation methodologies, the commitment and gross methods, and a further option, the advanced method, which can be used by managers on request.
Time runs short for regulatory co-operation
Esma has added detail on the form and content of information to be reported to regulators and investors, and the information to be included in a fund’s annual report.
Regarding the regulatory co-operation and exchange of information arrangements required to allow non-EU funds or funds from non-EU managers to be marketed in Europe, Esma proposes the institution of written agreements allowing for exchange of information for both supervisory and enforcement purposes.
Agreements should be signed by the European regulators concerned and the third-country regulator of the manager and/or fund, which could take the form of a multilateral memorandum of understanding centrally negotiated by Esma. The detailed content of the co-operation arrangements could take into account international standards, notably the Iosco Multilateral Memorandum of Understanding on co-operation for enforcement purposes and the Iosco Technical Committee Principles for Supervisory Co-operation.
But exactly how this will operate remains vague, and concern is growing within the industry that time is growing dangerously short. For example, co-operation arrangements need to be in place by July 2013 covering the oversight of non-EU service providers to funds that will be already eligible for pan-European distribution under passporting rules. There is more time to finalise arrangements with regard to passporting arrangements for managers and/or funds domiciled in non-EU jurisdictions, which will not come into force for at least a further two years.
While the Commission ponders Level 2 measures, Esma has moved on to the task of drawing up technical standards. A discussion document published in February on key concepts of the AIFM Directive has launched a consultation process designed to produce a harmonised interpretation of these concepts by Europe’s national regulators.
In the light of responses to the paper, it plans to issue a consultation paper during the second quarter setting out draft technical standards. The standards are due to be submitted for endorsement to the Commission by the end this year.
Defining alternative managers and funds
What is an alternative investment fund manager? That is one of the questions Esma seeks to answer: Article 4(1)(w) defines the activity of managing alternative funds as performing at least portfolio management or risk management functions, and argues that therefore an entity performing either functions should be considered as managing a fund, and thus require authorisation as an alternative fund manager under Article 6 of the directive, unless the function is carried out under a delegation arrangement with an alternative manager.
However, Esma says Article 6(5)(d) should be interpreted as requiring a manager to be capable of providing, and take responsibility for, both portfolio management and risk management functions in order to be authorised under the directive, but it can outsource either or both of these functions in line with the delegation rules in Article 20 of the directive and the forthcoming Level 2 measures to be announced by the Commission.
The manager’s liability is not affected by delegation (or further sub-delegation) of portfolio and/or risk management functions to a third-party entity. Esma says these functions may not be delegated to such an extent as to make the manager effectively a letterbox entity that can no longer be considered as manager of the fund in question. Thus a manager may delegate either or both portfolio and risk management in whole or in part, but it may not delegate both functions in whole simultaneously.
The paper also attempts to clarify what is an alternative investment fund. Article 2(3) seeks to define entities that fall outside the scope of the directive, notably holding companies, although Esma cautions that the holding company exemption should not be used by private equity firms as a means of circumventing the directive.
Article 3 lists entities that would fall under the scope of the directive were they not exempted, such as managers of funds whose sole investors are themselves, their parent companies, subsidiaries or affiliates, as well as family office and similar private investment vehicles, insurance contracts and joint ventures. Esma is now seeking feedback from stakeholders on whether in further clarification of these notions and expressions such as “investing the private wealth of investors without raising external capital” is necessary.
The authority has identified six categories of alternative fund: those that invest in similar assets as Ucits funds but do not meet the regime’s diversification or leverage rules; those that invest in assets not eligible for Ucits; private equity funds; venture capital funds; real estate funds; and ‘alternative alternatives’ vehicles including commodity funds.
More questions than answers?
Rather than asset classes or on investment strategies, Esma proposes that the criteria for determining what constitutes an alternative investment fund should include capital-raising that involves at least some kind of communication between the entity seeking capital or its representatives and prospective investors; collective investment that seeks to generate a return from pooling investors’ capital; the absence of any rule limiting the sale of shares or units to a single investor; a fixed, defined and communicated investment policy; the fund rather than the investors owning underlying assets; and the manager’s responsibility for managing those assets.
How some parts of the directive will apply depends on different characteristics of funds, such as whether they are open-ended or closed-ended, internally or externally managed, whether they employ substantial leverage and or whether or not they use a prime broker. Hence the need to define open-ended funds: those, Esma suggests, whose units or shares may, at the holder's request, be repurchased or redeemed without any limitation, directly or indirectly, at least annually. Esma will tackle the question of what constitutes an alternative fund “of significant size” when it drafts guidelines on sound remuneration policies.
Other questions include how to determine the designated manager of an alternative fund when there is more than one possibility; the treatment of Ucits management companies (which currently can also manage alternative funds as well as Ucits, but once the directive comes into effect will need a second authorisation); and the position of MiFID-authorised financial services firms and credit institutions, which according to Esma should continue to be able to provide portfolio management services to alternative funds under delegation arrangements, but not as the appointed manager.
Not everyone in the industry is convinced of the value of the discussion paper. “It leaves more questions than answers,” says Marie-Elisa Roussel-Alenda, an assurance partner and Luxembourg AIFMD leader with PricewaterhouseCoopers. “The paper has not added value. It’s still unclear what constitutes a fund under the AIFM Directive.”
Roussel-Alenda notes that the Commission is due to deliver its draft Level 2 legislation in March and to adopt the subsidiary directives or regulations – it’s not yet clear which, or whether the measures will be a combination of the two – by July. “There is substantial agreement between the Commission and Esma on the content, but there may be changes regarding the role of the depositary,” she says. “The Commission felt Esma didn’t go far enough on the scope of assets that must be held in custody. It believes that OTC derivatives and collateral posted by funds should be included.”
The sheer extent of the areas still to be completed, especially if the Commission were to adopt Level 2 measures as directives (which must be separately incorporated into the national legislation of member states) as opposed to regulations (which take effect automatically) raises doubts about how the legislation can be implemented by the July 22, 2013 deadline – especially given the example of Ucits IV.
So many EU member states failed to meet the July 1, 2011 deadline for adoption that Esma was obliged to draft guidelines on the legal and regulatory implications of funds from countries that had implemented the directive being marketed in countries that had not. It is easy to conceive of a similar situation arising regarding the passport distribution of alternative funds from one member state into another.
Seeking first-mover advantage
Luxembourg at least is planning to be ready on time. Earlier in March the country’s parliament approved legislation amending the law on Specialised Investment Funds, nearly 1,200 of which (with EUR259bn in assets) have been established since the regime was created in February 2007. The revised law includes various measures that will bring aspects of the SIF regime into line with the AIFM Directive, including risk management rules to be spelled out in detail by a forthcoming circular from the industry regulator, the Financial Services Supervisory Authority (CSSF).
The EU directive will still have to be formally transposed into Luxembourg law, though, and following extensive consultation between industry members, the government and the CSSF, the country’s overworked parliamentary draftsmen are due to produce a bill to be laid before the Chamber of Deputies before the end of June, according to Claude Niedner, a partner at law firm Arendt & Medernach.
Luxembourg is hoping that its promptness in getting the legislation in place – although it is likely to be emulated by rival EU fund jurisdictions Ireland and Malta – will give it a first-mover advantage in attracting funds and management companies set up by managers outside the EU, which otherwise will have to wait until mid-2015 at the earliest before gaining accessing to a marketing passport.
According to Niedner, a working party has also been examining the opportunity to introduce other changes that would broaden Luxembourg’s attraction as an alternative fund domicile and servicing centre, including creating additional forms of legal vehicle. These comprise notably a partnership structure suitable for private equity and property investment, a fund vehicle similar to a real estate investment trust, and a carried interest structure.
And industry members concede that not all the new regulation coming out of Brussels is unwelcome, especially if the EU delivers on its promise of creating a level playing field for financial services across the continent, as Peter Moore, head of regulation and compliance at IMS Group, winner of the Hedgeweek Global Award for Best European Regulatory Advisory Firm, acknowledges.
Moore says one of the more positive impending regulatory developments in Europe is the harmonised short-selling regime. “From November 1, 2012, the answer to the question of how the short-selling regime in Latvia compares with that of the UK will be that it’s the same,” he says. “That’s a good thing. The other hidden positive is the possibility that Esma will actually reduce the number of short-selling measures.” Never say never.
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