Nearly two years after the bankruptcy of Lehman Brothers brought home to the global financial industry the seriousness of the crisis that unfolded from the collapse of the US sub-prime mortgage market, the shape of the regulatory environment drawn up as a response to the past three years of turbulence is now taking shape, for better or worse. A major step came on July 21 with the signing into US law of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
For the alternative asset management sector in particular the Dodd-Frank Act, which covers a vast swathe of financial sector activity, promises significant changes in the way firms operate and are regulated. Few of the measures have been greeted with any great enthusiasm, but by and large there is acceptance in the US that this is the price required to restore confidence in the financial industry and that most investors support rules designed to introduce greater oversight and transparency in a previously loosely regulated and opaque part of the market.
Many managers from outside the US, especially in Europe, are likely to face double regulation as a result of the new measures, but this may be least of their worries. After well over a year of debate, the endgame is approaching for the European Union’s Alternative Investment Fund Managers Directive as the EU’s convoluted legislative process attempts to forge a definitive text out of two (maybe three?) conflicting and in some respects incompatible draft versions. A final decision might come as soon as September – but the legislators have missed plenty of deadlines already.
However, while US alternative investment firms has long accepted the inevitability of coming within the regulatory ambit of the Securities and Exchange Commission or state regulators, their counterparts in Europe are considerably less sanguine about many of the proposals embodied in drafts of the AIFM Directive, including notably measures that would regulate how – or whether – managers and funds located outside the EU could access investors within the 27-nation bloc.
“The two versions [of the directive] approved by the European Council and the European Parliament are strongly at variance with each other in important areas,” says Andrew Baker, chief executive of the Alternative Investment Management Association. “We have issues around leverage, remuneration, use of depositaries and the scope of the directive around valuation and the ability to delegate sub-management in and out of the EU. All those issues remain unsatisfactory. But the most contentious issue relates to third-country access.”
This unresolved question, Baker notes, affects a broad cross-section of the industry ranging from EU-based managers that run funds domiciled in offshore jurisdictions such the Cayman Islands, British Virgin Islands and Bermuda, as well as the UK’s Crown Dependencies, to any manager based in a country or territory outside the EU such as Switzerland, the US, Hong Kong and Singapore.
The uncertainty is already prompting managers to examine other ways of structuring their business. Some are setting up new funds using structures designed for sophisticated investors in the two main hubs for fund domicile and servicing within the EU, Ireland and Luxembourg, as well as the up-and-coming financial services centre of Malta. A few are examining the redomiciliation of existing offshore funds to a European jurisdiction.
Rather more are seeking to circumvent the possible impact of the AIFM Directive by packaging hedge fund strategies within fund structures that comply with the EU’s series of directives on Undertakings for Collective Investments in Transferable Securities (Ucits), which govern funds that can be registered (relatively) freely for sale to the general public anywhere in the EU once they have been authorised in one member state.
At least the US regulatory changes offer the merit of certainty. The Private Fund Investment Advisers Registration Act of 2010, part of the Dodd-Frank legislation, will greatly broaden the requirement to register with the SEC among investment advisers to private equity, venture capital, real estate, hedge and other alternative funds, many of which previously benefited from an exemption to the registration requirement under the Investment Advisers Act of 1940.
Says US law firm Goodwin Procter: “The private adviser exemption is available to an investment adviser with fewer than 15 ‘clients’ that does not hold itself out generally to the public as an investment adviser and does not advise mutual funds or business development companies. Many private equity, venture capital, real estate, hedge and other private fund managers have been able to rely on the private adviser exemption because they count the funds that they manage as clients rather than counting the investors in those funds.”
The SEC attempted to close this loophole in December 2004 by introducing a new rule that would require investment advisers to count individual investors rather than funds in calculating their number of clients, but in June 2006 the rule was overturned by a US appeal court that decided the regulator had exceeded its powers and misinterpreted the law. The new legislation simply eliminates the private adviser exemption, although it introduces others, such as advisers to (as yet undefined) venture capital funds or private funds, and (also undefined) family offices.
The Registration Act sets thresholds that determine whether investment advisers should be regulated by state financial supervisors or the SEC, which generally is responsible for regulating managers of assets exceeding USD100m. The legislation also redefines what constitutes a private investor accredited to invest in sophisticated funds as an individual or couple with a net worth of at least USD1m excluding their primary residence.
The new rules will restore the obligation on many non-US managers of funds with US investors to register with the SEC, as happened temporarily in 2004. According to consultancy Kinetic Partners, in addition to regular filings this will involve require measures such as developing a compliance manual, code of ethics and policy on personal investment dealings by employees for their own account, setting up a monitoring programme that meets with SEC requirements and industry best practice, an annual review and testing of the compliance programme, and annual compliance training. Managers must register with the SEC within a year of the passage of the legislation.
In order to be exempt from the requirement to register with the SEC, a non-US asset manager will have to meet all of a series of criteria: it must have no place of business in the US, have fewer than 15 US-based clients and investors in the hedge funds or private equity funds they manage, have less than USD25m in aggregate assets under management attributable to US clients, and not hold itself out generally to the US public as an asset manager.
“The expanded authority of the SEC will have a far reaching effect on the alternative investment industry, both in the US and in Europe,” says Kinetic Partners member Andrew Shrimpton. “Not only will asset managers who handle significant assets in the US now be required to register, they will also be faced with more onerous compliance and monitoring obligations. Managers in the UK and Europe need to consider whether they are obliged to register with the SEC and respond appropriately to the heightened scrutiny and new demands.”
The prospect of being caught up in the US regulatory net is an added complication for managers with a global investor base that are already grappling with how to respond to the requirements of the AIFM Directive once it has been finalised. Baker cautions that alternative investment firms would be ill advised to take hasty decisions about changes of domicile or fund structure, with the legislation not yet agreed and the actual implementation date still a long way off.
“It is too early to do anything like changing business model, moving jurisdiction or even closing down,” he says. “Even if the legislation were passed tomorrow, there would still be a two-year transposition period. That means that in the very worst of outcomes, there will be two years to do something about it. Whatever decisions you were going to take before this started, you should stick with those decisions until we have greater clarity.”
Baker was a speaker at a recent networking evening organised by fund administrator Ifina at BVI House, the London office of the government of the British Virgin Islands, bringing together fund managers and other members of the industry. The discussions focused extensively on the AIFM directive and the outlook for jurisdictions outside the EU, which fear that the introduction of measures widely viewed as protectionist will ultimately damage the industry worldwide.
“We could end up with a bloc of European investors and European managers,” he says. “If the EU starts kicking away the foundations of global capital flows, it will affect global markets. For example, any thoughts that what the EU is doing represents an opportunity for Asian countries to take advantage of what looks like a European own goal have quickly been dispelled. The Asians see it as nothing but a threat because of the risk of fragmentation of the markets into regional blocs, which would be a severely retrograde step.”
The current deadlock has arisen because in May the EU’s Council of Economic Affairs and Finance Ministers approved one version of the directive while the Economic and Monetary Affairs Committee of the European Parliament adopted another version. Representatives of the Parliament and of the Council, which represents EU member states, together with the European Commission, which – officially at least – is still backing the original, much derided draft it produced in April 2009, are currently involved in a process known as a trialogue to reach a compromise on the final version of the legislation.
Notes Baker: “The Lisbon Treaty gave equality of treatment between the Parliament and the Council in such negotiations. This is one of the first directives to go through under the terms of the Lisbon Treaty, so we’re interested to know what equality of treatment between the negotiating positions of the Parliament and the Council actually means.”
The biggest difference between the two versions concerns the treatment of funds and managers based outside the EU. The Council essentially is prepared to keep, with some modifications, the present system under which offshore funds are currently sold to institutional and other sophisticated EU investors via private placement arrangements, under rules laid down by each member state for its own market.
The Parliament rejects this approach as protectionist and would like to see the establishment of a European ‘passport’ for sophisticated funds, similar to the system in place for retail Ucits funds. Non-EU funds would be able to obtain a passport, allowing free access to European markets, as long as the jurisdiction in which they were domiciled was certified as meeting the same standards as EU countries in areas including regulation, reciprocal market access, anti-money laundering controls and exchange of tax information.
But there is as yet no mechanism in place for the passport, and the EU regulatory body that would oversee it, the planned European Securities and Markets Authority, does not yet exist. Many industry members fear that many existing offshore funds might be shut out of the EU if the jurisdictions in which they are domiciled are deemed not to meet European standards. And the legislation is equally vague about how managers based outside the EU could gain certification that they were subject to equal regulation.
“If the Council version gets through, that could be OK,” Baker says. “We can probably live with that. There’s a big question mark about what co-operation arrangements between regulators would look like – there are none in place today. The memorandums of understanding that regulators have already put in place are to assist with misconduct and fraud investigations, and do not relate to information-sharing.
“But the parliamentary version has gone down a much more dirigiste path and contains some extremely onerous restrictions that could reduce investor choice. If third-country managers or offshore fund domiciles cannot satisfy certain criteria, EU investors will not be permitted to invest with funds or managers from those jurisdictions. This version raises the spectre of an outright investor lockout, which is not in the interests of European investors and certainly not in the interests of the European asset management industry. It would leave the industry having to struggle very hard to continue to exist in its current form.”
The BVI, along with its Caribbean near-neighbour the Cayman Islands, is one of the jurisdictions in the firing line if the industry’s worst fears come to pass, but Sherri Ortiz, executive director of the BVI International Financial Centre, the government-sponsored body that promotes the territory’s financial sector, is relatively confident that the jurisdiction can meet any equivalency standards the EU imposes.
“Many of the islands’ fund practitioners are convinced we can meet the forthcoming regulations,” Ortiz says. “First, from every account the BVI can quite easily meet the level of regulation that will be required. Then once it has passed, the legislation will take at least another two years before it comes into full effect, which gives the BVI and any other country an opportunity to get its ducks in a row. However, for the most part we have already met the requirements that are currently mooted in order for funds to obtain a passport.”
Nevertheless, even offshore jurisdictions that are ready to meet international standards are concerned about the implications of being constantly under pressure to adapt to rules they have little or no influence in shaping. This is not just about the Organisation for Economic Co-operation and Development’s initiative on harmful tax practices, a process in which offshore territories have now been invited to participate actively, but earlier episodes such the EU Taxation of Savings Directive, which was all but forced on dependent territories of EU states and certain completely independent third countries. Where will this end, they ask.
Switzerland, which gave birth to the first fund of hedge funds more than half a century ago and whose managers today account for almost a third of the global alternative fund of funds business, also has a strong interest in seeing the creation of a level playing field in the European marketplace. Matthäus den Otter, chief executive of the Swiss Funds Association, reminded participants at the BVI House event that the country has always taken a liberal stance because it is in the interests of its wealth management industry for clients to enjoy access to the funds that best suit their investment goals, regardless of their domicile.
“More than 6,000 foreign-based funds are admitted for sale in Switzerland, compared with 1,300 Swiss-domiciled funds,” he notes. “We are a fund-importing country, although a large proportion of the 6,000 foreign-based funds have been set up by Swiss banks in other countries, from where they re-import them. Our view on the AIFM Directive is that everyone who wants to serve the European institutional investor, as long as they have sound business principles, investor protection, quality and solid regulations, should have the chance to be part of this market.
“Of course, third countries like Switzerland cannot expect to be treated like EU member states, but at least treatment similar to that under the Ucits directive would serve our industry very well. Moreover, EU professional investors should not be restricted in their choice of fund managers and products. If they have access to the most suitable products, we will all benefit in the end. I don’t think we are asking too much when we say that the AIFM Directive as it stands does not offer better protection for investors within the EU. Right now we are working to rebuild trust in our industry, but we do not think the current thrust of the directive is the right way to achieve this.”
Den Otter acknowledges that there is a limit to what his organisation, or indeed the Swiss government, can do to influence the EU’s deliberations, especially at this late stage. “We are conscious of being a non-EU member and we cannot do more than bring up arguments that we believe are sensible,” he says. “We want to do everything we can contribute toward investor protection, sound business principles and quality. But we shouldn’t be excluded from servicing our customers in the EU just because we are not a member state.”
If the deadlock in the trialogue negotiations is broken, a vote on the directive in the European Parliament could come in September, keeping the directive on course for final approval at the beginning of next year. And there have been tantalising although as yet unconfirmed hints that a compromise could be gaining favour that would slice through the Gordian knot represented by the third-country access issue.
The mooted compromise would allow third-country managers and funds to seek access to European markets through an equivalency certification and a passport if they wished and the regulatory and legal framework of their home jurisdiction allowed, but leave open the option of continuing to distribute their funds to qualifying EU investors through private placement arrangements and country-by-country approval.
That would beg the question of why the EU’s various decision-making bodies have spent more than a year wrestling with this issue. Says Baker: “If we go back to the status quo, what have we been doing for the past 12 months? While Rome burns, who’s been fiddling?” But many industry members would probably settle for a solution, however imperfect, that does not slam the doors of a Fortress Europe shut, leaving the rest of the world’s managers and funds outside.