By Simon Gray – After more than 18 months of often-heated debate and a succession of drafts, frequently in contradiction with each other, in a process that sought to reconcile strongly-held opposing positions, European Union economic affairs and finance ministers and then the European Parliament finally agreed last November on a (nearly) final version of the Directive on Alternative Investment Fund Managers. The directive is now set to take effect around mid-2013 after being incorporated into the legislation of EU member states.
The eventual outcome has left many of the participants dissatisfied to a greater or lesser extent. Industry members believe that even after extensive changes to remove some of the most damaging or least practical provisions, the directive still fails to take into account sufficiently the specific nature of different types of alternative fund. Meanwhile, critics of the hedge fund industry argue that it fails to rein in the industry effectively and that managers will easily be able to skirt its provisions.
However, there is a broad consensus that the changes made during the drafting and negotiating process have resolved many of the more controversial aspects of the legislation and produced a text that all sides can live with – subject, of course, to the detail that must now be added in subsidiary legislation and regulations by the newly-minted European Securities and Markets Authority (Esma), successor to the Committee of European Securities Regulators, in association with the European Commission.
Most importantly for the industry, the directive will offer non-EU-based funds and managers the opportunity to benefit from its ‘passporting’ provisions for the marketing of products to sophisticated investors throughout the 27-member union, albeit two years after EU managers with funds also domiciled in Europe. The extension of the passport regime is likely to lead to the abolition of private placement distribution arrangements under national rules, but not before at least five years after the directive takes effect in 2013, and subject to certification that a level playing field exists for managers and funds whether inside or outside the EU.
The final version also gives European sophisticated investors freedom – for now, at least – to invest on their own initiative with whichever managers they choose, and dilutes slightly the new responsibility laid on fund depositaries for the loss of assets in their custody, by allowing them to pass on liability to a sub-custodian. At one point it appeared that custodians would be subject to strict liability for losses by funds they serviced, whether or not they were in any position to observe or prevent the wrongdoing or negligence responsible.
Overall, the final compromise on the legislation has been met with widespread relief by members of the alternative investment fund industry, and also by investors. In combination with other legislative changes elsewhere in the world, it has contributed to greater certainty by providing a clearer picture of the future regulatory landscape in which managers, service providers and investors will have to operate. In addition, to some extent the directive formally enshrines in written rules practices on which investors are now insisting in the wake of the recent financial crisis, or that managers have already adopted.
Management of systemic risks
The starting point for the directive is that managers of alternative funds are responsible for a significant volume both of invested assets in Europe and of trading in markets for financial instruments, and therefore can exercise a significant influence on markets as well as on companies in which they invest.
The preamble to the legislation argues that the recent crisis has shown how alternative managers can spread or amplify risks through the financial system, and that efficient management of these risks is difficult through unco-ordinated national responses. While the accuracy of this assertion is widely contested throughout the industry, members are resigned – as in the US – to broader and more burdensome regulation as an inevitable part of the fall-out from the financial crisis.
The legislation aims to establish common authorisation and regulatory requirements for alternative managers and create a coherent approach to the management of systemic risks as well as the impact of alternative funds on investors and markets within the EU. It aims to address risks to investors, markets and other participants through comprehensive and common supervisory arrangements.
The authors of the directive, which applies to all types of fund not covered by the Ucits directives governing cross-border retail funds, say it seeks to take into account the variety of investment strategies, techniques and assets employed by the diverse managers covered by the directive. Whether the legislation has succeeded in this ambition is a matter of considerable debate as well.
The directive creates a single European internal market for alternative fund managers and a harmonised regulatory framework for all alternative managers active within the EU, whether they are based within the union or not. It provides for a two-year transition period, after which non-EU managers and EU managers of non-EU funds will gain access to the internal market, followed by a three-year period during which the harmonised passport regime will coexist with national private placement rules that are used for distribution of alternative funds today.
Subject to an assessment by the Commission that the passport regime is working satisfactorily, the national private placement regimes will be terminated at the end of this five-year period through a fresh legislative act. In addition, the Commission will review the application of the directive four years after it has been brought into force in the national legislation of member states, to determine whether or not the regime for alternative managers has caused market disruption, whether it is consistent with the principles of the EU single market, and whether it has created a level playing field for all managers targeting European investors.
While the extension of the passporting regime to non-EU managers and funds and the subsequent abolition of private placement arrangements is the core of the compromise that made final agreement on the directive possible, many industry professionals in offshore centres say they will believe it when they see it.
In particular, they are waiting for the level 2 subsidiary legislation and regulation and details of the regulatory co-operation arrangements with which non-EU jurisdictions will be required to comply before they acknowledge that the spectre of a Fortress Europe from which outside providers are effectively excluded has been completely dispelled.
Defining alternative investment fund managers
The directive applies to entities that manage alternative investment funds as a regular business, including both open-ended and closed-ended funds, regardless of the funds’ legal form or whether they are listed on a stock exchange, and that raise capital from investors in order to invest according to a defined policy.
The legislation does not cover managers of private wealth management vehicles such as family office structures, nor of holding companies, although this does not exclude managers either of private equity funds or of funds traded on regulated markets. Also excluded from its remit is the management of pension funds, employee benefit or saving schemes, institutions such as central banks, local or national government bodies that manage social security and pension systems, securitisation special purpose vehicles, insurance contracts and joint ventures. Nor does it apply to individual portfolio management services provided by investment firms authorised under the Markets in Financial Instruments Directive (MiFID) in respect of alternative investment funds.
The directive does not regulate alternative investment funds, which continue to be regulated and supervised at national level (if at all). It therefore allows member states to continue to set national requirements regarding alternative funds established on their territory.
The directive provides the option of a less burdensome regime for alternative managers whose combined assets under management total less than EUR100m, and for managers of unleveraged funds with assets totalling less than EUR500m with a lock-up period for investors of at least five years, on the grounds that such funds do not pose any significant systemic risk.
Managers falling into these categories should be subject to registration in their home member state and provide regulatory authorities there with information about the instruments in which they are trading and the principal exposures and concentrations of the funds they manage. However, these managers also have the choice to opt for full regulation under the AIFM Directive, should they judge it worthwhile in terms of their marketing appeal and investor base.
Authorisation of managers
The directive provides that only managers authorised under the directive may manage or market alternative funds in Europe, and that they must continue to comply with its rules at all times, or risk losing authorisation. Authorised managers are limited in scope to the management of alternative and Ucits funds as well as of segregated portfolios under individual mandates, as well as providing certain non-core services such as providing investment advice and the safekeeping and administration of fund shares or units.
Managers must apply for authorisation to the regulator of their home member state or, in the case of managers based outside the EU, the member state of reference, which should be the country with which they have the strongest link, either through the domicile of funds or marketing focus.
They must provide the relevant regulator with information on the shareholders of the fund management business and the executives involved in its operations, its organisational structure, remuneration policies and practices, and any delegation or sub-delegation of management functions. The information required also covers the strategies, risk profiles, use of leverage and other characteristics of the funds the company intends to manage, the fund domicile, fund rules or incorporation documents, and the appointed depositary.
For authorisation to be granted, the national regulator must be satisfied that the manager is capable of complying with the directive, has sufficient capital and assets, and is run by individuals with sufficient experience and of good reputation. If the manager is a subsidiary of an investment or other business authorised in another EU member state, their regulator must be consulted.
The regulator may restrict the scope of a manager’s authorisation, notably with regard to their expertise and experience in the strategies of funds they are applying to manage. A decision on a manager’s application for authorisation must be delivered within three (or in exceptional cases six) months.
Authorisation may be withdrawn if the manager does not make use of it within 12 months or otherwise ceases activity, if authorisation has been obtained through false information, or if the manager no longer fulfils the conditions laid down in the directive or infringes other conditions. National authorities should provide information about the grant or withdrawal of authorisations to Esma, which will keep a public record listing all managers authorised under the directive.
The directive covers both external and self-management of funds. Self-managed funds are subject to the directive in the same way as managers and in addition may not manage other funds. Alternative investment fund managers should provide at least investment management services, but they may also offer other services including administration and marketing of funds, management of discretionary accounts, investment advice, shareholder services and record-keeping.
Authorised managers should maintain robust governance controls and be managed and organised to avoid or minimise conflicts of interest. Minimum capital requirements are calibrated to ensure the stability of fund management activity of funds and cover professional liability exposure – at least EUR300,000 in initial capital for internally-managed funds and at least EUR125,000 for the external manager of one or more funds, increasing on a sliding scale to a maximum of EUR10m according to the total volume of assets under management.
The directive requires managers to draw up remuneration policies and practices consistent with sound and effective risk management for staff whose roles have a material impact on the risk profile of the funds managed; they should avoid creating financial incentives to undertake or tolerate risky behaviour. These provisions may be applied in different ways depending upon the size of the manager and of the funds they manage, their internal organisation, and the scope and complexity of their activities, and will be overseen by Esma in line with existing EU recommendations on remuneration applicable elsewhere in the financial services sector.
Role of the depositary
The directive requires the appointment of a depositary separate from the manager to carry out functions such as the safekeeping of assets. The rules applying to the role of depository vary according to the type of business model followed by the fund manager and the kind of assets in which the funds are investing. For funds with investment lock-up periods of at least five years or those that invest in illiquid assets for which custody may not be appropriate, including private equity, venture capital and real estate funds, member states may authorise service providers such as notaries, lawyers or registrars to carry out depositary functions.
For other types of fund the depositary should be a credit institution, investment firm or another type of financial institution permitted under the Ucits directives. This rule does not apply to non-EU funds, but in this case the depository must be a similar type of institution and subject to regulation and supervision equivalent to that in force within the EU. The depositary must have its head office or a branch in the country in which the fund is domiciled, although it is suggested that the Commission draw up a legislative framework for an internal market that would allow depositaries in one member state to provide services in another.
The depositary is responsible for monitoring the fund’s cash flows and the allocation of investor funds, safekeeping of the fund’s assets, including the custody of financial instruments, and verification of other assets held by the fund or by the manager on the fund’s behalf. Safekeeping of assets can be delegated to a third party or sub-delegated, subject to the suitability of the third party. A prime broker can only act as a depositary if the prime brokerage and depositary functions are kept separated and any potential conflicts of interest are identified and disclosed to fund investors.
The depositary is liable for the loss of financial instruments in its custody unless it can prove that the loss was due to an external event and was unavoidable despite all reasonable care. It is liable in the event of other losses where these arise as a result of intentional acts or negligence on the part of the depositary or its staff. In the event of losses under a sub-custody arrangement, the depositary may escape liability if there is a contractual transfer of liability to the sub-custodian and the arrangement has been agreed in advance with the fund and the manager.
This formulation represents an improvement from earlier drafts of the directive, which proposed strict liability of depositaries for any non-market related losses to investors, whether or not they were in any position to detect or prevent the loss. However, again much depends on the precise wording of the level 2 measures that spell out the specifics of depositaries’ responsibility.
The threat lingers of a substantial hike in depositaries’ fees (which ultimately would be borne by the investor), or of a withdrawal from the market by providers that cannot achieve adequate remuneration for the additional risks they will have to run. Market professionals say such a result would defeat the ostensible purpose of the change in depositaries’ responsibilities, which is to protect investors.
The directive also requires alternative managers to implement valuation procedures for the proper valuation of assets and the funds they manage, a function that should be independent of the portfolio management activity of the business and not vulnerable to conflicts of interest; they may appoint an external provider to carry out the valuation function. Managers may delegate or sub-delegate responsibility for some management functions to increase the efficiency, as long as the manager remains at all times responsible for the proper performance of these functions as well as compliance with the directive.
Managers must issue an annual report for each EU-based fund they manage or (if a not-EU fund) that they market in the EU. They must also disclose information on the level of leverage used by funds they manage, whether through borrowing of cash or securities or via derivative positions and the reuse of assets. They must demonstrate that the leverage limits set for each fund are reasonable and that that they are complied with. Additional disclosure requirements apply to companies over which funds managed by an alternative manager exert control (in practice, usually private equity managers), especially in the case of unlisted companies.
Marketing to EU countries
Subject to compliance with the provisions of the directive, an authorised manager may market shares or units of EU-domiciled funds to sophisticated investors throughout the union. To market a fund in its home country, the manager must submit a notification to the regulator, which must deliver a decision within 20 working days. It may only refuse permission if the manager is not in full compliance. If the decision is positive, the manager may begin marketing the fund as soon as it has received notification from the regulator.
The manager also applies to its home regulator if it wishes to market a fund in one or more other EU member states, providing a notification in respect of each fund and targeted market. As long as the manager meets the terms of the directive, the notification file, including supporting documentation, must be transmitted to the regulator of the target market within 20 working days. Once it has received notification that the application has been transmitted, the manager may immediately begin marketing in that country.
An authorised manager may also manage funds domiciled in other member states either directly or through a branch. It must submit details of the management activities or branch to its home regulator, which in turn must transmit the documentation within two months to the authorities of the member state where the manager proposes to carry out management activities.
Member states are free to allow the marketing of alternative funds to retail investors on their territory if they wish, irrespective of whether the funds are located in that country, another EU member state or in a non-EU country or territory. In this case, they may impose stricter requirements on the manager or fund than those applicable in the case of professional investors, but they may not impose stricter or additional requirements on funds from other member states than those applicable to domestic funds.
Third-country managers and funds
There is a two-year transition period after the final deadline for transposition of the directive into national law around mid-2013 before non-EU alternative fund managers can become eligible for a passport to perform management and/or marketing activities within the EU, and for EU managers to market non-EU funds under the passporting arrangements.
Esma will have oversight authority, power to decide authorisation questions on which regulators from different EU member states disagree, and a co-ordinating role in the exchange of information between national regulatory authorities. After the universal passport regime has been in place for three years, national private placement arrangements are scheduled to be abolished as long as the Commission has certified that passporting is working satisfactorily for all managers.
An EU manager may manage non-EU funds that are not marketed within Europe, subject to all the directive’s requirements apart from those relating to the depositary and annual report in respect of those funds. Co-operation arrangements must be in place between the supervisory authorities of the manager’s home member state and the regulator of the fund domicile to facilitate regulation of the manager and monitoring of systemic risk. As with other provisions regarding non-EU domiciled funds and managers, the directive requires the Commission to establish a framework for establishing co-operation arrangements with third countries, and Esma to draw up guidelines on how these measures are to be implemented.
Once the passporting system has been extended, EU managers may market non-EU funds (or EU-domiciled feeder funds invested in non-EU master funds) to sophisticated EU-based investors. This is subject to co-operation arrangements being in place between the manager’s home regulator and that of the fund domicile, certification that the domicile meets Financial Action Task Force standards on countering money laundering and terrorist financing, and the conclusion of OECD-standard tax information exchange agreements (Tieas) between the fund domicile and the manager’s home member state as well as any other EU countries in which the fund is to be marketed.
As with cross-border marketing of EU-domiciled funds, once the universal passporting regime is in place managers can apply for the distribution of non-EU funds to their home regulator; either authorisation or the transmission of notification to a third-country regulator is due within 20 working days of submission. Until private placement regimes are abolished, member states may continue to allow non-EU funds to be marketed by EU managers on their territory without a passport subject to equivalent depository arrangements, regulatory co-operation arrangements with the fund domicile and certification of AML compliance.
Member state of reference
Non-EU managers intending to manage or market EU-based alternative funds must receive prior authorisation from their member state of reference, which plays the same role as the home state of EU-based managers. They must appoint a legal representative in the member state of reference as a contact point in the EU and conduit for any official correspondence with EU regulators and investors, and to carry out compliance functions.
The manager’s home jurisdiction must also have concluded regulatory co-operation arrangements with the member state of reference, the fund domicile (if different) and any other EU countries where the funds are to be marketed, and meet the standard money laundering and tax information exchange conditions.
The member state of reference is determined according to where the manager’s funds are domiciled (if within the EU) or where they will be marketed. If there are several possibilities, the manager may submit a request to all the member states that would qualify, which should decide between them within a month. Any disagreement on the designation of a member state of reference can be referred to Esma.
The marketing of either EU-domiciled or non-EU funds within the European Union by a non-EU manager under the passporting regime involves the same procedures and timescales as for an EU manager, except that the manager submits applications to the regulator of the member state of reference rather than its home regulator. Again, non-EU funds are subject to the fund domicile having regulatory co-operation arrangements with the member state of reference, complying with money laundering standards, and having Tieas in place with the member state of reference and all other EU countries in which the fund is to be marketed.
Oversight and enforcement of the provisions of the directive are largely in the hands of the home member state of the fund manager in question, or the member state of reference in the case of managers based outside the EU, although in some cases member states where funds are being marketed can act directly to enforce the directive. Member states are responsible for laying down rules on sanctions applicable in the event of infringement of the directive’s provisions.
Esma will have a co-ordinating role and in certain cases will mediate between member states in the event of disagreements. It will also be responsible for drawing up standards for the content of the co-operation arrangements to be concluded by member states with supervisory authorities outside the EU and on arrangements for exchange of information. Esma may, for instance, provide a standardised format for co-operation agreements.
One additional element of the directive that has aroused the ire of the alternative investment industry is the so-called asset-stripping rules, which are primarily aimed at private equity firms but could also affect managers of certain hedge fund strategies. Special rules on ownership of unlisted companies include additional reporting requirements covering, for instance, any planned changes in employment or job conditions.
In addition, for a period of two years following the acquisition of control such managers are barred from carrying out, facilitating or encouraging any distribution, capital reduction, share redemption or repurchase that would reduce the company’s capital base or that would exceed its distributable profits and reserves. Private equity firms and other claim that these rules will place alternative funds at a disadvantage compared with other types of private company owner, which will not have to prove the same amount of public information nor face the restrictions on extraction of capital.
Toward 2015 and beyond
Various provisions of the directive are to be implemented through delegated acts adopted by the European Commission, including thresholds for the lighter regulatory regime, the treatment of managers whose assets move temporarily above or below the threshold for compliance with the directive, the definition of methods and calculation of leverage, capital levels and professional indemnity insurance, and the assessment and management of conflicts of interest.
Delegated acts will also set out rules on risk management, liquidity management, administrative and accounting procedures, valuation procedures, and permitted levels of outsourcing. They will be used in setting standards for third-country depositories, as well as the due diligence duties of depositories and the definition of the type of external event that may relieve depositories of liability for losses.
Two years after the final date for transposition of the directive into national law, Esma is due to issue an opinion on the functioning of the passport regime in force and of national private placement regimes, and will issue advice to the Commission on the extension of the passport to non-EU funds and managers. The Commission will adopt a delegated act within three months of receiving Esma’s advice, taking into account criteria such as the effectiveness of the internal market, investor protection and monitoring of systemic risk.
Three years after the European passport is extended to non-EU managers and funds, Esma will issue an opinion on the functioning of the regime and issue advice on the termination of national private placement regimes, upon which the commission will again have three months to adopt a delegated act. Either the European Parliament or the European Council may object to a delegated act within three months from the date of notification, a period that can be prolonged for an additional three months.
Four years after the transposition date, the Commission is scheduled launch a review of the application and scope of the directive, including its impact on investors, funds and managers both inside and outside the union and the extent to which the objectives of the directive have been achieved, as well as the respective roles of Esma and national authorities in supervising alternative fund managers operating in EU markets. If necessary, the Commission may propose amendments to the directive. It may also examine whether legislation is necessary to regulate the due diligence procedures to be undertaken by European professional investors when investing on their own initiative in non-EU products including funds.
What currently remains uncertain is the starting point for the timetable. Last month Jonathan Faull, director general of the Directorate General for Internal Market and Services at the European Commission, wrote to Carlos Tavares, acting chairman of Esma, indicating that the directive is now unlikely to enter into force before June. When the directive was approved by the European Parliament on November 11, the Commission expected it to come into effect in February or March.
The process is currently at the stage of legal and linguistic revision to correct any typographical or drafting errors and to ensure the internal consistency of the directive’s provisions, followed by translation of the finalised text into the EU’s various official languages. Once this is completed, the directive will be formally adopted by the Ecofin Council, which is scheduled to meet (currently under the presidency of Hungary) on May 17 and again on June 15.
A few days after its adoption the directive will be published in the Official Journal of the European Union, and will enter into force on the 20th day following publication. EU member states will then have two years to transpose the directive into their national law.