The European Commission Heads Off the “Trojan Horse” – Proposed New Regulation of Investment Funds

May 1, 2009

The European Union (EU) has become the first jurisdiction to propose a comprehensive framework for direct regulation and supervision of the entire investment funds industry – the proposed Directive on Alternative Investment Fund Managers.

The EU already has an established regime for regulating investment funds known as UCITS (Undertakings for Collective Investment in Transferable Securities)[1].  UCITS invest in a prescribed range of transferable securities and/or other liquid financial assets and are composed of a collective pool of investments from retail investors. 

The draft proposal which was published on 29 April aims to regulate investment funds within Europe which are not already covered by the UCITS regime, referred to in the proposal as alternative investment funds (AIFs). Rather than imposing requirements on the AIFs themselves, the proposals target AIF managers (AIFMs).  It was considered that a broad regime focusing on those who manage investment funds rather than a defined set of entities prevalent in the investment fund world (e.g. hedge funds) would be more effective and less easy to circumvent, with enhanced scrutiny on leveraged hedge funds.

Currently, this sector is regulated in the EU through a combination of fragmented national legislation as well as some general provisions of EU law, in addition to voluntary industry standards in certain cases (e.g. the Walker Guidelines in the UK). With investor protection as its fundamental aim, the European Commission’s rationale for the proposals is the introduction of harmonised regulatory standards and enhanced transparency.

Early drafts of the directive had been leaked to the public weeks before and received a barrage of criticism particularly from different interest groups across various member states and not surprisingly, the hedge fund industry. The final draft proposals however have come under even greater attack with the UK Financial Services Secretary and key UK and European industry bodies (in particular the British Private Equity & Venture Capital Association and the European Private Equity & Venture Capital Association) voicing their strong opposition to proposals they consider are "deeply undesirable" and "immensely damaging" to industry.

Some of the main points under the proposed legislation are set out below.

Who Is Regulated?

All EU domiciled AIFMs that meet either of the two threshold tests below will be regulated:

• Leveraged AIFMs – Total assets under management equal to or above €100m (approx. US$1334m, £90m) where assets under management are acquired through use of leverage.
• Non-leveraged AIFMs – Total assets under management equal to or above €500m (approx. US$670m, £448m) where: (i) none of the assets under management were acquired through use of leverage; and (ii) investments are locked into the fund for 5 years or more from the date of its constitution.

Authorisation Requirements

• Regulated AIFMs must be authorised by the competent regulatory authority of their home nation in the EU.
• In the application for authorisation, AIFMs must provide information on non-de minimis AIF stakeholders, a programme of activities, detailed AIF characteristics, constitutional or governing documentation, arrangements for delegation of services to third parties, arrangements for safe-keeping of AIF assets, and detailed information on disclosure to AIF investors.

Capital Requirements

• Regulated AIFMs must maintain a minimum capital of €125,000 (approx. $166,700, £112,000), which increases where assets under management exceed €250m (approx. $333m, £224m). The increase is equal to 0.02% of the value of assets under management above €250m.

Continuing Reporting and Other Obligations

• Regulated AIFMs must act honestly, with due skill, care and diligence, and in the best interests of the AIF under management, whilst also treating all AIF investors fairly. AIFMs are also under an obligation to identify and avoid conflicts of interest.
• Risk management must be kept separate to portfolio management, and there must be an adequate risk management system which is subject to a review and update, as necessary, each year.
• Liquidity management systems must be in place alongside an appropriate redemption policy to match the AIF liquidity profile.
• An independent valuator must be appointed to conduct a valuation of the AIF and its instruments at least once a year, and each time AIF instruments are issued or redeemed.
• Regulated AIFMs are not permitted to act as a depositary and therefore a third party depositor must be appointed to safe-keep AIF assets and make and receive all payments to and from AIF investors.
• Regulated AIFMs must prepare and make available an annual report for each AIF under management, which should be made available to investors and the national regulatory body within 4 months following the end of the financial year.
• Additional disclosure is required where the assets under management have either (i) been acquired through leverage, or (ii) include a controlling stake in a company (30% or more of the voting rights).

Pan-EU Marketing Restrictions & Requirements

• AIFMs authorised by their national regulatory body will be entitled to market their fund(s), or their management services, to professional investors in any other country within the EU (a procedure referred to as "passporting").
• Individual countries within the EU have flexibility to allow the marketing of non-EU based funds within their national territory, but such offshore funds will not enjoy the "passporting" rights within the EU.
• Suitable offshore funds which meet the proposed regulatory requirements for AIFM will eventually be able to avail of "passporting" once authorisation from a country within the EU has been obtained. However, it is expected that such a process will not be available to non-EU based funds until 3 years after the implementation of the initial legislation.

Analysis

The increasingly fervent debate around the proposals highlights a long-standing policy divide within different states within the European Union. A number of European member states (led by France and Germany) are of the view that the "locust" like-behaviour of hedge funds, in particular activist hedge funds, has got out of control and needs to be curbed. The latest round of commentary from the French government raises the spectre of hedge fund managers in the form of a "Trojan Horse" attacking the European economies. Other member states, notably the UK, take the view that whilst there is room for greater transparency and guidance on conduct, generally for this part of the industry, self-regulation and a principles-based approach which supports voluntary codes rather than black-letter law requirements will preserve and enhance, over the long-term, market operation and efficiency.

When one looks at the practical impact of the proposals – the context of the debate becomes clearer. The threshold of €100m implies that nearly 30% of hedge fund managers, managing almost 90% of assets of EU domiciled hedge funds, would be covered by the proposed Directive. However, as the UK is home to 80% of European hedge funds, it is likely to bear the brunt of the burden of the proposed new regulation. The other fear of many industry bodies is that the proposed new rules are premature and run the risk of placing the UK and Europe at a significant competitive disadvantage against the US in retaining and attracting the hedge fund industry, where President Barack Obama has recognised that hedge funds are the future, focussing his attentions instead on the banks.

Whilst it is unlikely that the "traditional" UK "comply or explain" voluntary code model for the alternative asset management industry is likely to survive in the wake of the global financial crisis and the public hunt for scapegoats, whether in the form of banks or hedge fund managers, there are serious questions of principle and approach arising from the draft new proposals. Government experts (the Turner Report being one key example) have recognised that hedge fund leverage is typically well below that of banks; the European Commission’s own press release acknowledges that private equity houses are "not regarded as posing systemic risks". If this is the case, how can the breadth of the proposed rules be justified?

What Next?

The proposed legislation will now be passed to the European Parliament and European Council for further debate and negotiation, with an industry consultation process also expected.  Even if final legislation is agreed by the end of this year, a European Directive requiring implementation by EU member states would not be expected to come into force until 2011. Now is the time for lobbying … the debate has just begun.