October 21, 2010
The curtain is slowly closing on the era of (relatively) light regulation of Alternative Investment Funds in Europe. Key developments flowing from a meeting of European Finance Ministers on 19 October to discuss the ‘AIFM Directive’ include agreement on a slightly less onerous regime for depositaries and confirmation that there will eventually be a ‘passport’ regime allowing marketing of non-EU Funds on a pan-European basis. Although progress has been made, we are nonetheless concerned that the overall effect of the Directive will be to render meaningless over time the distinction between alternative funds marketed to professional investors and the (higher cost) retail funds established under the UCITS regime.
As with related initiatives around the world, the proposal for a Directive on Alternative Investment Funds (AIFs) and their managers (AIFMs) is in the main a political response to the financial crisis that has engulfed the world since 2008. Although the title of the proposed Directive references the regulation of the managers/AIFMs the proposed Directive will when enacted in fact regulate the Funds/AIFs as well. Provisions biting on AIFMs include requirements as to capitalisation, conduct of business (including remuneration), conflicts of interest, risk management and marketing. Provisions biting at Fund/AIF level (by way of ‘procure’ obligations on the AIFM) include requirements on liquidity management, depositaries, transparency (annual reporting), the use of leverage and ‘asset-stripping’.
We left the story before the Summer when the European Parliament and Council adopted rival early draft versions of the proposed Directive which differed in some crucial respects including on the issue of the marketing within the EU of ‘third country’ funds (namely whether that would be via the existing private placement regimes or – subject to conditions – via a single EU ‘passport’). Other provisions were common to the two versions but of serious concern to commentators, notably proposals for an onerous and expensive ‘strict liability’ regime for depositaries of fund assets.
A few weeks by the seaside and a couple of months of seemingly effective lobbying by industry participants (and Treasury Secretary Geithner) have yielded some promising results.
Agreed Council Position
The key points agreed by EU Finance Ministers at the Ecofin meeting on 19 October are as follows:
Marketing of third country funds
During a two year transitional period, the existing member states’ private placement regimes will remain in force "subject to minimum conditions" contained in the draft Directive. Following that, a European passport regime will come into force and exist side-by-side with the private placement regimes. After a further period of three years, it is intended that the private placement regimes of members states will be abolished.
Detailed rules cover three different scenarios:
i) Marketing by EU AIFMs of Non-EU and EU AIFs
ii) Marketing by Non-EU AIFMs of EU AIFs
iii) Marketing by Non-EU AIFMs of Non-EU AIFs
There is overlap between the regime proposed for the three scenarios but common to the marketing of Non-EU AIFs (scenarios (i) and (iii)) include availability of the passport provided that the relevant third countries (i) have (detailed) cooperation arrangements in place; (ii) do not feature on the list of ‘non-cooperative’ countries (in respect of anti-money laundering or terrorist financing) on the FATF list; and (iii) have an agreement in place with the member states into which the AIF is to be marketed that is compliant with Art. 26 of the OECD Model Tax Convention as well as a tax information exchange agreement.
The draft Directive requires AIFMs to appoint a depositary to ‘safe-keep’ the assets of AIFs that they manage. As the scope of the Directive is so wide (covering not just hedge funds investing in publicly-traded securities that might already use a custodian but also private equity, real estate and venture capital funds that might invest only in unlisted assets), the requirement to use such depositaries will be greatly extended. Prior drafts of the Directive appeared to contemplate a ‘strict liability’ regime for depositaries that would make them fully responsible to underlying investors for almost any loss of assets, even resulting from things palpably not under their control. The risks and liabilities involved led many to warn of a wholesale retreat from the sector and huge increase in fees and costs to cover the extra work and potential liability involved.
The agreed Council version of the Directive still contains a requirement for a depositary whose responsibilities are to extend to "proper monitoring of cashflows", the "custody of financial assets" and "verification of ownership of all other assets by the AIF". However, the liability provisions are now bifurcated to distinguish between loss of financial instruments held in custody and "other losses".
In the case of financial assets held by it in custody, a depositary will be liable unless it can prove (i.e. a reverse burden of proof) that the loss is as a result of an external event, beyond its control. Employee fraud is expressly stated not to be an external event. Where the depositary is permitted to delegate custodianship to a third party, it has a prescribed contract in place and it has complied with "all" of a myriad of other requirements in selection and supervision of that third party, it may be relieved of liability.
In the case of "other losses", liability only flows if there is a "negligent or intentional" failure on the part of the depositary to comply with its obligations pursuant to the Directive.
Delegation of safe-keeping is allowed but "only when objectively justified". Prime brokers acting as a counter-party to an AIF will (absent strict functional separation) no longer be permitted to act as a depositary for that AIF.
Despite the improvement in the text over previous versions, the provisions still presage a significant increase in the work required of and liabilities assumed by depositaries, and the inevitable increase in cost (and reduced returns) that will follow. Time will tell whether an appropriate balance has been struck.
Remuneration: The draft Directive requires AIFMs to have remuneration policies and practices that are "consistent with sound and effective risk management" to cover all those categories of staff that have a "material impact on the risk profiles" of the AIFs that they manage including "senior management, risk takers . . . and control functions" (and those who are paid as much as such persons). This is consistent with global trends (seen already in the UK) for AIFM remuneration policies to reward both performance and the maintenance of sound systems and controls.
The new European Securities and Markets Authority (to be based in Paris) has been tasked with establishing the "sound remuneration policies" that should apply to the AIFM sector and ensuring that these are consistent with remuneration policies in the wider financial services sector (which is also under consideration at an EU level).
Valuation: The draft Directive requires AIFMs to implement a periodic valuation (annual at least) of the net asset value (NAV) of AIFs that they manage. Valuations conducted by the AIFM itself (as opposed to those performed by an external valuer) must be conducted in a way that is "functionally independent" of portfolio management.
Leverage: AIFMs that employ leverage on a substantial basis will be required to disclose information on the overall amount of leverage employed, the sources of leverage, and the reuse of assets. Individual member states will be empowered to impose individual leverage limits on AIFM regulated by them. Disclosure requirements regarding leverage will also extend to AIFMs managing EU AIFs and Non-EU AIFs they market in the EU.
Major shareholdings: AIFMs must make notifications when their AIFs acquire shares through the 10%, 20%, 30%, 50% and 75% voting right levels of non-listed companies (except for companies having fewer than 250 employees and an annual turnover not exceeding EUR 50 million, and/or an annual balance sheet not exceeding EUR 43 million).
Transparency: If the AIFs acquire "control" of a non-listed company (that is 50% or more of the voting rights) the AIFM must disclose to the board (and thence to the employee representatives) information on their future intentions for the business and the likely repercussions on employment (including any material change to the conditions of employment). AIFMs managing AIFs that have "control" over such non listed companies are also required to ensure that the annual reports of the relevant AIF include supplemental disclosures with regard to the controlled company and that such information is made available both to investors and to employee representatives of the issuer concerned. This is a significant requirement for AIFMs which was introduced in the wake of the largely Continental distrust of private equity/hedge funds and one which has been resisted by that sector from the outset of the consultative process.
Asset-stripping: Additional rules which build upon the concern in certain quarters about the predatory behaviour of certain funds, include provisions directed against perceived ‘asset-stripping’ of investee companies. Under the new text, these now bite for two years following acquisition of control, during which time the AIFM will (subject to certain exceptions) not be allowed to facilitate any "distribution, capital reduction, share redemption and/or acquisition of own shares by the company . . .". Indeed, the AIFM must use "best efforts" to prevent them. If implemented in this form, post-transaction reorganisations (except for certain exempted SMEs) will get a whole lot harder.
Delegated acts: The draft Directive also includes a sweeping provision empowering the EU Commission to make rules on a wide variety of matters including criteria to be used to assess whether AIFMs are acting in the best interests of investors; on conflicts of interest; to specify liquidity management systems to be employed; on provisions to ensure that delegation does not allow a manager to become a "letter box entity"; and on valuation methodologies.
"Could have been worse" is about the best that can be said for the current draft. In the current turmoil of contradictory positions on the appropriate response to the causes of the financial crisis, that is perhaps not a bad outcome.
What catches the eye is the apparent upwards harmonisation of many aspects of AIFM/AIF regulation such that they mirror (and in many places, for example in relation to depositaries, exceed) the standards required of UCITS (retail) funds. Already moves are under way to harmonise relevant provisions of the UCITS regime ‘up’ to match the AIFM/AIF standards.
So what next? The European Parliament is required to approve the final version of the text of the Directive – after the bloody, lengthy battle it is hoped that this exercise (scheduled for next week) will be a rubber stamping exercise.
It’s not over yet, but the future of the alternative (professional) funds industry in Europe is becoming clearer.
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