On 30 April 2009, the European Commission published a proposed directive (the “Directive”) to regulate alternative investment fundmanagers (“AIFMs”). If the draft Directive is adopted in its current form, the alternative asset management industry and itsmyriad investors would be subjected to significant and potentially disruptive change, not all of it rational or comprehensible. Click here to see our initial briefing on the draft Directive.
As part of the process of adopting the Directive, the text will pass through various stages and interested bodies. As described in our briefing on the legislative process, a key player in the adoption process is the Council of the European Union (the “Council”), whomust agree a compromise draft with European Parliament (“Parliament”) before the draft Directive can be adopted. Click here to see our briefing on the legislative process.
On 2 September 2009 the Council issued a note fromthe Swedish Presidency (the “Presidency”) which outlines some issues with the draft Directive and suggested ways forward (the “Note”). The Note is thoughtful, if not detailed, and is sometimes explicitly critical. The Note represents an informed starting point for debate on the numerous deficiencies of the draft Directive as we enter into an important phase in shaping the Directive’s final form. Indeed the Note was cited in two events on the Directive held in the days following the publication of the Note. At a recent conference hosted in the City of London on 11 September 2009 and attended by Poul Rasmussen, one of the architects of the Directive, it was accepted byMr Rasmussen that an impact assessment was needed to appreciate the implications of the Directive. At the same conference Lord Myners, Financial Services Secretary to the Treasury and City Minister, expressed the concerns ofmany interested parties that the Directive resorted to “protectionismposing as protection”. Doug Shaw of BlackRock observed that, whilst the aimof the Directivemight be to create a level playing field formarket participants, the Directive had resulted in “a curious equality of dissatisfaction” within the industry for both the Directives’ supporters and opponents. The Note also featured prominently in several speeches at the FSA’s annual AssetManagement Conference held on 17 September 2009.
While the Note is certainly a step in the right direction, it is not, and is not intended to be, a comprehensive solutions paper. It does, however, show that the Presidency has appreciated the wide range of issues and, in particular, that there is a diversity of fund structures which the Directive needs to recognise. This briefing covers the key points raised.
Currently exempted AIFMs The draft Directive currently exempts: AIFMs with assets undermanagement of €100million (or €500million if the Alternative Investments Funds (the “AIFs”) in the portfolio are unleveraged and lock investors in for five years from formation); AIFMs which do not provide “management services” to EU AIFs ormarket to investors in the EU; UCITS vehicles or their authorisedmanagement or investment companies; EU credit institutions; insurance and re-insurance undertakings;managers of pension funds; and certain supranational institutions.
The Note suggests that further potential exclusions from the scope of the Directive should be considered, thereby recognising the fact that in respect of certain types of AIFs the draft Directive is not helpful or will be a source of legal uncertainty as it overlaps with other sources of governance and law as discussed below. It also suggests that any exemption for credit institutions, insurance companies and pension funds should not apply when such entities manage third party funds.
The draft Directive is silent as to self-managed funds.Who, in such cases, is the AIF and who is the AIFM? How does the board of directors fit into the analysis? The Note does not explicitly state that all self-managed funds should be exempted, but states that it needs to bemade clear whether or not this will be the case.While not a wholly satisfactory response, it appears at least that such AIFs (or indeed AIFMs) will be considered and catered for.
Closed ended funds
The Presidency suggests that consideration should be given to excluding closed ended funds either:
- in general; or
- if they are self-managed; or
- if they are self-managed and have no leverage.
The Note also suggests that closed ended funds could be exempted fromthe Directive’s provisions onmarketing and disclosure so as to avoid double regulation with the Prospectus Directive (and, presumably, the Transparency Directive). The seemingly strong recognition that the exemption of closed ended funds warrants genuine consideration can be seen as evidence that the Presidency has appreciated that there exists a diversity of fund structures. Closed ended funds by definition are not subject to mass redemptions and are therefore less likely to contribute to de-leveraging in times of crisis. Indeedmany of themare listed companies and already subject to existing disclosure and transparency regimes and strict continuing obligations imposed both by competent authorities and exchanges.
Undertakings that do not sell or promote to the public within the Community
Another key exemption proposed is the exclusion of collective investment undertakings which raise capital without promoting the sale of their “units” to the public within the EU or any part of it. Although not elaborated upon, this presumably would exempt AIFMs of AIFs conducting private placements, which wouldmake a very positive contribution to carrying on business as usual, not least as it would allow non-EUmanagers to continue to market by way of private placement.
As noted above, AIFMs with less than€100million are excluded fromthe scope of the draft Directive. The Note recognises that there is concern about how this is to be applied in practice, given variations inmethods of calculating portfolio values and fluctuations in value. It is suggested that the thresholds could be deleted. If this approach is taken, the Note states that further considerationwould need to be given to “how the provisions of the AIFMdraft Directive could be tailored to be proportionate and not unduly burdensome for AIFMmanaging certain types of funds (egmanagers of venture capital funds)”. This would be a radical departure fromthe arbitrary and insensitive approach of a fixed de minimis and indicates that the Presidencymay share, to some degree at least, the view of the industry that the draft Directive is in its current formtoomuch of a blunt instrument that needs a nuanced re-working beyond simply distinguishing between big and small AIFMs. It will, however, be important to ensure that small AIFMs or new AIFMs are not forced out of themarket by reason of the compliance burden imposed by the Directive.
Who is the AIFM?
Unfortunately the Note does not deal directly with the troubling question of identifying the AIFM, which is fundamental to an analysis of the scope of the draft Directive. The draft Directive defines the AIFMas “any legal or natural person whose regular business is tomanage one or several AIFs”. In AIFs using limited partnership structures is this the general partner or, if applicable, the investment manager? In real estate limited partnerships could the assetmanager be considered an AIFMtoo? In closed ended investment companies or investment trusts an investmentmanager fits the AIFMdefinition, but itmust be made clear beyond doubt that boards of directors are not to be considered AIFMs in any circumstances. It is also not always clear even in the open-ended fund sphere who the AIFMis.When, for example, a unit trust or open-ended investment company is hosted by a service provider that acts as authorised corporate director or operator for a fund initially brought to it by a sponsor, who is the AIFM? Is it the authorised corporate director (who, in substance, is an administrative service provider availing the fund and fund manager of economies of scale, but for regulatory purposes is the party responsible for the fund and owing duties to investors) or is it the investment manager to whom themanagement of the fund is delegated by the authorised corporate director?Multi-manager funds are also not discussed.Whichmanager is the AIFMin such funds? Must the fund arrangements be re-structured? It is unfortunate that these questions are not raised in the Note but these points have been widelymade so it is to be hoped that this issue will be confronted in the next draft of the Directive.
Click here to view the diagrams
The note suggests that the capital and own funds provisions of the draft Directive could be aligned with that of the UCITS IV Directive (“UCITS IV”). Effectively thismay mean putting a cap on own funds, as required under UCITS IV of €10 million. The Note also suggests that it needs to be made clear whether AIFMs thatmanage both UCITS funds and AIFs will need tomeet capital requirements cumulatively in accordance with the two directives or not. These changes would be welcome but what ismost interesting is that the Note suggests excluding fromthis requirement AIFMsmanaging exclusively AIFs without redemption or repurchase rights or closed ended funds. This again evidences that the Presidency is now considering how each of the provisions applies to different types of AIFs. LordMyners at the FSA’s annual Asset Management Conference suggested that the rationale behind this exclusion is thatmanagers of open-ended AIFs ought to have cash to facilitate an orderly wind down in the event of insolvency of the AIFM. In a closed structure it is considered that should theManager become insolvent, capital stores in the AIFMfor an orderly wind down are not critical.
Under the draft Directive, AIFMs are to ensure that there is an independent valuator appointed to each AIFmanaged by it. There has been concern as to what thismeans for hard to value assets which the AIFMmay need to value itself or contribute to valuing, such as unquoted equities that some custodians or administrators are reluctant or unable to properly or accurately value. The way forward suggested in the Note is to remove the requirement to have an independent valuator but vest responsibility (and thus, it would seem, liability) in the AIFM, regardless of whether or not the valuation is actually undertaken by an independent third party or not.
While this solution might be seen to have somemerit (as it is indeed themodel used in UCITS IV) itmay not best serve the interests of investors. Ifmost valuations are undertaken independently then investorsmay not have direct recourse to those who actually conducted the valuations. Recourse (or, at least, relatively straightforward recourse) against such entities would lie only with the AIFMor AIF by way of a breach of contract claimand thus not be available to investors.Whether this is of benefit to investors or the AIF could depend on the relative financial positions of the AIFM and the valuator.
It would seemthat the simplest solution would be to delete the absolute requirement for an independent valuator (as, for example, this would be an unnecessary and cumbersome requirement for private equity funds) and to allow liability to fall where it should on the facts ie with the entity that does in fact conduct the valuation. The AIFM should simply bemade responsible for conducting appropriate due diligence and systems and process checks on the service provider both prior to appointment and on an on-going basis to ensure that they are equipped to provide valuations to whatever extent is described in the prospectus or marketing materials.
The problems with the draft Directive’s provisions on the need for and use of depositaries are perhaps themost serious practical issues of all.
Two principal problems arise out of the draft Directive mandating that the depositary (and, it seems any of their sub-depositaries) of an AIF be an EU credit institution. The first is that certain assets will fall out of the potential investment universe of EU and non-EU AIFs managed by EU AIFMs because assets in certain jurisdictions may only be held by a local custodian. Secondly, there are so few EU credit institutions that can perform the function of a depositary (let alone prime brokerage services) that counterparty risk is dramatically increased. In the wake of the Lehman collapse this is an extraordinary state of affairs to be created by proposed new legislation. The Note recognises these two issues of “concentration risk” and also reduced investor choice, noting “that the current draft [of the Directive] does not seem workable, as it in many cases will not be possible to hold the assets [of many market players] without incurring considerable costs for investors”.
Additionally the Note recognises that it “does not make sense” to require that each type of AIF be subjected to the depositary provisions (presumably referring to the imposition of having to have an independent depositary at all).
Finally the draft Directive imposes a strict liability on the appointed depositary of an AIF for the failures of its subcustodians. This will inevitably lead to an increase in depositary fees, if they are even willing to act in such a capacity. Indeed depositariesmay not take on liability for sub-custodians in certain jurisdictions (should the use of such sub-custodians eventually be allowed) for fear of not collecting successfully on any indemnity they in turn may have.
It is disappointing to note that the Presidency declines to commit to a solution or even a range of options in this area. The Note suggests waiting until the UCITS IV consultation with respect to depositaries is complete. Submissions were due on 15 September 2009. However, the consultation asks, among other things, whether the UCITS regime should be brought into line with the AIFM draft Directive. For example it considers the question of eligible depositaries and limiting them to EU credit institutions. The consultation also explicitly considers restricting delegation geographically, calling it an “additional safeguard” which consists of “limitations as to the nature of the sub-depositary or its location to ensure that the sub-depositary is subject to appropriate or equivalent levels of regulation and supervision”. Clearly using UCITS as a benchmark by which to rectify the draft Directive would be circular and nonsensical to the extent that it might be proposed that the UCITS depositary regime is itself based on the draft Directive. Furthermore, it has recently been reported that the Committee of European Securities Regulators’ (CESR) review of the liability of depositaries under the UCITS regime has been postponed. It would have formed an important piece of the UCITS IV consultation. Finally, there is an argument to be made that the draft Directive position on depositaries should be more relaxed than that of UCITS IV as UCITS is a retail product whereas the draft Directive is primarily aimed at funds targeting professional investors.
Whatever the solution, theremust not be an increase in counterparty risk normust there be a limitation of potentially lucrative assets to which investors within the EU will have access. A sensible approach would be to impose a duty of due diligence on the AIFMand to prohibit the use of any depositary that is not subject to satisfactory (not necessarily equivalent) supervision and prudential regulation.
The draft Directive provides that AIFMs may only delegate the portfolio management and risk management of an AIF to another AIFM authorised under the draft Directive. Essentially this limits delegation of management to other EU entities, thus curtailing the current practice of delegating portfolio segments to local managers who are often the best placed to make decisions at opportune moments based on their local knowledge. It appears that the Presidency has recognised that such a restriction is more onerous than those imposed by both the Markets in Financial Instruments Directive (“MiFID”) and UCITS IV. It suggests that the draft Directive’s provisions on delegation be aligned with the relevant clauses from UCITS IV (being Article 13.1(c)), MiFID (being Article 13(5)) and the MiFID Implementing draft Directive (being Article 15). Neither MiFID or UCITS IV restrict delegation of portfolio management to EU entities as the draft Directive effectively does. Softening the draft Directive so that it mirrors MiFID in particular and UCITS IV would be sensible. All portfolio managers would still be authorised or registered, just not under the Directive or necessarily in the EU. This will allow investors to benefit from local expertise on particular assets directly (rather than have it feed through as investment advice or, even worse, having to avoid certain assets altogether).
Furthermore, under the draft Directive, delegation of administrationmay only be to a third party country administrator if there is a cooperation agreement between the relevant competent authority of the AIFMand the supervisory authority of the administrator. Valuationmay only be delegated to a valuator outside the EU if the Commission decides that the valuation standards and rules used by valuators in the relevant third country are equivalent to those used in the Community. The Note suggests completely deleting these explicit restrictions on delegation to third countries and relying instead on the general article on delegation applicable to valuators and administrators within the EU.
Examples of delegation language in other directives
UCITS IV Article 13.1 (c) states that “when delegation concerns the investmentmanagement, themandatemust be given only to undertakings which are authorised or registered for the purpose of assetmanagement and subject to prudential supervision; the delegationmust be in accordance with investment-allocation criteria periodically laid down by themanagement companies”.
MiFID Article 13(5) states that “an investment firm shall ensure, when relying on a third party for the performance of operational functions which are critical for the provision of continuous and satisfactory service to clients and the performance of investment activities on a continuous and satisfactory basis, that it takes reasonable steps to avoid undue additional operational risk. Outsourcing of important operational functions may not be undertaken in such a way as to impair materially the quality of its internal control and the ability of the supervisor to monitor the firm’s compliance with all obligations. An investment firm shall have sound administrative and accounting procedures, internal control mechanisms, effective procedures for risk assessment, and effective control and safeguard arrangements for information processing systems”.
MiFID implementing directive Article 15 states that:
“1. […] Member States shall require that, where an investment firmoutsources the investment service of portfolio management provided to retail clients to a service provider located in a third country, that investment firmensures that the following conditions are satisfied: (a) the service providermust be authorised or registered in its home country to provide that service andmust be subject to prudential supervision; (b) theremust be an appropriate cooperation agreement between the competent authority of the investment firm and the supervisory authority of the service provider.
2. Where one or both of those conditionsmentioned in paragraph 1 are not satisfied, an investment firmmay outsource investment services to a service provider located in a third country only if the firmgives prior notification to its competent authority about the outsourcing arrangement and the competent authority does not object to that arrangement within a reasonable time following receipt of that notification.
The Presidency’s suggested changes would result in a delegation regime focused on the quality of the entity being delegated to and not the location of such entity. This is clearly a farmore sensible approach to that currently in the draft Directive.
It has beenwidely acknowledged that hedge funds are not leveraged nearly as highly as banks.Nevertheless there is concern that leverage levels do need to bemonitored to some degree so that if leverage levels in practice increase to such a level that hedge funds become systemically important, then the authoritieswill not be caught off guard. The concern is thatmass deleveraging at that point would be damaging to financial stability. The Turner Review summarises this view succinctly. Under the draft Directive various disclosure and reporting obligations are triggered if an AIF is deemed to employ “high levels of leverage on a systematic basis”. The draft Directive’s attempt to dealwith this issue is heavy handed. It is to be noted also that the draft Directive’s focus is not on systemic impacts of leverage use but on the systematic use of leverage, twowholly different concepts.
The definition of high levels of leverage on a systematic basis is crude (beingwhere the “combined leverage fromall sources exceeds the value of the equity capital of the AIF in two out of the past four quarters” (Article 22 of the draft Directive)). This is recognised by the Presidency as being “a bit blunt”. TheNote suggests: deleting the definition of high levels of leverage altogether; replacing the definitionwith a provision giving theCommission implementing powers in this regard (ie effectively postpone the analysis); or replacing “equity capital”with “net assets”. As theNote states, deleting the definition of high leverage altogetherwould lead to uncertainty and thus is not an appropriate solution. The suggestion that theCommission be given implementing powerswould also lead to uncertainty and in any event itmay bemore appropriate for the local regulator of the AIFMto decidewhat constitutes high leverage on a systematic basis simply because the regulatorwould be best placed to do so as recipient of relevant disclosures of financial information.
Simply replacing equity capital with net assets also causes problems given its variability in turbulentmarkets. It is unclear if the leverage would need to exceed net assets just once in two of the quarters or would need to be on average higher for each of two quarters.More fundamentally, the Note, while recognising that different AIF strategies should be catered for, fails to clearly articulate a way forward in which different AIF strategies are distinguished (although it doesmake passingmention of linking a definition of high leverage to the levels allowed for in an AIF’s prospectus or rules). Clearly the threat to stability posed by a highly leveraged open ended fund is greater than that posed by, for example, a highly leveraged closed ended fund (in which there is no right of redemption for investors whichmight trigger de-leveraging). Any definition of high leverage should factor this in. Alternatively, less problematic AIF types could be excluded fromthe provisions on leverage altogether.
The Note also states that fixed leverage caps should be removed, pointing out that inmarket downturns caps will be exceeded (presumably if expressed as a ratio in relation to equity capital or net assets), thereby triggering de-leveraging and deepening of the relevant downturn (ie pro-cyclicity).
The provisions on the acquisition of controlling stakes in investee companies (Articles 26–30) have been of special concern to private equity firms. As recognised in the Note, the provisions would create an un-level playing field whereby private equity funds are disadvantaged in relation to non-AIFMinvestors and EUmanaged private equity funds would be at a disadvantage to thosemanaged from elsewhere which, although required to comply with any relevant local laws, would not be subject to the Directive. The Note has also recognised that there seems to be overlap with other directives.
The solutions proposed are allworkable.One option is to make sure that the provisions apply in respect of investee companies of a greater size than that currently suggested (ie raise thresholds). The difficultywill be in deciding appropriate thresholds although onemight look to the Walker guidelines. Another optionwould be to delete the provisions altogether. The final option is a compromisewhereby: the provisions of the Directivewould be alignedwith that of the Takeover directive; issuers subject to the Disclosure Rules would be excluded; and any obligations imposed on the AIFM which fall under the responsibility of the investee companies themselves under existing rules should be deleted.
Third country provisions and marketing
It is perhaps the ‘third country’ articles of the draft Directive that have raised themost serious concerns in the industry and also among investors in AIFs. As detailed in our briefing Article 4 would prohibit entities which are not authorised in accordance with the Directive (or, where the entity is not covered by the Directive, in accordance with national law) frommanaging ormarketing AIFs within the EU. This, by itself, would prevent overseas AIFMs fromselling shares or units in AIFs to EU investors, unless authorised to do so under national laws. It is perhaps worth pausing to note that this highlights the significance of existing and future national private placement exemptions.
Articles 35 and 39, however set out conditions upon satisfaction of which shares or units in third country AIFs can bemarketed to EU investors (Article 35) and third country AIFMs canmarket AIFs to EU investors (Article 39). These conditions, particularly those of Article 39, are however commonly thought to be impossible to satisfy, whichmeans that third country products and expertise would effectively be barred fromEU investors.
The Presidency has acknowledged that “there seems to be an overwhelmingmajority ofMember States which are against imposing undue restrictions on investment opportunities for especially institutional investors, as well as creating other barriers to global capital flows.” Both the Securities and Exchange Commission and theManaged Funds Association in the US have expressed concerns over the implications of these provisions for US managers amongst others. The Note offers various solutions.
One option suggests completely deleting Articles 35 and 39. This, by itself, would have little effect if the actual prohibition in Article 4 remains unaltered. To this end the Note suggests relaxing the definition ofmarketing to allow investors to purchase shares or units in such AIF at their own initiative (ie allowing reverse solicitation). This would mean that while overseas AIFMs and AIFs could not proactively seek out EU investors, EU investorsmay seek them out.
A second option suggests removing Article 39 but retaining Article 35. As above, this wouldmean that third country AIFMs could notmarket AIFs unless permitted under national law. The change in the definition ofmarketing would therefore be necessary here too. In addition the AIFs that the AIFMs want tomarket would need to satisfy the conditions in Article 35.
Other suggested options are less clear. A third option is the same as the second option above but suggestsmaking Article 35 be conditional on a) the AIFMbeing domiciled in a Member State; or b) there being a cooperation agreement on “information-sharing” between the third country where the AIF is domiciled and theMember State(s) into which it markets. It is unclear if the cooperation agreement suggested would be additional to or a substitution of the tax exchange agreement required under the current Article 35.
The remaining two options suggested by the Presidency both retain Article 39. These are not satisfactory because, as stated above, these conditions are likely to be impossible to satisfy.
What the Presidency has unfortunately, apparently, not considered is retaining the current structure, but softening the conditions to the point that they are both realistic and provide comfort that any third country AIFMwill be appropriately regulated, well capitalised and satisfactory in other relevant respects. This would not leave third country AIFMs subject to unharmonised national level legislation and would keep EU investors adequately protected.
Article 35 – Conditions for themarketing in the Community of AIF domiciled in third countries
An AIFMmay only market shares or units of an AIF domiciled in a third country to professional investors domiciled in a Member State, if the third country has signed an agreement with this Member State which fully complies with the standards laid down in Article 26 of the OECDModel Tax Convention and ensures an effective exchange of information in taxmatters.
Before allowing AIFMtomarket shares or units of AIF domiciled in a third country, the homeMember State shall have particular regard to the arrangementsmade by the AIFMin accordance with Article 38, [on delegation to depositories by third country AIFs] where relevant.
Article 39 – Authorisation of AIFM established in third countries
- Member Statesmay authorise, in accordance with this Directive, AIFMestablished in a third country tomarket units or shares of an AIF to professional investors in the Community under the conditions of this Directive, provided that: (a) the third country is the subject of a decision taken pursuant to paragraph 3 (a) [of Article 39] stating that its legislation regarding prudential regulation and on-going supervision is equivalent to the provisions of this Directive and is effectively enforced; (b) the third country is the subject of a decision taken pursuant to paragraph 3 (b) [of Article 39] stating that it grants Community AIFMeffectivemarket access comparable to that granted by the Community to AIFMfromthat third country; (c) a cooperation-agreement between the competent authorities of thatMember State and the supervisor of the AIFMexists which ensures an efficient exchange of all information that are relevant formonitoring the potential implications of the activities of the AIFMfor the stability of systemically relevant financial institutions and the orderly functioning ofmarkets in which the AIFMis active. (d) the third country has signed an agreement with theMember State in which it applied for authorisation which fully complies with the standards laid down in Article 26 of the OECDModel Tax Convention and ensures an effective exchange of information in taxmatters.
At the recent FSA annual AssetManagement Conference, there were considerable concerns around retaining institutionalMember State private placement rules for professional investors along with a relaxation of its rules so as to allow reverse solicitation. There also needs to be further discussion of the three year transitional period and clarity around what would be permitted in that period.
What happens next?
As outlined in our briefing on the legislative process, the adoption of the Directive is subject to the co-decision procedure. Thismeans that both Parliament and the Council need to agree the text of the draft Directive before it is approved. The draft Directive is still awaiting its first reading (of amaximumof three) in Parliament. The Economic and Monetary Affairs Committee has been appointed as the lead standing committee to review the draft Directive (chaired by liberal democratMEP Sharon Bowles) and the Rapporteur has been appointed (Jean-Paul Gauzes, the European People’s Party’s representative for NorthWestern France). The Rapporteur will author a report setting out Parliament’s position on the draft Directive and any amendments theymay have. This report will be read and reviewed by the Council.
If the amended draft Directive is at this stage agreed it shall be adopted. If the Council rejects it, then they are obliged to draft a compromise version and the process continues fromthere as set out in our briefing. Almost the entire legislative adoption process still lies ahead. The Note issued by the Presidency is an informal contribution to the process that will hopefully be heeded by the Rapporteur in his report to the Council, thereby facilitating an expedited arrival at a common position. The proposed timing for the adoption of the Directive has been formally delayed by a number ofmonths until the end ofMay 2010 at the earliest. On that basis, the Directive will not come into force until the middle of 2012 and any transitional provisions would expire in 2015. Given the complexities of the issues that remain to be addressed, further delay is quite possible.
Issues not raised
The Note touches onmost of the key areas of concern. There are still some areas, however, which it does not deal with, including:
- Who exactly is the AIFM?
- Appropriateness of disclosure provisions
- Who will process this information?
- What will be done with it?
- Is there a genuine benefit tomatch the cost of compliance?
- Appropriateness of the approval process for marketing privately placed funds
- Appropriateness of risk governance regimes
- How willmaster-feeder structures be governed?