Introduction and Background
The European Commission published a draft Directive on 29th April 2009 proposing stricter regulation of Managers of Alternative Investment Funds established in an EU member state, and amending Directive 2004/39/EC, the Markets in Financial Instruments Directive. If approved by the European Parliament, the proposal’s provisions will come into force in 2011.
Scope of the Proposed Directive
The scope of the measures outlined in the proposal is defined as applying to Alternative Investment Funds Managers (“AIFM”), that is all funds that are not regulated under the UCITS Directive 85/611/EC, as amended. This includes hedge funds, commodity funds, infrastructure funds, real estate funds, private equity funds, feeder funds, funds of funds, and non-UCITS retail funds. The draft Directive will apply to Managers with assets under management of €100 million or more that use borrowed money. It further covers private equity groups that do not use borrowed money and manage a minimum of €500 million in assets.
The Commission has stated that the most effective way to regulate AIFM activity is to focus on the Managers themselves. This is reflective of calls for supervisory reform in Europe following the turmoil of the 2007 downturn. It is based on reasoning that the risks associated with hedge funds and private equity turn largely upon the activities of the Managers, as opposed to being associated with particular types of fund.
The main provisions which seek to reform the regulation and supervision of AIFM are as follows:
- Authorisation: Managers of alternative investment funds domiciled in an EU Member State will be required to obtain authorisation from the competent financial services regulator. This will then permit them to operate throughout the EEA.
- Ongoing supervision: The AIFM will be required to provide the competent state authority with regular update information on the identity of the AIF it manages, the organisational and risk management arrangements it has in place, the markets and assets in which it hopes to invest, its principal exposures, performance data and concentrations of risk. Details of the AIFM approaches to internal risk management must also be furnished on an ongoing basis, specifically those associated with short selling, conflicts of interest, valuation of assets and its depository arrangements. The Commission’s goal is for the regime to be tailored to suit the specific needs of the particular investment strategy in place.
- Minimum Threshold: The Directive’s proposals apply only to Managers with assets under management of €100 million or above. Information for Investors: Under the proposals, AIFM will be required to furnish their investors with ongoing information pursuant to their particular investment framework. An outline of the investment policy, assets, its use of leverage, its redemption policy, its valuation and risk management procedures as well as the range of fees involved in the investment are just some of the particulars to be made available on a regular basis.
- Professional Investors Only: Following authorisation in its Member State, an AIFM will have the right to market its EU domiciled fund throughout the EU territory, but this marketing is to be restricted to professional investors only, principally as a safeguard against the higher risks posed by alternative investment funds. AIFMs’ right to extend marketing to retail investors is at the discretion of each Member State, and each state’s policy should be specified in its implementation of the Directive.
- Non-EU domiciled AIF: These funds will only be able to be marketed to professional investors within the EU on a very restricted basis. Firstly, any such marketing will not be permitted for three years following the transposition of the Directive into law, delaying any marketing of non-EU funds until 2014 at the earliest. This is to allow for compliance with the stringent rules with which AIFs established outside of the EU must now comply before marketing will be approved, including a determination by the Commission that the domestic regulatory provisions of the third country in question are equivalent to the standard of protection provided by the Directive. As a further condition for marketing within the EU, the draft Directive also stipulates that the country in which such an AIF is domiciled must enter into an agreement with each Member State in which the AIFM wishes to avail of marketing, to provide it with sufficient tax information surrounding the AIF so as to enable the tax authority in the Member State to tax the AIF’s investors.
- Appointment of EU Depositories: Each AIFM will be required to appoint an EU credit institution as its depository, to hold cash and other assets. This task may be delegated to sub-depositories. For non-EU domiciled AIFs, the appointment of a sub-depository from its own country of domicile will be permitted subject to stringent conditions.
- Appointment of an Independent Value Agent: An independent value agent will be appointed by AIFM for the AIF it manages. If this agent is domiciled outside of the EU, the Commission must first determine that its standards of valuation are equivalent to corresponding EU standards.
- Restrictions and Limitations on Leverage: Where AIFM employ systematically high levels of leverage in one of more of their AIFs the Directive outlines the disclosures that must be then be made to investors and regulators. The Directive also contains a provision empowering the Commission to set a limit on the leverage which may be utilised by an AIFM, with regard to their record, sources and strategies, where this is required to ensure the integrity of the financial system.
- Disclosure of holdings in Companies: Additional annual disclosure obligations will be applied to AIFM who acquire a controlling interest in a company. An AIFM with a controlling stake in a portfolio company must furnish other shareholders and employees on the investment strategies and objectives of its fund. This requirement will also apply to delisted companies for a two-year period following delisting.
Critique of the Current Draft
EU Internal Market Commissioner Charlie McCreevy has described the draft as “a consensus” that is “appropriate” to provide for the kind of regulation needed in the industry. The Commission’s objective was to produce a regulatory framework that would attempt to avoid a repeat of what many see as the fund industry’s contribution to the worsening of the financial crisis in Europe.
However opinions voiced on the Directive following its publication have varied. In particular, concern has been voiced that the consultation process in finalising the draft’s provisions was less than satisfactory, with industry bodies sidelined in favour of producing a “quick fix” to please the electorate ahead of the upcoming elections. Immediately prior to publication, the threshold for exclusion of AIFM was lowered from €250 million to €100 million, a rather sweeping adjustment in relation to which no industry debate took place.
The Alternative Investment Management Association has issued a statement saying it is unclear how this new Directive will fit in with the regulatory framework envisaged by the G20, where it was agreed that both the Financial Stability Board and the International Organization of Securities Commissions (IOSCO) would review the regulation of AIFM. AIMA have announced plans to create a Steerage Group which will lobby against aspects of the Directive which have not been the subject of consultation within the industry, and which they claim will prove to be “unworkable”.
Reaction from the funds industry in London has been particularly critical, based on the opinion that such extensive regulation, effected without consideration for the industry’s ongoing internal reviews, will drive investors from the UK and permanently restrict the successful funds industry in London.
Conversely, French Finance Minister Christine Lagarde, has said that France will continue to push for much tighter regulation of the funds industry than the contents of the Commission’s proposal, calling it “regulation at its minimum”.
It is therefore likely, given the heated debate surrounding the proposal’s provisions, that an extensive review of the draft will take place as it is discussed in the European Parliament over the coming months.