On April 30, 2009, the European Commission issued its proposed Directive on Alternative Investment Fund Managers (the “Directive”). The Directive aims to create a comprehensive regulatory and supervisory framework for managers of hedge funds and private equity funds in the European Union. The Directive represents the first attempt to create a comprehensive framework for the direct regulation and supervision of the investment fund industry, and also represents the first proposed regulatory initiative to emerge from among the recommendations of the leaders of the G-20 as well as of the High Level Study Group on Financial Supervision chaired by Jacques de Larosière.
AIF Managers Subject to Regulation. The Directive applies to managers and administrators established in the EU who manage alternative investment funds that are not regulated under the UCITS Directive,1 including hedge funds, private equity funds, commodity funds, real estate funds, infrastructure funds and other types of institutional funds (such managers, “AIF Managers” and such funds, “AIFs”). The Directive would apply to the AIF Managers irrespective of the legal domicile of the AIFs managed (i.e., whether or not domiciled in the EU) or the legal structure of the AIF Managers and the AIFs. The Directive would only apply to:
- Leveraged AIF Managers – AIF Managers with assets under management (including any assets acquired through the use of leverage) equal to or greater than €100 million; and
- Non-Leveraged AIF Managers – AIF Managers with assets under management equal to or greater than €500 million, where the portfolio of AIFs consists of AIFs that are not leveraged and have no redemption rights exercisable during a period of five years following the date of constitution of each AIF.
The European Commission estimates that, as currently drafted, the Directive would cover approximately 30% of hedge fund managers, managing almost 90% of assets of EU domiciled hedge funds, and almost half of managers of other non-UCITS funds and provide almost full coverage of the assets invested in their funds.
Importantly, the Directive would not regulate an AIF itself, nor would it aim to regulate investment policies, except with respect to securitized products. Moreover, it would not constrain AIF Managers from taking short positions or borrowing or using derivatives, though other applicable regulations might do so. The Directive would not cover remuneration of AIF Managers or the fees that AIF Managers charge for their management services. The Directive would not apply to EU-domiciled AIF Managers that do not provide management services to an EU-domiciled AIF and do not market AIFs within the EU. Managers of AIFs that are below the financial thresholds described above would remain subject to national regulation and supervision of the Member States.
Authorization and Operating Requirements. To operate in the EU, regulated AIF Managers would be required to obtain authorization from the competent authority of their home Member Sate and would be subject to ongoing requirements. These AIF Managers would be required to demonstrate that they are suitably qualified to provide AIF management services and would be required to provide detailed information on their planned activities, the identity and characteristics of the AIFs managed, the governance of the AIF Managers (including any delegation arrangements), internal arrangements with respect to risk management, arrangements for the valuation and safe-keeping of assets and the systems of regulatory reporting. Regulated AIF Managers would be required to employ a liquidity risk management system to prevent a mismatch between the frequency of investor redemptions and the illiquid nature of a portfolio.
Regulated AIF Managers would be required to report on regular basis to their home Member State’s competent authority on the principal markets and instruments in which they trade, their principal exposures, performance data and concentrations of risk. These AIF Managers would also be required to notify the competent authority of the identity of the AIFs managed, the markets and assets in which the AIFs invest, and the organizational and risk management arrangements established in relation to the AIFs.
The Directive contains a number of common disclosure requirements that would be applicable to all regulated AIF Managers, such as risk, return and liquidity characteristics, identity of service providers, risk management systems, percentage of an AIF’s assets that are subject to special arrangements (e.g., side pockets), fees and charges that are directly or indirectly borne by investors and preferential treatment provided to other investors by the AIF Managers. Additional disclosure would be required where the assets under management have either been acquired through leverage, or include a controlling stake in an EU-domiciled company (30% or more of the voting rights, subject to certain exceptions). AIF Managers would also be required to make available audited annual reports of the AIFs to investors and the competent authorities within four months following the end of the financial year.
The Directive also imposes duties on the AIF Mangers to act in the best interest of the AIFs, the investors of those AIFS and the integrity of the market, and to ensure that all AIF investors are treated fairly. Preferential treatment of investors would not be permitted unless disclosed in the AIF rules or constitutive documents. AIF Managers would also be required to take all reasonable steps to identify and prevent conflicts of interest between the AIF Manager (including its mangers, employees or control persons) and the investors in the AIFs managed by the AIF Manager, or between investors, that arise in the course of managing one or more AIFs.
Capital Requirements. Regulated AIF Managers would be required to hold and retain a minimum level of capital of at least €125,000, plus 0.02% of the amount by which the value of an AIF Manager’s portfolios exceeds €250 million. AIF portfolios that are managed by an AIF Manager under delegation would be included in the calculation.
Securitized Products. In order for AIF Managers to be able to invest in securitized products issued after January 1, 2011, originators of such products would have to meet certain, yet unspecified, requirements. At the very least, the originators of such products would have to retain a net economic interest in the products of not less than five percent (similar to the proposal included in the amended Capital Requirements Directive). Also, the AIF Managers would have to meet qualitative requirements, also unspecified, to be able to invest in such products.
Supervisory Cooperation Information Sharing and Mediation. The Directive envisions significant levels of cooperation and information sharing. Competent authorities of Member States would be required to transmit relevant macro-prudential data to public authorities in other Member States and to the Committee of European Securities Regulators (CESR).
Rights of AIF Managers under the Directive. An AIF Manager authorized in its home Member State would be entitled to provide management services and/or market AIFs to “professional investors” in any country within the EU (subject to a notification procedure under which relevant information is provided to the home and host Member State). AIF Managers would be permitted to continue marketing to retail investors in those Member States that allow such marketing, and those Member States may impose additional regulatory requirements on the AIF Managers or the AIFs. However, marketing to retail investors would only be permitted where a Member State expressly grants that right and such right may not be “passported” to any other Member State.
Third Country Aspects. The Directive permits EU-authorized AIF Managers to market third country (i.e., non-EU domiciled) AIFs to professional investors domiciled in a Member State if the third country has signed an agreement with the relevant Member State which fully complies with the standards for tax transparency set forth in Article 26 of the OECD Model Tax Convention and ensures an effective exchange of information in tax matters.
In addition, Member States may authorize AIF Managers established in a third country to market units or shares of an AIF to professional investors in the EU under the Directive, provided that:
- the third country’s legislation regarding prudential regulation and on-going supervision is equivalent to the provisions of the Directive and is effectively enforced;
- the third country grants EU AIF Managers comparable market access;
- the AIF Manager provides the competent authorities of the Member State in which is applies for authorization with relevant information;
- a cooperation agreement between the competent authority of the relevant Member State and the supervisor of the AIF Manager exists, ensuring efficient information exchange; and
- the third country has signed an agreement with the Member State that fully complies with the standards for tax transparency set forth in Article 26 of the OECD Model Tax Convention and ensures an effective exchange of information in tax matters.
Due to the complexity of creating such a system, passporting rules would only come into force three years after the Directive becomes effective. In the meantime, Member States may allow or continue to allow AIF Managers domiciled in third countries to market AIFs, and third country-AIFs to be marketed, to professional investors subject to national law.
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The terms of the Directive have, not surprisingly, attracted a fair amount of scrutiny and controversy in the short period since the draft was released. Significant criticism has been leveled from both sides – the proposed rules go too far, or they do not go far enough. It remains to be seen which direction the EU regulations ultimately will go.
The Directive now passes to the European Parliament and then the European Council for further debate and consideration. Following adoption, the Directive would be complemented by implementing measures adopted by the European Commission and would then need to be transposed into national law by the Member States. Member States would have flexibility in incorporating the Directive into national law. The Directive is not expected to come into force until 2011.