Hedge funds, private equity funds and other alternative investment funds and their managers have been ever-present on the regulatory reform agenda for the past two years. Rosali Pretorius of Denton Wilde Sapte and Mary Joan Hoene of Sonnenschein Nath and Rosenthal examine legislative proposals in Europe and the States and suggest it may become harder for US-based promoters to target EU investors and, to a lesser extent, for EU-based promoters to target US investors.

Diverging drafts

The end of the European Parliament summer recess, which temporarily halted the already slow progress of the Alternative Investment Fund Managers Directive (the AIFMD), has been marked by the publication by the European Council of a new compromise proposal for the AIFMD prepared by the Belgian Presidency.

There has been much discussion and intense lobbying since the AIFMD was first published by the European Commission and the original draft did not get a generally positive reception in the UK and several other European countries.

“The current draft EU directive… will be damaging to the UK and EU economy,” the Confederation of British Industry said. “It is clear to us all that the draft directive is flawed,” commented the then UK Financial Services Secretary Paul Myners, while the Alternative Investment Management Association (AIMA) said, “hastily prepared and without consultation, the directive contains many ill-considered provisions which are impracticable and may prove unworkable”.

The controversial nature of the AIFMD has delayed the progress of the directive. The original European Commission draft dates back to 30 April 2009 and the AIFMD is still only at the first level of the Commission’s legislative process. This process (known as the Lamfalussy Process) consists of level one, framework legislation; level two, implementing measures; level three, best practice and supervisory convergence; and level four, enforcement.

Level one finishes with the adoption of a directive, and has a number of stages. The first of these started for the AIFMD in April last year when the Commission proposed its draft to the European Parliament and the EU Council of Ministers. The AIFMD has since undergone review and change by the committees of both Parliament and the Council.

As a result, there are now two updated versions of the AIFMD: the Parliament draft, which was approved by Parliament’s Economic and Monetary Affairs Committee on 17 May 2010, and the Council draft, which was approved by the Economic and Monetary Affairs Council (composed of the member states’ economic and finance ministers) on 18 May 2010. The compromise proposal by the Belgian Presidency published on 27 August 2010 has not yet been adopted by the Council and is not yet complete. It does not include new text on the controversial third country proposals – only headings - and the recitals are to follow. The approved drafts diverge in several key areas, and the Belgian Presidency’s compromise proposal is different again. Given the extent of the differences, and the possible legislative process, it may be several months before a level one directive is adopted, if at all. And then time has to be allowed for the implementing measures, and for member states to implement the directive.

In the meantime, the US has enacted – but not yet implemented – new provisions which will affect alternative investment funds and fund managers.

Effect of new US legislation

While the EU’s planned overhaul of legislation regulating alternative investment fund managers (AIFMs) looks set to be subject to further delays, the US has moved ahead. The Private Fund Investment Advisers Registration Act (the Registration Act) was passed on 21 July 2010 as Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act).

End of private adviser exemption

The Registration Act amends the Investment Advisers Act of 1940 (the Advisers Act) and eliminates the ‘private adviser’ exemption that managers of most private investment funds have relied upon in the past to avoid registering as an investment adviser with the US Securities and Exchange Commission (the SEC). The old law exempted from registration an adviser with fewer than 15 clients so long as the adviser did not ‘hold itself out’ to the public as an investment adviser. A fund is considered a single client, so a fund manager could run 14 funds and avoid registering so long as it did not advertise its services to or actively solicit the general public.

The Registration Act defines as a ‘private fund’ a fund that would be required to register as an investment company under the Investment Company Act of 1940 but for the exemptions available under either section 3(c)(1) or section 3(c)(7) of that Act. Such a fund may not be distributed in a ‘public offering’ as defined under the Securities Act of 1933 provisions and rules, and generally must be offered privately to high-net-worth ‘accredited investors’. Section 3(c)(1) funds may not exceed 100 investors. Section 3(c) (7) funds are further limited to ‘qualified purchasers’, such as individuals with at least US $5 million of investment assets, and institutions with at least $25 million in such assets. The number of shareholders in a section 3(c)(7) fund must stay under 500, in order for the fund to maintain its private status.

After 22 July 2011, private fund managers in the US with at least $100 million (or, in certain cases, $150 million) of assets under management must register with the SEC, comply with the Advisers Act rules and be subject to SEC inspections. Smaller advisers will move to a state registration regime.

Foreign private adviser exemption

Non-US fund managers with US clients or who manage private funds that have US clients will be subject to the Advisers Act, including SEC registration, unless they fall within a new ‘foreign private adviser’ exemption. This narrow exemption is limited to those managers with fewer than 15 clients or fund investors in the US or less than US $25 million under management with respect to US clients or fund investors, so long as the manager does not ‘hold itself out’ to the public in the US as an investment adviser or advise a US investment company or business development company. The SEC has the authority to set a higher threshold for registration than US $25 million under management, which it could do through rulemaking or exemptive relief.

The foreign adviser aspect of the Registration Act has received remarkably little attention to date; however, it is a significant expansion of US jurisdiction outside its borders to reach non-US banks and other institutions providing asset management services or private funds to more than 15 US clients or fund investors. Previously, private fund managers had no monetary trigger for jurisdiction, and simply needed to have fewer than 15 funds with US investors and otherwise observe the offering and investor limitations referenced above.

SEC registration process

SEC registration is accomplished by filing a Form ADV electronically with the SEC through the Investment Adviser Registration Depository. Part II of the form operates as a disclosure form for clients. The SEC recently adopted significant changes to Part II, effective 1 January 2011, which are designed to provide more information for investors about an adviser’s business, personnel, fees, conflicts of interest and operations, with the goal of enabling the public to compare the services and products offered. Once registered, an adviser must update its Form ADV annually and promptly in the event of a material change to its business. Registered advisers must comply with the Advisers Act rules, which include having a code of ethics, restrictions on personal trading by personnel, appointment of a chief compliance officer and adoption of compliance policies and procedures, restrictions on principal and agency trades with clients, custody requirements, and limitations on political contributions.

All non-US fund managers who have US investors and who are not SEC-registered will need to evaluate their business models. Managers of offshore funds with feeder funds for US investors will almost certainly have to register, along with the sub-adviser to these funds. Note that recent US Department of Justice and SEC investigations into tax abuse by US persons with offshore accounts and resulting actions have caused many smaller and mid-size financial institutions outside the US to close accounts and otherwise adjust their businesses to US tax and securities law risk. This trend can be expected to continue as a result of the Registration Act.

Volcker Rule

The Dodd-Frank enacted new restrictions limiting the size and risk-taking activities of banking institutions, known as the ‘Volcker Rule’. The effect is to limit the number of potential investors in funds: US banks will be restricted from ‘sponsoring and investing in’ hedge funds and private equity funds. “Sponsoring” means acting as a general partner, controlling the majority of the fund’s board or sharing the same name as a fund. Certain de minimis activities are permitted, and there is a phase-in period, but it seems inevitable that US banks will need to divest in this area going forward.

Systemic risk

The Dodd-Frank Bill also creates a new ‘systemic risk regulator’, consisting of a council of all the financial regulators. This regulator has authority to identify market participants (including a ‘non-bank financial company’) who pose a systemic risk. It is possible that a private fund could be deemed to be a non-bank financial company, in which event the fund and its manager could be subject to additional record-keeping, supervision and regulatory requirements.

Where we are on EU proposals

It is not at all clear what the final form of the level-one directive will be. The two updated draft forms of the AIFMD contain key differences which remain to be resolved. If pursued, the current proposals will have a profound effect not just on funds and fund managers, but on all service providers, especially custodians.

Further stages in the process

The next stage of the legislative process is the co-decision procedure. This involves up to three readings in which both Parliament and the Council vote on the proposed directive. The AIFMD is still in the pre-first-reading stage. A starting point for the co-decision procedure can involve negotiations between the Commission, the Council and Parliament (so-called trialogue discussions) to produce a compromise text for acceptance by both the Council and Parliament. There have been several trialogue meetings on the AIFMD since the end of May 2010 with a view to agree a text for approval at the first-reading phase.

A first-reading Parliament vote for the AIFMD was originally planned for 6 July 2010, but was cancelled due to a lack of agreement between the bodies. There is now supposed to be a vote in late September but it seems, from the last trialogue meeting, that it is unlikely that Parliament will close its first reading in time. Once Parliament has voted, the Council has its first reading of the Parliament-approved text.

If the Council accepts this text, the co-decision procedure comes to an end and the proposed directive is adopted. If the Council cannot agree the text, it must decide a common position between the member states. As the Council should, in principle, take Parliament’s approved text into consideration, this common position is often a compromise. If a compromise situation does arise, the co-decision procedure must enter a second-reading phase. If Parliament does nothing within three months of the Council sending it its common position, or approves the common position, the common position enters into force as a directive. If Parliament does not agree with the common position, it may either vote to reject it, in which case the co-decision procedure comes to an end, or vote to change the text.

If Parliament votes to change the text at the second reading, the amended text is sent to both the Council and the Commission and the third-reading phase is entered. The Commission must prepare an opinion on the proposed amendments. Again, a period of three months starts from when the Council receives the amendments, within which period the Council must vote on the amendments.

If Council does not approve all the amendments, a Conciliation Committee must be convened within six weeks of the Council’s decision. The Conciliation Committee comprises an equal number of representatives from the Council and Parliament. The Conciliation Committee has six weeks in which to adopt a text. If the Conciliation Committee agrees a joint text, the Council and Parliament have a further six weeks to vote on the text. If the Conciliation Committee does not adopt a joint text or either of the Council or Parliament does not approve the joint text, the directive is not adopted.

The periods of three months and six weeks can be extended by one month and two weeks respectively.

Given the key differences between the Council and Parliament discussed below, the proposal may well reach the Conciliation Committee. Even if this results in a directive, and it may not, it will be after a very long drawnout process.


Under the AIFMD, anyone that is an AIFM – a legal person whose regular business is ‘managing’ alternative investment funds – AIFs – is to be regulated unless an exemption applies.

The Council and Parliament drafts clarified that the AIFMD applies to all AIFMs ‘established’ in any of the EU member states. Certain provisions – notably those on marketing – also apply to non-EU AIFMs.

Although the detail is yet to be inserted, the Belgian Presidency’s compromise text, which contains a heading that suggests that it will make a proposal following trialogue discussions, expands the scope of the AIFMD to allow for non-EU AIFMs, who manage EU AIFs, to be registered by the soon-to-be-created European Securities and Markets Authority (ESMA), presumably to manage EU AIFs and/or to market into the EU.

It extends to all collective portfolio management activities regardless of underlying assets. Unfortunately it is not clear what is meant by ‘management services’ for the purposes of the directive.

Currently, investment management is a regulated activity, at least in the UK, but only if it relates to ‘investments’ as defined. The Markets in Financial Instruments Directive (MiFID) specifically exempts managers of collective investment undertakings, whether coordinated at EU level or not, from its requirements, so there is currently no pan-EU licensing requirement for alternative fund managers. There is no mention of ‘operating’ as a specific activity covered by the AIFMD. Many of the activities currently carried on by FSA-authorised operators seem to be subsumed under ‘administration’. How current UK categories of regulated activity around alternative investment funds will map across to new rules remains to be seen.

The Commission’s explanatory memorandum stated that the management and administration of all AIFs in the EU must be authorised and supervised in accordance with the requirements of the AIFMD. The Commission draft is a little ambiguous in that an “AIFM” is defined as any legal or natural person whose regular business is to manage one or several AIFs, and the ‘management services’ which an AIFM may provide include both managing and administering activities. So it seems from this that administrating on its own will not make a person a manager; management is needed.

The Parliament draft has added a further qualification to the AIFM definition so that an AIFM is a manager that is responsible for compliance with the AIFMD. It is difficult to see, in practical terms, how this qualification will make any difference to the scope of the directive. The Parliament draft also expands further the definition of management services and adds a definition of ‘administration’. It includes legal and fund management accounting services, customer enquiries, maintenance of unit-holder registers and recordkeeping. ‘Marketing’ is also covered by the definition of management services.

The Council draft deletes the definition of ‘management services’ and instead defines what is meant by ‘managing’ an AIF. Managing activities are listed as portfolio management and risk management functions. The Belgian Presidency’s compromise text says that a person must provide “at least” portfolio management and risk management to be a manager. While the Council draft includes administration and marketing as functions that an AIFM may carry out, these are not defined as ‘managing activities’.

The Council draft is more in line with the way most alternative investment funds are organised. Very few investment fund managers are also administrators.

An EU-licensed AIFM will have to comply with the requirements of the AIFMD. These will include capital requirements and operational standards. On the plus side, an authorised AIFM can benefit from the ‘passport’ provisions of the AIFMD to set up a branch or provide cross-border services into another member state without needing separate authorisation from that host state. It can also market EU funds across the EU – non-EU funds may also be marketed, but not on a passport basis. The ability of non-EUlicensed AIFMs to market in the EU is far more restricted.

Are all funds equal?

The original Commission draft suffered much criticism for adopting a one-size-fits-all approach to funds. Both the Parliament and the Council drafts have moved away from the Commission’s approach and altered the proposed scope.

The Parliament draft provides for different levels of regulation to apply to AIFMs managing different types of funds. Its draft includes partial exemptions for AIFMs that are ‘non-systemically relevant’ and for those that manage private-equity funds and real-estate funds.

A non-systemically relevant AIFM is one which manages portfolios of AIFs that are not leveraged and whose individual assets under management do not exceed €100 million, and in total do not exceed a threshold of €250 million, and that do not have redemption rights exercisable during a period of five years following the date of constitution of each AIF.

They have to comply with the directive’s provisions on authorisation, ethics and prevention of conflict of interest, transparency requirements, reporting, risk management and capital. But the directive’s other provisions, including the restrictive proposals on depositories and third countries (marketing of third-country AIFs and marketing by thirdcountry AIFMs) will not apply.

Periodic valuation is optional for an AIFM managing a real-estate fund and the requirements on depositories do not apply.

Parliament also proposes to regulate AIFMs managing private-equity funds more lightly, but not to exclude application of the controversial provisions on thirdcountry funds and managers. Also note that an AIFM managing a private-equity fund cannot benefit from the non-systemically relevant AIFM exemption, so cannot circumvent the third-country rules by remaining under the size limits.

A “private-equity AIF” is defined as a fund the policy of which is to invest in equity and equity-related securities of, principally, private companies and businesses in order to finance venture capital, growth plans and buyouts. Closedend funds and fund of funds are expressly included.

By contrast, the Council draft gives member states the ability to choose whether to apply all or even just parts of the directive to certain AIFMs, including AIFMs with managed assets of less than €100 million (if they use leverage) or with managed assets of less than €500 million (if they do not use leverage and there are no redemption rights within five years). Such lighter-regulated AIFMs will not benefit from a European passport.

The Council approach offers more flexibility but increases the possibility of uneven regulation across member states.

The Belgian Presidency’s compromise text is even more favourable to smaller fund managers (it uses the same limits and definitions as the Council draft). There is no member state ability to choose whether to apply certain parts of the AIFMD. The only requirements for smaller AIFMs will be to register with the home regulator and provide information on trading to enable systemic risk monitoring. Again, such lighter-regulated AIFMs will not benefit from a European passport or any other rights under the AIFMD. But they can choose to opt into regulation.


A common structure currently adopted with a view to lighten tax and regulatory burdens is to split management activities from advising and arranging activities by delegating certain tasks. Delegation of functions is permitted under all three drafts of the AIFMD, but the additional requirements may be too onerous. The Council draft requires AIFMs to notify the regulatory authorities of its delegation arrangements.

Delegation of portfolio management or risk management may only be given to bodies that are authorised or registered for the purposes of asset management and subject to supervision. If the sub-manager to whom management is delegated is in a third country, there must in addition be cooperation between the regulatory authorities in the home member state and that which supervises the delegated body. The Parliament draft goes further. It implies that delegation of portfolio management, risk management or liquidity management may be to other AIFMs only.

In contrast to the Council draft, which requires notification, both the Commission and the Parliament drafts imply that delegation requires prior approval by the regulatory authorities. The Parliament draft also requires that AIFMs must inform investors which functions have been delegated and to whom. The Belgian Presidency’s compromise text keeps notification but includes an alarming further requirement for AIFMs to justify their entire delegation structure to their regulator with ‘objective reasons’, no doubt so as to assuage those insisting on prior approval.

All three drafts place a limit on the extent to which an AIFM may delegate the performance of its functions. The Commission draft states that an AIFM may not delegate its functions to the extent that it may no longer be considered to be the manager of an AIF. The Parliament and Council drafts use the term ‘letter-box entity’ to describe the state at which an AIFM ceases to be the manager of an AIF. However, they provide that liability of the AIFM under the AIFD shall not be affected by any delegation, even if it has delegated to the point of becoming a ‘letter-box entity’.

These provisions should be taken into account by any third-country promoter – someone in the US, for instance, wishing to set up an EU-based AIF with an EU-based AIFM aimed at EU investors. If any of the current versions of the directive is adopted, it will be necessary to give careful thought to the allocation of responsibility between EU and non-EU managers and sub-managers, and the likely concomitant regulatory hurdles.

Master feeder structures

Many a fund promoter may have wondered whether an obvious way around the new provisions is to set up European feeder funds for European investors. But the drafts contain proposals that will make this a less realistic proposition. The Council draft defines a ‘feeder AIF’ as an AIF that invests at least 85% of its assets in a master AIF, or in more than one master AIF where the master AIFs have identical investment strategies, or, according to the compromise text, an AIF that has an exposure of least 85% of its assets to one or more master AIFs. The Council draft allows a feeder AIF to be marketed in the EU only if the master AIF is established in the EU and managed by an EU-licensed AIFM. The Parliament draft is less restrictive. It does not permit marketing to retail investors where an AIF invests more than 30% in other AIFs that do not benefit from a marketing passport under the AIFMD.

Third countries

Probably the most controversial and problematic of the outstanding points are the so-called third-country issues concerning the provisions of the AIFMD that deal with how non-EU managers can market their funds into the EU and how anyone can market non-EU funds within the EU. The difficulties in achieving agreement on these provisions is highlighted in the Belgian Presidency’s compromise draft which, while retaining article headings, omits the text. Instead, the Council draft contains a note stating that the text will be included after the third-country section of the trialogue discussions.

The Council and the Parliament drafts define “marketing” as any direct or indirect offering or placement to or with investors who are “domiciled” (as defined in the Council draft) or “established” (as defined in the Parliament draft) in the EU. This definition differs from the Prospectus Directive, which refers to an “offer of securities to the public”, and requires marketing material to present “sufficient information … so as to enable an investor to decide to purchase or subscribe” to the securities. The Council and the Parliament drafts’ concept of marketing is far wider than that of the Prospectus Directive, capturing preliminary and ancillary information as well as formal offering documentation.

The Council draft lets each individual member state decide whether non-EU funds may be marketed in its territory (regardless of whether the manager marketing the fund is from the EU or not). However, where an AIFM is licensed within the EU, it requires cooperation arrangements between that AIFM’s home state regulator and the regulator in the non-EU jurisdiction where the AIF is established, and for the manager to comply with certain key provisions of the AIFMD. The detail of the marketing provisions for non- EU funds is missing from the compromise text.

The Council draft also allows marketing by a non-EU AIFM to professional investors. However, as well as requiring that cooperation arrangements must be in place between the regulators of the member state and of the non-EU AIFM, the Council draft requires that a non-EU AIFM also complies with certain reporting requirements. The Parliament draft is more restrictive than that of the Council draft, particularly on marketing by non-EU AIFMs (of either EU or non-EU AIFs). It requires that non-EU AIFMs may market solely to professional investors and only then if the country in which the non-EU AIFM is domiciled: enters into a cooperation agreement with the regulator in the investors’ domicile; has an equivalent anti-money laundering regulation; complies with the OECD model tax convention standards; grants reciprocal market access to EU fund managers; and recognises and enforces judgments by the EU on matters connected with the AIFMD.

There are similar requirements for the marketing of non-EU AIFs, whether marketed by EU or non-EU AIFMs.

Also, the Parliament draft includes an extraordinary provision in article 35a, prohibiting professional investors in the EU from investing in third-country AIFs unless all the conditions set out above for third-country AIFMs are met by the country in which the AIF is domiciled. There is no grandfathering provision. It is unlikely that all funds currently domiciled outside the EU would look to relocate to an EU jurisdiction and that each third country would implement the reciprocity provisions. So, if implemented, this provision could severely limit the universe of funds available to EU investors.

What next?

With the Registration Act in force, an EU fund manager could easily find itself subject to registration in the US within the next year. Similarly, once the AIFMD is in operation, a US investment adviser could be required to comply with EU record-keeping and disclosure obligations to be able to market to investors located in the EU.

While the new US law will affect managers of certain non-US funds, US Senator Charles Schumer has described the European proposals as “protectionist rules that discriminate against US firms and activities”. In a letter to the US Treasury Secretary he said that he is ready to call on Congress to pass legislation that would prohibit funds not based in the US from marketing and raising money in the US, as well as require funds operating in the US to use custodian banks based in the US. Leaked letters from the US Treasury Secretary to the EU Commission and to individual finance ministers express concerns that the EU proposals would “discriminate against US firms and deny them the access to the European market that they currently have”.

It is curious the Senator would take this position given the assertion of jurisdiction over non-US advisory firms by the Registration Act, which can be considered equally protectionist. Also, section 7(d) of the Investment Company Act already makes it virtually impossible for a non-US investment company to make a public offering in the US without full registration as an investment company with the SEC, which as a practical matter is simply too difficult for various structural and operational reasons. Non-US managers may only engage in private offerings under sections 3(c)(1) and 3(c)(7) and other limited activities. It will be very interesting indeed to see what the result of the trialogue discussions on third-country provisions in the AIFMD will be in the light of the US changes.

With the progress of the AIFMD unlikely to speed up substantially, and not coming into force until 24 months after it is adopted, the effect of the EU regulation will be seen much later than US regulation already enacted.

The longer-term effect on capital flows from the US legislation and whatever happens in the EU remains to be seen. Presumably, the very large banking institutions will be able to cope and prosper, but this may also result in further concentration of risk in the financial system, contradicting policy goals.

This article was written for Compliance Monitor