The European Parliament approved the long-awaited Alternative Investment Fund Managers Directive (the “AIFM Directive” or the “Directive”) on November 11, 2010. The good news for non-EU fund managers is that the AIFM Directive allows non-EU fund managers the same rights of access as EU fund managers to the European Union markets via a “passport” system. The bad news is that the AIFM Directive imposes a high regulatory burden on all fund managers managing or marketing funds within the European Union. The new regulatory scheme will be phased in over time with most rules becoming effective in early 2013. The passport system for non-EU fund managers will not be implemented until 2015 or later.
The AIFM Directive is a response to the financial crisis and aims to establish uniform requirements governing fund managers in order to moderate the risks in the financial system. The Directive will generally apply to fund managers managing all types of hedge, private equity and real estate funds other than collective investments in transferable securities and family office vehicles that do not raise external capital. The definition of alternative investment funds is quite broad and may also apply to certain joint ventures. The AIFM Directive applies to (i) all EU fund managers managing funds regardless of where they are marketed, (ii) non-EU fund managers managing EU funds regardless of where they are marketed, and (iii) non-EU fund managers marketing funds within the EU. The size of the funds managed by a fund manager along with the use of leverage by a fund manager will determine the amount of regulation to which the fund manager is subject. The Directive focuses on the fund managers and does not regulate the funds themselves. As a result, the funds may be subject to additional regulation and supervision at the national level. The AIFM Directive, however, does not impact the ability of a professional investor based in the EU to initiate an investment in a fund regardless of where the fund manager or the fund is established.1
The AIFM Directive mandates comprehensive oversight of fund managers coming within its scope by requiring specified capital requirements, establishing policies with respect to compensation, conflicts of interests, risk management, valuation and use of leverage and imposing certain reporting obligations. Fund managers with total assets under management up to EUR 100 million (approximately $140 million) and fund managers with unleveraged total assets under management of up to EUR 500 million (approximately $700 million) with no redemption rights do not have to comply with many of the requirements set out in the Directive. Rather the Directive requires member states to ensure that such fund managers are subject to registration at the national level and specify minimum registration requirements. Member states are allowed to impose additional requirements with respect to these fund managers. Fund managers that fall into one of these categories may not benefit from the passport rights granted by the Directive unless the fund manager affirmatively opts to be covered by the Directive.
We have highlighted below some of the key provisions of the AIFM Directive. Note that once the passport system is applicable to non-EU fund managers (whether by choice subsequent to 2015 or upon the elimination of the national private placement regimes subsequent to 2018), the provisions discussed below will be generally applicable to non- EU fund managers.
Fund managers will have to apply to the relevant authority in their home country for authorization to manage funds.2 Such applications must set forth information on the management team, identify the holders of 10% or more of the capital or voting interests, disclose the organizational structure of the manager and explain how the fund manager will comply with the requirements of the Directive, including the compensation policies. The fund manager must also provide information about the investment strategy, leverage policy and risk profile of, and the depositaries engaged by, the funds it manages. The home country will grant the authorizations of fund managers if it is satisfied that (i) the fund manager will be able to fulfill the requirements of the Directive, (ii) the fund manager is adequately capitalized, (iii) the management has a good reputation and is experienced with respect to the investment strategies identified, (iv) the over 10% holders are suitable and (v) the head office and registered office are in the same home country. Once authorization is granted, it will be valid in all member countries of the EU (“Member Country”). The approval may be granted in full or may be limited — in particular, with respect to the investment strategies of the fund.3
The Directive requires fund managers to have an initial capital of at least EUR 125,000 (approximately $175,000).4 Where the assets under management of a fund manager exceeds EUR 250 million (approximately $350 million), the fund manager must provide an additional amount of “own funds” equal to 0.02% of the amount by which the value of the assets under management exceed EUR 250 million, up to a maximum amount with the initial capital of EUR 10 million (approximately $14 million).5 Member Countries may allow up to 50% of the additional amount of own funds required to be satisfied by a guarantee from a credit institution or an insurance undertaking. Fund managers are also required to have an appropriate amount of additional own funds or appropriate professional indemnity insurance to cover potential liability from professional negligence. The European Commission is to adopt, by delegated acts, provisions specifying the risks the additional own funds or insurance must cover and the manner for determining the appropriateness of such funds or insurance. The own funds must be invested in liquid assets or assets easily converted to cash and cannot include speculative positions.
- Standard of Care
The Directive codifies a standard of care for the fund managers requiring, inter alia, that the fund manager “act honestly, with due skill, care and diligence and fairly in conducting its activities,”6 act in the best interests of the fund or the investors of the fund, take all reasonable steps to avoid conflicts of interests and, if unavoidable, identify, manage and disclose such conflicts and treat all fund investors fairly. In addition, no fund investor may receive preferential treatment unless it is disclosed in the fund’s governing documents.
While seemingly reasonable, these provisions may cause difficulty for fund managers of Delaware funds. Generally, under Delaware law and the governing documents of such funds, the manager’s duty is to act in the best interest of the fund with no specific duty to the investors. Therefore, a fund manager of a fund governed by Delaware law would be required to act in the best interest of the fund, even if doing so would be unfair to a particular investor in the fund. The restriction on preferential treatment is also problematic given the prevalence of side letters granted to investors in funds. To comply with this provision could result in a cumbersome process of amending the governing documents each time a new investor is admitted and given special provisions. It is not clear whether it would be permissible simply to disclose in the organizational documents that the fund manager may enter into preferential arrangements with investors and agree to disclose all such arrangements to the investors.
Fund managers must adopt compensation policies for staff whose “professional activities have a material impact on the risk profiles of the [funds] they manage . . .”7 The staff to be covered include senior management, risk takers, control functions and any employee receiving total compensation that places them in the same compensation bracket as senior management and risk takers. Annex II to the Directive sets forth general principles regarding compensation. Such principles include: a compensation policy that is consistent with and promotes sound and effective risk management, and is in line with the business strategy; the policy should be subject to an annual internal independent review; the assessment of performance should be based on a multiyear framework appropriate to the life-cycle of the fund; guaranteed bonuses should be limited to new staff and only for the first year; payments related to early termination of a contract should reflect performance achieved over time and should not reward failure; if permitted by the legal structure of the fund, at least 50% of any bonus should be paid in ownership interests in the fund; at least 40-60% of the bonus (depending on the size of the bonus) should be deferred over a period of at least three to five years8 commensurate to the life cycle and redemption policy of the fund; and the bonus should be paid only if it is sustainable according to the financial situation of the fund manager on a whole and justified according to the performance of the business unit, fund and individual. Significant fund managers9must form a remuneration committee constituted of individuals who can exercise competent and independent judgment.
- Conflicts of Interest and Risk Management
The Directive requires fund managers to take all reasonable steps to identify, prevent and manage conflicts of interest including segregating tasks and responsibilities which “may be regarded as incompatible with each other or which may potentially generate systematic conflicts of interests.”10 Fund managers must disclose to investors the general nature or sources of conflicts which may not be prevented.
Under the Directive, fund managers must separate the functions of risk management from the operating units. The fund managers must also have a documented and updated due diligence process and ensure that the risks associated with each investment can be properly identified, measured and monitored by the use of appropriate stress testing procedures and other means. Stress tests are also required regularly to assess and monitor the liquidity risks of the fund.
Each fund managed by the fund manager must have a maximum level of leverage established for such fund. The fund manager must make available to the authorities in its home Member Country information about the leverage used by each fund. The Directive gives the authorities of the Member Country the authority to assess the risks of the use of leverage, and if necessary, impose limits on the level of leverage after notifying the European Securities and Markets Authority (ESMA) and the European Systematic Risk Board. ESMA’s role is to ensure consistency among the measures proposed by the various Member Country authorities to govern leverage and may also, on its own accord, specify that the Member Country authorities take certain remedial actions with respect to the leverage allowed by a fund manager.
Fund managers must establish procedures to allow for independent valuation of the assets of the fund at least annually. Independence in the valuation can be met by using an external valuer or an internal valuer so long as the valuation task is functionally independent from the portfolio management and the compensation policy. If the valuation is performed internally, the home Member Country may require the fund manager to have its evaluation procedures and/or valuations verified by an external valuer or auditor. The Directive overrides standard contractual provisions by specifying that “irrespective of any contractual arrangements providing otherwise, the external valuer shall be liable to the [fund manager] for any losses suffered by the [fund manager] as a result of the external valuer’s negligence or intentional failure to perform its tasks.”11 Therefore, common contract provisions, which limit liability to the fees received for the services performed, would seemingly not be respected.
The Directive requires fund managers to appoint a depositary for each fund it manages. Only credit institutions or investment firms with registered offices in the EU and authorized or subject to regulation by the European Parliament and similar institutions may be depositaries. Non-EU funds may use a credit institution or similar entity not established in the EU if such institution is subject to effective regulation and supervision to the same extent as provided in the European Union. For non-EU funds, the depositary must be located in the same country where the fund is established or the home Member Country or Member Country of reference of the fund manager of the fund.12
The role of the depositary seems to be somewhat expansive. The depositary is to ensure that the fund’s cash flows are properly monitored and for assets that cannot be held in custody, it must verify and maintain a record of the ownership of these assets by the fund. The depositary is also to ensure that sales or redemptions of units of a fund (including the calculation of the value of the units) are carried out in accordance with the applicable national law and the governing documents of the fund. The depositary will be liable to the fund or its investors for the loss of any financial instruments held in custody by the depositary and for any losses suffered by the fund or its investors as a result of the depositary’s negligent or intentional failure to perform its obligations. The requirement to use a depositary and the duties assigned to the depositary will likely greatly increase the costs of fund managers.
- Transparency Requirements
The Directive imposes significant reporting requirements on fund managers. Fund managers have to make available an annual report for each of the funds it manages and markets in the EU within six months following the end of the fiscal year. In addition to customary items such as a balance sheet and income statement, the annual report must show the total amount of compensation (split between fixed and variable) paid to staff and the number of staff, and must disclose any carried interest paid.
The Directive also specifies certain disclosure which must be made to investors before they invest in the fund. Most of the items covered would typically be included in an offering memorandum for U.S. funds and therefore would not require special disclosure in order to market in the EU. The Directive does, however, require the disclosure of any preferential treatment being granted to an investor specifying the type of treatment, the investors who obtain such treatment and the legal or economic connection to the fund or fund manager. Fund managers are also required to “periodically disclose” to their investors certain information including the risk profile of the fund and to “disclose on a regular basis” the amount of leverage used by the fund.13 The frequency of the disclosure obligations will be set by delegated acts. In addition to providing disclosure to their investors, the fund managers must also regularly report to the relevant authorities in their home Member Country.14
The Directive requires fund managers to notify the authorities in its home Member Country whenever a fund acquires or disposes of shares of a non-listed company with its registered office in the EU and the holdings reaches or falls below the following thresholds: 10%, 20%, 30%, 50% and 75%.15 A special level of disclosure is specified for managers of funds acquiring more than 50% of the voting rights of a non-listed company. When such control is acquired, the fund manager must notify the private company (and request that the board of directors inform the employees) and its shareholders as well as the authorities in its home Member Country. The Directive goes so far as to require the fund manager to disclose to these constituencies its intentions with respect to the business and the likely repercussions on employment. The Directive also prevents a fund from stripping out the assets of a company it took control of within a two-year period of the acquisition.
- Rules for Non-EU Countries
Chapter VII of the Directive sets forth the requirements that must be met in order to market non-EU funds in the EU. The requirements vary depending on whether the fund is managed by an EU or non-EU manager and whether or not the fund is taking advantage of the passport ability. In order for a non-EU fund manager to market funds in the EU with a passport it must generally comply with the provisions of the Directive16 and must have a legal representative appointed in its Member Country of reference. In addition, cooperation agreements must be in place between the Member Country of reference and the supervisory authorities of the country where the non-EU fund manager is established (the “Home Country”),17 and the Home Country and the Member Country of reference must have signed an agreement which meets the standards set out in Article 26 of the OECD Model Tax Convention. ESMA will flesh out the minimum content of the cooperation agreements.
Until the national private placement regimes are eliminated, non-EU fund managers may choose to market funds in specific Member Countries without a passport. At a minimum, the Member Countries must require the fund managers to comply with the transparency requirements discussed in Section IX above, appropriate cooperation agreements must be in place between the authorities of the Member Country where the fund is marketed and the Home Country, and the Home Country may not be listed as a Non-Cooperative Country and Territory by the Financial Action Task Force. The requirements specified by the AIFM Directive apply in addition to any securities laws of the Member Countries and the Member Countries are allowed to impose stricter rules than those set forth in the Directive. Therefore, prior to elimination of the national private placement regimes, non-EU fund managers must assess the costs and benefits of complying in full with the AIFM Directive in order to use the passport system against the costs of complying with the various private placement requirements of all the Member Countries in which it wishes to market.
Note that any disputes between the Member Country of reference and the fund manager will be governed by and subject to the jurisdiction of the Member Country of reference. Further, any disputes between the fund manager or the fund and the EU investors will be governed by and subject to the jurisdiction of a Member Country.
The Directive will generally become effective on the 20th day following its publication in the Official Journal of the European Union expected to be published sometime in January 2011. Member Countries are required to adopt laws and regulations necessary to comply with the Directive within two years of the effective date of the Directive. ESMA is required to assess the functioning of the passport system and issue an opinion to the Commission, the European Parliament and the Council in early 2015 (within four years of the effective date of the Directive). Once ESMA has issued a positive report, the Commission will adopt a delegated act specifying when the passport system shall be applicable in all Member Countries.18Once this report is issued, the passport system will be available for the non-EU fund managers. Three years after the passport system has become applicable in all Member Countries, ESMA will issue an opinion on the functioning of the passport system and advice on the termination of the existing national private placement regimes. Once ESMA has issued a positive report, the Commission will adopt a delegated act specifying when the national regimes will terminate and the passport system will become the only system applicable in the Member Countries.19 Therefore, until at least early 2018, non-EU funds will have the ability to market to EU investors without complying with the passport requirements.
In many instances the AIFM Directive provides only broad brushstrokes with respect to the new regulatory regime — leaving the implementing rules and delegated acts to fill in the details. It is clear, however, that once implemented, the AIFM Directive will impose significant additional regulatory requirements on fund managers and may have the unintended effect of having non-EU fund managers avoid marketing funds in the EU.