UK: The Draft Alternative Investment Fund Managers Directive: Where Are We Now, And How Will Fund Marketing Be Affected?

Last Updated: 13 June 2010
Article by John Langan

Introduction

In March 2009, the European Commission ('Commission') proposed an "ambitious reform programme" for the European financial system. In this context, on 30 April 2009 it published the text of a proposed Alternative Investment Fund Managers Directive ('Draft Directive') which aims to introduce a harmonised regulatory framework across the European Union ('EU') for managers of alternative investment funds. The Draft Directive's history so far has been somewhat controversial, and there remain areas of significant difficulty and contention.

Following the EU's usual legislative process, the Draft Directive must be adopted by both the European Parliament ('Parliament') and by Member State governments in the Council of the European Union ('Council'). The Commission's original proposal is therefore debated, amended and voted on, in parallel, by the Council and the Parliament.

After a meeting on 18 May 2010, the Council's Economic and Financial Affairs Council ('ECOFIN') announced that it had discussed and agreed on its approach to the Draft Directive.

On the same day, the Parliament also announced that, after a meeting of its Economic and Monetary Affairs Committee ('ECON') on 17 May 2010, it too had agreed on its approach to the Draft Directive. There are, therefore, at present two versions of the Draft Directive, with significant differences.

All three organs of the EU legislature (the Council, the Parliament and the Commission) will now negotiate a common position on the final text of the Draft Directive, so that it may be adopted by the Parliament in plenary session in July 2010.

The story does not, of course, end there, as the directive as finally adopted will need to be implemented by legislation in each EU Member State: there will, no doubt, be ample scope for variations, at least within the parameters allowed by the directive.

This article discusses the scope of the Draft Directive, and in particular its provisions relating to fund marketing, and summarises the key differences between the Parliament and Council drafts.

Background

The Presidency of the European Union rotates on a 6 monthly basis. The Swedish government held the Presidency from July 2009 through December 2009, and in January 2010 the mantle was assumed by the Spanish. The Belgian government takes over in July 2010. One of the responsibilities of the Presidency is to push draft legislation through the various organs of the legislature. On 10 March 2010, the Spanish Presidency published the latest compromise text of the Draft Directive. There was considerable controversy in the alternative fund world on its publication, as the Spaniards re-introduced the problematical provisions on fund marketing which had previously been toned down by the Swedish (Article 35), and introduced new wording in the Recital and at Articles 34a and 34aa, also dealing with fund marketing.

Scope of the Draft Directive - to which funds does the Draft Directive apply?

The scope of the Draft Directive is extensive. It defines an alternative investment fund ('AIF') as 'any collective investment undertaking, including investment compartments thereof, which raises capital from a number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors'. It therefore extends, subject to certain exclusions, to funds which may be open or closed-ended; listed or unlisted; and in whatever legal form constituted, whether as a trust, limited partnership, company or contractual common fund. As the term 'collective investment undertaking' has not been defined or limited, the concept may now include structures not previously considered as 'collective investment schemes' within the UK legislation, as well as (potentially) structures which would not necessarily be thought of as 'alternative funds': for instance, carried interest vehicles, investment trusts and venture capital trusts.

An 'AIFM' is defined as 'any legal person whose regular business is managing one or more AIF'. 'Managing an AIF' means the provision of 'investment management services' to one or more AIF. The AIFM may perform certain other functions listed in the Draft Directive, including marketing and administrative functions.

Exemptions from the scope of the Draft Directive are provided for AIFM whose only investors are the AIFM or related companies, UCITS fund managers and institutions such as national central banks and employee participation schemes (a UCITS fund is one set up under the UCITS Directive, as amended, which largely covers long-only retail mutual funds, though also now extends to certain funds - 'UCITS III Funds' - which have wider discretion to invest in derivatives). Member States may apply optional exemptions for AIFM whose assets under management AUM are under EUR100 million, or EUR500million where the underlying AUM are not leveraged and no redemptions are possible within 5 years (this latter exemption being aimed chiefly at private equity funds).

On the other hand, the Parliament claims to propose a system which applies different levels of regulation according to the types of fund, rather than the 'one-size-fits-all' approach taken by the Council. The Member State authorities will establish who qualifies for lighter treatment on the basis of the rules of the Draft Directive. Private equity funds and non-systemically important AIFMs will be able to avoid full implementation of the Draft Directive. Here again, as with many aspects of implementation, the devil will be in the detail.

Third country provisions and the marketing of funds

This is one of the most controversial areas, and successive drafts have drawn accusations of both protectionism and impracticality.

According to the Council's proposed text, an authorised AIFM may manage an AIF, which is neither established nor marketed in the EU, if there are appropriate cooperation arrangements, in line with international standards, between the home Member State of the AIFM and the supervisory authority of the third country where the AIF is established, in order to ensure an efficient exchange of information to allow the home authorities of the AIFM to carry out their duties according to the Draft Directive.

A Member State may allow an authorised AIFM to market a non-EU AIF to professional investors on its territory if: (a) the AIFM complies with all the requirements of the Draft Directive (other than, broadly speaking, those relating to Depositaries); and (b) appropriate cooperation arrangements in line with international standards are in place between the competent authorities of the home Member State of the AIFM and the supervisory authority in the AIF's home country, to ensure an efficient exchange of information allowing the competent authorities of the AIFM to carry out their duties according to the Draft Directive.

The Council's Draft further provides that a Member State may allow an AIFM established in a 'third country' (ie outside the EU) to market its AIF to professional investors in that Member State if the AIF:

  • complies with substantial requirements regarding disclosure to investors, reporting to authorities, annual reports, leverage, and disclosure and notification re acquisition of control of non-listed companies; and
  • appropriate cooperation arrangements for the purpose of systemic risk oversight and in line with international standards are in place between the competent authorities of the Member State where the AIF is marketed and the competent authorities of the AIFM, to ensure an efficient exchange of information to allow the competent authorities to carry out their duties according to the Draft Directive.

The Parliament's text goes significantly further. A non-EU AIFM seeking access to the EU markets would be required to voluntarily comply with the Draft Directive, and its financial supervisor to act as agent to the European Securities and Markets Authority (ESMA) (which is intended to be in operation next year) in the supervision of that manager and (effectively) in enforcement of EU regulation. A non-EU AIF would be allowed to be marketed in the EU if the country where it is located has high enough standards to combat money laundering and terrorist financing, grants reciprocal access to marketing of EU funds on its territory, and has agreements in place with each Member State where marketing is intended on exchange of information related to taxation and monitoring matters. In addition, the country concerned must recognise and enforce judgments given in the EU.

It is hard to see any non-EU financial supervisor agreeing to act as agent for ESMA, and equally difficult to see how EU law and regulatory decisions could be enforced outside the EU (absent a treaty for the mutual reorganization thereof in any given jurisdiction). This would require (say) the Securities and Exchange Commission ('SEC') of the US to enforce EU law against a SEC-registered investment advisor, as agent for ESMA: a prospect less in the realms of practicality than of speculative fiction.

Although the Council's draft text is more reasonable on this aspect, it nevertheless still requires arrangements to be set up between different EU and non-EU states which would likely be difficult to achieve, in many cases. For example, where a non-EU AIFM wants to access more than one EU market, separate co-operation agreements would need to be in place between the AIFM's financial supervisor and each relevant Member State. This is bound to be easier to achieve for some non-EU states than for others, and indeed with some Member States than with others. The existing position, whereby a fund manager or promoter seeking to access the EU markets for alternative funds must rely on a variety of different local private placement exemptions (a complex situation, but generally manageable), would therefore cease. Non-EU promoters or managers face instead the prospect of dealing with one or other of the two regimes set out in the Draft Directives, each of which is fraught with difficulties and one - Parliament's draft - evidently unrealistic.

As regards EU AIFMs marketing funds in the EU which are established outside the EU, Parliament's draft allows this only where the non-EU jurisdiction has "high enough standards" on money-laundering, grants reciprocal access to EU funds and has an agreement with the relevant EU state on taxation and monitoring matters. Again the Council's draft is slightly more flexible, permitting marketing of such funds if the relevant country complies with certain (but not all) provisions of the Draft Directive and the relevant EU state allows it, but still is likely to present issues in terms of how this will work in practice.

Other areas of contention

Both Draft Directives contain provisions which, subject to narrow carve-outs, would subject custodians to (in effect) strict liability for their sub-custodians. This is bound to be a particular concern for custodians and prime brokers of funds with significant exposure to emerging markets, where custody and settlement procedures, and the law and regulatory practice around them, are relatively undeveloped and subject to significant local risk. In addition, the Parliament's draft, in dealing with the role of the 'valuator', refers to an AIFM remaining liable for valuations of assets carried out by a 'valuator', which seems inconsistent with the way most funds are structured (particularly corporate funds, where valuation is ultimately a Board responsibility, which is delegated to the administrator). Further areas of contention include remuneration (where the Draft Directive seeks to apply the banking directive provisions) and the ban on naked short-selling in the Parliament draft.

Conclusion

There has been substantial debate and concern expressed about the Draft Directive, both within and outside the European Union and by commentators (and organisations) of considerable substance and influence. Most commentators accept, however, that the directive is likely to become a reality in the relatively near term, and the hope is that a compromise will be reached which, while in all likelihood imperfect, will be liveable with. A likely long-term result of the directive's implementation, as far as one can predict at this stage, may be to bifurcate the market for 'alternative funds' (or at least those of a significant size) and their managers between those aimed, to a material degree, at EU-based investors and those with little or no EU-based investment.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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