Few investment managers would disagree that the current state of affairs has translated into one of the most challenging periods in the history of the investment industry. Not only is this the worst economic downturn since the Great Depression of 1929, but investment professionals are also facing an unprecedented amount of new wide-reaching legislation as regulators attempt to avoid another financial crisis of this magnitude.
In a survey on 24 global investment management firms, advisory firm Investit (www.investit.com ) found that the top 5 regulatory activities that are causing them the most concern were the Alternative Investment Fund Managers Directive (53%), the Dodd-Frank Act (51%), the Foreign Account Tax Compliance Act (43%), the Solvency II Directive (38%) and the Retail Distribution Review (32%).
This article describes these 5 pieces of legislation, keeping the order of importance as per the Investit survey, being adopted in the US, EU and the UK and analyses their impact on investment managers.
ALTERNATIVE INVESTMENT FUND MANAGERS DIRECTIVE 2011/61/EU ("AIFMD")
Implementation date: 22nd July 2013.
Official purpose: "To establish common requirements governing the authorisation and supervision of AIFMs in order to provide a coherent approach to the related risks and their impact on investors and markets in the EU."
Types of investment managers affected: Those that manage non-UCITS EU funds or want to market non-EU funds in the EU.
AIFMD is the new piece of regulation which is most concerning to investment managers, especially those who are based in the EU or who intend to market their funds within the EU. As from 22nd July 2013, all alternative investment fund managers ("AIFMs") will need to comply with AIFMD should they fall within its scope.
AIFMD applies to all AIFMs except those that manage alternative investment funds ("AIFs"):
- whose assets under management, including any assets acquired through the use of leverage, in total do not exceed €100 million; or
- whose assets under management in total do not exceed a
threshold of €500 million when the portfolios of AIFs consist
of AIFs that are unleveraged and have no redemption rights
exercisable during a period of 5 years following the date of the
initial investment in each AIF.
Any investment manager that does not fall within the above thresholds will have to mandatorily comply with its provisions. Investment managers that fall outside the scope of AIFMD may however choose to opt-in for example to take advantage of the passporting provisions of the directive. Investment managers must pay particular attention to the following implications of AIFMD:
The depositary is the key independent party in AIFMD and is charged with protecting the investors in the AIF. The depositary has three major roles as safe keeper of assets, monitor of cash, and overseer of NAV calculation and fund administration. The depositary is liable for the loss of assets and financial instruments in its control unless the loss is out of the depositary's reasonable control and was unavoidable. This liability goes beyond negligence and is more resemblant of strict liability. These increased responsibilities for depositaries will translate into increased depositary costs and larger total expense ratios which will ultimately be passed on to the investors.
Self-managed AIFs must have an initial capital of at least €300,000. Where an AIFM is appointed as external manager of AIFs, the AIFM must have an initial capital of at least €125,000. Where the value of the portfolio of the AIFs managed by an AIFM exceeds €250 million, the AIFM must have additional capital of 0.02% of the amount exceeding €250 million, up to but not greater than €10 million.
AIFMs can delegate certain tasks subject to specific procedures being followed. Delegation of portfolio and/or risk management is limited only to authorised and supervised asset managers. The AIFM may not delegate its functions to the extent that it becomes a letter-box entity. The AIFM will still be liable towards the AIF and the investors notwithstanding any delegation.
The directive requires that the AIFM carries out substantially more functions than it delegates. This means that the common model where a self-managed fund delegates the day-to-day management to an investment manager and other functions to service providers (such as valuation), whilst retaining overall control and supervision, will not be compatible with AIFMD. These models will need to undergo significant restructuring and insource enough functions in order to comply.
Managers with non-EU funds face uncertainty over which distribution channels will be available to them once AIFMD comes into force. According to AIFMD, such non-EU funds may be marketed under the private placement regimes of each EU jurisdiction until 2018. However, some countries may look to amend their private placement regimes once they transpose AIFMD into their domestic law. Germany for example will require that all funds that are to be marketed in its jurisdiction be registered with their regulator, BaFin, before marketing commences. After 2018, such managers will have to rely solely on the so-called 'third country provision' which will first be available as from 2015. These provisions require the signing of supervisory and exchange of information cooperation agreements between all the jurisdictions involved which may result in this route to market being unworkable or even unavailable for some countries.
Changes in contractual arrangements
Managers will need to revise all agreements with each service provider to ensure that they can meet, as AIFMs, the requirements under AIFMD. In addition, an entity cannot simultaneously hold a MiFID and an AIFM licence, which means that some investment managers may need to consider restructuring their firm or group of entities. Tax residency must also be taken into consideration if the fund management shifts from one jurisdiction to another.
These new requirements form part of a wider EU initiative to set conditions on remuneration to combat excessive risk taking and to harmonise remuneration provisions across financial sectors. Investment managers will need to revise their remuneration policies to ensure compliance.
General changes to the investment manager's operations will also be required to comply with new rules relating to risk management, leverage, calculation methodologies, regulatory reporting and others.
Investment managers should be running a full gap analysis to identify the areas in which they would not be compliant with AIFMD. They will also need to weigh up the advantages and disadvantages of being AIFMD compliant. The two main benefits of AIFMD are passporting and branding. Once authorised, AIFMs will be able to passport their services and market their AIFs freely within the EU. In addition, many are of the opinion that the AIFMD product may create its own brand and reputation similar to the UCITS product in the retail sector. Such branding may enhance investor confidence in the AIFMD product making it more appealing to investors. However, becoming AIFMD authorised carries the burden of compliance plus the significant additional costs. For these reasons, it is expected that many small EU investment managers will leave this market and that less non-EU managers will operate in the EU. This will pave the way for larger players to take advantage of the reduced competition as a result of the higher barriers to entry imposed by AIFMD.
THE DODD-FRANK WALL STREET AND CONSUMER PROTECTION ACT ("DODD-FRANK ACT")
Implementation date: In force since 21st July 2010.
Official purpose: "To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes."
Types of investment managers affected: Those with US clients or who carry out business in the US.
The Dodd-Frank Act was signed into law on 21st July 2010 and amended certain provisions of the U.S. Investment Advisers Act 1940. (the "Advisers Act"). The Advisers Act is intended to protect investors whose assets are managed by investment advisers either directly as regards their own individual portfolio, or indirectly in connection with pooled vehicles.
Importantly, the changes to the Advisers Act as a result of the Dodd-Frank Act have expanded the authority of the U.S. Securities and Exchange Commission ("SEC") to cover investment advisers to private funds including some categories of non-U.S. investment advisers who would previously qualify for an exemption.
Non-U.S. investment advisers should take note that the Dodd-Frank Act eliminates a registration exemption on which many non-U.S. advisers have traditionally relied. The Dodd-Frank Act removes the "private investment adviser" exemption previously contained in the Advisers Act. This exemption was available to non-U.S. investment advisers who, among other things, had fewer than 15 U.S. clients over the preceding 12 months and who did not hold themselves out generally to the public in the U.S. as investment advisers. Such non-U.S. investment advisers will now need to rely on one of the new exemptions provided by the Dodd-Frank Act.
The Dodd-Frank Act now provides two types of exemptions. Firstly, advisers solely to venture capital funds and advisers solely to private funds with less than $150 million in regulatory assets under management in the U.S. will fall under the category of Exempt Reporting Advisers ("ERA's"). Although ERA's will not be required to register with the SEC, or to comply with all of the provisions of the Advisers Act, ERAs will nevertheless be required to submit regular reports to the SEC. ERAs must prepare and file Form ADV Part 1A with the SEC and comply with certain other reporting and record keeping requirements under the Advisers Act, such as insider trading prohibitions, anti-fraud provisions, and pay-to-play rules.
Secondly, the Dodd-Frank Act provides a narrow registration exemption for certain foreign private advisers without a place of business in the U.S. ("Foreign Private Adviser Exemption"). Advisers qualifying for this exemption shall not be required to register with the SEC and shall not have any reporting requirements. A foreign private adviser who would qualify under this exemption is an investment adviser that:
- has no place of business in the U.S;
- has, in total, fewer than 15 clients and investors in the U.S. in private funds advised by the adviser;
- has aggregate assets under management of less than $25 million attributable to clients in the U.S. including U.S. domiciled private funds and U.S. investors in private funds advised by the adviser;
- does not hold itself out generally to the public in the U.S. as an investment adviser; and
- does not advise registered investment companies or registered business development companies.
Investment managers who have traditionally relied on the old and now defunct private investment adviser exemption should re-assess their current position to determine whether they fall within the new Foreign Private Adviser Exemption. If in doubt, US advice should be sought at the earliest opportunity.
FOREIGN ACCOUNT TAX COMPLIANCE ACT ("FATCA")
Implementation date: 1st January 2014.
Official purpose: "FATCA, enacted in 2010 as part of the Hiring Incentives to Restore Employment (HIRE) Act, is an important development in US efforts to combat tax evasion by US persons holding investments in offshore accounts."
Types of investment managers affected: All investment managers unless they do not receive US source payments.
As stated above, FATCA's goal is to properly tax all income of US persons on their investments outside the US.
The US will effect this by imposing a 30% withholding tax on US source payments ("withholdable payments") which include:
- interest, dividends and other determinable periodic payments from US assets;
- gross proceeds on the disposal of assets of a type that can produce interest or dividends from a US source; and
- deposit interest paid by US and foreign branches of US banks.
To avoid the 30% withholding tax, FATCA will require all foreign financial institutions ("FFIs") and certain non-financial foreign entities ("NFFEs") to enter into an agreement with the US Internal Revenue Service ("IRS"). Under the agreements, FFIs will report to the IRS the accounts of their US clients and NFFEs will report to the IRS about their "substantial US owners". In addition, if an FFI cannot obtain the required documentation on the account of a US client, the account is considered recalcitrant and the FFI is obliged to withhold 30% on all withholdable payments allocated to that account. FFIs can alternatively elect for such withholdable payments to be withheld the requisite 30% before it reaches their account, therefore not having to withhold the payment themselves. FFIs may seek assistance for compliance from their appointed service providers but the ultimate responsibility is always with the FFI that has the agreement with the IRS.
Alternatively, the US Treasury Department has developed an intergovernmental approach in order to facilitate compliance with FATCA by entities in certain countries. On 26th July 2012, the US Treasury Department released a model intergovernmental agreement ("IGA") to implement FATCA in consultation with France, Germany, Italy, Spain and the United Kingdom. Under an IGA, FFIs would report the requisite information under FATCA to their local tax authorities with this information being automatically sent to the IRS under existing bilateral tax treaties or tax information exchange agreements. This clearly facilitates compliance with FATCA as FFIs would not need to enter into a cross-border agreement with the IRS. Instead, they would simply report to their local tax authority albeit with the increased level of information regarding their US accounts. However, some investment managers also feel that IGAs add an extra layer of complexity to FATCA compliance.
FFIs include investment managers not registered in the US and therefore these firms must get familiar with the requirements and obligations that FATCA imposes to try to understand how this will affect their business. Investment managers will need to:
- be aware of what information they require from their investors and ensure that they will be able to obtain the requisite information;
- identify affected accounts;
- implement systems and controls to address compliance;
- implement policies to deal with recalcitrant accounts;
- consider impacts on investments, if any;
- ensure that agreements with service providers meet the ongoing compliance responsibilities;
- enter into an agreement with the IRS or with the local authority if the jurisdiction has entered into an IGA; and
- ensure ongoing compliance monitoring and reassessment.
Although the implementation date is still some time away and seems to be delayed time and again, FFIs should commence a full review on how best to cope with FATCA to ensure that they have the correct systems in place when it finally does come in to play.
SOLVENCY II DIRECTIVE 2009/138/EC ("SOLVENCY II")
Implementation date: 1st January 2014.
Official purpose: "To ensure financial soundness of insurance undertakings, and in particular to ensure that they can survive difficult periods in order to protect policyholders (consumers, businesses) and the stability of the financial system."
Types of investment managers affected: Those engaged by EU insurance companies.
Solvency II will impact insurance companies with increased disclosure requirements, minimum capital requirements and enhanced qualitative requirements. Insurance companies will require their investment managers to provide them with substantial additional information and in a timely manner. Investment managers will need to adapt in order to service these insurance companies in a Solvency II compliant manner. The proposed Solvency II framework is divided into three main areas commonly referred to as 'pillars':
Pillar I – Capital Adequacy
Pillar I deals with the capital adequacy of insurance companies. It sets out the minimum capital requirements and allows insurance companies to use a "Standard Formula" where capital charges are standardised by asset class or an "Internal Model" whereby insurers calculate their capital requirements using a bespoke model. To calculate the minimum capital requirement for an insurance company, an analysis of all its investment holdings will need to be carried out. Each investment will have a 'capital charge' assigned to it with the totality of all investments providing the minimum capital requirement of the insurer.
Every investment has a distinct capital charge assigned to it and insurance companies will therefore be looking at assets with equal or better risk/return ratios than their current holdings but which carry a lower capital charge. In addition, insurance companies will be looking to match their assets and liabilities since mismatches will attract a regulatory capital charge. Investment managers will be called upon to provide their expertise and to construct the most efficient Solvency II compliant portfolios possible.
Pillar II – Qualitative Requirements
Pillar II sets out the qualitative requirements for insurance companies and includes the Own Risk and Solvency Assessment ("ORSA") which is at the heart of Solvency II. Insurance companies will need to demonstrate that they have the appropriate risk management, governance and compliance systems in place.
Insurers will be required to properly supervise their investment managers to ensure that they are operating effectively. Investment managers will in return need to be aware of exactly what the insurance companies require to remain compliant so that they are ready to assist the insurance companies in meeting the new requirements.
Pillar III – Disclosure Requirements
Pillar III sets out transparency and disclosure requirements. Aside from the substantial disclosures that will need to be made, insurance companies are concerned with the very short time limits imposed by Solvency II in which these disclosures need to be made to the national regulator.
Key to meeting these disclosure deadlines is the time which investment managers take to supply the insurance companies with the relevant information. In addition, investment managers will also need to make sure that this information is accurate and up-to-date.
Furthermore, to remain compliant with other Solvency II requirements, insurers will also need to carry out their own checks to ensure that the information they disclose to the regulator is accurate and conforms to the directive, all within the deadlines!
Insurance companies will be highly dependent on the efficiency and speed of service provided by their investment managers. Investment managers which can provide such Solvency II compliant service at reasonable-to-low cost will attract a host of new insurance clients as other firms may exit the market because they are not capable of providing such services or because the provision of these services are not economically viable for them. In addition, given that the implementation date has recently been pushed back to 1st January 2014, investment managers can stay ahead of the curve by reviewing the service they offer and creating optimized Solvency II compliant investment strategies or standardised portfolios to attract insurers and gain market share.
RETAIL DISTRIBUTION REVIEW ("RDR")
Implementation date: 31st December 2012.
Official purpose: "To establish a resilient, effective and attractive retail investment market that consumers can have confidence in and trust at a time when they need more help and advice than ever with their retirement and investment planning.
Types of investment managers affected: Those who wish to market to the UK retail investors.
The FSA has undertaken a detailed review of the advice and sale of 'retail investment products' aimed at improving public confidence in the market and avoiding a recurrence of the mis-selling scandals of the last decade. 'Retail investment products' include:
- collective investment schemes (both regulated and unregulated);
- life assurance policies with an investment component;
- all investments in investment trusts, including investment savings trust schemes;
- certain types of pensions (not group personal pensions); and structured investment products.
RDR also applies to all 'regulated advice' and any sales guidance concerning these related products. RDR applies only to advisers in the retail investment market; regardless of the type of firm they work for (banks, independent financial advisers, wealth managers, etc.).
The new RDR rules require (i) advisory firms to explicitly disclose and separately charge clients for their services; (ii) advisory firms to clearly describe their services as either independent or restricted; and (iii) individual advisers to adhere to consistent professional standards, including a code of ethics.
As from 31st December 2012 advisers will need to:
- subscribe to a code of ethics;
- hold an 'appropriate qualification', including any 'qualification gap-fill';
- carry out at least 35 hours of continuing professional development a year; and
- hold a Statement of Professional Standing from an accredited body.
The increase in fees may be positive for well-performing managers as their value will increase relative to average or badly performing managers who will still be required to justify their fees. By the same token, we may see an exodus of investors moving to the top managers.
Discretionary managers, as opposed to active managers, may also benefit from the RDR as investment advisers may begin to outsource functions such as investment recommendations if they feel that they lack the relevant skills. Active managers and 'rebate dependent' managers need to review how they will remain competitive, whether by superior performance, better product packaging, lower fees or improved service. Investment managers will face the challenge of keeping costs down while implementing new policies, investing in restricting and developing new innovative propositions.
Managers are faced with a large and onerous set of RDR rules which must be adhered to if dealing with retail clients in the UK. Affected investment managers should carry out a gap analysis as soon as possible and begin developing a strategic business plan to ensure that their firms are best placed to cope with the requirements of RDR. The new rules also open up a number of strategic opportunities and threats as well as required operational changes. Each will require investment managers to fundamentally assess how current profitability will be affected. One thing is for certain, affected managers will need to make significant adjustments and the road to compliance will most certainly be a bumpy one.
It is unclear how investment managers will tackle the regulatory challenge, whether it be through the appointment of a compliance officer, training individual asset managers within the firm or by engaging third party compliance advisers. It will be crucial however that they keep their costs down and be operationally efficient if they intend to be competitive in their particular market. In economic terms, the barriers to entry of this industry are being raised higher than ever which means that new firms or latecomers will struggle to gain market share whilst the biggest and most efficient investment managers will thrive.
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.