The marketing and distribution in the European Union of alternative investment funds is currently going through a series of changes not seen since the European Union Alternative Investment Fund Managers Directive (together with rules and regulations made under it, the AIFMD) came into effect in 2014. Under the AIFMD, alternative investment fund managers (AIFMs) from the US and anywhere else outside the EU (Third Country AIFMs) have been subject to filing and disclosure requirements when marketing their alternative investment funds (AIFs or Funds) in the EU. This filing and disclosure regime has comprehensively reshaped the environment in which AIFMs operate, and the practices associated with the marketing and distribution of AIFs, in the EU. This regime also creates significant traps for unwary AIF managers and other persons seeking to raise investment capital in Europe for issuers that would constitute AIFs under the AIFMD.
On 10 March 2021, Funds being marketed in the EU have been subject to mandatory disclosures under the EU's Sustainable Finance Disclosure Regulation (SFDR). Later this year, the EU Directive CBD Directive) and Regulation (CBD Regulation) on facilitating cross-border distribution of collective investment undertakings will come fully into effect. This Directive and Regulation (together referred to as the CBD Legislation) amend the AIFMD (as well as other EU legislation) to introduce an enhanced "pre-marketing" regime and other changes to the marketing regime introduced by the AIFMD. These changes have potentially significant consequences for alternative investment fund managers based and operating outside the EU (Third Country AIFMs, referred to in the AIFMD as non-EU AIFMS). At the same time and after years of drama, the United Kingdom has left the EU and begins to plough once more its own furrow in financial services legislation, further complicating the compliance obligations, and market practices, of investment managers operating in the UK and the EU.
In this article we remind Third Country AIFMs marketing or contemplating marketing AIFs in the EU and the UK to professional investors of the obligations imposed on such them under AIFMD and assess the impact of the SFDR on them. We also consider how the CBD Legislation might affect the ability of Third Country AIFMs to rely on reverse solicitation, a practice that remains common within the industry.
"Marketing" is defined in the AIFMD as "a direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM of units or shares of an AIF it manages to or with investors domiciled in the EU". When a Third Country AIFM markets an AIF in the European Economic Area (EEA), wherever the AIF is formed, it must do so under the requirements of the national private placement rules (NPPRs) of the EEA member state (Member State) in which it proposes to market the AIF and subject to the requirements of Article 42 of the AIFMD, namely:
- Reporting certain matters to the regulator in each Member State where the AIF is marketed, on a quarterly, half-yearly or annual basis depending on the AUM of the AIF, the AIFM and the type of AIF;
- Making prescribed disclosures to the AIF's investors;
- If the AIF raises money from investors in a particular Member State, providing investors in that Member State with an annual report for the AIF which includes, among other matters, information about the remuneration of certain of the AIFM's staff. This disclosure can be limited to remuneration of the AIFM's staff who are fully or partly involved in the activities of the AIF that is marketed in the EU, and does not cover all of the AIF's staff. However, disclosure of the remuneration of specific individuals, named or otherwise, is not required. As a practical matter, this compensation disclosure requirement has proved a deterrent to Third Country AIFMs wanting to market their Funds in the EEA; and
- If the AIF acquires participations in, or acquires control of, a non-listed company registered in the EEA, making certain disclosures to the company itself and its shareholders.
In the case of the last bullet above, additional rules apply that seek to prevent 'asset stripping' by the AIFM following the acquisition of a non-listed EEA registered company.
In addition, as a precondition to marketing in any Member State, (a) a co-operation agreement must be in place between the regulator of the Third Country AIFM (e.g., the US Securities and Exchange Commission (SEC) for an AIFM based in the United States) and the Member State's regulator; (b) a similar cooperation agreement must be in place with respect to the regulator of the jurisdiction in which the AIF is organised (Delaware and the Cayman Islands, for example, qualify for this purpose); and (c) the AIF must not be formed in a FATF blacklisted country.
Member States have different NPPRs, and in some Member States additional requirements are imposed. For example, Germany requires that an AIF marketed in Germany appoint a depositary. In other Member States, NPPRs, or the absence of applicable NPPRs, may effectively preclude marketing of an AIF by a Third Country AIFM.
The AIFMD, and consequently the requirements described above, apply only where the AIF, the AIFM or the persons acting on behalf of the AIF or the AIFM engage or seek to engage in marketing activities in one or more Member States. The AIFMD does not apply where an investor subscribes for an interest in a Fund in circumstances where an investor is solicited outside the EU (for example, many institutional investors in the EU may have offices in locations outside the EU) or the EU investor initiates contact with the AIF or its investment manager. Investor initiated contacts are known as reverse solicitation, and are discussed further under "Reverse Solicitation" below. Importantly, single investor funds, whose constitutional documents restrict the fund to a single investor, are outside the scope of the AIFMD.
If a Third Country AIFM manages assets in one or more AIFs (including through a company with which the AIFM is linked by common control or by a substantive direct or indirect holding) which do not in aggregate exceed:
- €500 million, in the case of unleveraged AIFs which have no redemption rights for five years from the date of initial investment, or
- €100 million (including assets acquired through leverage) for all other AIFs,
then the AIFM will be sub-threshold (Small Third Country AIFM) and not required to report to local regulators or make the disclosures to investors listed above, unless specifically required to do so under any Member State's NPPRs. An AIFM may have assets under management in excess of the specified thresholds provided that the funds that it manages or advises that constitute AIFs for AIFMD purposes fall below the specified thresholds. However, a Small Third Country AIFM may not be eligible to rely upon available NPPRs, and should review local laws and regulations in any Member State in which such Small Third Country AIFM wishes to market a Fund.
The United Kingdom
Prior to leaving the EU, the UK adopted the AIFMD requirements, and these requirements were "on-shored" into national law. Consequently, the AIFMD continues to apply in the UK and the requirements for marketing a Fund in the UK remain subject to the requirements described above.
The UK regulator, the Financial Conduct Authority (FCA), has issued guidance on what constitutes "marketing" in the UK by way of interpretation of what "offering" and "placement" mean by reference to the AIFMD definition of marketing (see above). FCA guidelines provide that an offering or placement occurs in the UK when a person seeks to raise capital by making a unit or share of an AIF available in the UK for purchase by a potential investor located in the UK. This includes situations that constitute:
- a contractual offer that can be accepted by a potential investor to make the investment and form a binding contract; or
- an invitation to the investor to make an offer to subscribe for the investment.
Therefore providing the UK based investor with a private placement memorandum and a subscription agreement (whether in the UK or from outside) will amount to marketing for UK purposes, triggering the requirement to make an NPPR notification to the FCA. Marketing in the UK that does not meet these criteria will not trigger an NPPR notification and the consequent reporting and disclosure requirements listed above. Note that this liberal interpretation of marketing is not one applied by most EEA regulators.
The CBD Legislation
While certain largely technical aspects of the CBD Legislation has applied with direct effect since 1 August 2019, a number of material requirements imposed by the CBD Legislation, including rules that apply to pre-marketing, come into force on 2 August 2021.
The CBD Legislation applies directly only to EEA-based AIFMs. Nonetheless, it may affect Third Country AIFMs indirectly. We consider the pre-marketing rules introduced by the CBD Legislation in that context.
Pre-Marketing of AIFs
The CBD Directive introduces a concept of "pre-marketing" for AIFs, defined in the Directive as the:
"provision of information or communication, direct or indirect, on investment strategies or investment ideas by an EU AIFM or on its behalf, to potential professional investors . . . in order to test their interest in an AIF or a compartment which is not yet established, or which is established, but not yet notified for marketing . . . and which in each case does not amount to an offer or placement to the potential investor to invest in the units or shares of that AIF or compartment."
The CBD Directive then provides detail on pre-marketing, including in the case of an AIF that:
- contacts with prospective investors should speak to an investment idea or investment strategy and communications should be limited to those necessary to test investor interest in an AIF or a compartment that is not yet established;
- it should not be possible for investors to subscribe to the units or shares of an AIF at the time of the contact;
- the distribution of subscription forms or similar documents (whether in draft or final form) is not permitted;
- any subscription by professional investors within 18 months of the EU AIFM having started pre-marketing, should be considered to be the result of marketing and is subject to applicable notification procedures; and
- within two weeks of having started pre-marketing, an EU AIFM must inform its home Member State regulator about its pre-marketing activities.
Intermediaries (third parties) can be used for pre-marketing, but only if they comply with the conditions for pre-marketing.
Discontinuation of Marketing
The CBD Legislation amends the AIFMD to provide that an EU AIFM can discontinue marketing of an EU AIF that it manages in host Member States. For discontinuation to occur, among other requirements, a blanket offer must be made to repurchase or redeem, free of any charges or deductions, all interests in an AIF held by investors in the relevant Member State. This condition does not apply to closed-ended AIFs.
For a period of 36 months after the date of denotification, an AIFM cannot engage in pre-marketing of units or shares of the EU AIFs referred to in the notification, or in respect of similar investment strategies or investment ideas, in the relevant Member State(s). The AIFMD transparency requirements discussed above will continue to apply to investors from the relevant Member State(s) who remain invested in the AIF.
Implications for Third Country AIFMs
Unless individual Member States amend their NPPRs to track the CBD Legislation changes to the AIFMD, non-EU AIFMs will continue to be able to market AIFs to professional investors in the EU as described above since most of the CBD Legislation applies only to EEA AIFMs. It should be noted, however, that AIFMs marketing Funds to retail investors in the EU will be required to provide local facilities to investors in their Member States. As noted above, however, retail marketing is beyond the scope of this article.
It follows, however, that a Third Country AIFM cannot "pre-market" in the EEA. Any pre-marketing now will be treated as "marketing", and require compliance with the reporting and other transparency obligations described under "The AIFMD" above.
In addition, the CBD Legislation has important implications for the significant number of AIFMs that rely upon "reverse solicitation".
The CBD Legislation has not been implemented in the UK, and the FCA's liberal interpretation of AIFMD marketing summarised under "The AIFMD" above remains in place.
AIFM reliance upon the exception to AIFMD regulation afforded by 'reverse solicitation' is coming under increased regulatory scrutiny. This development threatens to make the limited admission of EU investors by non-EU AIFMs even more difficult. Each Member State has a different interpretation of reverse solicitation as the AIFMD does not define it. However, the recitals to the AIFMD state that "the Directive does not affect the current situation, whereby a professional investor established in the [EU] may invest in AIFs on its own initiative, irrespective of where the AIF and/or the AIFM is established". A 2017 European Commission report to the EU Council and Parliament, refers to the Commission's expert group of Member States' representatives of construing reverse solicitation as:
a request by a professional client regarding units or shares of a specifically designated existing fund without a prior direct or indirect offer or placement (i.e. solicitation) from the management company or on its behalf. This contact is thus to be established only on the investor's initiative and may not constitute a reaction to previous offers or placements.
This description serves as a useful unofficial definition, and makes clear that reverse solicitation does not allow any prior communication of Fund information by the AIFM, Fund, or any related intermediary such as a distribution or placement agent. The investor has to conduct its own research and contact the Fund, the AIFM or intermediary first and of its own volition. Note also the limitation on reliance upon prior offers or placements.
Earlier this year the European Securities and Markets Authority (ESMA) issued a statement on reverse solicitation under the EU Markets in Financial Instruments Directive, as amended (MiFID), the EU Directive that regulates EU investment firms, including investment managers who are not AIFMs. In response to a perception that UK firms have been relying extensively upon reverse solicitation to keep and win significant numbers of EU investors, ESMA emphasised the intended, very limited scope of reverse solicitation, saying "where a third-country firm solicits clients or potential clients in the [EU] or promotes or advertises investment services or activities together with ancillary services in the [EU], it should not be deemed as a service provided at the own exclusive initiative of the client." ESMA also says that where an EU client is provided with investment services by a non-EU firm, that the provision of those services "should not be deemed as a service provided at the own exclusive initiative of the client, regardless of any contractual clause or disclaimer purporting to state that the third country firm . . . will be deemed to respond to the exclusive initiative of the client."
In this context, note that for the UK the FCA's view is that a confirmation from the investor that the offering or placement of interests in an AIF was made at its initiative, should normally be sufficient to demonstrate that this is the case, provided this is obtained before the offer or placement takes place. However, AIFMs and investment firms should not be able to rely upon such confirmation if this representation has been obtained to circumvent the AIFMD marketing requirements. Following ESMA's comments on contractual clauses addressing reverse solicitation, it is clear these provisions cannot be used on a blanket basis.
Although ESMA's statement addresses solicitations for MiFID services and not AIFMD, it is clear that reverse solicitation under AIFMD is in the regulators' sights. In its review of AIFMD conducted in 2020, ESMA recommended clarifying the notion of, and rules applicable to, reverse solicitation. If ESMA adopt an approach similar to the MiFID interpretation, accepting EU investors (and likely UK investors too) will become even more restricted. An EU Commission report to the European Parliament and Council on reverse solicitation is due by August and can be expected to bring additional (and in the eyes of at least some non-EU AIFMs, unwanted) attention to the practice of reverse solicitation.
The CBD Legislation position that any subscription by professional investors that occurs within 18 months of an EU AIFM having started pre-marketing interests of an AIF referred to in pre-marketing, or of an AIF established as a result of the pre-marketing, will be considered to be the result of marketing extends to related investment products. That applies not just to a particular Fund, but to any Fund managed by the relevant AIFM with the same or a similar strategy.
Taken together, these developments are likely to inhibit reverse solicitation except in cases that clearly meet the requirements of the unofficial definition of reverse solicitation set out above. Arrangements that some Third Country AIFMs and intermediaries have devised to engineer reverse solicitations will be in the firing line if regulators turn the screws on reverse solicitation. For example, if the CBD Legislation is extended to Third Country AIFMs, then the 18 month rule (see above) would mean any EEA investor subscribing to a Fund that had been pre-marketed (or that seeks to apply an investment program substantially similar to the Fund that was pre-marketed) could not be accepted as an investor investing at its own initiative. It is not clear if this requirement relates only to a Member State where pre-marketing had been notified, or to the EEA as a whole.
In any case, as we and other market participants have long warned, reverse solicitation is not and never was a distribution strategy. AIFMs must be able to demonstrate clearly, for example through emails and telephone record, that an investor genuinely contacted the AIFM or it distributor of its own initiative. Even with a complete audit trail of past communications, AIFMs remain exposed to the risk that EU investors could sue for reimbursement of any losses arising from its investment as a result of a putative breach of the AIFMD.
As previously noted, the SFDR came into force on 10 March. The SFDR requires financial market participants (including investment managers regulated under MiFID, AIFMs, and UCITS management companies) and financial advisers to make policy decisions pertaining to the integration of sustainability principles in their businesses. The SFDR also requires EEA firms to make certain disclosures on their websites and to clients and investors on a pre-contractual and periodic basis about financial products (e.g. Funds), and to varying degrees depending upon whether the Fund has an environmental, social or governance (ESG) focus falling within Articles 8 or 9 of the SFDR (ESG Fund).
Like the CBD Legislation, the SFDR does not apply directly to Third Country AIFMs. It will, however, affect Third Country AIFMs that:
- market Funds in the EEA (which does not include the UK) under NPPRs, or has EEA investors (see below);
- act as the delegated investment manager to an EEA firm which is subject to SFDR where that firm imposes obligations to comply with the SFDR on the Third Country AIFM;
- comes under client or investor pressure to comply with SFDR and therefore decides to opt in; or
- is part of a global group that has EU-based entities within its group and therefore decides to implement SFDR as a global standard.
Consequently the SFDR will require any Third Country AIFM so affected to make certain pre-contractual disclosures to EEA investors in a Fund which is registered or notified for marketing in any Member State. Those disclosures need to be made either in the private placement memorandum or separately. They include:
- the manner in which sustainability risks are integrated into the AIFM's investment decisions; and
- the results of the AIFM's assessments of the likely impacts of sustainability risks on the returns of the Fund.
The SFDR defines "sustainability risk" as an ESG event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of an investment in the Fund. The SFDR relates sustainability as a risk to financial value rather than ethical or moral values.
If the Third Country AIFM deems that sustainability risks are not relevant to a Fund, instead it needs to provide a clear and concise explanation of the reasons why. Certain other negative and technical disclosures are also required.
Further, ESG Funds managed by a Third Country AIFM need to make additional disclosures to those described above in their offering materials, and in the same circumstances, and are also subject to periodic reporting requirements, typically through a Fund's annual report. Although the SFDR does not directly address this situation, the consensus is that a Third Country AIFM which markets an ESG Fund will also be required to make certain website disclosures (required of an EEA AIFM), as well and to make periodic reports even where a Fund is no longer marketed in the EEA but has EEA investors. Given the uncertainties about the application of SFDR to Third Country AIFMs in this and other areas, guidance is being sought from ESMA.
Subject as provided above with respect to periodic and website disclosures for ESG Funds, a Third Country AIFM will not need to make SFDR disclosures:
- where a Fund is not registered or notified for marketing in an EEA member state;
- where an investor invests through reverse solicitation (see above); or
- to UK investors where a Fund is registered with the FCA for marketing in the UK (see below).
Subject to confirmation from ESMA, it appears likely that at least closed-end Funds other than ESG Funds that are no longer marketed in the EEA by a Third Country AIFM but do have EEA investors do not need to make SFDR mandated disclosures.
In one of the first breaks with EU legislation since Brexit, the UK has not adopted the SFDR, and plans to adopt its own legislation in this area, including implementing a new green taxonomy. For now, as noted above, a Third Country AIFM which is marketing a Fund in the UK or is a delegate of a UK manager (and is not marketing that Fund in any Member State) is not subject to SFDR disclosure obligations.
Post-Brexit Fund marketing in the EEA has become more regulated, but in the UK remains largely the same. Third Country AIFMs that have, or may in the future accept, EU investors need to be alert to the creeping tide of regulation in the EEA affecting Fund marketing and should, as always, tread carefully when accepting investors in reliance upon the AIFMD exception afforded by reverse solicitation.
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.