At the October 19, 2010, Economic and Affairs (“ECOFIN”) Council, agreement was finally reached among the European Union Member States on the text of the AIFM Directive, paving the way for the adoption of the final text at first reading in the European Parliament plenary session on November 10/11, 2010. Subject to any final changes by the Parliament, the ECOFIN text (the “Directive”) could then conceivably enter into force before Christmas, with Member States required to implement the Directive into their national laws within two years.
Due to intense industry lobbying and pressure from the Belgian Presidency and European Commission to reach a workable compromise on the controversial “third countries” and private equity provisions (see below), the Directive is arguably the most industry-friendly draft to date. The maintenance of private placement regimes until 2018/2019 along with the ability to obtain a marketing “passport” from 2015, in particular, reflect a more pragmatic approach to regulating the activities of EU and non-EU managers of off-shore (non-EU) funds. This is of course scant consolation for many firms, who have yet to be provided with a convincing rationale for the Directive, and whose compliance costs will increase from January 2013 when the transposed Directive should enter into force in the various Member States. Increased costs may in turn lead to lower returns for some investors, regardless of where the managers and funds are based.
For managers still wishing to market non-EU funds to EU investors the Directive will spur some additional on-shoring to EU UCITS/fund jurisdictions. Conversely some managers may decide to exit the EU altogether or significantly scale down their presence in order to avoid falling within the Directive and being subject to other new European laws. Clients may wish to prepare for the key operational and other changes required, evaluate structural and compliance options — such as off-shoring to other jurisdictions in Asia and the Americas, and establishing onshore funds pursuing parallel investment objectives.
1. Key Directive Requirements
Scope: The Directive applies to all alternative investment fund managers (“AIFM”) established in the EU managing alternative investment funds (“AIF”), regardless of fund domicile, and non-EU AIFM managing EU AIF or non-EU AIF where the latter are marketed to EU investors. The definition of AIFM is wide, covering any legal person whose regular business is managing (ie providing at least portfolio and risk management services to) one or more AIF. AIF is also defined broadly to cover “any collective investment undertaking…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” and which does not require authorisation pursuant to the UCITS regime.
Thus, all hedge fund managers and private equity houses based in London or elsewhere in the EU are likely to be within scope, unless it is possible for them to benefit from an exemption — either in the Directive itself (eg on the ground that the AIF AUM do not exceed €100 million, or €500 million for private equity, or are pension funds) or via subsequent delegated acts/implementing measures. The Directive will also catch US, Asian and other non-EU managers of AIF (including in principle mutual funds) which will be marketed to EU investors. Whilst the precise definition of “marketing” will be fleshed out by EU/national technical experts next year (see 3 below), the Directive intends to cover active marketing by or on behalf of the AIFM.
Authorisation: EU AIFM will have to be authorised by the Member State in which they are established, pursuant to a harmonised procedure. It is currently envisaged that London managers would be authorised by the Consumer Protection and Markets Agency, which will be created during the restructuring of the UK financial regulatory landscape as the FSA is dismantled over the next 18 months. Non-EU AIFM marketing AIF to EU investors follow a different procedure which involves making a notification to its Member State of Reference (broadly, the Member State where its primary activities take place —see below).
Operational, Capital and Other Requirements: Due to intense industry lobbying, many of the original operational requirements have become more workable for many firms. For example, whilst the original draft mandated structural separation of risk management and portfolio management, national regulators will now only require such separation if it is proportionate. Minimum capital requirements on the AIFM remain (€300,000 for self-managed AIF and €125,000 for externally appointed AIFM plus 0.02 percent of total assets under management in excess of €250 million) subject to a cap of €10 million.
Other ongoing requirements include compliance with conduct of business rules, periodic valuations of assets, liquidity management controls (so that redemption requests can be met), and requirements regarding management and disclosure of conflicts of interests. Some rules will only apply to AIFM that employ certain strategies in the management of their AIF, such as the systemic use of a high degree of leverage. The details of these ongoing requirements will, to a large extent, be set out by the European Commission in consultation with national experts via secondary legislation next year (see 3 below). Note that these requirements will apply to EU AIFM of EU AIF, non-EU AIFM of EU AIF, and EU AIFM and non-EU AIFM of non-EU AIF marketed in the EU via the “passport” (see below).
Marketing to EU Investors: EU AIFM managing EU AIF will be permitted to market such funds across the EU using the passport, following a process of pre-filing and clearance by their regulators. The treatment of AIFM of non-EU AIF is more complex, however.
The accord reached envisages the introduction of a passport regime for “third country” (non-EU) based funds with a two-year transition phase (meaning entry into force around 2015) and in which the new European Securities and Markets Authority (“ESMA”) is to play a significant role. Managers of non-EU AIF can continue to benefit from national private placement regimes until 2018/2019 however, which is helpful as utilising private placement will involve complying with fewer conditions than for obtaining a passport. This is particularly the case for non-EU AIFM, although non-EU AIFM will still need to comply with, inter alia, the onerous transparency/disclosure obligations when marketing under existing private placement regimes (see 2 below).
For non-EU AIFM wishing to market AIF in the EU under the passport, the Directive introduces an authorisation and supervision mechanism to appoint a de facto EU Member State of Reference as the home supervisor in the EU. The Directive introduces a range of provisions to ensure effective coordination between that Member State, other Member States where the funds are marketed and the third country where the AIFM is established. ESMA is given peer review powers to ensure that the authorisation is consistent across the EU. For a more detailed explanation of the marketing regimes please see 2 below.
Depositary: A single depositary will generally be required to hold the assets of the AIF that the AIFM is managing, monitor the cash flow of the AIF, ensure that transactions involving AIF shares or units comply with national law, and act in the best interests of the AIF and its investors. Whilst the original depositary liability provisions were strict and a very limited pool of entities were able to act as a depositary, these provisions have since been liberalised. In particular, the Directive allows for the discharge of the depositary’s liability for loss of financial instruments by a sub-custodian, as well as allowing the depositary to exclude liability for loss of financial instruments in certain limited circumstances. Further, a prime broker acting as counterparty to an AIF could now act as depositary if it has functionally and hierarchically separated its depositary functions from its tasks as prime broker, properly identified and managed potential conflicts of interest, and disclosed these to investors.
For non-EU AIF, the depositary must no longer necessarily be established in the third country where the AIF is established, but can also be established in the home Member State of the EU AIFM or, as the case may be, in the non-EU AIFM’s Member State of Reference. Unfortunately the single depositary requirement remains, subject to provisions for sub-delegation (see below), which will in practice increase systemic risk. Having said this, EU AIFM marketing non-EU AIF via private placement regimes will not have to comply with many of the depositary requirements (see 2 below).
Surprisingly, depositary liability is more onerous under the Directive than under the current UCITS regime, ostensibly in response to the Madoff affair. That said, even under the Directive, depositaries should only be responsible for losses which are within their control. They will be permitted to delegate to sub-depositaries meeting certain standards, but where no delegate in a particular third country meets such standards, and the law of that country requires the depositary to use a local entity, the decision to invest will be at the risk of the investors, not at the risk of the depositary. Ultimately, the Commission intends to bring UCITS IV in line with the Directive, so that the same standard of depositary liability applies across the board, and the same standard of risk management generally.
Remuneration: In response to political pressure, the Directive also contains various remuneration “principles” applying to senior management, risk takers and others having a material impact on the AIF they manage. These principles include deferral of 40 or 60 percent of variable remuneration over at least three years, and require that the fixed component represents a sufficiently high proportion of the total remuneration and, in certain circumstances, that 50 percent of variable remuneration should be paid in shares or share-like instruments. For UK investment firms (which will include many London AIFM) the Directive’s remuneration principles have been pre-empted by the binding principles contained in the Third Capital Requirements Directive (“CRD III”). CRD III is due to be implemented in the UK next year, although certain other Member States will not necessarily be implementing on time, or even at all for hedge funds and private equity houses. CRD III contains similar remuneration principles to those in the Directive. The FSA and CEBS are currently in the process of finalising their policy statements and guidance on the CRD III principles, and are using the principle of proportionality to ensure that the principles applied to investment firms are not unduly burdensome.
Disclosure/Transparency: EU AIFM, and non-EU AIFM marketing to EU investors, will have a number of onerous disclosure obligations with regard to investors for each AIF they manage, including information on the planned investment strategy, use of leverage, procedures to change the investment strategy as well as rules applying to leverage, details of fees and expenses, valuation procedures and details on the depositary. An AIFM will also have to inform investors where the AIF it manages are established.
They will also have to report to the relevant authorities in the Member State in which they are established on a number of issues including risk and liquidity management, special provisions relating to redemption in case of illiquid assets, the main categories of assets in which the AIF under management invest, particular concentrations of such assets, and risks connected to the use of leverage.
Private Equity: Onerous disclosure and notification obligations as well as anti-asset-stripping controls will apply to private equity houses within scope, ie AIFM which manage one or more AIF which individually or jointly acquire control of a non-listed company (“control” being defined as more than 50 percent of voting rights in the company), and AIFM which cooperate with other AIFM to jointly manage AIF that acquire control of a non-listed company. These provisions do not apply where the AIF acquires control of small or medium enterprises (less than 250 employees and less than €50 million turnover/€43 million assets) or of real estate special purpose vehicles.
An AIFM must notify its home regulator when the voting rights in the company held by an AIF managed by the AIFM reach, exceed or fall below 10, 20, 30, 50 and 75 percent. An AIFM must also notify the company and its shareholders when control is acquired. These parties must be provided with information on the AIFM, its conflict of interests policy and its communication policy regarding the company. Additionally, the company, its shareholders and its employees must be provided with information on the AIFM’s future intentions regarding the company and the likely repercussions for employees. The AIFM must also procure that the board of the company provides this information to the employees of the company or their representative, and that relevant past and likely future developments are taken into account in the company’s annual report.
On the controversial socio-political issue of asset-stripping, the Directive introduces provisions that apply in respect of the acquisition of control of non-listed companies as well as issuers. In the period of 24 months from the acquisition, an AIFM must not facilitate, support or instruct any capital reduction, any share redemption, any distribution to shareholders/own share purchase where the net assets of the company fall short of its subscribed capital and non-distributable reserves, and any distribution to shareholders which would exceed the amount of available profits.
Delegation by AIFM: The Directive permits the delegation of an AIFM’s functions provided that the AIFM notifies the competent authorities of its home Member State before the delegation arrangements become effective and meets specified requirements. The fact that such delegation has occurred must not prevent the AIFM from being effectively supervised and the AIFM must be able to demonstrate that its delegate is qualified and capable of undertaking the functions in question, that it was selected with all due care and that the AIFM is in a position to monitor effectively at all times the delegated activity, to give further instructions to the delegate and to withdraw the delegation with immediate effect when this is in the interests of investors. Where the delegate is not within the EU, there is an additional requirement that there be cooperation between the competent authority of the EU Member State of the AIFM and the supervisory authority of the delegate. The AIFM’s liability to the AIF and its investors cannot be affected by the delegation of its responsibilities. Sub-delegation of functions by a delegate is permitted provided that certain specified criteria are met.
2. Dual Marketing Regime for Non-EU AIFM/AIF
Whilst EU AIFM of EU AIF can market cross-border as long as they comply with the Directive, additional rules apply for non-EU AIF. This is ostensibly on investor protection grounds but, in reality, these rules have been inspired by the desire of certain Member States, led by France, to encourage on-shoring of funds and generally to put additional pressure on off-shore tax havens to become more transparent and consistent with G20 objectives.
EU AIFM of non-EU AIF: EU AIFM will be able to rely on existing private placement regimes until 2018/19, provided they comply with the Directive in full, except for certain provisions relating to depositaries. Further, appropriate cooperation arrangements for the purpose of systemic risk oversight (and in line with international standards) must be in place between the AIFM’s home Member State and the AIF’s supervisory authority. To this end we note that the FSA already has a similar agreement in place with the Cayman Islands. Finally, the non-EU AIF’s country of establishment must not be listed as a Non-Cooperative Country and Territory (an “NCCT”) by the Financial Action Task Force on anti-money laundering and terrorist financing.
From around 2015 AIFM would be able to obtain the passport to market cross-border if they fully comply with the Directive. In addition to appropriate cooperation arrangements being in place and the non-EU AIF’s country not being listed as a NCCT, its country must have signed an agreement with the AIFM’s home Member State and with each other Member State in which the non-EU AIF is proposed to be marketed, which fully complies with the standards laid down in Article 26 of the OECD Model Tax Convention.
Non-EU AIFM of non-EU AIF: In order to continue marketing pursuant to national private placement regimes (until 2018/19), a non-EU AIFM will need to comply with the onerous transparency and reporting requirements and, if appropriate, the private equity requirements. In addition, appropriate cooperation arrangements must be in place (see above). Further, the country where the non-EU AIFM is established must not be listed as a NCCT.
Once passporting is available, a non-EU AIFM must first be authorised to obtain a passport, by meeting each of the following requirements: (i) the non-EU AIFM must have a legal representative established in its Member State of Reference; (ii) appropriate cooperation arrangements must be in place; (iii) the country where the non-EU AIFM is established must not be listed as a NCCT; (iv) the country where the non-EU AIFM is established must have signed an agreement with the Member State of Reference, which fully complies with the standards laid down in Article 26 of the OECD Model Tax Convention; (v) the effective exercise by the competent authorities of their supervisory functions under the Directive must not be prevented by the laws, regulations or administrative provisions of the country governing the non-EU AIFM (nor by limitations in the supervisory and investigatory powers of that country’s supervisory authorities); and (vi) the non-EU AIFM will need to comply with the Directive in full, except where the non-EU AIFM can demonstrate that it is impossible to combine compliance with adhering to a mandatory provision in the law to which the non-EU AIFM and/or, as the case may be, the non-EU AIF marketed in the EU, is submitted. Where this is the case, the non-EU AIFM will have to show that the law to which the non-EU AIFM and/or the non-EU AIF submits provides for an equivalent rule having the same regulatory purpose and offering the same level of protection to the investors of the relevant AIF; and the non-EU AIFM and/or the non-EU AIF complies with that equivalent rule.
3. Timing, Implementation and Technical ‘Level 2’ Acts
The deadline for Member State implementation of the Directive into their national laws is currently likely to be January 2013. Leading the national regulators, the FSA is already finalising an initial planning document in order to help firms prepare for the new regime. The Directive is currently at the end of the first stage of the four-stage “Lamfalussy” process. Once adopted next month/early January, the Directive will enter “Level 2” pursuant to which technicians from the various Member States and the Commission will prepare detailed “delegated acts” which help flesh out key definitions and provisions. Simultaneously “Level 3” cooperation among national regulators to ensure consistent interpretation and implementation of the rules at Member State level will ensue. Thus, the next 18 months will see various EU and Member State consultations and engagement with industry as the provisions of the Directive and its delegated acts and guidance are brought to life. Finally, “Level 4” will see monitoring, compliance and enforcement of all measures led by the Commission to ensure consistent implementation, with a review by the Commission to take place in due course.
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This article was originally published by Bingham McCutchen LLP.