Devil in the detail - Diana Bentley

A new EU Directive to regulate the financial services industry has received a lukewarm response from lawyers.

Governments and regulators have done plenty of soul searching in the wake of the global financial crisis. Hedge funds have come in for particular scrutiny and while the European Union – and other bodies – contend that hedge funds were not the main culprits responsible for the world’s financial ills, it nonetheless believes that they contributed to market turbulence. So it is no surprise that hedge funds now fall within a new EU regulatory regime.

New regime

Released on 30 April, the European Union’s draft Directive on Alternative Investment Fund Managers (AIFMs) will provide a new regulatory scheme for EU organisations that manage alternative investment funds (AIFs) based inside – or outside – the European Union. Though it was expected that the Directive would only govern hedge funds, it is, in fact, much wider in scope, ambitiously extending to all non-UCITS (undertakings for collective investment in transferable securities) – closed or open-ended – and including not only hedge funds but private equity funds, commodity funds, property funds and others. Explaining the wider approach, Oliver Drewes of the European Commission says: ‘Basic features of AIFs – and issues they confront like risk management and conflicts of interest – are the same in many respects.’

But the Directive’s all-embracing scope has dismayed those in the fi nancial services industry. ‘The draft Directive is one of the most significant – possibly the most significant and far-reaching – proposals for regulating the European financial services industry in EU history’, remarks Stuart Martin, head of European financial services and investment funds at Dechert, London. Many are concerned that the Directive is unwieldy in its range. Gráinne McEvoy of Ireland’s Financial Regulator notes that the attempted regulation of all funds raises many issues, ‘not least because of the diverse nature of the funds involved ranging from daily dealing money market funds to very complex professional investor funds’.

Widespread complaints include that much of the Directive – drafted rapidly with little consultation – is ambiguous and that it overlaps with UCITS regulation and the Markets in Financial Instruments Directive (MiFID). Its potentially protectionist effect, however, is especially controversial with UK politicians and industry leaders, who argue that the Directive could seriously damage the UK – and EU – financial services industry and charge that the scheme has been orchestrated by Member States with little to lose. ‘It is perhaps easy for other European countries to make political capital out of demanding intrusive regulation on an industry in which they have little or no direct experience’, says Lord Myners, Financial Services Secretary to the UK Treasury, ‘But it’s woefully short-sighted protectionism. Europe has a lot to gain from a thriving alternative investment industry.’

Commentators point out that there is already good national regulation in place. David Dillon, senior partner at Dillon Eustace of Dublin and Co-Chair of the IBA’s Investment Funds Committee, comments: ‘In Ireland hedge funds have been well regulated for years – with robust rules on annual audits, custody and administration, disclosure and conflicts of interest. In the UK, they’re regulated by the FSA. There’s no evidence to suggest that what is contained in the Directive is necessary or proportionate.’ Nonetheless, the European Union insists that national approaches in the Union are fragmentary and fail to provide a comprehensive response to managing risks in the sector – so the Directive is necessary. With the Directive now before the Council of Ministers and the European Parliament, interest groups are lobbying hard to secure desired amendments before it is adopted.

Concentrating on managers

Under the Directive, the European Union has opted to regulate EU domiciled AIFMs in their management and marketing of AIFs, rather than registering AIFs. AIFMs must meet certain requirements – including levels of capital – to have the right to work throughout the European Union; a right that is known as the EU ‘passport’. Lawyers say that initially what constitutes an AIFM is unclear: does the Directive regulate AIFMs that provide management and administration services to AIFs only or pure investment managers? ‘It looks like a directive for operators and not investment managers’, comments Stuart Martin.

Some bodies, too, are exempted from the Directive’s provisions. AIFMs below fixed monetary thresholds are exempted and, while some argue that the level is too low, more angst is being generated over the exemption of banks and insurance institutions. SJ Berwin’s Tamasin Little, a London partner in financial markets, considers the exemption to be ‘odd’. ‘The EU insists that they are only exempted insofar as their own account business is concerned, but while this is referred to in the Preamble, it isn’t in the body of the Directive.’ And the Alternative Investment Management Association (AIMA), the international representative body of hedge funds, insists that while it welcomes EU-wide regulation, the exemption is a ‘striking omission’. ‘Desks of banks can act like hedge funds too’, their spokesman says.

‘There's no evidence to suggest that what is contained in the Directive is necessary or proportionate’

David Dillon
Dillon Eustace

Operations

Many operational rules will govern AIFMs and AIFs. As a point of principle, Tamasin Little insists, ‘It regards professional investors as needing the full weight of the investor protection it sets out.’ Supervisory obligations are imposed on AIFMs who must ensure investors are treated fairly and other rules on liquidity and redemption policies of AIFs are in place. AIFMs are obliged to make point of sale and ongoing disclosure to investors – including disclosure of preferential treatment. The control of risks includes a prohibition on naked short selling. AIFMs must ensure risk and portfolio management be segregated, which practitioners say will be challenging. ‘Separating risk from portfolio management is questionable. In reality some managers will need to combine the function’, observes Little.

Limits on leverage may be imposed. The EU’s Oliver Drewes explains: ‘Leverage caps should help avoid excesses in the market. How they should be implemented will be determined in the later technical implementing measures.’ For hedge funds in particular, however, caps could be problematic, the AIMA argues. ‘In practice managers have particular strategies for individual funds. It makes no sense to arbitrarily impose limits that apply across the board to funds that employ diverse strategies. Some use a lot of leverage, some use none.’ Ireland’s Financial Regulator is also unconvinced that caps are useful. ‘There’s no evidence that such a restriction is necessary and it would be diffi cult to implement in practice, not least because leverage can be employed in various ways – for example through borrowings or the use of derivatives’, says McEvoy. In any event, hedge funds have often used much less leverage than banks, say commentators.

On the organisational front, each AIF must have a valuer who is independent of the manager appointed to value its assets – a proposal apparently based on a concern that many hedge funds lacked appropriate valuation policies. ‘This is a valid concern but the proposal should focus on the valuation process – perhaps by reference to the principles set out by IOSCO [International Organization of Securities Commissions]’, comments McEvoy.

Third country aspects

Real concerns exist about the damage to the EU financial services industry that may be wrought by the provisions concerning non-EU AIFs and non-EU AIFMs. While some relate to the operation of AIFM, others affect management and marketing. Lawyers believe that although the rule that each AIF must have a depositary to receive moneys and hold assets may be reasonable, the proviso in effect limiting the provision of depositary and custody services to EU credit institutions is questionable. ‘Preventing depository companies delegating custody to sub-depositories outside the EU will make it impossible for EU AIFMs to manage anything other than investment funds investing in European markets’, asserts Stuart Martin, while the AIMA is concerned about increased costs.

Similarly, the delegation of portfolio management or risk management to AIFMs that are not authorised under the Directive could cause problems as, in practice, many AIFMs need to delegate these functions to companies outside the European Union, including their own regulated group operations. ‘The normal UCITS-style approach of allowing delegation to suitably authorised overseas entities should be adopted’, argues Martin.

Then there is management and marketing. Each Member State in which non-EU AIFs are to be marketed by AIFMs must have agreements with the AIFs’ country of domicile to share information on tax matters. But the passport to market non-EU funds only becomes available three years after the Directive comes into force. Until then, EU Member States can allow AIFMs to market non-EU AIFs to professional investors under the national private placement rules – though in places such as France and Italy, lawyers say, this is not allowed anyway. ‘Tax considerations are a dubious “bolt on” to a Directive for regulatory reform on investor protection and especially given the EU concerns on tax centres like the Cayman Islands’, says Robert Duggan, a partner of international firm Walkers, which has offices in the islands. The regime, commentators say, may be unfair to jurisdictions such as the Cayman Islands – a hedge fund centre – the Channel Islands and the Isle of Man.

SJ Berwin’s Tamasin Little insists that a particularly difficult issue is the marketing of non-EU AIFs into the European Union by non- EU AIFMs. ‘This may be possible if the home state of the manager has equivalent prudential requirements and supervision and offers reciprocal marketing access. But it’s left in the hands of the Commission what that means.’ The lingering question is whether all these provisions will lead to overseas funds being frozen out of the European Union, limiting the choice for EU investors.

‘Our international partners won't look kindly on a "fortress Europe" approach’

Stuart Martin
Dechert

Lawyers and politicians

The Directive should undoubtedly lead to a surge in the work of financial services lawyers. UK hedge fund lawyers should be well occupied while lawyers in continental Europe will be more concerned with work on other types of funds. Angelo Lercara, a partner of Dechert’s Munich office and head of the firm’s German financial services business, confirms: ‘In Germany the hedge fund industry is still underdeveloped although German investors are aware of the importance of this asset class.’ But lawyers will be busy too helping clients devise new strategies. Lercara adds: ‘Several high-profile hedge fund managers have recently launched UCITS and with uncertainty surrounding the AIFM more hedge fund managers are likely to look at the advantages of the UCITS regime.’ Addressing the non- EU AIF issue, Cayman Islands practitioner Robert Duggan comments: ‘What you could see emerging in time is that offshore AIFs will have parallel EU AIFS to accommodate EU investors, whether as parallel funds or within a master/feeder structure.’

Like others, Dechert’s Stuart Martin is concerned that overall the Directive could badly affect EU fi nancial markets and that London in particular could suffer. ‘Short term it could lead to more work for lawyers in the EU. Long term it will damage London as a financial services centre and be bad for Europe’s position in the international services market. Our international partners won’t look kindly on a “fortress Europe” approach and it’s not consistent with our international obligations.’ Likewise, David Dillon believes that any increase in work could be short lived. ‘It may comprise mostly reporting and compliance work. An appropriate level of harmonisation is desirable but what is proposed will potentially stunt the development of an important, strategic industry because fundamentally it is limiting rather than enabling in nature.’

In the meantime, lobbying continues. Lord Myners argues that to provide a framework for an efficient industry and to enable the European Union to compete effectively in global markets the Directive needs ‘major surgery’. Lawyers hope that provisions of key concern – such as the third country provisions – will be clarifi ed or modified. If adopted next year, the Directive will come into force around 2012. Then – and in the future – there is much to come in the way of detail.

At a glance

Proposed Directive

The European Union says that the proposed Directive on Alternative Investment Fund Managers (AIFMs) will:

apply to AIFMs managing a portfolio of more than €100 million. A higher threshold of €500 million applies to AIFMs not using leverage and having a five-year lock-in period for their investors;
ensure AIFMs are authorised and subject to ongoing regulation and key service providers such as depositories and administrators are subject to regulatory standards;
enhance the transparency of AIFMs and the funds they manage for the benefit of supervisors, investors and other key stakeholders;
ensure all regulated entities are subject to appropriate governance standards and have robust systems in place for the management of risks, liquidity and conflicts of
interest;
allow AIFMs to market funds to professional investors in the european Union subject to compliance with regulatory standards; and
grant access to the European market to third country funds after a transitional period of three years – to allow the european Union to determine if the necessary guarantees are in place in the countries where the funds are domiciled.

Market

Hedge funds manage around US$1.3 trillion for pension funds, institutions and individuals worldwide.
Approximately one-quarter of these assets are managed from europe.
Of this approximately 80 per cent are managed in the United Kingdom.

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Diana Bentley is a former practising lawyer and is now a journalist, writer and public relations adviser based in London. She can be contacted by e-mail at dianab@dircon.co.uk.