In the wake of the financial crisis that began in 2008, nearly every developed country has discussed and proposed heightened regulation for managers of pooled investment vehicles—primarily hedge funds, but also private equity funds, venture funds and real estate funds. Notwithstanding that there is ample room for debate as to whether the activities of those managers contributed to or exacerbated the crisis and whether more stringent regulation could have prevented it, legislators and regulators are capitalizing on current popular support for governments to “do something.”
Perhaps the most aggressive proposals have come from the European Union, in the form of the EU Alternative Investment Fund Managers Directive. The Directive’s professed objectives are investor protection, market integrity and stability, the prevention of systemic risk, the elimination of “social externalities” (whatever that means), domestication of non-EU based funds and taxation of such funds’ revenues—quite a tall order. The Directive is filled with references to “orderly markets,” with not one use of the phrase “efficient markets.”
In May, each of the European Parliament and Council of the European Union published its latest version of the draft Directive, which now must be reconciled in the coming months before being voted on by the two bodies and advancing through several levels of regulatory elaboration to potential final implementation.
The latest drafts reflect responsiveness in some respects to the outcry from commentators and market participants to the initial proposals. But it is still hard to understand how the Directive could be implemented in either current form without creating, at least in the short term, considerable disruption and, ultimately, fewer investment opportunities for EU-resident investors. The two versions of the Directive are different, but for the sake of space at the expense of completeness, this post will focus on the Parliament’s proposal.
The Directive generally applies to alternative investment fund managers (AIFM) established in the EU that market to “professional” (primarily institutional) investors, regardless of whether the funds they advise are established in the EU or elsewhere (what the Directive calls a “third country”). Initially, an EU AIFM applying for authorization under the Directive would be required to submit basic information to the relevant regulatory authority, similar to the information required by the SEC of registered investment advisers. If no authorization were affirmatively granted within three months, then the AIFM would be deemed to have been refused authorization, and no communication or reasoning for the deemed refusal would be required. An authorization could be limited in scope; for example, as to the type of fund the AIFM is authorized to manage. An approved AIFM would have to keep its applicable regulatory authority (called a “competent authority” by the Directive) informed about any changes to the basic information submitted, including any changes to its funds’ investment strategies, and the competent authority could approve, restrict, or reject the proposed changes. To my knowledge, this goes beyond the scope even of bodies, such as the Cayman Islands Monetary Authority, that currently require submission of offering documents for their regulated funds. Once authorized, an AIFM would be required to notify the competent authority whenever it intended to market a fund (whether the fund were established inside or outside the EU) and get permission to begin marketing, which could be refused or could include conditions and restrictions.
The proposed Directive includes several provisions that are bound to be troubling to EU-based AIFM (for example, the specificity of many provisions contradicts the UK FSA’s widely admired “principles-based” approach to regulation). One can only imagine the likely reaction of non-EU managers that would have to comply in order to market in the EU. As proposed, the Directive includes the following requirements:
Information reporting: Annual audited financial reporting is required—not only to investors, but to the relevant competent authorities, inclusive of remuneration amounts to the AIFM and its employees. The AIFM must supply detailed information regarding the leverage employed by its funds; its fee structures, performance information for its funds, asset valuation data, and the results of self-conducted “stress tests.” All information considered relevant to systemic risk supervision must be forwarded by the competent authority to the European Securities and Markets Authority (ESMA), a proposed new supranational regulatory body, and European Systemic Risk Board (“ESRB”).
Short selling: An AIFM must disclose its significant short positions (or, potentially, all of its short positions) to its competent authority. This information will be transmitted to the ESMA, which may restrict short-selling activities.
Side letters: If preferential treatment is offered to any investor (which may only be done if permitted by the fund’s governing documents), full disclosure must be made in the fund’s offering documents, including the identity of the investor receiving preferential treatment and details regarding the preference provided. Many US managers would currently be precluded from making such disclosure by the terms of their side letters.
Remuneration: AIFM are required to establish remuneration policies for the AIFM (including carried interest) and their personnel meeting the Directive’s guidelines and to disclose those policies and practices to their competent authorities. The policies must comply with a dozen points, including that the performance-based compensation be based on a multi-year period “appropriate to the life-cycle of the fund” taking into account the fund’s investor redemption policy and investment risks. A substantial portion (at least 50%) of variable remuneration must be deferred over an “appropriate period” that is not less than four years. This provision would cause particular difficulty for US-based managers (even in the unlikely event that they wanted to comply with the policy guidelines and provide the information) due to the IRS’s treatment of deferred income. The Directive guidelines also require the establishment by the AIFM of a remuneration committee chaired by a member of management that does not perform any executive functions for AIFM. How could this work for small organizations?
Leverage: Each AIFM must set leverage limits in respect of each fund it manages, based on a list of criteria. The competent authority is given the authority to decide whether the limits are reasonable, based on ESMA guidelines.
In order for an EU-based manager to be awarded permission to market a fund established in a third country to professional investors in the EU and in order for a professional investor to be permitted to invest in such a fund, the third country where the fund is established must meet certain anti-money laundering requirements, must have signed a tax agreement with the relevant Member State(s), must afford reciprocal access to its resident investors to EU-based funds, and must agree to recognize and enforce judgments rendered in the EU on matters connected to the Directive.
What would this mean for US-based managers wishing to market a non-EU-based fund? In addition to the preceding requirements, a manager not established in the EU would be required to comply with the Directive just as though it were an EU-based manager and would be required to submit to the jurisdiction of courts in the EU. Of course, entry into an agreement to comply would be voluntary on the part of the AIFM, but, to ensure enforcement of the Directive, the regulator of the AIFM would also be required to agree with the ESMA to enforce compliance. This may be the stickiest point. Even if no requirement of the Directive were controversial, and even if the SEC were not about to be swamped with supervision and enforcement of comprehensive new US regulation, what are the chances that it has the manpower, resources, or inclination to enforce another body’s laws? In order to qualify, the non-EU competent authority would need the authority to employ a laundry list of powers and the ability to exercise them at any time, including the ability:
- to access any document in any form and to receive a copy of it from the AIFM;
- to require information from any person and, if necessary, to summon and question any person with a view to obtaining information;
- to impose a suspension of professional activity;
- to curtail any practice that is contrary to the regulations implementing the Directive;
- to freeze or sequester assets;
- to impose suspension of the issue, repurchase, or redemption of fund units; and
- to withdraw any authorization previously granted to an AIFM.
Some Directive provisions are not likely to be controversial, either because they encompass accepted best practices and/or because sophisticated investors routinely require their implementation already: maintenance of professional indemnification insurance, investment of personal resources by the manager, independent verification of asset value, and full disclosure of existing and potential conflicts of interest. There is even a bright side: it would be easier and less costly for managers to market to professional investors throughout the EU using just one set of rules.
It is unimaginable, however, that the Directive could be adopted in either of its current forms. If it were, a huge subset of managers, including those based in the US, would be precluded from marketing to or accepting unsolicited investments from EU professional investors, and the ultimate result would be fewer choices for those investors.
Marie T. DeFalco is a member of Lowenstein Sandler and Vice Chair of the Investment Management Group.