Download Hedge Fund Directive clashes with Irish regulations If the European

Hedge Fund Directive clashes with Irish regulations
If the European Commission draft on Alternative Investment Fund
Managers Directive, which is proposing to regulate the managers of
“alternative investment funds, is implemented in its current form, it will
affect the operations of all managers of non-UCITS funds, writes Fionán
Breathnach. The draft legislation conflicts with Ireland’s current
regulatory regime in a number of areas, which may lead to difficulties for
Ireland’s funds industry if the Directive is passed in its current form.
The original justification by the European Commission for the draft Directive
on Alternative Investment Fund Managers was a response to systemic
concerns arising from the global financial crisis. The Explanatory
Memorandum accompanying the draft Directive states that Alternative
Investment Fund Managers (“AIFM”) are vulnerable to risks that present “a
threat to creditors, trading counterparties and to the stability and integrity of
European financial markets”.
However, in the draft Directive, Alternative Investment Funds (“AIF”) are
defined as any fund that is not regulated under the UCITS Directive. The draft
Directive proposes, therefore, to affect the operations of managers of all nonUCITS funds, irrespective of the legal structure of the fund, its investment
strategy, whether it is domiciled inside or outside of the EU or whether it is an
open or closed-ended fund.
The Explanatory Memorandum concedes that AIFs “employ a variety of
investment techniques investing in different asset markets and catering to
different populations” and that the sector “includes” hedge funds and private
equity funds. If these latter types of funds are of concern to the European
Commission in terms of systemic risk (a position which itself can be
contested), the proportionality of the measures included in the draft Directive
needs to be questioned. A large number of non-UCITS funds, which are
proposed to be within the ambit of the draft Directive, pose no systemic risk
whatsoever to the stability of the underlying markets and this one-size-fits-all
approach appears to be rife with practical challenges.
It is proposed that certain AIFM will be exempt from the Directive, including
AIFM which either directly or indirectly manage portfolios of AIFs whose
assets under management do not exceed €100 million in total. If the AIF is not
leveraged and has a lock-in period of five years or more, this threshold is
raised to €500 million. Exempted AIFM will, however, be permitted to ‘opt in’
to the provisions of the Directive.
However, there is a distinct lack of clarity as to the method of calculation of
these asset thresholds. The European Commission’s analysis suggests that
the €100m threshold will account for approximately 30% of hedge fund
managers, managing almost 90% of assets of EU domiciled hedge funds.
MHC-2441336-1
However, what seems to have been ignored is the fact that in a number of
Member States, including Ireland, there are a significant number of funds,
which do not fall within the UCITS regime but which are already directly
regulated. The fact that the European Commission, in introducing the draft
Directive, has focused on regulating the managers of funds, rather than the
funds themselves is notable. In Ireland, the model is to regulate the fund.
The regulated QIF product, for example, has the flexibility to accommodate
typical hedge fund characteristics and yet it is authorised and fully regulated
by the Financial Regulator. All the parties to the QIF are approved in advance
by the Financial Regulator and the QIF is required to have a custodian/trustee
appointed. Any prime broker that provides services to it must also be
regulated. The QIF can only be available to qualifying investors; retail
investors are not permitted. The QIF represents a highly successful regulated
product, providing transparency and flexibility but the future interaction
between this Irish model and the proposed Directive is unclear at the moment.
Furthermore, the draft Directive is stated as not applying to UCITS. However,
many mangers of UCITS funds also manage non-UCITS funds. This is
increasingly becoming the case as alternative managers continue to see the
opportunities presented by the UCITS regime. Will those managers be
required to hold a licence under the proposed Directive together with a UCITS
licence? If so, there appears to be a lack of consistency between the rules
proposed under the draft Directive and the existing UCITS rules.
Authorisation
To obtain authorisation, the AIFM will need to demonstrate that it is suitably
qualified to provide AIF management services. Each AIFM will need to
provide detailed information on its planned activities, its internal arrangements
for governance, the identity and characteristics of each AIF managed, and
information on the identities of shareholders or members having a qualifying
holding (10% or more or significant influence over management). The AIFM
will also be required to hold a minimum level of capital of €125,000 with
additional capital required if the assets under management exceed €250
million.
Marketing
Once authorised, an AIFM will be able to market its funds to “professional
investors” (as the term is defined in the Markets in Financial Instruments
Directive (“MiFID”)) in any Member State, and to manage AIFs in any Member
State, subject to notification to the home Member State. Does this mean that
AIFM need to introduce procedures to assess the suitability of clients as
required by MiFID?
The Directive also provides that Member States may allow for marketing to
retail investors within their territory and may apply additional regulatory
safeguards for this purpose but there will be no ‘passport’ rights for marketing
AIF to retail investors.
MHC-2441336-1
Third Country Aspects
The draft Directive proposes that AIFM based in the EU may market AIFs
domiciled in third countries to professional investors throughout Europe,
provided such third country complies with the OECD model tax convention
and ensures an efficient exchange of tax information (and subject to
notification to the host Member State). Member States may also authorise
AIFM established in third countries to market AIF to professional investors in
the EU under certain conditions. The detail is yet to be finalised and these
provisions will only come into force after a period of three years from the
effective date of the Directive. In the interim, non-EU funds may continue to
be sold in Member States which currently permit this.
Valuation
Each AIF must be valued by an independent valuer to establish the value of
assets acquired by the AIF. The registered office of the valuation agent must
be in the EU, although the Commission intends to make a determination
where the valuation rules and standards used by a valuation agent located in
a third country are equivalent to those in the EU. Unfortunately, we cannot
assume that this role, contemplated by the draft Directive, will be
accommodated within the fund administrator as currently understood in the
Irish model due to specific independence and responsibility requirements set
out in the draft Directive.
Reporting and Disclosure
The Directive proposes greater transparency and disclosure requirements.
For each AIF it manages, and for each financial year, the AIFM will be
required to make an annual report available to investors and competent
authorities. The AIFM will also be required to provide information to the
investor before an investment is made, such as information relating to
investment policy, fees, and redemption rights. The AIFM must also disclose
the risk profile of the AIF and the risk management system employed by the
AIFM. These disclosure requirements are not exactly aligned with the
disclosure requirements applicable to Irish non-UCITS funds, which is another
issue which will need to be resolved.
An authorised AIFM will be required to report to the competent authority of its
home Member State regularly (a terms which is not defined) on the principal
markets and instruments in which it trades, its principal exposures,
performance data and concentration of risk, and the use of short selling, if
relevant.
The draft Directive also proposes special disclosure and reporting
requirements where the AIF employs “high levels of leverage on a systematic
basis” i.e. where the combined leverage from all sources exceeds the value of
the equity capital of the AIF in two out of the past four quarters. The AIFM will
be required to assess on a quarterly basis whether the AIF employs high
MHC-2441336-1
levels of leverage on a systematic basis and, if it does, it must inform the
competent authority.
Depositories
One of the more controversial aspects of the draft Directive arises from the
proposed measures relating to the liability of depositories of AIFs. As drafted,
the proposed Directive contains provisions which would impose a level of
liability on depositories of AIFs which is stricter than that applying to
depositories of UCITS. On 28 May last, Commissioner McCreevy announced
that he intends to bring the liability provisions relating to depositories of
UCITS up to the level of the proposed AIFM Directive. This will have serious
repercussions for custodians and the costs associated with their services.
Also, the draft Directive proposes that all depositories of EU domiciled AIFs
must be EU credit institutions. There is no such requirement for custodians of
Irish domiciled funds and therefore, if drafted as implemented, this will have
serious consequences for the Irish funds industry.
What Happens Next?
The Commission has forwarded the proposed Directive to the European
Parliament and European Council and it anticipates “intense political
discussion and negotiation”. Already the proposal has met with criticism from
politicians and industry bodies. The UK’s Hedge Fund Standard Board
expressed “strong reservations” about the Directive and concern about the
lack of consultation and AIMA have committed to mobilising the world’s hedge
fund industry on the draft Directive.
There is no doubt that there is a long road yet to be travelled in relation to
these measures. The level of ambiguity and resultant controversy needs to be
addressed and significant changes to the proposals will need to be made
during the legislative process.
If political approval is reached by the end of 2009, the Directive could come
into force in 2011. A period of intense lobbying at European level by the
industry is inevitable in the meantime.
Fionán Breathnach is head of the Investment Funds and Regulatory practice
at Mason Hayes+Curran
This article appeared in Finance Dublin in the June 2009 issue.
MHC-2441336-1