Focus: Impact of proposed EU directive on Australian and Asian fund managers
18 June 2009
In brief: In the wake of the financial crisis, the European Union is moving towards tighter regulation of alternative investment funds, in particular hedge funds and private equity funds, through a proposed Directive on Alterative Investment Fund Managers. The proposed directive would have considerable extra-territorial reach and may result in additional regulatory burdens for managers of alternative investment funds based outside Europe. Partner Tim Manefield , Senior Associates Marc Kemp and Charlie Harrison, and Lawyer John Henderson report.
- Who is affected?
- Regulatory burdens on funds marketed to EU investors
- Next steps
How does it affect you?
- The precise extent or effect of the proposed Directive on Alternative Investment Fund Managers (the directive) is presently unclear, as it is loosely and broadly drafted, and in many aspects ambiguous. It is hoped that the proposed directive will be revised and clarified before it is implemented.
- The proposed directive seems intended to apply not only to EU-based managers of alternative investment funds, but also to non-EU-based managers that provide management services to alternative investment funds or market alternative investment funds in any EU member state.
- In particular, Australian- and Asian-based sponsors and managers of hedge funds, private equity funds, unregistered property funds and others who market to EU investors are likely to be caught by the new regulatory regime.
- Custodians and depositaries which are not established in the EU may be disadvantaged due to a requirement that the depositary role in respect of a fund established outside the EU (eg, in Australia or Asia) but managed from the EU must be delegated by an EU-established credit institution. It is arguable that this requirement also applies to funds established outside the EU and simply marketed in the EU, but the directive is ambiguous on this point.
- The proposed directive is presently subject to public comment (and industry bodies are known to be pressing for amendments to the directive). It could come into force at an EU member state level in 2011. The EU contemplates a three-year term before managers based outside the EU may market their funds in the EU in accordance with the directive. The directive is ambiguous, but it appears that they may market their funds in the EU under existing national laws during that term.
There is a growing trend, world-wide, towards additional regulation for alternative investment funds which are regarded by regulators as potentially posing risks for financial market participants.
In the EU, managers of EU-based hedge funds, financial advisers and financial intermediaries are already regulated under the EU's Markets in Financial Instruments Directive. This regulation includes a need to be licensed, to hold certain levels of capital and to have risk management processes in place.
The EU also has in place a regime known as Undertakings for Collective Investments in Transferable Securities (UCITS) which allows open-ended collective investment schemes that invest mainly in listed (or transferable) securities and which have been authorised in an EU member state to market themselves to retail investors across the EU.
In addition to the above legislation, the Commission of the European Communities recently proposed the directive that sets out the basis of a regulatory framework for managers of alternative investment funds. The directive proposes that each EU member state regulates, in a harmonised manner, alternative investment fund managers (AIFMs) that manage and market alternative investment funds in or into a member state. An alternative investment fund (AIF) is defined as being any collective investment undertaking whose object is collective investment in assets and which does not require authorisation under the UCITS. This is not limited to EU-based funds and so has the potential to impose significant compliance burdens on funds outside the EU which have investors located in an EU member state.
The directive is currently being debated in the European Parliament and Council. Assuming political approval is achieved by the end of this year, it could come into force at an EU member state level sometime in 2011.
The EU then contemplates a three-year term before managers based outside the EU may market their funds in the EU in accordance with the directive. It is unclear, but appears that they may market their funds in the EU under existing national laws during that term.
The directive appears to be aimed at any AIFM:
- established in the EU; or
- established anywhere else, which:
- supplies management services to an AIF in an EU member state; or
- markets an AIF into an EU member state.
The regulations under the directive will only apply above certain asset thresholds. AIFMs whose cumulative funds under management do not exceed €100 million are exempted. There is also a higher exemption threshold of €500 million for AIFMs which only manage funds that do not use leverage and which have a lock-up period of at least five years.
While these thresholds may exempt some smaller fund managers, they also pose a number of questions. What happens if a leveraged fund with EU investors and €95 million under management receives an additional investment of €10 million? What if market volatility results in a fund's asset values fluctuating above €100 million? Must the fund manager cease all marketing activities in EU member states until it obtains AIFM authorisation?
It is unclear at this stage whether exemptions will be provided for managed investments schemes which are registered in overseas jurisdictions (eg, Australia, Hong Kong or Singapore) on the principle of reciprocity.
Under the directive, affected funds would be required to separate asset safe-keeping and management functions and therefore to segregate investor assets from those of the manager by using a depositary.
A depositary's role is described in the directive as including the booking of investor money on a segregated account, the safe-keeping of financial instruments and the verification of whether the AIF (or the AIFM on behalf of the AIF) has obtained ownership of all relevant assets. On this basis, we assume that custodians and prime brokers would be included in the concept of 'depositary'.
An EU-based depositary may delegate its role to a depositary domiciled in a non-EU country, provided that the legislation of that country ensures a level of protection of investor interests which is equivalent to that in the EU.
This has possible implications for Australian- and Asian-based investor services providers. As presently drafted, it is arguable that the directive will require Australian and Asian AIFs, which are marketed in the EU, to engage a depositary established in the EU, which may then delegate its role to a subsidiary in Australia/Asia. Those Australian/Asian depositaries which are not established in the EU might well be concerned that this process would see existing work move to competitors with a formal presence in the EU.
It also remains to be seen which jurisdictions have, in the EU's opinion, an 'equivalent' level of investor protection to that in the EU.
What constitutes 'marketing'?
The directive at this stage defines 'marketing' broadly to include any general offering to EU-investors in units or shares in an AIF 'regardless of at whose initiative the offer or placement takes place'. This approach is contrary to that in many jurisdictions in which an unsolicited approach by a prospective investor is, typically, not included in the concept of marketing, promotion or solicitation. The directive does not clearly address limited partnerships which do not issue units or shares, although it is intended to apply to all AIFs regardless of legal form.
Under the directive, any non-EU-based AIFM that wishes to market its funds to investors in EU member states will need to apply to the relevant member state for an AIFM authorisation. The requirements for authorisation presently set out in the directive are onerous and include the following:
- The fund manager must provide the same type of information to the regulator as if it were based in the EU.
- The fund manager must comply with the business and transparency rules set out in the directive (including the disclosure of specified information to investors).
- The non-EU country in which the fund manager is domiciled must have equivalent prudential regulation and supervision as set out in the directive. The directive does not identify specific international regulators which provide equivalent supervision.
- The regulator in the non-EU country must have signed a co-operation agreement with the EU member state(s) into which funds will be marketed.
- EU-based AIFMs must be granted effective market access by the country in which the non-EU-based AIFM is established, comparable to that granted by the EU to that non-EU-based AIFM.
- Both the non-EU country in which the fund is established and the non-EU country in which the fund manager is domiciled must have tax treaties in place for the sharing of information with the EU state in which the fund is to be marketed. This may be a problem for funds managed by AIFMs established in some offshore and Asian jurisdictions, such as Hong Kong and Singapore.
As presently drafted, the Directive arguably imposes largely the same obligations on AIFMs regardless of whether they are established in or outside the EU. This has been criticised by stakeholders on the basis that in practice it ignores the facts that:
- under the Directive, a non-EU AIFM may already have to be subject to an equivalent regulatory framework in its home country; and
- a non-EU AIFM may simply be marketing its funds in the EU (as opposed to managing them in that jurisdiction).
The directive does not presently contemplate the granting of relief for non-EU funds. This may be contrasted with the situation for European managers who may apply for relief from the licensing requirements in the Corporations Act 2001 (Cth.) of Australia in respect of wholesale/sophisticated client business.
As presently drafted, the directive has the potential to impose significant regulatory costs and compliance burdens on Australian and Asian AIFs which have EU investors. There is expected to be intense debate in the European Parliament and Council over the directive in the coming months. We will follow its progress and update you with significant developments.
- John BeckinsalePartner,
Ph: +61 7 3334 3520
- Mark CerchéPartner,
Ph: +61 3 9613 8872