Draft Compromise Directive for Alternative Investment Fund Managers (

Originally published 24 November 2009

Keywords: AIFM, alternative investment fund managers, draft compromise directive, EU, Council,

On 12 November 2009, the Council of the European Union ("Council") published a compromise proposal draft of the Directive on Alternative Investment Fund Managers (the "Directive") (http://register.consilium.europa.eu/pdf/en/09/st15/st15910.en09.pdf). However, the Council is only one of three parties to the co-decision process under which the Directive must be approved. Neither the European Parliament, nor the European Commission has stated the extent to which it accepts the Council's draft of 12 November 2009. Therefore, at this stage, it will be necessary for industry participants to lobby in relation to the two "live" drafts. The European Parliament's Committee on Economic and Monetary Affairs is due to discuss the original draft of the Directive on 1 and 2 December 2009.

The initial version of the Directive was drafted in the midst of the financial crisis with minimal industry consultation and was published on 30 April 2009. It has been widely criticised since publication (for a summary of the terms of the initial draft, see our Client Alert dated 1 May 2009 at http://www.mayerbrown.com/publications/article.asp?id=6607&nid=6). Although it is generally acknowledged that hedge funds were not the cause of the recent financial turmoil, it is recognised that AIFM, and the alternative investment funds ("AIF") that they manage, did contribute to the manifestation of systemic risk (for example, a combination of margin calls, redemption notices and declining asset values caused many hedge funds to have to liquidate positions which resulted in asset values declining more steeply). In proposing the Directive, the European authorities are attempting to mitigate future manifestation of systemic risk and also address issues such as the direct exposure of systemically important banks to AIF, the potential damage of herding and risk concentration in certain markets and related liquidity and stability issues, inadequate investor disclosure and conflicts of interest. The Directive also seeks to minimise the potential for market abuse by AIFM in certain investment techniques (for example, short selling) and to address transparency issues for AIF when building stakes in listed and non-listed companies. The draft Directive seeks to regulate managers of all types of unregulated funds, not only hedge funds.

The initial draft of the Directive impacted areas that it may not have intended to and, industry participants argued, the cost and detriment of certain provisions would have significantly outweighed the benefits. Most recently, a report commissioned by the European Parliament's Committee on Economic and Monetary Affairs described the initial draft of the Directive as "poorly constructed, ill-focused and premature".

The Swedish Presidency of the European Union ("EU") has taken on board many of the concerns of the various industry participants in producing the 12 November draft of the Directive. In the revised Directive, the numerous concerns in relation to leverage, liquidity, valuation and marketing have broadly been addressed, although certain issues require clarification. Unfortunately, the Directive still does not adequately address many of the commercial and practical problems that would arise from the provisions relating to "depositaries". In addition, new provisions regulating remuneration practices of AIFM will no doubt be vigorously contested.

This alert summarises the principal provisions of the version published on 12 November 2009 and comments on the changes as compared with the initial draft. As noted above, the text is the version of the Council only and may be subject to further change before a compromise draft is reached.

Application

As previously, the Directive would apply to all AIFM established in a Member State of the EU which manage one or more AIF which are non-UCITS regardless of whether the AIF itself is established inside or outside of the EU. Its application would extend to closed-ended and open-ended AIF and would continue to apply in the UK to investment trusts and Charities Act common investment funds.
The minimum threshold for registration has not changed and AIFM managing assets €100 million or more would be within the scope of the Directive, unless redemptions in the AIF are prohibited for the first five years and there is no leverage, in which case the threshold for registration is €500 million.
In addition to the investment management function, the functions of marketing and administration would be deemed to be management functions under the Directive.

Conditions for granting authorisation

For an AIFM to be approved under the Directive, it would have to be authorised by the regulatory authority that is responsible for the jurisdiction in which that AIFM's head office and registered office are located. In addition, an AIFM's head office and registered office would have to be located in the same Member State.
There would also be suitability requirements for those involved in the management of an AIFM and its shareholders.
The relevant regulatory authority would have six months (as opposed to two months in the previous draft) to grant or refuse an AIFM's application under the Directive.
The relevant Member State's regulatory authority would be able to refuse authorisation if the exercise of their supervisory duties would be restricted by the AIFM having close links with other natural or legal persons. It is not clear precisely what this provision is aiming to prevent. However, it could be an attempt to ensure that AIFM not authorised under the Directive do not perform influential functions behind the scenes. Similar provisions have already been introduced in the UK under the FSA's Approved Persons regime.
An AIFM would also have to satisfy minimum capital requirements (see below).

Capital maintenance

AIFM would have to maintain capital of at least €125,000 and, where the value of AIF-managed assets exceeds €250 million, the AIFM would have to maintain an additional 0.02% of the amount by which the AIF assets exceed €250 million. However, capital requirements would be capped at €10 million. The Directive would allow for Member States to reduce capital requirements for AIFM managing in excess of €250 million by 50% of the supplemental amount if such AIFM benefit from appropriate parent company or similar guarantees. In the UK, these requirements would in most cases be in excess of the present minimum capital requirements for FSA-regulated AIFM.
Minimum capital requirements would also apply to AIFM managing solely private equity–type AIF (i.e. AIF that are not leveraged, have no redemption rights exercisable during a period of five years following constitution and which make investment and divestments on a non-frequent basis). However, such AIFM managing AIF with assets of €250 million or more would be required to maintain minimum capital of €50,000 or €60,000 (the figure is not yet final). The requirements for AIFM of private equity-type AIF managed in the UK would have limited effect due to the current minimum capital requirements for FSA-authorised AIFM.

Changes to the scope of an authorisation

Material changes to an AIFM's activities would have to be approved in advance by the relevant regulatory authority. The relevant authority would have three months to impose restrictions on or reject the requested changes.
A material change would clearly cover the establishment of a AIF or new sub-fund within an AIF. It would also cover material changes to an AIF's rules, identity and investment strategy or policy.

Remuneration policies

In an apparent last minute addition to the revised draft, the Directive contains wide-ranging provisions relating to the remuneration of AIFM executives. These provisions include:
1. restrictions on the cross-subsidisation of revenue streams which would prevent AIFM from using revenues from performing areas to remunerate executives in non-per forming areas;
2. a potential requirement for hedge fund managers to defer up to 60% of executive remuneration for up to three years; and
3. a requirement for larger AIFM to establish independent remuneration committees.
The remuneration provisions follow similar principles to those recently proposed for senior executives of large banks, but that would not, at this stage, apply to stockbrokers or medium-sized banks. It is unsurprising therefore that the initial reaction of industry participants is an assertion that many aspects are inappropriate for AIF primarily because AIFM performance fees are already broadly aligned with investor interests.

Liquidity management

Sensibly, the requirements to employ liquidity management systems and adopt appropriate procedures would be limited to AIF "of the open-ended style". Presumably, therefore, AIFM of private equity-type AIF would not be subject to these requirements.

Valuation

The Directive's valuation provisions have been significantly diluted. An independent "valuator" would not be mandatory in all cases. Instead, an AIFM would be required, where appropriate, to use an independent valuation agent bearing in mind the nature, scale and complexity of each AIF that it manages. However, when an external valuer is not used, the relevant regulatory authority could require the AIFM to have its valuations externally verified.

Depositary

The amended provisions relating to "depositaries" remain commercially and/or practically problematic in a number of areas.
For each managed AIF, an AIFM would be required to ensure that a "depositary" holds all financial instruments that can be kept, and that are subject to regular trading, in segregated accounts opened or held in the name of one or more AIF. This requirement runs contrary to current market practice for custodians (in those instances where global custodian banks rather than prime brokers etc., are currently used) who hold assets in their nominee name or the name of a sub-custodian nominee company for the benefit of the relevant AIF.
A depositary would be required to ensure that no AIFM instructions conflict with applicable national law, relevant AIF rules or instruments of incorporation. The literal interpretation of this provision is such that a depositary would be required to confirm prior to settling any investment that the trade is in accordance with applicable laws and the AIF's offering documents and constitution. For AIFs which regularly trade such an approval process would be commercially unworkable. Furthermore, depositaries may not have the systems or procedures in place, particularly at sub-custodian level, to fulfil this function and may not be able to put in place such a function.
The Directive would allow depositaries to "delegate" certain functions to sub-custodians such that depositaries retain liability for any financial loss arising from such delegation whether or not they have exercised due skill, care and diligence. This is contrary to current market practice where custodians "appoint" sub-custodians to perform functions in jurisdictions where they do not themselves operate rather than "delegate" functions to them i.e. they do not accept a primary obligation for functions that they do not themselves perform. Therefore, although custodians generally have a duty to exercise due skill, care and diligence in the selection, appointment and review of sub-custodians, custodians would not be strictly liable for any losses suffered as a result of a sub-custodian failing to perform its duties through default.
Although the Directive would allow a "depositary" (in relation to loss of securities only) to discharge itself of the above strict liability on a contractual basis i.e. not as against third parties, it would have to prove that it had exercised due skill, care and diligence and would be required to disclose this contractual discharge to investors.
No distinction is made between assets held by sub-custodians and assets held by securities depositories, which would render "depositaries" potentially liable for the default of securities depositories.
It remains to be seen whether the major financial institutions would be able to provide any service at all on the basis of the additional burdens of responsibility and liability that this version of the Directive proposes.

Influence in non-listed companies

The obligations for AIFM managing AIF that acquire interests in non-listed companies would be less onerous than in the previous draft. Previously any interest of 30% or more in a non-listed company was subject to the obligations in this respect. The Directive now only applies to interests of 50% or more in a non-listed company that is not categorised as a small or medium-sized company.
The reporting and disclosure requirements are broadly in line with the previous draft and include disclosure of the voting rights and the conditions under which any controlling influence has been reached. This will create an uneven playing field for private equity-type AIFM when compared with the rest of the market. There is therefore little doubt that private equity AIFM will continue to lobby against these requirements.

Marketing

As with the initial version, AIFM registered under the Directive may market shares of AIF to professional investors throughout the EU.
This revised version provides that Member States would have the discretion to allow AIFM to market shares or units of AIF that they manage and that are established outside of the EU to professional investors. This would seem to open up the possibility of an ongoing private placement route for non-EU AIF to be marketed to professional investors notwithstanding that they are not registered under the Directive. However, the definition of AIFM suggests that this potential private placement route would be available solely to AIFM registered under the Directive. On this basis, a US broker-dealer registered with the Securities and Exchange Commission ("SEC") would have to establish business in the EU and arrange for that business to be authorised by a Member State regulatory authority before it could market any AIF that it manages.
The marketing provisions include anti-avoidance measures to ensure that feeder AIF not established in the EU would not be able to invest in master AIF outside of the EU that are not authorised under the Directive.

Management of AIF in third countries

AIFM would only be allowed to manage AIF established in a non-EU jurisdiction if:
1. the legislation in the non-EU jurisdiction is in accordance with standards set by IOSCO; and
2. an appropriate co-operation agreement is in place been the AIFM home Member State and the relevant non-EU jurisdiction.
These requirements would seem to be less severe than in the initial draft (that required the relevant third country to have signed an agreement that fully complied with the standards of Article 26 of the OECD Model Tax Convention ensuring an effective exchange of information in tax matters). Nevertheless, the provisions would likely require significant changes to the fund regimes in some offshore jurisdictions to enable AIFM to manage AIF established in such jurisdictions. Moreover, the precise rules of the revised draft would not be clear until implementing measures were put in place.
The restrictions on the appointment of service providers in relation to the non-management functions of an AIF outside of the EU are removed from the revised version.

Transitional provisions

All AIFM operating in the EU on the date of the Directive would be required to adopt all measures under the Directive and would be required to submit an application to the relevant regulatory authority within one year of the effective date.
However, grandfathering provisions would be available such that closed-ended AIF that make no additional investments after the effective date would be able to be managed without authorisation for 24 months after the effective date of the Directive.

CONCLUSION

It would seem that there is a political will on the part of the Swedish Presidency to progress the Directive in a proportionate manner, addressing the specific issues it aims to regulate. Forward steps have been made in the Council's draft. However, before industry participants are able to accept the Directive as a workable regime, certain areas, in particular those relating to depositaries and remuneration, require further amendment. In addition, as with the initial draft, a significant amount of detail remains to be provided in level two measures, meaning that it will be difficult for AIFM to get a full sense of their likely obligations (e.g. in respect of marketing and disclosure) until the process is much further advanced.

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UK: Draft Compromise Directive for Alternative Investment Fund Managers ("AIFM")