The draft Directive had an unusually quick consultation period prior to publication. EU politicians were desperate to be seen to be fire-fighting during the economic crisis, even though most now admit that hedge funds are not the culprits. Whilst the industry views a degree of increased regulation as sensible, given the rush job drafting and knee-jerk EU reaction, certain ideas underpinning the Directive are arguably flawed. In particular, an important aspect of the proposed regulatory deal seems to be that European AIFMs get a cross-border EU passport to market their funds to European investors, in return for significantly greater regulation. But certain larger funds’ EU investors tend to be concentrated in just one Member State, the UK, and so substantially greater increased regulation for them is arguably unjustified and disproportionate.
Certain aspects of the Directive, such as transparency for investors and some limits on leverage, are sensible responses to the financial crisis. Indeed some provisions like increased disclosure are already UK industry practice. Further, the application of basic legal requirements and protections across the EU would remove the existing complex and at times inefficient patchwork quilt of national laws.
Having said this, there are a number of potentially problematic provisions in the Directive. Indeed, what is perhaps most concerning about the Directive is the ostensibly great scope for making the ensuing law even more restrictive via “implementing measures”. This article therefore focuses on the provisions and implementing measures in the draft which are of genuine concern to the hedge fund industry, together with the UK Government’s position (as stated by Lord Myners in July in his address to the House of Lords EU Sub-Committee on Economic and Financial Affairs) and provides a summary of the complex process for adoption of the Directive.
Unjustifiable restrictions on trading
Many of the Directive’s restrictions will be fleshed out later this year and in early 2010, in parallel with the finalising of the Directive’s text, by “implementing measures”. Unless the UK Government and industry can convince the relevant representatives in the European Parliament and Council (see legislative procedure, below) otherwise, there is plenty of scope for the Directive to result in unjustifiable restrictions on funds’ trading activities.
One of the most worrying potential trading restrictions relates to the level of leverage most UK AIFMs can employ. There is every chance that the Commission’s limits “could morph into prescriptive regulation of hedge funds that could prove destructive,” according to the FSA. Imposing strict leverage restrictions on hedge funds similar to those imposed on UCITs funds is unnecessary as they are not marketed to the retail public. Under the current draft Directive, the Member State financial authorities may also in exceptional circumstances further restrict leverage. The preamble to the Directive suggests that such limits could either consist of a threshold that should not be breached at any time or a limit on average leverage employed during a given period, such as monthly or quarterly.
Whilst most UK AIFMs will be subject to strict disclosure requirements to investors/authorities on leverage levels and the sources of leverage, which is sensible, giving carte blanche to the Commission to cap leverage is an unjustifiable restriction on trading. Lord Myners has told the House of Lords that a cap would be a blunt instrument giving rise to false confidence. Subject to the outcome of the UK Working Group on Leverage (see UK Government approach, below) the UK will lobby for higher standards of supervision of managers and prime-brokers, enhanced by greater data-gathering processes, as an alternative to leverage caps.
Whilst under the draft Directive not all hedge funds would be covered by the leverage restrictions – the provisions apply to any AIF employing leverage exceeding the value of its equity capital – these leverage provisions de facto would cover most UK AIFMs. This threshold is low and goes far beyond the test adopted by IOSCO, the G20 and the Turner Report, which is limited to hedge funds which are systemically important. The threshold ignores the consensus that AIFs are generally far less leveraged than banks, determines “high leverage” to be not much more than that of a UCITS fund and is insensitive to real systemic risk.
Other types of trading restrictions the current draft makes provision for include minimum liquidity requirements and restrictions on securitised products. Specifically, the Commission will also adopt, inter alia, “the minimum liquidity requirements for AIFs which redeem units or shares more often than half-yearly”, as well as implementing measures specifying requirements for investing or trading in repackaged loans and other types of securitised financial instruments.
The Commission has also given itself unlimited freedom to adopt further implementing measures via a catch-all provision “including any relevant restrictions that might be needed to protect the AIF from undue risk exposure.” Whilst short-selling bans, inter alia, are not explicitly provided for in the Directive, under the current draft the Commission would have the power to implement such bans.
Other problematic provisions
Funds outside the EU: The current draft only allows AIFMs to market cross-border in the EU funds domiciled in a “third country” (a country outside the EU) from 2014, or three years after the Directive becomes law in Europe. Third country funds, such as those based offshore in Cayman or the BVI – the norm among European AIFMs – are ostensibly treated differently because the Commission needs more time to check whether the regulatory framework and supervisory arrangements there will be equivalent to those in the Directive. The third country must have entered into an agreement based on the OECD Model Tax Convention, and EU AIFs must enjoy comparable access to that third country market.
The current draft third country requirements should be amended as they unnecessarily restrict both fund managers located in third countries operating in the EU and EU-based fund managers managing funds in third countries. In either case, European investors would be harmed because the Directive unduly limits their ability to implement investment strategies internationally, by restricting their access to third country funds. The rationale behind this provision appears to be tax-driven, but the politics of cross-border tax arrangements should not be the concern of legislation seeking to reduce systemic risk to the economy.
We also note that the third country provisions may adversely affect relations with other jurisdictions, in particular the US, to the detriment of efficient markets and investors. The Commission should therefore liaise closely with the US authorities, in particular, to ensure a cohesive approach which would not cause further fragmentation geographically. Specifically, the final version of the third country provisions should recognise that it is common and legitimate for an AIF to be based in a jurisdiction which ensures that global investors are taxed in their own jurisdiction and do not suffer double taxation. Further, Member States should not be allowed to oppose non EU based funds marketing AlFs in their territory when the mutual recognition criteria are satisfied under the Directive. This should not prevent a given Member State from authorizing third country funds limited to its own territory now or going forward. Also, AIF located in third countries should be able to operate in the EU before the three year deadline foreseen in the proposal and at least as soon as they meet the mutual recognition criteria under the Directive.
EU depositary: One of the conditions for obtaining an EU passport is that AIFMs marketing AIFs to institutional clients in the EU would need to appoint an EU-domiciled depository. Depositaries must be “credit institutions” with registered offices in the EU. Under this provision, US custody providers, for instance, Bank of New York Mellon and JPMorgan, and Swiss providers such as UBS, would be unlikely to qualify because they are domiciled outside the EU. EU investment banks will therefore in practice hold a monopoly, thereby disadvantaging non-EU custodial banks which are currently choice of many hedge funds. Indeed, in many jurisdictions, title to certain assets can, by law, only be held by a local custodian. The UK Government is currently lobbying for the ability to appoint local depositaries for funds outside the EU subject to appropriate supervision.
It is not clear whether sub-depositaries of offshore AIFs must be EU credit institutions or whether they can also include the prime brokers which are not EU credit institutions. In any event, we understand that since currently only two of the principal prime brokers are EU credit institutions or have such an institution in their group, and none of the principal prime brokers are established in the usual offshore jurisdictions, these restrictions will make it difficult for an AIF to appoint or continue the appointment of the prime broker(s) of its choice.
Independent valuator: Hedge funds must ensure that each AIF they manage has an independent valuation agent who will value “the assets, shares and units… at least once a year, and each time shares or units of the AIF are issued or redeemed if this is more frequent”. Given the many offshore AIFs, if the registered office of the valuation agent is outside the EU, the Commission must first have determined that the valuation rules and standards used by the valuation agents offshore are equivalent to those applicable in the EU.
Although IOSCO, AIMA and the Hedge Fund Standards Board recommend that an independent valuation agent be appointed, they all recognise that circumstances can exist where it is not always appropriate. Indeed this is not yet a generally recognised practice among US hedge fund managers. Nevertheless, AIFMs will not obtain authorisation unless and until each AIF in respect of which it has been appointed as sub-adviser has appointed an independent valuation agent. Many other AIFMs may be reluctant, for reasons of confidentiality and/or cost, to comply. In order to avoid these burdensome changes, the costs of which would get passed onto consumers, the UK Government is currently lobbying for the option of internal valuation, provided that an independent valuator confirms the valuation.
The UK Government approach
The UK hedge fund industry, the UK Government and more recently the FSA are all going in to bat in Brussels in a bid to get the voice of the – predominantly UK-based – EU hedge fund industry heard. The UK lobbies now realise that the UK is still largely isolated in Europe. During the boom years, Blair and Brown paid scant attention to the EU economic and financial committees and groups which are now key influencers in the Directive’s evolution. The UK Government, AIMA, a group of larger hedge funds, City Minister Lord Myners, and even Mayor Boris Johnson are now trying to reverse this damage by lobbying key UK and EU politicians/officials to take a more reasoned approach.
In July, Lord Myners reassured the House of Lords that “the Government is very closely engaged in negotiations with the EU…and there is much in this Directive which we welcome, in particular the facility for passporting which will help open up a single market in alternative investment funds”. He also acknowledged that the EU should establish a framework for mitigating further systemic risks.
However, the rushed drafting process has resulted in “a number of major flaws which need to be rectified”. To this end the UK Government has established seven expert Working Groups to help the Treasury further assess the impact of the draft Directive, to develop principles to significantly improve the Commission’s draft and to draft amendments to the text and implementing measures. Each Working Group is tackling an area of genuine concern to the industry and the UK as a whole, including custodians, delegation and structure, leverage, closed-ended applications, third country fund issues and marketing. Treasury officials are lobbying their counterparts in France, Germany and the other key Member States over the summer, as well as working closely with industry participants/investors to make sure the proposed amendments adequately reflect the needs of the industry and are workable.
The UK Government’s endeavours, and the industry’s recent swing from completely rejecting the Directive to a more reasonable, less polarizing approach, are smart moves. Rightly or wrongly, the Directive follows the UCITS and other Directives promoting the single market. Free movement of capital/investment to create a single EU market in financial services is a fundamental Treaty aim. Nothing short of leaving the EU would get the UK out of this. Accepting this but pushing for lighter restrictions with reasoned justifications will make it easier for the UK to engage with the relevant EU institutions/representatives and will increase the UK industry’s credibility at the most critical time in the history of hedge funds.
EU legislative procedure
The draft Directive must now be approved by the European Parliament and the Council of the EU, pursuant to the EU Co-Decision procedure. Co-Decision is a widely used but complex legislative process in which a draft law proposed by the Commission is reviewed by several EU institutions, expert groups and requires approval in the same terms by the European Parliament and the Council. They are equally important in the Co-Decision procedure with the adoption of the draft requiring joint approval.
Fortunately for the UK hedge fund industry, the Socialists lost around one quarter of their seats in the recent elections. The Conservatives – largely but by no means exclusively pro-business – now have approximately 264 seats (versus 164 for the Socialists). We note, of course, that France and Germany are the main Conservative nations, who are both in favour of tougher regulation, and so the UK still faces formidable opposition.
After the summer holidays, in early September, the ECON committee is due to exchange views on the Directive with the Commission, with the Council Working Group making initial contact with the Rapporteur. Autumn will be dominated by meetings, hearings, amendments and drafts in the Committees and Working Groups, with stakeholders pushing their amendments and trying to influence the process as much as possible. Commissioner McCreevy’s original aim to have the Directive adopted by the end of the year now looks wholly unrealistic. Once adopted next year Member States will then have 18 months to transpose the Directive into national law. During this period, and depending on the final version of the Directive and implementing measures, the FSA and UK Government may have scope to take a more liberal approach to interpretation and pass more workable national laws.
Davina Garrod is a partner in the London office of international law firm McDermott Will & Emery UK LLP. In addition to advising on competition and regulatory issues in M&A, restructurings and disputes for principals and investors, she works closely with certain hedge, facilitating their navigation through the increasingly complex legal and regulatory landscape.