This article was originally published in Financial Services Quarterly Report.
The European Commission Proposal for a Directive on Alternative Investment Fund Managers (the "Directive") was published in April last year in the wake of the financial crisis. With the approval this past May of draft texts by the Committee on Economic and Monetary Affairs of the Parliament (the "Parliamentary Draft") and by the Council of Ministers (the "Council Draft"), the legislative process has now entered the so called "trialogue" negotiations designed to establish a compromise position between the Commission, the Council and Parliament. However, there remain considerable differences between the drafts, and the Parliamentary Draft and to a lesser extent the Council Draft (which arguably provides a more workable framework for the industry) still pose significant difficulties and uncertainty for many alternative investment fund managers ("AIFM") both inside and outside the EU.
What has perhaps surprised many informed observers the most is that, even at this advanced stage in the process, there are new or surviving elements, particularly in the Parliamentary Draft, that would be unworkable for many industry participants or that would seem to defeat the stated purposes of the Directive.
Depositaries
By way of example, the Directive would require AIFM to ensure that a single depositary was appointed for each alternative investment fund ("AIF") it managed. Both Drafts would require that the depositary be EUdomiciled or authorized and, under the Parliamentary Draft, the depositary for an EU AIF must be domiciled in the same Member State as the AIF.
Following the recent crisis, there has been an industryled trend towards use of multiple prime brokers by hedge funds, primarily driven by a desire to spread and minimize counterparty risk exposures (with benefits for the AIF, their investors and counterparts alike). The proposal for a single, EU-based depositary would seem likely to increase, not reduce, the potential for systemic risk by reducing scope for AIF to spread counterparty risk and also by concentrating that risk within the EU and among a smaller number of eligible depositaries. It is hard to reconcile these proposals (which would seem to reverse many of the risk mitigation measures taken by the industry) with the stated intention of reducing systemic risk and these measures will be perceived by many as protectionist.
Marketing
Another controversial area is the restriction on EU marketing rights for third country AIFM and AIF. While the Council Draft leaves open the possibility of third country marketing rights through private placements (provided certain provisions of the Directive are complied with), there is also a requirement for cooperation agreements between the relevant third country and each Member State where marketing is to take place. The content of the cooperation agreements is to be set out in secondary legislation and as such it is unclear, and will remain so for several years, whether these agreements will be achievable in practice.
At first glance, the Parliamentary Draft looks more positive in that it expressly extends the marketing "passport" to non-EU AIFM and AIF. However, the conditions that would apply are so extensive that it is doubtful whether these could be met, even by many developed jurisdictions. The conditions include a requirement that third country AIFM agree to comply with the Directive and that the third country regulator agree to enforce the Directive on the third country AIFM. It is hard to imagine that the SEC, for example, would submit to EU legislation in this way. In any event, to the extent of any conflict between the local regulations and the EU regime, this approach would be unworkable.
As a more general matter, adopting a stance where EU marketing rights for third country AIFM and AIF are conditional on compliance with, and enforcement of, EU standards in those countries is likely to be perceived as aggressive or isolationist. If this stance were to prevail, there is a risk that global professional investor markets would be polarized into one grouping that subjected itself to compliance with the EU standards and a separate (and largely segregated) grouping that did not. This polarization would be amplified if other jurisdictions were to adopt the same stance as the Parliament and make compliance with their domestic frameworks a condition of access to domestic investors.
Under such a regime, AIFM groups operating on an international basis would face the prospect of compliance with multiple, and potentially conflicting, regulatory regimes if they wished to access investors on a global basis. This would likely be costly and inefficient.
A further difficulty under the Parliamentary Draft would be that the "passport" for non-EU AIFM and AIF would not provide for a single point of entry into the EU, as it does for EU AIFM. Instead, cooperation agreements would be required to be entered into between the relevant third country and each relevant Member State before a meaningful marketing network would be available. Many third country and international AIFM will perceive these restrictions on marketing as rendering their international marketing structures unworkable (in the case of the Parliamentary Draft) or subject to prolonged uncertainty (in the case of the Council Draft).
As marketing would, in any event, be restricted to professional investors, who by their nature are expert in making investment decisions, many will question whether the investor protection or other objectives of the Directive justify marketing restrictions that would have a negative impact on investment choice for EU professional investors and increase the risk of reciprocal protectionist action by non-EU jurisdictions.
Management
Similarly, while the Parliamentary Draft notionally extends the management "passport" to non-EU AIFM, requirements similar to those for the marketing passport would apply, including the requirement that the AIFM comply with, and its regulator enforce, the provisions of the Directive. This currently would be unworkable for many, if not the majority, of non-EU AIFM with European management mandates. While such arrangements might be achieved through the delegation route provided for under the Council Draft, this would be unworkable for many under the Parliamentary Draft.
The Parliamentary Draft also requires that any delegation of portfolio management must be to an authorised AIFM, with the result that many EU managers operating global or emerging markets strategies would no longer be able to directly access local management expertise, with negative impacts on performance.
These aspects of the Parliamentary Draft could require non-EU management groups to implement structural changes to management delegation arrangements in order to service existing EU clients.
Conclusion
If adopted in its current form, the Parliamentary Draft would require very significant restructuring of many international portfolio management structures, imposing a cost burden that in large part would be borne by end investors. Many of the proposals would appear to have potential for adverse impacts that outweigh the potential benefits. Reaching political agreement on these points has proved impossible within the planned timetable and the process has been deferred until September.
There is a real risk that the stance under the Parliamentary Draft would trigger reciprocal action by other jurisdictions, resulting in unnatural dislocations in investor capital flows and dislocation of a currently global industry.
The recent financial crisis has shown that systemic risks are increasingly global in nature and require coordinated global measures to address them. Proposals that would tend to set the EU at odds with other jurisdictions would be viewed by many as, at best, a missed opportunity in this regard.
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