Monday, June 14, 2010

Competing Drafts of EU Hedge Fund Legislation Differ Radically in Treatment of US Hedge Funds and Advisers

As European hedge fund legislation moves towards final passage, there remains a material differences of view between the Council of Ministers and the European Parliament over the treatment of US and other non-EU hedge funds and hedge fund advisers, called third country funds and fund managers in EU regulatory parlance. The vehicle for EU regulation of hedge funds and private equity funds is the proposed Alternative Investment Fund Managers Directive (AIFMD), which has just entered the important trialogue phase of negotiations between Parliament, the Council of Ministers and the European Commission, which originally proposed it.
Two different versions of the Directive have emerged regarding the access of US hedge funds to EU investors. The marketing of US and non-European managed funds has been the most contentious subject during negotiations over the last year. The two institutions debating the Directive in Europe, the Council of Ministers and the European Parliament, have adopted markedly different positions on this important and sensitive issue.

In a version that UK FSA official Dan Waters has called draconian and protectionist, a parliamentary committee supports provisions that could sharply limit the access of European professional and institutional investors to legitimate investment opportunities from US hedge funds. The Economic and Monetary Affairs Committee (ECON) sets forth a draft of the Directive that would impose conditions on both the fund manager and on the domicile of the fund. These conditions must be met in order for the fund manager to be granted a marketing passport in the EU. Under ECON’s version, the private placement of funds would be prohibited. Further, if the conditions in respect of the domicile of the fund are not satisfied, then investment into the fund, even at a European investor’s own initiative, would be banned.

A notable feature of the ECON draft is the role envisaged for the European Securities and Markets Authority (ESMA), a new EU body likely to have specific responsibility for securities and asset management regulation. The ECON draft envisages that a US hedge fund manager would need to agree with ESMA to comply with all of the provisions of the Directive. In the view of FSA official Waters, this would give ESMA a direct regulatory role that it has with no other financial institution. Moreover, a prerequisite to a US fund manager being able to market to European investors is the existence of an agreement between the SEC, the fund manager’s regulator, and ESMA. Mr. Waters envisions a number of potential concerns with this arrangement.

In the case of a US fund manager and fund, the ECON draft would require an agreement to be in place between the SEC and ESMA, which would involve the delegation of ESMA’s powers under the Directive to the SEC and agreement by the SEC to exercise the powers of ESMA in relation to the US fund manager. The agreement would also require that US fund managers submit themselves to the jurisdiction of European courts for matters arising from the Directive.
According to Director Waters, requiring an agreement with the SEC or other third country regulators to exercise the regulatory powers of another authority raises a host of complex questions around extraterritorial powers, jurisdictional competence and conflicts of law. Although the UK has supported the idea of an international passport from the outset, he noted, the ECON draft needs a lot of work to make it feasible in practice.

The draft would also impose conditions on funds domiciled outside of Europe. For example, a US hedge fund not meeting the conditions could not be marketed in the EU, and it would be completely prohibited from accepting any investment from European investors, even those acting on their own initiative. It was difficult for the FSA official to see how these provisions can be reconciled with the comments by the Rapporteur for ECON, Jean Paul Gauz├Ęs, during the Parliamentary debate, that Europe should not be a fortress and should avoid closing the door to non-European funds.

The FSA has supported the concept of the marketing passport since it was originally proposed by the Commission last year. An outright ban on non-EU funds and managers who can not obtain the passport, however, would restrict the access of European investors to valuable, open and successful markets, in the FSA’s view without justification. The FSA believes that a radical departure from current arrangements would also create real practical problems for investors and limit their ability to benefit from the diversification offered by the alternative investment fund sector.

In its original proposal, the European Commission contemplated granting a marketing passport to non-European fund managers on the condition that certain regulatory equivalence criteria were met. Such a passport would enable a US based fund manager, for instance, to sell its funds to investors across Europe under a harmonized set of rules. The proposal is designed to replace the costly processes of understanding and complying with each individual EU state’s marketing requirements before being able to sell to its resident investors.

As opposed to the ECON draft, the Council of Ministers is promoting a draft of the Directive that would allow a non-EU fund manager to market into Europe on a private placement basis subject to compliance with a number of disclosure requirements and subject to the existence of a cooperative agreement between the fund manager’s regulator and the regulator in the EU country where the investor is based. The disclosure requirements on, for instance, a US fund manager operating under this regime would be very significant and include disclosures to investors, to European authorities and for private equity funds, to employees of portfolio companies.

A US fund manager would also need to report certain information to each regulator in the EU jurisdiction where the hedge fund’s investors are based. These reports are significant and would need to include the main categories of assets the fund invested in, the fund’s use of short selling, its risk profile, the arrangements for managing liquidity and the results of stress tests.

For private equity funds which have controlling stakes in small to medium sized and larger European companies, fund managers would also need to disclose certain information in respect of the management of conflicts of interest, and internal and external communication to the employees. Private equity fund managers would also have to disclose the debt supported directly or indirectly by the portfolio company before and immediately after the fund assumed control.

In the FSA’s view it is necessary to continue to permit the private placement of US and non-European managed and domiciled funds alongside a marketing passport regime. Mr. Waters noted that the UK has successfully permitted non-EU funds of various types to be marketed locally for a number of years. At the same time, the UK has banned the marketing of hedge funds to the retail market, only permitting them to be marketed to institutional and sophisticated investors. The FSA believes that this arrangement provides an appropriate level of investor protection, noted Mr. Waters, without unduly restricting investor choice and access to specific investment management expertise.

More broadly, he continued, and particularly with US legislation on hedge funds imminent, the global nature and cross-border reality of hedge fund and other market components must be kept in mind. There is a need to create a proportionate and effective regulatory approach that recognizes the global nature of the hedge fund industry and the practical realities of how alternative investment fund management, including its supporting services, inevitably involves cross-border markets and jurisdictions.

The FSA official was buoyed by recent remarks of EU Commissioner for the Internal Market Barnier acknowledging the G-20’s call to build a globally consistent regulatory framework for financial services. Commissioner Barnier also reaffirmed in a letter to Treasury Secretary Tim Geithner that he would oppose any discriminatory outcome arising from the proposed Directive.

In an earlier letter to Commissioner Barnier, Secretary Geithner expressed concern over provisions in the proposed Alternative Investment Funds Management Directive that would discriminate against US hedge funds and deny them the access to the EU market that they currently enjoy. He urged the Commission to adopt rules ensuring that non-EU fund managers and global custodian banks have the same access to their EU counterparts. More broadly, he said that it was essential to fulfill the G-20’s commitment to avoid discrimination and maintain a level playing field in regulating the alternative investment fund management industry.

In a letter to EU Finance Ministers, the Secretary said that the US hedge fund regulatory regime embodied in the financial reform legislation pending in Congress will give equal treatment to all funds and advisers operating in the US regardless of their country of origin. He thus urged that the AIFM Directive allow US and other third country funds and fund managers the opportunity to access the EU single market through a passport approach.