By a vote of 513 to 92, the European Parliament has approved legislation regulating hedge funds and private equity funds. In approving the Directive on Investment Funds Managers, Parliament set up a new regulatory regime designed to bring transparency and regulation in the way these funds are managed and operated. The final step is formal approval by the European Council of Ministers, which is expected soon. The Directive should come into force in early 2011. European Commissioner for the Internal Market Michel Barnier hailed the Directive for increasing transparency, reinforcing investor protection and strengthening the internal market in a responsible and non-discriminatory manner.
The legislation makes full use of the opportunities afforded by the new European securities and markets authorities to strengthen supervision and to enhance the macro-prudential oversight of hedge and private equity funds. The term alternative investment fund encompasses a wide range of investment funds that are not already regulated at a European level by the UCITS Directive, including hedge funds, private equity funds, real estate funds and a wide range of other types of institutional funds. The Directive will not apply to entities such as governments managing funds supporting social security and pension systems; supranational institutions, such as the World Bank and member organizations of the World Bank Group.
The all-encompassing approach of the European Commission’s draft proposal has been retained in the final legislation, covering all the major types of alternative investment fund managers and alternative investment funds. This will ensure a level playing field and help minimize the risks of regulatory arbitrage. Strict rules have been included on the valuation and safekeeping of assets, risk and liquidity management, the use of leverage and the acquisition of companies.
The strong single market dimension of the draft has also been preserved, introducing a single market passport for European managers and funds, as well as a third country passport, which will in due course become a single harmonized regime for third country access to investors in the EU. Specifically, once a hedge fund manager is authorized under the legislation in one Member State and complies with the rules of the Directive, the manager will be entitled upon notification to manage or market funds to professional investors throughout the EU.
There was a fierce debate over whether or not to grant the same rights to EU and non-EU hedge fund managers until a compromise was reached on the passport question that allowed the legislation to be passed. The final agreement allows US and other non-EU hedge fund managers to acquire a passport to market funds in the EU.
Following a limited transition period of two years, and subject to the conditions set out in the legislation, the passport will be extended to the marketing of US and other non-EU funds in the EU, managed both by EU fund managers and fund managers based outside the EU. In accordance with the principle of same rights, same obligations, this approach will ensure a level playing field and a consistently high level of transparency and protection of European investors.
The phased introduction of the US and other third country passports is designed to allow European regulators to ensure that the appropriate controls and cooperation arrangements necessary for the effective regulation of non-EU alternative investment fund managers are operating effectively.
Before the third country passport is introduced and for a period of three years thereafter, national regimes will remain available subject to certain harmonized safeguards. Once this period has elapsed, and on the basis of conditions set out in the legislation, a decision will be taken to eliminate the parallel national regimes. At this point, all hedge fund and private equity fund managers active in the EU will be subject to the same high standards and will enjoy the same rights.
Thus, there will be a dual system for about three years during which US and other non-EU hedge funds and fund managers will be governed by national private placement regimes under which registration in each jurisdiction will be required, until the rules allowing them to obtain a passport take effect.
The legislation also imposes a range of transparency requirements and robust safeguards in relation to the use of leverage by hedge funds and private equity funds. Fund managers will be required to set a limit on the leverage they use and will have to comply with these limits on an ongoing basis. Fund managers will also be required to inform regulators about their use of leverage so that the authorities can assess whether the use of leverage by the manager contributes to the build-up of systemic risk in the financial system. This information will be shared with the European Systemic Risk Board.
The legislation also authorizes regulators to intervene to impose limits on leverage when deemed necessary in order to ensure the stability and integrity of the financial system. The new European Securities and Markets Authority will advise competent authorities in this regard and will coordinate their action, in order to ensure a consistent approach.
Rules on compensation practices are being introduced in all major financial services sectors and the hedge fund sector will be no exception. Specifically, the legislation requires hedge fund managers to implement compensation policies promoting sound risk management. The compensation policies cannot encourage risk-taking that is inconsistent with the risk profile and fund rules of the funds being managed.
The legislation contains a number of investor protection safeguards to ensure that investors in alternative investment funds are well-informed and adequately protected. In particular, conflicts of interest will be avoided or will have to be managed and disclosed. Hedge fund managers will be required to employ adequate risk management systems and ensure that the fund’s liquidity profile reflects the obligations towards investors. Further, valuation must be performed properly and independently and strict conditions must be met when the fund manager delegate functions to third parties.
Importantly, investment in many types of hedge funds and other alternative investment funds is limited to professional investors. Consequently, the Directive creates rights for marketing to professional investors only. At the same time, Member States are not prevented from making certain types of hedge funds and private equity funds available to retail investors. However, in this situation, regulators are authorized to apply additional safeguards to ensure that retail investors are adequately protected.
The legislation mandates that a hedge fund's assets must be kept by an independent and qualified depositary subject to a high liability standard. In the event of a loss of fund assets, the burden of proof will be on the depositary. The legislation also provides for a robust mechanism for the delegation of depositary functions and careful regulation of the circumstances under which liability can be transferred to a sub-depositary, including when the sub-depositary is located outside the EU. This requirement is intended to allow investors to benefit from investment in third countries without compromising the level of investor protection.
The Commission is currently examining the corresponding depositary rules in the UCITS Directive with a view to producing proposals for their revision in 2011. This will ensure that the standard of protection afforded to investors in mutual funds regulated under the UCITS Directive does not fall below the standard for hedge funds. The rules adopted under the hedge fund legislation will serve as a clear benchmark for this work, but the Commission will also assess whether additional safeguards are required to reinforce the protection of retail investors.