Monday, June 04, 2012

Global Hedge Fund Group Finds Significant Divergence between ESMA Advice on Hedge Fund Directive and European Commission Draft Regulation

The European Commission draft regulation implementing the Alternative Investment Fund Managers Directive 2011/61/EU diverges significantly from the technical advice provided to the Commission by the European Securities and Markets Authority, in the view of a global hedge fund association. In a report, the Alternative Investment Management Association said that the differences between the Commission draft regulation and the ESMA advice could be disruptive to the asset management industry in the EU and globally, potentially undermining investor protection and financial stability.

Third country cooperation arrangements are the foundation of the US and other third country regimes under the hedge fund Directive. The ESMA advice states that the cooperation agreements between EU authorities and US and other third country authorities, which enable the functioning of the AIFMD third country regime, should provide for a number of different areas, such as the exchange of information or assistance in enforcement between the relevant competent authorities. The Commission draft regulation, on the other hand, creates an obligation on EU competent authorities to ensure through the cooperation agreements the access to all information necessary, the ability to carry out on-site inspections, as well as the assistance of non EU competent authorities.

The association said that the Commission’s draft regulation introduces strong and unqualified obligations for EU authorities to obtain all information and assistance necessary for the performance of their tasks under the AIFMD. Without clarification that such agreements are to be concluded on a best-efforts basis and cannot legally bind the EU and third country competent authorities, cautioned the hedge fund association, the third country regime could become unworkable.

The hedge fund Directive does not allow fund managers to outsource their tasks to the extent that they become letter box entities that can no longer be considered to be managing the fund portfolio. In its technical advice interpreting this provision, ESMA stated that if the manager no longer retains the necessary expertise and resources to supervise the delegated tasks effectively and manage the risks associated with the delegation, and no longer has the legal powers to take decisions in key areas of its responsibility, the fund manager will no longer meet the requirements of the Directive.

The Commission draft adds two additional conditions, noted the association, one of which states that the totality of the individually delegated tasks cannot exceed the tasks remaining with the fund manager. This restriction on delegation is much more onerous than the existing practice in the majority of EU fund jurisdictions, noted the association, and goes beyond both the MiFID and the UCITS Directive obligations. If implemented, cautioned the association, the vast majority of EU-based funds and managers would have to significantly restructure their business without any apparent benefits to investor protection.

ESMA stated that assets subject to security and title-transfer collateral arrangements cannot be considered to be in custody by the fund’s depositary as the depositary no longer has any control over these assets. Under the proposed Commission draft regulation, depositaries may be required to treat third parties, such as brokers appointed by hedge fund managers, collateral agents and central counterparties, as delegates of the custody function whenever they hold most financial instruments of the fund as collateral for either party to a particular transaction.

In the view of the hedge fund association, this could cause major disruptions in global capital markets. Further, it would impose stress on banks which perform depositary functions, since they would become liable for losses caused by the failure of agents, brokers and central counterparties, thereby exacerbating the too-big-to-fail problem.

In addition, requiring depositaries to retain control of fund financial instruments through delegation arrangements would fundamentally undermine the purposes served by the Financial Collateral Directive in providing a level playing field across title transfer and security financial collateral arrangements, which in turn would reduce certainty in the financial markets and therefore increase systemic risk in insolvency settings. 

With regard to selecting counterparties or appointing prime brokers, ESMA advises fund managers to ensure that selected counterparties and prime brokers are subject to ongoing supervision by a public authority, are of financial soundness, and have the necessary organizational structure for the services provided by them to the fund manager or the fund.

In the view of the association, the Commission draft goes much further by requiring the fund manager, in appraising the financial soundness of the counterparties or prime brokers, to take into account whether they are able to comply and continue to comply with the prudential requirements of EU law.

The draft regulation would appear to restrict prime brokers and OTC counterparties to EU entities, noted the association, which goes beyond the ESMA advice and does not seem justified in terms of the Level 1 text. It is also highly restrictive given typical prime brokerage models and the desire to source best terms in relation to credit and counterparty risk profiles across global OTC counterparties generally. According to the hedge fund group, there is no justification for determining financial soundness by reference to Union law only. Indeed, forcing EU hedge fund managers to transact solely with EU prime brokers and banks could be detrimental to investors.