Senior FSA Official Decries Protectionism in Proposed EU Hedge Fund Directive

The revised proposed Alternative Investment Fund Managers Directive would restrict the access of EU institutional investors to valid investment opportunities in US hedge funds while delivering little real benefit to European market stability or investor protection. In remarks at the recent Euromoney seminar, Dan Waters, Director of Asset Management at the Financial Services Authority, said that the current draft can be seen as an attempt to protect European funds from competition from legitimate US and other third-country funds. In today’s fragile international economic environment, he noted, introducing damaging constraints on international investment flows is not a sensible policy.

The proposed Directive is designed to create a comprehensive regulatory framework for hedge and private equity fund managers at the European level. It would impose regulatory standards for all alternative investment funds within its scope and enhance the transparency of the activities of the funds towards investors and public authorities. The draft proposes regulations that will affect, among others, the entire European hedge fund, private equity, and venture capital industries.

Last year a compromise proposal provided that the marketing of third-country funds by both non-EU and EU fund managers would be subject to the national private placement regimes of Member States, who could impose any requirements the local regulator thought appropriate for their investor bases, including even banning marketing all together. In the FSA official’s view, private placement regimes were preserved for the very sensible reason that, if these funds had no passport, they should not be required to meet the requirements that were being put in place for passporting EU funds. The exception to this rule, which the FSA supported, was that systemic information could be gathered from EU-based fund managers of US and other third-country funds.

But a revised draft published in mid-February by the Council of Ministers puts the Commission in what the Director calls ``the remarkable position’’ of attempting to dictate to the SEC and other non-EU regulators the terms of information-sharing arrangements they must enter into with EU Members. According to Mr. Waters, this would enable the Commission to dictate to the SEC and the FSA the terms of agreement between them on the marketing by US managers in the UK on a private placement basis of funds that do not have a European passport, which would offend well-established principles of international cooperation between financial regulators.

In the case of a US hedge fund marketed in the EU by US fund managers, he continued, the recent changes would impose a huge raft of detailed requirements on the funds, while not offering them the passport. He noted that the UK has always favored granting a passport to third country funds managed outside the EU on terms equivalent to those applying in Europe.

This was a feature of the original Commission proposal. In his view, the implementation of a sensible European alternative investment funds regime would produce economic growth and development in Europe from an international passport based on equivalence to such a regime.
Far from producing an international passport for hedge funds, the current draft would impose burdensome, detailed requirements on funds that have no passport. The draft also puts the Commission in the ``astonishing’’ position of dictating to the SEC and other regulators the information they have to receive from the fund managers they regulate. In his belief, there are few, if any, precedents for imposing such prescriptive preconditions on non-EU funds and their regulators in relation to cross-border marketing of financial products to institutional investors.

Many EU investors, such as Dutch pension funds, have already publicly aired their views on such a restriction, he noted, to say nothing of the impracticability of such an approach.
In addition to third-country aspects, other parts of the Directive, including those in respect of the liability of depositaries, the delegation of activities outside the EU, the requirements on valuers and the rules on remuneration all remain the subject of debate. There are difficult discussions still to be had in the Council working groups on these issues, in addition to the raft of challenges coming from the Parliamentary side.

The FSA is digesting the significant number of amendments proposed to the Directive. On the issue of scope, there are amendments to exclude listed closed-ended funds, private equity funds and those funds that are just marketed in the country in which they are authorized. Other amendments support a limited application of the Directive to funds that are not systemically relevant. Whatever approach is eventually decided on, noted the FSA official, there is consensus on the need for proportionality and differentiation in the Directive between fund managers of different sizes and types.

There is also an acknowledgement that the depositary model does not sit well with all types of fund, including private equity models, and strong support for permitting a wider range of institutions to be depositaries and permitting delegation to sub-custodians in third countries On the complex and sensitive issue of depositary liability, there is also strong support for an alignment to the UCITS standards and the ability for liability to be passed to sub-custodians.

The FSA supports the pragmatic approach of providing an appropriate level of investor protection without unduly constraining investor choice. Negotiators are also nearing consensus in a number of other areas, including removing the requirements for legally independent valuers and restricting the definition of marketing to the proactive offering or placement by fund managers, rather than also at the initiative of investors.

.