EU authorities reached a final compromise on draft legislation regulating hedge funds and alternative investment funds. The European Parliament is expected to vote on the legislation in early November. Commissioner for the Internal Market Michel Barnier hailed the breakthrough agreement as a victory for transparency and risk management in the alternative investment fund area. He said that the legislation will require regulators to authorize hedge fund managers and give regulators the tools to control risk-taking, including the level of leverage. Information on leverage and other systemically important information must be shared with the new European Systemic Risk Board. On the very sensitive question of access of US and other non-EU funds to the EU market, the issue of an EU passport, the draft foresees a passport for US and other third-country funds and managers. According to Commissioner Barnier, it will be a passport on merit, founded on a solid basis and providing strong controls in terms of risk management. It will also reinforce the internal market.
The European Council noted the compromise legislation established a harmonized framework for monitoring and supervising the risks that hedge fund and other alternative investment fund managers pose to their investors, to counterparties, to other market participants and to the stability of the financial system. The draft also allows fund managers to provide services and to market funds throughout the EU single market, subject to compliance with strict requirements.
Generally, the vehicle for the legislation, the proposed Directive on Alternative Investment Fund Managers, centered on enhanced disclosure and effective risk management, is designed to create a comprehensive and effective regulatory framework for hedge and private equity fund managers at the European level. The proposed Directive 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
Article 35 of the new draft legislation sets forth conditions for an EU hedge fund manager with an EU passport to market shares in a US hedge fund to professional investors in the European Union. Note that EU Member States must require that the US funds managed and marketed by the fund manager are only marketed to professional investors. Article 36 provides for a transitional regime allowing EU fund managers to market US hedge funds in the EU without a passport. This transitional regime may or may not be extended depending on the results of a study by the European Securities and Markets Authority.
In order to market a US fund in the EU with a passport, the draft requires that appropriate cooperative arrangements be in place between the authorities of the fund manager’s country, those member states hosting the fund manager, and the supervisory authorities of the US or other third country where the non-EU hedge fund is established in order to ensure an efficient exchange of information allowing the authorities to carry out their duties according to the Directive
In addition, the US or other the third country where the fund is established must sign an agreement with the home Member State of the authorized fund managers and with each Member State in which the shares of the fund are proposed to be marketed, which fully complies with the standards laid down in Article 26 of the OECD Model Tax Convention and ensures an effective exchange of information in tax matters, including multilateral tax agreements. Also, the third country where the non-EU hedge fund is established must not be listed as a Non-Cooperative Country and Territory by the Financial Action Task Force on anti-money laundering and terrorist financing.
Under Article 36, EU Members may, without a passport, allow authorized EU fund managers to market to professional investors shares of US and other non-EU funds that they manage. The marketing of the US fund in the EU is conditioned on the existence of cooperative arrangements for the purpose of systemic risk oversight between the authorities of the fund manager’s home jurisdiction and US authorities in order to ensure an efficient exchange of information that allows the authorities of the fund manager’s jurisdiction to carry out their duties according to the Alternative Investment Management Directive. Another condition is that the fund manager cannot perform depositary functions. Rather, the fund manager must ensure that another entity is appointed to carry out the depositary functions and inform its regulator of the identity of the appointed entity.
The legislation commands ESMA to conduct a review three years after the legislation’s enactment of the managing and marketing of US and other non-EU hedge funds under the passport regime with an eye to seeing if the transitional non-passport regime can be terminated. The ESMA will consider investor protection, market disruption, competition and the supervision of systemic risk issues.
The conditions under which US hedge funds could be marketed in the EU has been the one of the most hotly contested issues as the EU attempts to pass legislation regulating hedge funds in 2010. In an earlier letter to EU Commissioner for the Internal Market Michel Barnier, Treasury Secretary Tim 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. More broadly, he said that it was essential to fulfill the G-20 commitment to avoid discrimination and maintain a level playing field in regulating the alternative investment fund management industry.
The UK’s position has consistently been that the legislation should not restrict EU institutional investors from taking advantage of valid investment opportunities in US and other third-country hedge funds. Earlier, Dan Waters, FSA Director of Asset Management, emphasized that the legislation should not 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