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.