Vol. XV No.3
March 2010



In April 2009, the European Parliament and Council issued its draft Proposal for a Directive on Alternative Investment Fund Managers, which is aimed at extending uniform European Community (EC) regulation and oversight to investment funds not currently subject to regulation as Undertakings for Collective Investment in Transferable Securities (UCITS). UCITS are essentially mutual funds that are marketed and sold to retail investors. The proposed Directive would affect virtually all private and institutional alternative investment funds, including hedge funds, private equity funds, larger venture capital funds, commodities funds and real estate funds (with certain possible exceptions, which will be discussed below), as well as portfolio companies owned by private equity funds, and is particularly restrictive of funds and managers established outside of the European Union (EU).

There is currently an estimated €2 trillion in assets under management invested in alternative investment funds in the EU. Since Romania is a member of the EU, the Directive would apply to non-UCITS funds established in Romania as well as funds established in other countries that are marketed to institutional investors in Romania; but it should also be noted that there are several areas where the Directive will most likely allow some discretion to each individual Member state. For example, the Directive would allow each Member state the discretion to determine whether to allow covered funds to be marketed to retail investors as well as the discretion to enter into cooperation agreements with so-called “third-country” states. In addition, the regulatory authority in each Member state is charged, subject to EU guidelines, with determining standards for authorization under the new scheme. Informed use of such discretion in tailoring Romania’s internal regulations and standards could help to make Romania a more attractive home jurisdiction and market for alternative investment funds.

The regulatory approach taken by the Commission is similar to that taken by U.S. regulators, in that it focuses on fund managers (dubbed “AIFM”) rather than on the funds themselves. Unlike U.S. regulations, however, the Directive would affect a host of players acting in various different capacities. Fund marketers, administrators, custodians, appraisers and valuation specialists and their delegates, as well as investment advisors, would all be subject to a raft of regulations, including authorization and approval requirements, reporting requirements, minimum capital and liquidity and risk management requirements and restrictions on marketing and management of non-EU funds, remuneration policies, retention of sub-managers and service providers and use of leverage and certain trading techniques (such as short sales) as well as other industry practices.

The original draft Proposal was written in the wake of the global financial crisis in response to political pressure resulting from perceptions that AIFM contributed to elevated levels of leverage and risk of various types that exacerbated market volatility and led to the near-collapse of the banking and financial system. In addition, there was expressed concern with, among other things, the level of secrecy characteristic of AIFM, which operate with minimal public disclosure requirements, and that private equity funds in particular jeopardize the companies they acquire by over leveraging and are responsible for job loss. The Proposal calls for the institution of a new regulatory framework aimed at creating more transparency and reducing the “macro-prudential” (i.e., systemic) and “micro-prudential” (i.e., specific to individual companies).

The failure of the Council to solicit input from the funds industry, among other things, provoked fierce criticism of the Proposal following its initial issue. On November 12, 2009, the Swedish Presidency of the European Council of Ministers published a modified proposal which incorporated a number of compromises from the original draft; however, a subsequent text published on February 15 by the new Spanish Presidency of the Council reverses some of those changes. In addition, the European Parliament, through its Rapporteur, issued a detailed report or its view on each article of the proposal.

According to the Secretary General of the European Venture Capital Association, Members of the European Parliament have submitted well over a thousand proposed amendments. On January 27, the JURI Committee (the EU Committee on Legal Affairs), which is advising the European Parliamentary Committee on Economic and Monetary Affairs, held a meeting to discuss the potential impact of the Directive and presented 29 amendments, including a proposal to change the name of the Directive itself to include funds. Last month, the Economic and Monetary Affairs Committee of the European Parliament held its first formal consideration of some 1,700 amendments. A second consideration is scheduled to be held this month.

Among the more hotly debated provisions of the Directive are:
  • Provisions regulating the marketing of non-EU, “third-country” funds
  • Restrictions relating to depositaries
  • Rules relating to fund valuations
  • Rules relating to remuneration policies of AIFM
  • Reporting and disclosure requirements as applied to certain types of funds
  • Caps on the use of leverage
The Directive requires EU fund managers to obtain authorization from the relevant regulatory authority in their home jurisdictions to market alternative investment funds in EU countries. Under the Commission’s proposal, AIFM with less than €100 million in assets under management, including assets acquired through leverage, or with funds that are not leveraged and not subject to redemption for the first five years and who have less than €500 million under management, are exempt from the requirements of the Directive; however, the Parliament’s text would eliminate this threshold exemption. Some have argued that these thresholds are too high, while others have argued they are too low. While the original draft allowed such authorities up to two months to determine whether to grant authorization, the current amended draft allows up to six months – a considerably longer period of time. In addition, material changes, such as establishing a new fund or sub-fund, or changes in investment strategy or the level of leverage used, would require pre-approval by the relevant authority, which could take up to three months to obtain. Such delays, particularly as regards changes, could prove cumbersome and result in an inability of fund managers to timely respond to changing or volatile market conditions; a result which would be detrimental both to fund managers and to fund investors. A regulatory authority which is capable of providing swift and timely responses to applications and requests for authorization would greatly improve a Member state’s attractiveness to the alternative investment fund industry.

Once authorized, AIFMs would be able to market EU-based funds to institutional investors in countries throughout the EU - a sort of “passport” system. In addition, individual Member states would have discretion to allow marketing of funds to retail investors, subject to additional requirements. Management and marketing of so-called “third country” funds based outside of the EU, however, would be subject to substantial restrictions. Under the Commission’s proposal, AIFM would be able to market third country funds only if the funds’ home country has legislation in place that is ‘substantially equivalent’ to the Directive. [1] A key distinction between the Commission’s original proposal and the current text is the additional requirement by the latter of approval by each individual Member state for marketing of a non-EU based fund except where there is a cooperation agreement in place [2] between the Member states and the home third-country, which effectively renders the “passport” system for EU-based funds unavailable to non-EU-based funds. No provision is made for the authorization of Non-EU-based AIFM under the Directive.

[1] An initial proposal for a three-year freeze on the marketing of non-EU funds has been dropped.
[2] The cooperation agreements would be required to meet certain criteria established by the Commission.

The restrictions on marketing of non-EU-based funds have elicited particularly fierce criticism over concerns that they are protectionist and would limit the choices of funds available to EU investors. Many countries do not have legislation comparable to the EU’s Directive; most notably, the U.S. does not have any substantially equivalent legislation, nor do many of the other, more popular “jurisdictions of choice” for alternative investment funds. Thus, for practical purposes, funds in most third-country jurisdictions would be off-limits to EU fund managers. The net effect of such restrictions could therefore prove detrimental to EU fund managers and investors alike, putting them at a relative disadvantage to fund managers and investors in other countries.

The authorization requirement applies to sub-managers as well, thereby restricting the ability of AIFM to delegate their functions to non-EU sub-managers unless they are in jurisdictions that meet the criteria for AIFM to market and manage funds in the EU. In addition, under the new scheme AIFM would be held strictly liable to their investors for the acts of their delegees. AIFM would need to notify the regulatory authorities of any delegations of its functions; an earlier requirement that delegations be pre-approved by regulatory authorities has been dropped.

Other criticisms of the Directive center on its treatment of depositaries. The Directive calls for the appointment of an independent depositary, which must be approved by competent authorities of the home Member state of the fund (or, where the fund’s home state does not regulate, then by a regulatory authority of the AIFM’s home state). Depositaries must be EU-established undertakings and must be either a credit institution or an investment firm – a requirement which some have argued is too restrictive. In addition, the Directive would charge the depositary with custodial, administrative and transfer agent duties, as well as with responsibility for verifying compliance of trades with applicable laws and the fund’s governing documents, which functions are not currently performed by most depositaries. It would also impose strict liability on depositaries for the actions of their sub-custodians, except where liability for lost securities is contractually discharged, and require the maintenance of a performance bond, contrary to current practice in which depositaries do not accept primary obligations for functions that they do not themselves perform. The Directive would also require that all financial instruments be kept in segregated accounts in the names of the funds, thereby precluding securities from being held in “street name,” as is currently common practice where global custodian banks rather than prime brokers are used.

The Directive also requires that AIFM ensure the independence of the valuation function where the AIFM’s compensation is determined either directly or indirectly by the fund’s performance. A blanket requirement in the original proposal that the valuator be an external, independent entity has been dropped in the revised version.

Remuneration is another area which has provoked much criticism. Although the Council’s Proposal requires AIFM to maintain remuneration policies that align compensation to performance and partially defer payment of variable compensation, and sets out a number of guidelines, the most specific of which appears in brackets and requires that at least 40% (60%, if the variable remuneration component is very high) of the variable remuneration component be deferred. In addition, the Parliament’s Proposal indicates that remuneration policies should be consistent with those of credit institutions – a requirement that has provoked fierce objections form the fund industry.

The Directive imposes new disclosure requirements aimed at achieving greater transparency. Members of the fund industry argue that some of these requirements would put them at a competitive disadvantage, particularly with respect to funds established in third-countries. Funds would be required to make available to investors and relevant authorities disclosure regarding, among other things, their remuneration, risk and liquidity management, delegation policies and investment strategies. In addition, in cases where a fund acquires more than 50% (increased from the 30% specified in the original draft) of the outstanding voting rights of a non-listed company, the fund would be required to disclose to both the acquired company’s shareholders and its employees information regarding the acquisition, use of leverage, the resulting change in ownership structure and fund’s intent regarding management of the company.[3] Hedge fund managers argue that disclosing their investment strategies would put them at a competitive disadvantage to funds in other jurisdictions, while AIFM of funds that invest in or acquire non-listed companies argue that they would be put at a disadvantage relative to other buyers and investors.

A final area of particular debate concerns proposed caps on the use of leverage. The original proposal called for the Commission to set caps on the amount of leverage allowed to a fund. Industry lobbies argued forcefully that such caps could prevent funds from responding to changes in market conditions or, more seriously, could result in forced liquidations which would exacerbate market volatility in downturns. The new draft eliminates the caps, but still provides for Member state authorities to establish caps as appropriate

In sum, the Commission’s new draft incorporates many compromise changes from the original; however, certain areas of vigorous debate and challenges of feasibility relative to current market practices and capabilities remain. Therefore, we can expect to see a lot more commentary and further changes as the Directive works its way through the rule-making process. Careful observation and consideration to the evolving framework and provisions, however, could provide Member states with opportunities to make internal adjustments that would increase their attractiveness to alternative investment funds and their managers and investors.

[3] An exception is made for “small and medium enterprises,” defined as companies which, according to their latest annual consolidated accounts, meet two out of three of the following: (i) have an average number of employees less than 250; (ii) have a total balance sheet not more than €43 million; and (iii) have annual net turnover of note more than €50 million.

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Editors Note: It is our policy not to mention our clients by name in The Romanian Digest™ or discuss their business unless it is a matter of public record and our clients approve. The information herein is correct to the best of our knowledge and belief at press time. Specific advice should be sought from us, however, before investment or other decisions are made.

Copyright 2010 Rubin Meyer Doru & Trandafir, societate civila de avocati. All rights reserved. No part of The Romanian Digest™ may be reproduced, reused or redistributed in any form without prior written permission from the publisher.

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