EC shocks hedge funds with decision to implement AIFM as regulation

The latest draft of the EU AIFM directive has been leaked, prompting an unofficial consultation over changes to several key points and accusations that the European Commission ignored Esma’s advice.

The European Commission’s decision to implement its controversial hedge fund rules as a regulation rather than a directive has rankled the hedge fund industry and the wider European financial and political communities.

A draft version of the implementation rules for the alternative investment fund managers (AIFM) directive has been leaked, sparking debate across the industry about why the Commission is ignoring much of the Level 2 advice from the European Securities and Markets Authority (Esma) and reverts back to Level 1 detail in some areas.

On several key points, including third-country provisions, depositary liability, delegation and leverage, the new text differs substantially from Esma’s advice, according to those familiar with the draft.

But one of the biggest surprises contained within the latest iteration of the directive is that the Commission now wants to implement it as a regulation.

As a regulation the rules will become effective sooner whereas a directive allows a couple of years for transposition into national laws. A regulation also removes the flexibility of national regulators to implement the measures into local laws.

While surprising, it is not the first time this has happened. The Commission has shown recent preference for regulations in its bid to create a single European rulebook. It is worried individual member states may interpret an AIFM directive in different ways, giving rise to the possibility of regulatory arbitrage.

But as a regulation the legislation could create problems, particularly as national regulators have a limited consultation period of only two weeks in which to comment on the draft.

“If you use a regulation it is a directly applicable law which means that the wording has to be very sharp and very good. It has to be a consistent and coherent legal framework,” says Hans Hack, senior vice president, strategic communications at FTI Consulting.

“In directives sometimes the wording is not as clear and there are things that have not been thought through. The national implementing lawyers have corrected that and made sure everything works legally,” he adds.

“In a regulation that cannot be done. That is why the timeframe should allow for genuine study of the text, because if in a regulation you get it legally wrong, there is no way to correct it. That is where there is a valid concern.”

Koen Vanderheyden, partner at law firm DLA Piper, says the legislation is being rushed through as a result of political pressure. But even those within the political sphere are now concerned about the draft.

Syed Kamall, Conservative MEP (UK) and member of the European Parliament’s Economic and Monetary Affairs Committee, said that during a recent meeting with the Commission to discuss technical details “it was clear the Commission had not taken on board the concerns that I and the London-based hedge fund and private equity industry had raised over its inflexible interpretation of the directive”. He made the comment in an article in City AM.

Changes to the third-country provisions have caused particular alarm. Until now it has been understood that there would be memoranda of understanding agreed between non-EU and EU regulators, consistent with the International Organization of Securities Commissions (Iosco) framework. The draft implies that the Commission wants to go further and introduce legally binding cross-border agreements.

“These would be extremely problematic, if not impossible, to conclude if the regulation prescribes that the co-operation agreements ensure that third-country regulators enforce EU law in their territories. It could be extremely difficult for many regulators to be able to sign up to that,” says Alternative Investment Management Association (Aima) CEO Andrew Baker.

He calls for further clarification on the issue and adds, “Without cooperation agreements, asset managers outside the EU will not be able to access investors in the EU except through reverse solicitation. This would close the door to national private placement regimes in the EU, which would have a major impact on asset managers globally.”

MEP Kamall accuses the Commission of reneging on its promise to allow EU investors to continue to invest in non-EU funds.

Problematic for US
While there is still a lack of clarity over what form the final agreements between EU and non-EU regulators will take, Paul Govier, partner at Maples and Calder, thinks that a legally binding agreement could be problematic for US-based managers. “I am confident that the offshore jurisdictions are willing and able to sign up to whatever the form of cooperation is. They know they have to and most of them have a long history of complying with these sorts of international standards,” he says.

“Where I think it could become much more problematic is the US. It looks like some of these forms of cooperation will give EU entities direct access to the third country’s market, the right of enforcement on their turf. I am not sure how that will go down in the US. I am not sure it is even permissible. Even if they can do it as a matter of domestic law, how will they receive an EU regulator arriving in the US seeking to take direct enforcement action against a US citizen or company?”

Govier questions whether non-EU managers will opt out of doing business in the EU or use exemptions such as managed accounts or reverse solicitation.


Other areas of the Commission’s draft text are also being questioned by the industry. One fear is that the directive in its final form will impose tougher restrictions than Ucits does for retail funds. This point was raised by Jiří Król, director of government and regulatory affairs at Aima,recently. “If that’s the case then even if willing and able to comply, [funds] may not be able to maintain business in the EU,” he said.

This could be the case for the depository liability rules. It is still unclear what the final rules will entail but Christopher Stuart-Sinclair, advisory and consulting director at Deloitte Luxembourg, has previously raised concerns that this is one area where tougher sanctions are being handed down to alternative managers compared with the retail sector.

The Commission also looks set to impose tougher restrictions on alternatives than on retail funds in the areas of delegation and leverage. According to a source familiar with the latest draft, it restricts the Level 1 flexibility on delegation, is much stricter than Ucits and in essence will not allow management companies to outsource portfolio management. The definition of substantial leverage is set at 2x, which reflects the Ucits model, and is not relevant to alternative investment fund managers.

Aima says the draft regulation “appears to significantly and substantially diverge from the Esma advice in a number of key areas”. This has raised questions about Esma’s role. The supervisory body was established only last year and among its mandates is to give technical advice to the Commission.

An Esma spokesperson declined to comment but FTI Consulting’s Hack says: “One of the ambitions of the European Union and the Commission is to have a strong and independent Esma. These are the first important Level 2 measures since Esma has been set up. Considering that Esma consists of experienced regulators and knows the market well, the Commission will realise that deviating from Esma advice could have an impact on how Esma is viewed.

“If the Commission deviates too much from Esma’s advice, it could be tricky because a big role is seen for them in new legislation,” he says. “In the near future Esma will be drafting technical standards which the Commission should more or less rubber-stamp.”

The Commission denies it has ignored a large part of Esma’s advice. A spokesperson says, “There are a few areas where the Commission does indeed intend to propose changes to the Esma advice. This is necessary because the advice provided does not take the form of a legal text. Implementing measures are made to make the directive operational on the ground. It is important that all operators have legal certainty and that the regulation is well drafted, precise and not open to divergent interpretation.”

In response to allegations that the Commission has reverted back to Level 1, the spokesperson said, “The Commission is in no way trying to get back on what might have been lost in earlier compromises found in the original negotiations on AIFMD. Level 2 cannot change Level 1 so it would not be possible to do so in the first place.” It accuses parts of the industry of reopening old issues and says it is not the time to do so.

According to Aima, national regulators now have just two weeks to respond to the draft regulation. Although there is no official consultation, the leaked documents have prompted an unofficial one. But with limited time, there may be little that can be done.

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