AIMA chairman Todd Groome expressed concerns over the EU Commission’s draft regulation that is going to implement the Alternative Investment Fund Managers Directive at a luncheon hosted by the Cayman chapter of the Alternative Investment Management Association in April.
The deviations from the wording of the EU directive and the tight July deadline will pose problems for both the hedge fund industry and regulators like the Cayman Islands Monetary Authority.
Groome said he gives high marks to the process managed by the new European Securities Market Authority (ESMA) for producing its level 2 guidance and recommendations for the EU Alternative Investment Manager Directive. The new regulatory body, which was established in January 2011, reached out to the industry and member states, before making its recommendations.
However, when the document was fed into the machinery of Brussels, politics reemerged, Groome said. The topic had been off the European agenda for several months but when the tri-party group of EU Commission, Parliament and Council opened the debate on the directive again in February old conversations returned and new conversations were opened.
This set alarm bells off, Groome said. In April, AIMA went public with its concerns over the changes in the proposed regulation published by the Commission which not only deviated from the original wording of the directive but also ignored much of the recommendations made by ESMA.
It constitutes an “awkward start” for ESMA that the first major act by this new regulatory body was fairly dramatically changed by the EU Commission, said Groome, who added that ESMA did a good job, and the EC is within its right to make further changes, but the influence of politics is unfortunate. The question going forward will be how ESMA relates to the industry and the financial markets, given the political influence.
By turning the AIFM directive into a regulation the Commission also sends the message to member states that there is no room here for national discretion, which would exist if it remained a directive. The regulation has effectively to be adopted verbatim.
“This is reflective of the ongoing battle within Europe between central authority and national discretion,” Groome said.
He drew attention to several topic areas where the regulation as now proposed differs significantly from the directive and the recommendations made by ESMA, including depositaries, delegation, leverage and third country issues.
The delegation authority or ability of fund managers to outsource activities is limited by the directive to the extent that the fund manager cannot become a letter box entity unable to manage the fund portfolio. In practice this means the manager needs to retain the expertise and resources to control and supervise the delegated tasks effectively. The draft regulation now adds that the delegated tasks cannot exceed the tasks remaining with the manager. This would have the effect that the vast majority of EU based funds and fund managers would have to significantly restructure their business without any apparent benefits to investor protection, AIMA said in a paper.
The draft regulation has dropped ESMA’s proposed advanced method for determining leverage. This leaves the calculation of leverage to the standard or commitment method, which is “more bank-like” in methodology, and thus less accurately reflects hedge fund leverage, according to Groome. “Use of the UCITS commitment approach does not reflect the role of leverage in AIFs and could provide misleading picture of leverage in the industry,” AIMA noted in its report. The draft regulation proposes that an AIF will be considered to use leverage on a substantial basis, if the leverage ratio exceeds 2 times the net asset value as calculated under the commitment method.
Depositaries may be required under the draft regulation to treat third parties, such as brokers appointed by fund managers, collateral agents and central counterparties, as delegates of the custody function whenever these third parties hold most financial instruments of the alternative investment fund as collateral for either party to a particular transaction. This could, according to AIMA, cause disruptions in the global capital markets and would increase liability concerns for instance for banks when performing depositary functions.
Third country issues
The third country regime of the directive is based on cooperation agreements. The Commission draft creates an obligation for EU competent authorities to ensure access to all information necessary, the ability to carry out on-site inspections and the assistance of non EU competent authorities through binding cooperation agreements. This effectively asks foreign authorities to comply and enforce EU regulations and EU laws.
For Yolanda McCoy, the head of the Investments and Securities Division of the Cayman Islands Monetary Authority, this would be a departure from standard memoranda of understanding. CIMA has established key tax information exchange agreements with countries like France, Germany or Ireland but these agreements are not MoUs. Monitoring and enforcing EU law would require sanction powers that CIMA currently does not have, she said.
Ultimately these powers would have to be granted with a change in legislation to enable such cooperation agreements. As such the regulations have changed the playing field. They create a lot of work and will be challenging for service providers and regulators alike, McCoy said.
CIMA has already engaged with ESMA as well as other national regulators in Luxembourg, UK, France, Germany, Ireland, Italy to build rapport.
For the time being, she explained, CIMA has established a formal AIFMD working group which comprises of senior members of CIMA, government and members of industry to undertake a gap analysis of the Directive and the recently issued level 2 measures by the EU Commission and propose sound recommendation for action to CIMA’s board and the Cayman Islands government. 20 per cent of Cayman funds are managed in the UK and only 6 per cent are managed by European managers. One area that that the Authority will be closely assessing is whether changes to the regulatory regime should be adopted on a whole across all regulated funds or whether a new product specifically for Europe should be created, McCoy said.