Political and regulatory news

Issue 2 - 19 May 09

European proposals threaten investment companies

The European Commission has published draft rules for managers of alternative investment funds.

The European Commission has published draft rules for managers of alternative investment funds as part of its ongoing programme to increase regulation and oversight of sectors and activities considered to be ‘risky’.  Since the emergence of the financial crisis, the regulation of hedge funds has been a particular area of focus in the European political arena and these proposals represent the next stage in a series of reviews and reports on the sector.  (Two previous articles in Political and Regulatory News on this issue can be found here and here.)

Despite the original intention to target regulation on hedge funds and private equity funds, the new proposals cover all funds which are not regulated under UCITS (UCITS, or Undertakings for Collective Investment in Transferable Securities, are a set of EU rules governing certain collective investment schemes).  Investment companies are non-UCITS funds and are therefore caught up in the new regime.  If enacted in their current form, these proposals are likely to have significant and damaging implications for investment companies.  Managers will be subject to additional regulatory burdens and compliance costs as a result of new authorisation requirements, reporting obligations and limitations on marketing.  In many cases, the design of the new rules is not suitable to the investment company sector.

The key areas of concern for investment companies are as follows:

• The proposal suggests that all investment companies must have an authorised fund manager.  This has significant implications for self-managed investment companies.
• The basic position is that fund managers will face restrictions on delegating fund management and administration to non-EU firms, even for the management of assets outside the EU.
• The proposals assume that the manager is responsible for the entire operation of the investment company, both fund management and administration.  The proposals do not take account of the role of the board.  They also fail to recognise that many investment companies choose to separate portfolio management and administrative activities.  It is not clear whether the rules would permit this in future, due to the nature of the obligations imposed on the manager.  Similarly, it is not clear how multi-manager structures would fit into the proposals, as the rules envisage that there will only be one manager responsible for all the requirements.
• The assets of the investment company must be independently valued at least once a year, and each time shares are issued or redeemed.  This will be particularly onerous and costly for investment companies with illiquid assets, such as private equity.
• An investment company must appoint a depositary for the safe-keeping of the company’s assets.  Although most investment companies use an independent custodian for quoted securities, this is not generally the case for most unquoted assets.
• Shares in investment companies will be deemed to be complex financial instruments, meaning that it could be harder for retail investors to buy them.

The proposals also require each manager to provide the regulator with a range of information about itself and the funds it manages to obtain authorisation.  Minimum capital requirements will also be imposed, along with obligations to make regular disclosures to regulators on matters such as the markets and instruments in which the fund trades, principal exposures and risks, illiquid assets, short-selling, leverage and controlling interests in investee companies.

The AIC is very disappointed with these proposals.  As feared, the Commission has been unable to resist a political desire to be seen to act – unfortunately this had led to initial proposals which are poorly targeted and disproportionate.  They threaten to impose significant additional costs on the investment company sector and to undermine its commercial flexibility.  The draft rules also fail to recognise the key role of the board of an investment company, and the transparency and quality of governance that arises through the listed company structure.

The AIC will be focussing its efforts on engaging with regulatory and political bodies at a UK and European level to reverse, or substantially amend, as many of the rules as possible in order to protect the interests of the investment company sector.

The full text of the EU Directive on Alternative Investment Fund Managers can be found here.

Next article: Budget brings important changes for investment companies

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