Splitting the Difference

Following a protracted period of intense lobbying at European level, the European Parliament and the EU Council recently finalised their respective drafts of the Alternative Investment Fund Managers Directive.

There are currently a number of differences between the two draft texts on areas such as the treatment of third-country funds, delegation requirements and depositary liability, and further efforts are needed to try and reconcile the two competing texts. Sarah Lyons reports.

The aim of the Alternative Investment Fund Managers Directive is to enhance the transparency of the activities of alternative investment fund managers and the funds they manage. The Directive aims to regulate alternative fund managers, rather than the alternative investment funds themselves. However the provisions of the Directive indirectly impose requirements on alternative investment funds, including requirements for valuation, risk management and depositary rules. It also applies to the marketing of alternative investment funds in an EU Member State, whether or not the fund manager or the fund is established in the European Union.

Under the new regime, alternative investment fund managers will need to obtain authorisation in their home member state to operate within the EU. This will require fund managers to demonstrate that they are suitably qualified to manage alternative investment funds and to submit detailed information about planned activities, details of the characteristics of the funds under management and extensive information where it is intended to delegate management of a fund. Fund managers will be subject to conduct of business rules, conflicts of interest procedures and other regulatory requirements. The main justification for the draft Directive was the alleged susceptibility of alternative investment fund managers to risk and their ability to undermine the integrity of the European financial markets. However, many see the new legislation as another regulatory measure that will drive hedge fund activity offshore to avoid regulation. There are still a number of issues which are a cause of concern for member states and these issues need to be resolved. The main areas that will generate further debate are as follows:

Depositary Liability.

The assets of the alternative investment fund must be placed with a depositary that is an EU credit institution, an investment firm compliant with the Markets in Financial Instruments Directive, or a firm prudentially recognised by a domestic EU regulatory authority. The depositary is, in turn, permitted to appoint a sub-depositary in the country of incorporation of the alternative investment fund, where that sub-depositary is itself subject to prudential regulation, supervision and anti-money laundering rules equivalent to those under EU law. For third-country funds, that country must be signatory to a reciprocal tax disclosure treaty with the EU. The European Parliament and European Council both agree that while depositaries can delegate certain tasks to other firms, they remain liable for all losses caused by their mistakes, or the mistakes of their delegates. However, this standard of full liability is not commonly accepted throughout the EU and this is one of the most contentious areas of the proposed Directive.


The draft Directive requires that fund managers appoint an EU-based valuator to value the assets of any alternative investment funds under their management where they fall within the scope of the Directive. The valuator must ensure that the shares and units of the alternative investment funds are valued at least once a year and each time the units of the fund are issued or redeemed, if this is more frequent. Issues relating to valuator liability are still under consideration and review. Delegation of portfolio management. There are tough restrictions on delegation that are likely to prove difficult in practice for fund managers to comply with. The Council's draft of the Directive allows delegates of fund managers to in turn delegate activities to other firms, whereas this is not permitted in the Parliament's text.

Third-Country Rules.

Both the European Council and the European Parliament are in overall agreement on the rules for EU-based managers. The Parliament's version of the Directive imposes a more stringent regime on non-EU-based managers and will require non-EU fund managers to comply with the full text of the legislation in order to get access to EU investors. The Parliament's text also contains a provision that prohibits investors entering non-EU-based funds which do not meet the required standards. It is highly unusual for legislation of this nature to attempt to impose rules on investors themselves.


The Parliament and the Council agree that fund managers should provide information to their home regulators on the levels of leverage employed by their funds. If the regulator deems the leverage to pose a systemic risk, a cap can be imposed. The two texts do differ, however, and the Parliament's draft is more prescriptive and makes explicit reference to a planned EU financial regulator, the European Securities and Markets Authority, which would also have the power to set caps.

A final vote on the draft Directive by the European Parliament has been scheduled for July, but there is still a long way to go before the Alternative Investment Fund Managers Directive is implemented. It is likely that many of its provisions, including the rules on valuation, delegation, third-party rules and depositary liability, will remain hotly contested. Ultimately, fund managers may seek to rely more upon the flexibility of the UCITS product in an effort to avoid having to deal with some of the more onerous provisions of the draft Directive.

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