Changes to Fund Regulation

Funds have always been a complex area of law and an area where it is essential to ensure you receive the right advice. In recent months there have been a number of legislative and regulatory changes to the ways in which funds are managed. Financial services specialist Tony Watts looks at the changes which have come into force in this technical guide to fund regulation.

The Alternative Investment Fund Managers Directive (“AIFMD”)

AIFMD became part of the UK legal and regulatory landscape from 22 July 2013. It was implemented by a mixture of directly applicable EU legislation, statute (both statutory instrument and changes to the FSMA) and FCA rules.At the same time, the European Venture Capital Funds (EuVECA) Regulation and the European Social Entrepreneurship Funds (EuSEF) Regulation became effective, giving the possibility of a wider framework for the regulation and marketing of certain kinds of funds.The new regime provides a significantly different basis for regulation in this area, and all firms acting in the fund management area will be, to a greater or lesser extent, affected by them. The changes apply irrespective of assets managed, which can range from fine wine through forestry to traditional investments such as shares or bonds.It also significantly widens the type fund which is regulated – extending, for example, to structures such as closed-ended investment companies, formerly largely outside the FCA net as they were not collective investment schemes (“CIS”). The UK rules implementing the new regime still rely to some extent on controversial concepts such as CIS which co-exist with the new rules – providing a further level of technical detail to what would in any event be a very difficult area.Alternative Investment Fund Managers (“AIFMs”)An AIFM is a person who manages an Alternative Investment Fund (”AIF”). Management for these purposes involves performing at least risk management or portfolio management for an AIF. An AIF is defined generally as a collective investment undertaking which is not a UCITS Fund (a UCITS Fund being the main form of retail investment fund which can be offered through the EEA).An AIF can take any legal form and can be open-ended or closed-ended. Therefore closed-ended companies may now be AIFs (when broadly they were carved out of the old UK rules on CIS).An AIFM can be an internal or external AIFM. An example of an internal AIFM is where risk management/portfolio management is performed by the board of directors of an AIF which takes the form of a company.The UK Regulations and FCA Guidance clarify what is intended to fall within this wide definition – excluding, for example, certain joint ventures, family offices and trading companies.Summary of AIFMD RequirementsThe new regime imposes a requirement on AIFMs to obtain authorisation or registration (on the distinction, see below) from the FCA – even if they have authorisations under the old rules to carry on broadly similar activity. There are, however, transitional provisions which will benefit some firms (again, see below).At its most extensive, the AIFM regime imposes:

• New internal governance requirements.
• Conduct requirements.
• Remuneration policies and practices.
• New financial resources and liquidity requirements, with initial capital and own funds requirements of based on €125k for external managers and €300m for internally managed AIFs.
• Rules on portfolio composition including exposure to securitisation issues.
• Independent valuation of AIF assets.
• New rules on delegation of AIF functions.
• The appointment of a depositary with detailed defined responsibilities involving custody and monitoring assets and transactions of the AIF – and the depositary function itself which is also a regulated activity requiring FCA authorisation.
• Transparency and “asset stripping” requirements. These include obligations to provide information in relation to unlisted companies in an AIF portfolio to the FCA or others; information may need to be provided to employees or shareholders. The asset-stripping requirements impose limits on distributions, capital reductions, share redemptions or acquisitions in relation to unlisted portfolio companies for a period of 24 months after acquiring control. Control is defined in detailed terms, but with a starting threshold of 10% of the voting power.

Advice should be taken on the exact rules applying to any specific fund but, as a general guide, the above apply to the fullest extent to “full-scope” AIFMs. Those qualifying as “Small AIFMs” (see next paragraph) will continue to enjoy a regulatory framework more similar to that in place before 22 July 2013.Small AIFMsThere is a much lighter regime for Small AIFMs, which are:

• Those where the cumulative assets under management fall below a threshold of €100m; or
• Those where the cumulative assets under management fall below a threshold of €500m where there are no redemption rights for five years and the portfolios are unleveraged (with leverage given a detailed definition).

Small AIFMs will still be subject to requirements to provide regulatory information and are subject to authorisation/registration requirements. They will not benefit from the EU Passport to market throughout the EEA (see “Marketing” below).

Authorisation and Registration of AIFMsAll AIFMs carrying on business in the UK must either be authorised by the FCA or, in the case of some Small AIFMs, be registered with the FCA.

Under transitional provisions, firms managing AIFs before 22 July 2013 have until 22 July 2014 to obtain authorisation or registration. Those starting this activity for the first time after 22 July 2013 must be authorised or registered before starting business.

Registration is a less onerous procedure than authorisation and can only be refused on a limited number of grounds. It is, however, only available to a limited sub-class of Small UK AIFMs, i.e. those with their registered office in the UK) including:

• Internally managed corporate bodies which were not CIS under the old law.
• Certain real estate funds – though this does not significantly change the basis on which CIS were regulated before the changes (still requiring an FCA-authorised operator); and
• Those who have applied for registration as managers of qualifying European Venture Capital Funds and qualifying European Social Entrepreneurship Funds – this is an interesting development considered in more detail below.

MarketingThe Directive will have a significant impact in this area, both for marketing funds from and into the UK. For the first time, the AIFMD imposes requirements for regulatory authorisation and/or notification requirements in respect of the marketing of specific non-UCITS funds. The rules centre around the marketing to professional clients, i.e. those who satisfy the very specific tests of knowledge, experience and resources specified in EU legislation; marketing to retail clients is subject to country-specific rules. The rules are intensely complex but can be broadly summarized as follows for full-scope AIFMs:

• Prior approval must be obtained from the FCA by a UK AIFM (or by an EEA AIFM if it wishes to market to retail clients in the UK).
• There is a passport available to full-scope UK AIFMs to enable them to market to professional clients in the EEA. This is not available if either the AIF being managed or the AIFM managing it is from a “third country” (i.e. outside the EU), though there are plans to introduce a passporting regime in such circumstances after 2015.
• If either the AIFM or the AIF is from a third country, specific notifications to the FCA are required, based on the regulatory environment of the AIFM/AIF being broadly equivalent in certain respects to that under AIFMD.

An AIFM from a third country which fulfils the requirements of a Small AIFM (see above) must also give a pre-marketing notification to the FCA, providing certain specified information (but again the requirements are less stringent than for full-scope AIFMs).The AIFMD regime overlaps partially (but not entirely) with the existing FCA financial promotion rules, including those relating to the promotion of Unregulated CIS – and the very limited circumstances in which they can be promoted to high-net-worth or sophisticated retail clients. Other countries in the EEA may not allow marketing to retail clients at all.

European Venture Capital and Social Entrepreneurship FundsAt the same time as the implementation of AIFMD, the European Venture Capital Funds (EuVECA) Regulation and the European Social Entrepreneurship Funds (EuSEF) Regulation entered into force.These provide a parallel (and overlapping) regime for managers of such funds, which must meet detailed requirements as to, inter alia, the assets in which they invest and the composition of their portfolios (broadly 70% being invested in the core SME/social investments defined in the Regulations). They may be marketed (broadly) to those who are professional investors or to others who show sufficient knowledge and understanding and who will invest at least €100k. They will be subject to certain “lighter touch” regulatory requirements including eligibility for the registration regime referred to above, subject to being below a portfolio threshold of €500m. These funds can, however, be marketed in the EEA by managers who have the relevant EEA passport. They are likely to provide an interesting regulatory platform for managers and funds which can comply with their requirements.