Phil Bartram, Travers Smith LLP
In March 2018, the European Commission published legislative proposals for a new directive and regulation relating to the cross-border distribution of investment funds, now commonly known as the “Omnibus” proposals. This legislation will amend existing EU legislation governing investment funds, including AIFMD, the UCITS Directive and the EuSEF and EuVECA Regulations.
The expressed intention is to reduce fragmentation in EU capital markets by lessening existing regulatory barriers which act as a disincentive to cross-border fund distribution. This is a laudable goal, but the practical effect of the Commission’s proposals might in fact increase barriers and disrupt hitherto well-rehearsed fundraising processes, particularly in relation to certain forms of closed-ended private funds.
At the time of writing, indications from the European Parliament and Council are that the Commission’s suggestions may be watered down, but as with the original text of AIFMD, the challenge of introducing new concepts which will work across a heterogeneous industry remains daunting. The risk of unintended consequences is high. This article focuses on three key elements of the proposals in light of current market practice and suggests that in these areas at least, legislators should rethink.
The most important change results from the introduction of a definition of “pre-marketing”. This was designed to solve the difficulties arising from the fact that AIFMD creates a pan-EEA regime only for “marketing” of AIFs and the point at which an AIFM is deemed to be marketing has been interpreted differently across the member states. It is also intended to create a harmonised pan-EEA regime for testing investor appetite during early-stage promotional activities, on which the existing legislation is currently silent.
The Commission’s proposed definition of “pre-marketing” is:
a direct or indirect provision of information on investment strategies or investment ideas by an AIFM or on its behalf to professional investors domiciled or registered in the Union in order to test their interest in an AIF which is not yet established.
AIFMD will also be amended to require EU member states to allow EEA AIFMs to engage in pre-marketing in their territories, unless, broadly speaking, the relevant promotional activities relate to AIFs that have already been established, or include the circulation of draft or final form investor documents which would allow investors to take an investment decision, whether or not the AIF has been established.
In practice, this proposed approach is likely to be highly disruptive for many AIFMs. In many private fund structures, it is common to establish the fund vehicles early in the fundraising process. The reasons for this vary, but often relate to the need to conclude registration processes in good time, to engage fund service providers and/or to implement broader structural arrangements. In addition, in certain private fund arrangements, where the limited partnership fund model is paramount, it is also common to circulate draft investor documentation such as limited partnership agreements and/or proposed subscription documents, which form part of the iterative negotiation process with prospective investors.
Where an AIFM has already established the relevant AIF or is circulating sufficiently advanced drafts of investment documents, it cannot be “pre-marketing” within the Commission’s proposed definition and, on the assumption that the Commission does not intend that there should be a gap between the concepts of pre-marketing and marketing, it must therefore be “marketing”. This would be at odds with the approach currently adopted in a number of member states, including the UK and Germany, where promotional activities in relation to an AIF are only deemed to constitute AIFMD marketing at a late stage in the process, when potential investors are in a position to enter into a binding contractual agreement to invest or to make an offer to the AIFM to do so. In future, the AIFM would need to have registered for marketing with its home state regulator and have activated the marketing passport into every other relevant EEA jurisdiction in this situation.
Recasting the AIFMD marketing regime in this way would be likely to require significant practical changes which would cause inefficiencies in the fundraising process. Once an AIFM has registered the AIF for marketing, other substantive AIFMD obligations begin to apply including, importantly, the obligation to notify the home state regulator of any material changes to the information provided at the time of registration. Since there is a potential 30-day waiting period in which a regulator must decide whether to approve or reject any proposed changes, where the fundraise involves ongoing substantive negotiations (as in most private funds contexts), this risks potential periodic halts in marketing which could significantly lengthen the process or render it impractical. It is difficult to see how this could be in the interests of AIFMs, prospective investors, regulators (who will be burdened with processing additional material change notifications) or the EU financial markets as a whole.
Although the new definition is expressed in the proposals to be relevant only to authorised EEA AIFMs in the context of the AIFMD marketing passport, in practice individual member states which currently offer national private placement regimes (NPPRs) will likely also apply the same concept to those regimes. This means that non-EEA managers may also find that they have to register at an earlier stage under national NPPRs, triggering earlier obligations in connection with regulatory reporting and the payment of periodic fees. This may prove to be particularly significant for UK fund managers in the context of Brexit. Following the UK’s departure from the EU, UK AIFMs will likely be treated as “third country” managers under AIFMD and therefore will be treated like other non-EEA AIFMs. If the “pre-marketing” requirements were cross-applied by member states to their NPPRs, this would mean that UK AIFMs will need to register for marketing in individual member states at an early stage. Registration under certain jurisdictions’ NPPRs can be a lengthy process and may be significantly more burdensome than the exercise of the AIFMD passport for EU AIFMs, which would impact fundraising timelines and could prompt a more considered and selective approach to which member states are ultimately targeted.
The AIFMD marketing passport currently applies only in relation to marketing to professional investors (as defined in the MiFID II Directive). The question of whether (and if so, subject to which conditions) an AIFM may market a fund to retail investors currently falls to be determined by the national law of the member state concerned. Individuals must generally be “opted-up” in order to constitute MiFID professional investors and the opt-up criteria are onerous and frequently difficult to satisfy. In practice, this means that even sophisticated, high-net-worth investors may fall within the definition of MiFID retail investors for these purposes.
The new Omnibus Directive would impose certain minimum requirements on any AIFM (ie, whether EEA or non-EEA) which is marketing an AIF to retail investors within the EU. Broadly speaking, the proposed rules would require the AIFM to implement “facilities” in the investor’s member state to perform certain administrative functions, largely akin to those of a paying agent. This would not need to be a physical presence and therefore the AIFM could, in theory at least, provide these through an online portal or other electronic system. However, it must ensure that all functions are provided in the official language(s) of the member state concerned and that if a third party is performing the role, it is subject to regulation in relation to the relevant activities.
Presumably, the Commission is concerned that retail investors may require an additional level of protection. However, the Omnibus Directive does not create any new rights to market to retail investors in member states and therefore access to such investors will remain subject to national law. It is unclear why, in member states where national regulators consider that marketing to retail investors should be permitted (subject to conditions), the Commission considers it necessary to impose additional requirements which are likely to act as a disincentive to such marketing. Some of the proposed requirements may be disproportionate or impractical in certain circumstances: for example, an AIFM seeking to market to sophisticated investors across 15 EEA jurisdictions may need to translate investor documents and other communications into 15 different languages, even where all relevant investors are used to communicating in English or another common language. The requirement for third parties providing the relevant facilities to be regulated may also materially increase the AIFM’s costs. Rather than protecting retail investors, the Commission’s proposals may in fact limit their choice as AIFMs choose to restrict marketing to key target jurisdictions in order to avoid unnecessary expense and administrative burdens (although to a certain extent, the PRIIPs Regulation and its onerous key-information-document requirements may already have significantly decreased the attractiveness of marketing fund products to EU retail investors).
AIFMD is currently silent on when an AIFM is permitted to deactivate its marketing passport in a jurisdiction or withdraw a marketing notification under an NPPR. The Omnibus Directive attempts to harmonise member states’ approaches in this area by introducing a set of conditions which must be satisfied before an EEA AIFM can switch off the marketing passport.
Broadly, the Commission has proposed that new conditions would require that the AIFM had not admitted more than 10 investors in the member state into the AIF being marketed and that those investors in aggregate did not represent more than 1 per cent of the assets under management of that AIF. In addition, the AIFM would be required to make a blanket public offer to all investors (which must also be addressed individually to each relevant investor who can be identified) in that member state, open for at least 30 working days, to repurchase their units in the AIF.
Although these requirements are not expressed to apply to non-EEA AIFMs marketing under the NPPRs, it again seems likely that member states would choose to apply it to such managers in order to ensure a level playing field.
The conditions for discontinuation of marketing are manifestly unworkable for many funds, particularly those which are structured as closed-ended vehicles and which are unlikely to have excess cash permitting them to redeem investors’ interests (eg, private equity, property, debt or infrastructure funds). In practice, therefore, if these proposals are implemented, they may effectively prevent some AIFMs from deactivating the marketing passport or withdrawing a notification under the NPPR. This may trigger requirements to pay periodic fees in some jurisdictions, which may be significant on a cumulative basis. In addition, non-EEA AIFMs will be subject to periodic Annex IV reporting in all EEA jurisdictions in which they are registered for marketing and therefore they would remain subject to a significant ongoing regulatory burden, despite carrying on no further marketing.
Although clarification of the rules relating to discontinuation of marketing may be welcome, the current proposed conditions are clearly inappropriate for many fund managers. It is to be hoped that the EU legislators will adopt a more practical approach in this area, allowing marketing to be discontinued subject only to ensuring the continuation of basic investor protection provisions.
The Omnibus proposals are a classic example of the old adage “be careful what you wish for”. Market participants have frequently identified issues such as difficulties in pre-marketing and uncertainty around discontinuation of marketing as areas that would ideally be solved by clarifications to AIFMD. Now that they are faced with the Commission’s proposals, however, many fund managers would probably have preferred to retain the status quo, where most have at least found suitable work-arounds to practical problems. That is not going to happen. However, active and thoughtful engagement from the industry and proper scrutiny by the European Parliament and Council may enable a welcome and pragmatic result to emerge. If it does not, we could all be lamenting another missed opportunity.