Legal base	(a) Article 47(2) EC; co-decision; QMV (b) —
Deposited in Parliament	(b) 6 November 2009
Department	HM Treasury
Basis of consideration	(a) Minister's letter of 17 December 2009 (b) EM of 18 November 2009
Previous Committee Report	(a) HC 19-xviii (2008-09), chapter 9 (3 June 2009) and HC 19-xxii (2008-09), chapter 3 (1 July 2009) (b) None
To be discussed in Council	Not known
Committee's assessment	Politically important
Committee's decision	Both documents for debate in European Committee B

Background

2.1  In its Communication Driving European Recovery the Commission said "To deliver responsible and reliable financial markets for the future, the Commission will propose an ambitious new reform programme, with five key objectives." The second objective was "To fill gaps where European or national regulation is insufficient or incomplete, based on a 'safety first' approach." Amongst the proposals in this connection that the Commission said it would make was "A comprehensive legislative instrument establishing regulatory and supervisory standards for hedge funds, private equity and other systemically important market players."[6]

2.2  In document (a) the Commission has proposed an Alternative Investment Fund Managers Directive which would harmonise Community regulation of managers of hedge funds, private equity funds and any other form of investment fund, apart from pension funds and the already harmonised UCITS (Undertakings for Collective Investments in Transferable Securities) funds (as in the recast UCITS Directive of July 2009).[7] The Commission presented the draft Directive as part of a programme to extend appropriate regulation and oversight to all actors and activities that embed significant risks and noted calls for closer regulatory engagement in the sector from the European Parliament[8] and in the de Larosière Report.[9]

2.3  When we first considered this document, in June 2009, we heard that the Government supported the principle of harmonising regulation of Alternative Investment Fund Managers across the Community, but that it planned to seek important improvements to the draft Directive to ensure that it avoided imposing unnecessary burdens on the industry, while at the same time delivering the necessary improvement in regulatory standards. We noted particularly that:

• on non-Community firms and funds, the Government planned to argue for a more open approach to funds, managers and service providers from outside the Community;
• on private equity disclosure, the UK private equity industry had already taken voluntary action in this area through the Walker guidelines[10] — the Government believed stakeholders were broadly content with the level of disclosure provided by these guidelines and therefore intended to oppose the imposition of new regulatory requirements which could, in any case, only apply to Community-managed private equity funds and not to other forms of private ownership, for example non-Community private equity funds or family ownership;
• on greater supervisory discretion, the Government agreed that greater oversight of the potential systemic risks posed by Alternative Investment Fund Managers was necessary — it believed, however, that to do this effectively supervisors would have to exercise judgement over which data to collect and the Government intended to argue for this approach to be permitted under the Directive;
• the Government was establishing a number of stakeholder groups to give affected firms an opportunity to share views on the draft Directive, Council working group discussion of which was likely to continue at least until the end of 2009, and to gain a more developed understanding of the cost impacts of the proposal;
• the Commission impact assessment did not include a specific estimate of administrative costs —it argued that they would depend on existing national legislation — and the Government would seek further information on the likely impacts on affected sectors from UK firms.

2.4  We said that the draft Directive clearly could have a significant effect on Alternative Investment Fund Managers and that it was likely that in due course we would wish to recommend it for debate. But before considering that possibility further we asked to hear about:

• the outcome of the Government's consultations on the matter, including information on possible impacts; and
• progress in negotiations on the Government's aspirations in relation to non-Community firms and funds, private equity disclosure and greater supervisory discretion.

2.5  When we considered the matter again, in July 2009, we heard about both the Government's discussions with affected firms and progress in negotiations in relation to non-Community firms and funds, private equity disclosure and greater supervisory discretion. On the Government's consultative discussions we were told that:

• there had been group meetings at official level with managers of hedge funds, private equity funds and traditional or long-only funds,[11] involving around one hundred firms and trade bodies in total, and a number of ministerial meetings with senior industry representatives;
• the Government had drawn the conclusion from these discussions that the proposed Directive would impose significant new burdens and constraints on affected firms if implemented as drafted;
• some of these were justified by the additional regulatory protections they would offer, particularly the provision for enhanced data collection from managers to monitor systemic risk;
• many affected managers had indicated their support for such provisions;
• other proposals, however, appeared to impose unnecessary burdens;
• hedge fund managers were concerned at the proposal to impose leverage caps on the funds they managed, arguing that this could force them to liquidate assets at times of market stress, since leverage generally rises following a fall in the value of a fund's assets;
• they also argued that leverage was not a good proxy for risk, since this depended to a considerable extent on the volatility and structure of a fund's assets;
• the Government agreed with the Commission that excessive leverage in hedge funds and other vehicles could contribute to systemic risk — it believed, however, that the best way to deal with this risk was for supervisors to monitor leverage across significant market sectors and to intervene in exceptional circumstances where necessary, to prevent unsustainable degrees of leverage developing on an aggregate basis;
• leverage caps which were set on a fund-by-fund basis risked being counterproductive in this process since the Government would expect any systemic risks to stem from the combined behaviour and leverage of a number of funds rather than any one fund on its own;
• for private equity firms the proposals for stringent disclosure requirements on portfolio companies were a major concern — managers argued that this would put the firms in which their funds had invested at a competitive disadvantage to competitors held in other forms of private ownership, for example family ownership;
• the Government agreed with the concern expressed and was pushing in negotiations for substantial rewriting of the relevant aspects of the draft Directive;
• for traditional or long-only managers the requirement for the fund's assets to be valued by an external valuer would pose significant difficulties and differed from the model prescribed in the UCITS Directive;
• the Government would argue for a more proportionate approach in this area, emphasising that an internal valuation subject to appropriate external oversight and audit could deliver the necessary checks and balances;
• for closed ended funds (those which do not create or redeem shares on demand) there were a number of significant practical issues stemming from the fact that the Directive seemed to have been drafted mainly with the open ended sector in mind — for example, liquidity requirements on the fund or controls on marketing of shares in the fund by the manager were not generally relevant to this sector; and
• the Government believed that as far as possible existing Community rules, including the Prospectus Directive and the Transparency Directive, should continue to govern this sector and would push for this approach.

2.6  On progress in negotiations we heard that so far there had been two meetings of the Council working group and it had considered only the early articles of the Directive, so it was difficult to have a complete overview. Nevertheless we were told that:

• based on those meetings and bilateral discussions with other Member States, the Government believed that there was widespread acceptance that the Commission's proposal was technically deficient in a number of areas and that the Council should work pragmatically to develop appropriate remedies; and
• the Government therefore believed it likely that the negotiations would deliver significant improvements in the quality of the draft Directive and reductions in unjustified cost impacts.

2.7  We noted the Government's optimism about the likelihood of obtaining significant improvements to the drafting of the proposal in the continuing negotiations. And we said that we were now clear that we wished to recommend this document for debate. But before doing so we asked to hear again about the continuing working group negotiations, particularly as to progress on obtaining more certainty on the significant improvements in the drafting, of which the Government was hopeful. [12]

The new document

2.8  In June 2009, as part of its consideration of the draft Directive, the Council asked the European Central Bank for an Opinion on the Commission's proposal — document (b) is the Bank's response. In the Opinion the Bank says that it:

• supports the intention to provide a harmonised regulatory and supervisory framework for the activities of Alternative Investment Fund Managers in the EU;
• considers the proposed reporting obligations on Alternative Investment Fund Managers to their supervisors should, in principle, contribute to improved financial stability monitoring and a better-informed assessment of the financial stability risks posed by Alternative Investment Fund Managers and the funds they manage;
• considers that the harmonised rules and resulting passporting for Alternative Investment Fund Managers to sell their funds across the EU should benefit financial integration;
• urges the Commission to continue dialogue with international partners, particularly the US, to ensure a globally coherent regulatory framework and to avoid risks of regulatory arbitrage and evasion;
• considers that the provisions of the proposed Directive could be better tailored to reflect the fundamental differences between alternative investment funds;
• suggests the need to include other provisions in the Directive, for example, 'fit and proper' criteria and minimum experience requirements for senior Alternative Investment Fund Managers, to maintain the EU financial acquis and so avoid regulatory arbitrage between Alternative Investment Fund Managers, insurance companies and credit insurance companies;
• considers that provisions that have a horizontal impact, for example, short selling or acquisition of controlling influence on companies, should be dealt with separately in legislation that maintains the level playing field and not through this proposal;
• welcomes the reporting obligations on Alternative Investment Fund Managers and the mechanisms for exchange of information between supervisory authorities;
• considers, however, that more analysis is needed to focus reporting obligations on data relevant for monitoring financial stability;
• considers that the proposed European Systemic Risk Board and the European Supervisory Authorities should be able to obtain the information necessary to fulfil their respective tasks;
• suggests that the use of standardised reporting would minimise the reporting burden of alternative investment funds;
• comments that should include reporting on a fund's balance sheet, income statements, cash flow statement and projections (including primary sources of funding, list of prime brokers and contingency liquidity arrangements in different scenarios), investor redemptions restrictions, assets held using a mark to model valuation, leverage, positions in derivatives (including notional amount and collateral posted), illiquid assets and non investment grade assets and the use of short selling;
• considers that the Commission's proposal to set leverage limits requires a balanced and appropriately risk-adjusted leverage limits applicable to alternative investment funds that take their full risk profile into account while not excessively hindering their investment flexibility; and
• considers that the definition of leverage should be further clarified.

The Government's view of the new document

2.9  The Financial Services Secretary to the Treasury (Lord Myners) says that in the main the Bank's Opinion is similar to the Government's, noting again that the Government supports the intention to provide a harmonised regulatory framework for the activities of Alternative Investment Fund Managers. The Minister comments further that:

• the Government considers that the reporting obligations on Alternative Investment Fund Managers should help improve financial stability, but thinks that it should be up to national supervisors to determine what information they require, taking appropriate account of the size and risk of the manager concerned;
• the Financial Services Authority's hedge fund managers' survey, which is being piloted, will give it much improved oversight of the impact of hedge fund's trading and leverage on assets markets;
• much of the data suggested by the Bank is already being captured in the Authority's survey;
• the Authority is in contact with the Bank about the survey as it refines the survey's parameters;
• the Government agrees that the proposed Directive should be better tailored to reflect the different types of alternative investment funds — this has been one of its key negotiating objectives;
• the Government does not agree with giving the Commission ex ante [before the event] powers to set leverage limits as this control might have the perverse effect of increasing instability, particularly in a market downturn, when Alternative Investment Fund Managers may be forced sellers of assets to simply meet their leverage limit;
• the Government also considers that there is a high risk that any ex ante leverage limit would severely reduce investment flexibility;
• the Government does agree, however, that national supervisors should have powers to set leverage limits or take any other relevant measures to deal with a risk to financial stability; and
• the Government is giving the Financial Services Authority a new stability objective and powers to intervene wherever it identifies immediate systemic risks, which would include the ability to set leverage limits.

The Minister's letter

2.10  In his letter the Minister gives us a further account of developments on the draft Directive. Reminding us first of the Government's view that, although containing a number of deficiencies, which it has been working to address, the proposal has the potential to open up the Union market, providing new opportunities for EU managers, and to extend EU cooperation on systemic issues, which the Government supports, the Minister tells us that:

• several meetings have been held by the Swedish Presidency to try and find a compromise that would allow the Council to agree a general approach;
• as some Member States have, however, been unwilling to compromise at this stage, the Presidency decided that it was better to pause the negotiations to allow heads to clear over the Christmas break;
• the Presidency produced a progress report and one further compromise text[13] to hand over to the incoming Spanish Presidency;
• the Government expects the Spanish Presidency to seek a general approach sometime between March and May 2010;
• the Government had been expecting this development for some weeks and is not unduly concerned; and
• in all the Government's dealings with Spain so far its government has been clear, much like Sweden's, that its focus will be on agreeing legislation which is properly thought through and which works.

2.11  The Minister then outlines the main changes in the Swedish Presidency compromise:

Leverage

• the original Commission proposal would give powers to the Commission and national supervisors to set ex ante leverage caps;
• the compromise text removes the Commission's power in this area, leaving it to national regulators to set caps where justified by an immediate systemic risk — something the Government supports;

Portfolio company disclosure

• the compromise text maintains the requirement for additional disclosure requirements on private equity portfolio companies, but substantially pares back those requirements so that they require only notification to the target once a controlling interest is attained and a summary annual financial statement;
• it also includes a requirement for private equity firms to disclose leverage in a portfolio company to its supervisor immediately prior to a buy-out, six months after a buy-out and 12 months after;

Delegation

• the Commission proposal would prevent delegation of portfolio management outside of the EU;
• the compromise text would allow delegation of portfolio management to non-EU firms, provided those firms were authorised as asset managers — which the Government strongly supports;

Valuation

• the compromise text would make valuation the responsibility of the manager and removes the requirement for an independent valuer;
• the Government welcomes this as it would remove the independent valuation obligation from classes of fund manager, particularly private equity, for which it is not appropriate;
• the Government is, however, seeking clarifications to ensure that managers could continue to use independent valuers where appropriate;

Capital

• the compromise text aligns capital requirements more closely to the UCITS Directive, on the grounds that the original proposal would have created too much of a distortion in requirements between a UCITS manager and an Alternative Investment Fund Manager;
• there is also now an option for small and medium size private equity firms to opt into the proposed Directive to benefit from the passport, but to have a lower capital requirement of €50,000 to €60,000 (figure yet to be discussed by the Council);

Short selling

• the compromise text removes rules in this area on the basis that the Commission should bring forward proposals to govern the market as a whole;

Liquidity

• the compromise text removes the provision for the Commission to set quantitative liquidity thresholds;

Passport

• as part of the overall compromise, the Swedish Presidency has proposed restricting the passport to funds both managed and domiciled in the EU;
• only EU domiciled and managed funds could be sold without restriction to all EU professional investors;
• all other funds, that is third country funds, even with an EU manager, would be subject to national private placement rules, that is subject to the marketing requirements in each Member State;
• EU managers with third country funds would still have to comply with the draft Directive, except for the depositary requirements;
• some of the larger Member States do not agree with the carve out of the depositary requirements so this will be a key area for discussion during the Spanish Presidency;

Access to the EU market for third country fund managers

• under the Commission proposal non-EU managers would only be allowed to sell their funds in the EU where their local regulation had been deemed equivalent to that in force in the EU and managers which met that test would benefit from the passport;
• the compromise text removes both of these provisions;
• Member States would retain discretion over how much to open their market to third country managers and those managers will not benefit from a passport;
• the Government broadly supports this as it ensures the UK can maintain its open approach, allowing professional investors access to the best global managers;

Depositaries

• the compromise text clarifies that for assets which could not sensibly be held in independent custody, for example shares in unlisted companies, real property or derivatives, the depositary should be responsible only for verifying that the assets were held by the fund;
• there is also provision for a broader range of entities to act as depositary including Markets in Financial Instruments Directive investment firms and suitably authorised entities outside the EU and clarification of depositaries' liability for loss of assets and other failures;

Remuneration

• the majority view in the Council is that these rules should draw heavily on the agreed rules in the Capital Requirements Directive;
• the initial compromise text had a requirement to defer 40% of the bonus over three years or 60% where the bonus element to fixed remuneration was particularly high;
• the present compromise text removes the hard time limit for bonus deferral and now links it to a time period appropriate to the type of fund;
• this change, and the ability to apply the requirements on a proportionate basis, offers flexibility in making sure that these requirements can be applied sensibly;
• the Government will, nevertheless, continue to argue that the quantitative limits of 40 and 60% should be removed;

Supervision

• in relation to greater discretion for supervisors there is some support for allowing supervisors discretion to collect additional information where justified on systemic grounds, although there is a concern from the Commission that such additional requirements should not get in the way of an effective single market;
• the compromise text tries to balance these positions by requiring certain basic information to be provided routinely by all managers and for other information to be provided on request by the supervisor; and
• the Government believes this strikes an appropriate balance.

Conclusion

2.12  We are grateful to the Minister for his latest account of where matters stand on this draft Directive, document (a). In the light of his report we think the time is now appropriate for a debate on the draft Directive. So we now recommend that there should be such a debate in European Committee B, which would allow Members to explore to what extent the revisions proposed to the original text improve the proposal and what further improvements might be necessary.

2.13  We recommend also that the European Central Bank's comments on the proposal, document (b), should be debated at the same time.

7   (29873) 12149/08 + ADDs 1-2: see HC 16-xxxii (2007-08), chapter 4 (22 October 2008), HC 16-xxxv (2007-08), chapter 1 (12 November 2008) and Stg Co Deb, European Committee, 25 November 2008, cols. 3-24. Back

8   See http://www.europarl.europa.eu/sides/getDoc.do?type=TA&reference=P6-TA-2008-0425&language=EN&ring=A6-2008-0338 and http://www.europarl.europa.eu/sides/getDoc.do?type=TA&reference=P6-TA-2008-0426&language=EN&ring=A6-2008-0296.  Back

9   See http://ec.europa.eu/commission_barroso/president/pdf/statement_20090225_en.pdf, seventh recommendation, page 25. Back

10   The Walker Guidelines set standards for public disclosure by private equity portfolio companies - see www.walker-gmg.co.uk. Back

11   A long-only fund is not allowed to take short positions, that is bet on the price of investments falling. Because short selling is used much more widely in newer fund management styles, for example, hedge funds, long-only is also used partly as a descriptor of the traditional fund management industry (unit trust managers, etc). Back

12   See headnote. Back

13   See http://register.consilium.europa.eu/pdf/en/09/st17/st17330.en09.pdf.  Back