Alternative investment fund managers based outside the European Economic Area (EEA)¹ who wish to market their alternative investment funds (AIFs) to European investors are rightly concerned about additional restrictions and obligations imposed by the European Union (EU)’s Alternative Investment Fund Managers Directive (Directive). This alert addresses some of those marketing issues for non-European managers who want to continue to seek investment from European sources, and discusses recent regulatory developments in the United Kingdom, which illustrate how one country interprets the Directive.

Each EEA member state is required to implement the Directive through its own rules and, as applicable, to provide transitional relief as the member state sees fit. Therefore, the United Kingdom’s determination of how to translate the Directive into national law may differ from how other EEA member states adopt the rules. Furthermore, in many cases, such rules are still in flux and not yet definitive. We advise ongoing caution, as EEA states, including the United Kingdom, progress toward full implementation of the Directive.

Pepper Hamilton LLP does not have an office in the United Kingdom or any other EEA member state, and its lawyers are not admitted to practice in those jurisdictions. The information in this alert is based on the authors’ own review of the Directive and pertinent regulations and is provided only as general information, which does not constitute legal advice and should not be relied upon by managers undertaking an offering or other initiatives. Such managers are advised to seek legal counsel in the applicable jurisdiction of their offering or initiative.

Background

In response to high-profile scandals involving perceived investment recklessness during the recent financial crisis, European regulators, like their U.S. counterparts, turned to broad-based legislative proposals. The European Securities and Markets Authority (ESMA) introduced the Directive in 2009 to aid in investor protection; mitigate market instability; and permit the marketing of any authorized AIF² to professional investors in all EEA jurisdictions under a “passport,” without the need to comply with any further local requirements. The Directive was finalized and introduced into law in the EU on July 1, 2011. The “Level 2” regulations, which guide the implementation of the Directive at the state level, were published in December 2012, and individual EEA states had until July 22, 2013 to transpose the Directive into state law.

As enacted, the Directive applies to managers (AIFMs)³ of AIFs wherever they are located, provided they manage an AIF in the EU (because the AIF’s or the AIFM’s registered office is in the EU) or market its interests to EU investors. An AIFM is exempt from the Directive, and needs to comply only with the applicable EEA jurisdiction’s national registration scheme, if the total assets under management of the AIFM are less than €100 million (including assets acquired by leverage) or less than €500 million (if there is no leverage and the fund is closed-ended for five years).⁴

Issues for Non-European Fund Managers

For many AIFMs based outside the EEA, the important focus is on (i) the meaning of the term “marketing” and (ii) its compliance obligations if it is marketing in the United Kingdom or other EEA member states.

Marketing

“Marketing” is defined under the Directive as “a direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM of units or shares of an AIF it manages to or with investors domiciled or with a registered office in the Union.” The definition is very broad, covering activities undertaken by placement agents and other intermediaries on behalf of an AIFM as well as activities undertaken by the AIFM itself. Many U.S. commentators on the Directive have raised questions about the scope of this definition. Does it encompass regular communications with existing investors about an existing investment? How about communications with an existing investor about re-upping in the next fund? Does it matter if that fund is just contemplated or already in formation? What about brand marketing efforts designed to build relationships with potential future investors? What about actual pitch meetings for a fund to test whether a prospect is interested in a particular strategy? There have been many, many questions.

While few are yet resolved, one universal question is addressed by the Directive: the use of the phrase “at the initiative of the AIFM” in the definition of “marketing” means that “passive marketing” or “reverse solicitation,” where the investor or potential investor contacts the fund manager, is not captured by the Directive’s restrictions.

Pepper Points:

• U.S. managers who expect to rely on reverse solicitations to do or continue business with European investors should exercise caution – there is very little guidance from the Directive or EEA regulators on what these terms actually mean.
• A U.S. manager seeking to rely on these non-solicited sales should make sure it has a satisfactory compliance program that can support the contention and provide evidence that the investment was made outside the scope of “marketing” (as defined in the Directive) and would not be viewed in hindsight as a circumvention of the regulation.

The United Kingdom’s Financial Conduct Authority (FCA) published its Policy Statement 13/5 in June 2013 (Policy Statement), which sets forth its mostly final rules for implementing the Directive. With respect to “marketing,” the Policy Statement includes some guidance on that term as used in the Directive. In terms of reverse solicitation or passive marketing – where the investor initiates the outreach resulting in marketing – the FCA, in chapter 7 of its Policy Statement, has “greatly simplified [its] guidance on marketing at the investors own initiative”:

Rather than trying to give exhaustive guidance on this topic, we have removed material on how to determine whether the marketing is at the investor’s initiative and on scenarios that caused concerns … such as the investor’s prior knowledge of the AIF or previous involvement with the AIFM. Instead we simply explain that firms may generally rely on confirmation from an investor that the approach is at his/her own initiative.

In providing that guidance, the FCA cautioned that such confirmation should not be relied upon if the marketing activity in question suggests circumvention of the Directive’s requirements.

The FCA also clarified that marketing “now includes a condition that the offering or placement seeks to raise capital in the AIF.” Consequently, many secondary offerings will not be considered within the scope of “marketing” (unless the secondary offering is a part of an integrated transaction and thus treated as a direct offering or placement, e.g., if the placement agent purchases units in an AIF for distribution to investors). The FCA also confirmed that a listing on a public market of an AIF will not in itself constitute an offering or placement, although it may well be accompanied by marketing activity, which would be captured.

With respect to communications with investors using draft documentation, the FCA explained that, in its view, such communications do not fall within the meaning of an ‘offer’ or ‘placement’ under the Directive. This would include promotional presentations or a pathfinder/draft prospectus version of the private placement memorandum; however, the potential investor cannot make use of such documentation to make an investment in the AIF. Similarly, interests in the AIF “should not be made available for purchase as part of the capital raising of the AIF on the basis of draft documentation in order to circumvent the marketing restriction.”⁵

Pepper Points:

• An AIFM based outside the United Kingdom sending a routine investor report to an existing investor in the United Kingdom would not appear to run afoul of the FCA’s marketing guidance.
• However, caution should be used to avoid any implication that such an investor report is being used to circumvent the marketing restrictions. Continued Use of National Private Placement Regime.

Continued Use of National Private Placement Regime

Currently, the Directive only makes the passport regime available to authorized European AIFMs to market interests in their European AIFs in any EEA jurisdiction, provided they are fully compliant with the requirements of the Directive.⁶ The Directive may introduce a passport for non-European AIFMs and non-European AIFs as early as 2015 if there is a positive opinion by the ESMA and with EU consent, as well as cooperation arrangements between the AIFM/AIF’s non-European country and the EU. While 2015 is the earliest opportunity for the issuance of such a passport, the potential for EU objection at that time means that such a passport may not become available until after 2015, or not at all.

In the case of non-European AIFMs (which are not Europe-based but which market fund securities in Europe), the Directive will permit their marketing of interests to professional investors by their continued use of the national private placement regimes (to the extent the target EEA member state permits that use) through the end of 2018.⁷ The United Kingdom is one such EEA member state that permits the continued use of its national private placement regime. However, under the Directive, continued use of the national private placement regime comes with a price – from July 22, 2013, non-European AIFMs who make use of the private placement regime will need to comply with disclosure and transparency requirements, as discussed below, in addition to any other local requirements. Also, cooperation agreements have to be in place between the regulators in the non-European jurisdictions of the AIF and AIFM and each of the EEA jurisdictions where the interests are to be marketed under the national private placement regimes. The non-European jurisdiction also must not be in an FATF⁸ non-cooperative jurisdiction.

The ESMA has approved several cooperation agreements on behalf of the EEA jurisdictions, including with the U.S. Securities and Exchange Commission, Office of the Comptroller of the Currency, and the Federal Reserve. The cooperation agreements must be bilaterally signed by each EEA jurisdiction and each third country to allow the non-European AIF to be marketed in the EEA after July 22, 2013. Certainly, each EEA jurisdiction could refuse to sign the cooperation agreement or seek to add additional requirements. These cooperation agreements are intended to assist the enforcement of the supervisory laws of each country as well as the mutual exchange of information.

Pepper Points:

• The United Kingdom’s FCA has announced that it has signed all the ESMA-approved cooperation agreements that the ESMA has with non-European regulators.
  • These include the pertinent non-European regulators in the United States, Canada, Brazil, India, Switzerland, Australia, Hong Kong and Singapore, Cayman Islands, Guernsey, Jersey and the Isle of Man, all jurisdictions very much welcomed by AIFMs.⁹

Required Disclosures

Any non-European AIFM wishing to rely on the continued use of the national private placement regime to market its fund’s securities in the EEA will be required under the Directive to insert new disclosures in its marketing materials and private placement memoranda, to the extent that such items are not already covered in its documentation. (See Annex 1 for a non-exhaustive list of such pre-investment disclosure items.) In addition, after the investment, the non-European AIFM will be obligated to disclose the following to its investors in the EEA:

1. material changes in the information disclosed before the investment
2. the percentage of the AIF’s assets subject to special arrangements as a result of illiquidity
3. new arrangements for managing liquidity
4. the current risk profile of the AIF and the risk management systems it employs, and
5. the total amount of leverage employed by the AIF.

The non-European AIFM also will need to produce an annual report for each applicable AIF and send it (or otherwise make it available) to EEA investors no later than six months after each financial year. The annual report must include:

1. a balance-sheet/statement of assets and liabilities
2. an income and expenditure account for the financial year
3. a report on the activities of the financial year
4. any material changes in the information disclosed in the marketing information during the financial year
5. the total amount of remuneration for the financial year, split into fixed and variable remuneration, paid by the AIFM to its staff, and number of beneficiaries, and, where relevant, carried interest paid by the AIF, and
6. the aggregate amount of remuneration broken down by senior management and members of staff of the AIFM whose actions have a material impact on the risk profile of the AIF.

Transitional Arrangements – Good for One Year

Aside from relying on the national private placement regime, non-European AIFMs may continue pre-existing marketing campaigns under pre-Directive rules, for up to one year, if the applicable EEA jurisdiction permits these so-called “transitional arrangements.” (The lack of a cooperation agreement between the applicable EEA regulator and the non-European jurisdiction where the AIF or AIFM is located will not prevent the non-European AIFM from utilizing the transitional arrangement.)

The United Kingdom allows such a transitional arrangement. U.S. and other non-European AIFMs wishing to take advantage of this option have until July 21, 2014 to be authorized or registered with the United Kingdom’s FCA and comply with the applicable provisions of the Directive, or otherwise stop marketing the AIF in the United Kingdom. In addition, non-European AIFMs benefiting from the transitional arrangement will be permitted to launch and market a new AIF in the United Kingdom so long as the launch and marketing activity is before July 21, 2014.

Penalties

While the Directive does not specify the penalties to be applied for non-compliance with its provisions, it does obligate its EEA member states to “lay down rules on penalties applicable to infringements of [the] Directive and ensure that they are implemented.”¹⁰ Article 48 of the Directive requires member states to ensure, in accordance with their respective national laws, that administrative measures and penalties be imposed for noncompliance, which may be in addition to criminal penalties under national laws. Such measures are required to be “effective, proportionate and dissuasive.”¹¹ The Directive also obligates member states to enable their respective regulatory authorities to publicly disclose any measure or penalty that will be imposed for infringement of member states’ implementing legislation, unless such disclosure would seriously jeopardize the financial markets or cause disproportionate damage.¹²

In the case of the United Kingdom, non-European AIFMs who fail to comply with the United Kingdom’s Directive-implementing laws on marketing could have their non-compliant agreements rendered unenforceable as well as be imprisoned for a term not exceeding three months.¹³

Concluding Pepper Points:

• Under the Directive as applied under the United Kingdom’s rules, non-European AIFMs will be allowed to continue to participate, through 2018, in the United Kingdom’s private placement regime, provided they comply with the new disclosure and transparency requirements discussed above.
  • The non-European AIFM using the private placement regime would need to notify the FCA of its intention to market its AIFs to United Kingdom investors, and identify itself as the AIFM tasked with the responsibility for overseeing compliance with the Directive.
• In addition to the private placement regime, the United Kingdom has helpfully allowed non-European AIFMs to take advantage of transitional arrangements, for up to one year, that are permitted, subject to local authorization, under the Directive.
• Should a non-European AIFM wish to continue pre-existing marketing campaigns for its fund under the United Kingdom’s permitted transitional arrangements, it would then have until July 21, 2014 to register with the FCA and comply with the applicable Directive provisions, including the new private placement disclosure and transparency rules outlined above, or cease to market its AIFs in the United Kingdom.
  • “Registration” is akin to notification and not a detailed filing and approval process.
  • Start the process early in 2014 if you think you will need to register.
• Starting in 2019, non-European AIFMs would have to obtain a “passport,” assuming the passport regime is extended to such managers based outside of Europe.

Annex 1

Certain New Disclosure Items

1. a description of the investment strategy and objectives of the AIF, information on where any master AIF is established and where the underlying funds are established if the AIF is a fund of funds, a description of the types of assets in which the AIF may invest, the techniques it may employ and all associated risks, any applicable investment restrictions, the circumstances in which the AIF may use leverage, the types and sources of leverage permitted and the associated risks, any restrictions on the use of leverage and any collateral and asset reuse arrangements, and the maximum level of leverage that the AIFM are entitled to employ on behalf of the AIF
2. a description of how the AIF may change its investment strategy or investment policy, or both
3. a description of the main legal implications of the contractual relationship entered into for the purpose of investment, including information on jurisdiction, on the applicable law and on the existence or not of any legal instruments providing for the recognition and enforcement of judgments in the territory where the AIF is established
4. the identity of the AIFM, the AIF’s depositary, auditor and any other service providers, and a description of their duties and the investors’ rights
5. a description of how the AIFM is complying with the requirements of the Directive regarding potential professional liability risks
6. a description of any delegated management function as referred to in Annex I by the AIFM and of any safe-keeping function delegated by the depositary, the identification of the delegate and any conflicts of interest that may arise from such delegations
7. a description of the AIF’s valuation procedure and of the pricing methodology for valuing assets, including the methods used in valuing hard-to-value assets in accordance with the requirements of the Directive regarding valuation
8. a description of the AIF’s liquidity risk management, including the redemption rights both in normal and in exceptional circumstances, and the existing redemption arrangements with investors
9. a description of all fees, charges and expenses, and of the maximum amounts that are directly or indirectly borne by investors
10. a description of how the AIFM ensures a fair treatment of investors and, whenever an investor obtains preferential treatment or the right to obtain preferential treatment, a description of that preferential treatment, the type of investors who obtain it, and, where relevant, their legal or economic links with the AIF or AIFM
11. the latest annual report
12. the procedure and conditions for the issue and sale of units or shares
13. the latest net asset value of the AIF or the latest market price of the unit or share of the AIF, in accordance with the applicable provisions of the Directive
14. where available, the historical performance of the AIF
15. the identity of the prime broker and a description of any material arrangements of the AIF with its prime brokers and the way the conflicts of interest in relation thereto are managed and the provision in the contract with the depositary on the possibility of transfer and reuse of AIF assets, and information about any transfer of liability to the prime broker that may exist.

Endnotes

¹ The European Economic Area includes the member states of the EU, as well as Iceland, Liechtenstein and Norway.

² AIFs are defined as collective investment schemes (other than undertakings for collective investment in transferable securities (UCITs) “which raise capital from a number of investors with a view to investing that capital for the benefit of those investors in accordance with a defined investment policy.” The definition covers all legal forms of AIFs, whether open-ended or closed-ended, and would include hedge funds, private equity funds, real estate and other types of alternative asset funds. The definition specifically excludes family offices where no external capital is raised, holding companies, securitization special-purpose entities, insurance contracts, joint ventures, pension funds and employee participation or savings schemes.

³ AIFMs are defined as “legal persons whose regular business is managing one or more AIFs.” Managing AIFs is further defined to mean at least performing the investment management functions of portfolio management or risk management.

⁴ “Closed end,” in the case of the Directive, refers to allowing no redemptions.

⁵ The Perimeter Guidance Manual (PERG) 8.37.6(1).

⁶ Such requirements are beyond the scope of this article, but include new rules for AIFMs relating to due diligence procedures on the target investments, inducements, fair treatment of investors, dealing arrangements, remuneration, conflicts of interest, risk and liquidity management, leverage and valuation requirements, reporting, depositary and regulatory capital requirements.

⁷ Should the passport become available to non-European AIFMs in or after 2015, then it would exist side-by-side with the private placement regime for at least three years.

⁸ Financial Action Task Force on Money Laundering. For a current list of FATF members, see http://www.fatf-gafi.org/pages/0,3417,en_32250379_32236869_1_1_1_1_1,00.html.

⁹ ESMA approved cooperation agreements between securities regulators from the 27 EU member states, Croatia and the European Economic Area (Iceland, Liechtenstein and Norway) and the following third-country regulators: Alberta Securities Commission (Canada), Australian Securities and Investments Commission, Autorité des Marchés Financiers du Quebec (Canada), Bermuda Monetary Authority, British Columbia Securities Commission (Canada), British Virgin Islands Financial Services Commission, Capital Markets and Securities Authority of Tanzania, Capital Markets Authority of Kenya, Cayman Islands Monetary Authority, Comissão de Valores Mobiliários do Brasil, Conseil Déontologique des Valeurs Mobilières of Morocco, Dubai Financial Services Authority, Emirates Securities and Commodities Authority, Federal Reserve Board (US), Financial Services Commission of Mauritius, Financial Supervision Commission of the Isle of Man, Financial Supervisory Authority of Albania, Guernsey Financial Services Commission, Hong Kong Monetary Authority, Hong Kong Securities and Futures Commission, Israel Securities Authority, Jersey Financial Services Commission, Labuan Financial Services Authority, Monetary Authority of Singapore, Office of the Comptroller of the Currency (US), Office of the Superintendent of Financial Institutions (Canada), Ontario Securities Commission (Canada), Republic of Srpska Securities Commission, Securities and Exchange Board of India, Securities and Exchange Commission (US), Securities and Exchange Commission of Montenegro, Securities and Exchange Commission of Pakistan, Securities and Exchange Commission Thailand, and the Swiss Financial Market Supervisory Authority (FINMA). ESMA press release, May 30, 2013.

¹⁰ Directive, Recital 75.

¹¹ Directive, Article 48(1).

¹² Directive, Article 48(2).

¹³ PERG 8.37.13.