Impact of EU regulations on Investment Managers
On 29 April the European Union published the text of a draft Directive which would, if approved, lead to the regulation of alternative investment fund managers in the EU. This sounds incredibly boring. However, the scale of Cayman’s funds industry and its importance for the local economy mean that any proposed regulation in this area will without doubt affect Cayman.
The EU’s stated motives for the draft Directive include preserving the stability and integrity of European financial markets and protecting investors. Fund managers are already regulated by the individual EU member states, but the European Commission considers that national regulation requires greater cross-border coordination to be effective.
The Directive would require the authorisation and regulation of managers who are domiciled in the EU and who manage alternative investment funds (including hedge funds, private equity funds, commodity funds and real estate funds) with a combined value exceeding €100 million.
All such managers will be required to demonstrate that they are suitably qualified to provide management services and will be required to provide detailed information on the planned activity of the manager, internal arrangements with respect to risk management and arrangements for the valuation and safe-keeping of assets and audit arrangements. Such managers will also be required to hold and retain a minimum level of capital.
At the investment level, managers will be required to report on a regular basis on the principal markets and instruments in which they trade, their principal exposures, performance data and concentrations of risk. Additional disclosure obligations will apply to managers managing leveraged funds and controlling stakes in companies.
From a Cayman perspective, the effect ofthis aspect of the regulation should be limited. It is possible that increased costs and inconvenience may deter some new managers from launching fund management businesses, but this should not be significant.
The Directive also provides that only managers established in Europe can provide their services in Europe. So for example US managers will need to establish a European presence if they are to manage Luxembourg funds. This may slightly reduce the number of investment management vehicles formed in Cayman.
More importantly for Cayman, however, the Directive provides that only funds domiciled in Europe can be marketed by EU authorized managers in Europe. As more than 9,500 of the world’s hedge funds (not to mention private equity funds etc) are domiciled in Cayman, this could have a significant impact on Cayman’s funds industry. On the face of it, managers may be faced with the choice of forming a fund in Europe and being able to operate largely as they wish, or incorporating the fund in Cayman and being unable to offer the fund’s interests in the world’s largest economic bloc.
The good news is that there are at least four reasons why the position may not be as bad as it seems.
First, for the time being and for a three year period after the Directive comes into effect, EU authorised managers will continue to be able to market Cayman funds under existing rules in the individual member states. So nothing much will change for the next few years, although when the Directive comes into force there will be a competitive advantage for fund domiciles such as Luxembourg and Ireland over Cayman as EU funds will be marketable in countries like France and Italy while under current rules Cayman funds will not.
Secondly, the draft Directive includes a passporting mechanism which will commence three years after the Directive takes effect, under which non-EU funds may be marketed in the EU provided that certain conditions are fulfilled. One of the requirements is that there must be a tax information exchange agreement between the territory where the fund is domiciled (eg. Cayman) and the EU country where the fund is to be marketed. Leaving aside the question of why it is considered appropriate to introduce a tax-related requirement into legislation regulating fund managers, this obviously increases the importance of the Cayman Islands Government’s efforts to negotiate tax information exchange agreements with EU member states. It is not clear whether Cayman’s unilateral mechanism would satisfy this condition as drafted.
Thirdly, the Directive is not expected to come into force until 2011, and even that assumes that political approval of the proposal is achieved by the end of 2009. So Cayman’s funds sector, and the international fund management industry as a whole, will have some time to adapt. It may be, for example, that the common master-feeder structure will be modified so that in addition to a US feeder fund for US investors, an EU feeder will be added for EU investors to sit alongside a Cayman feeder for non-US and non-EU investors.
The final cause for modest optimism is that almost everyone hates the draft Directive. The European Commission itself has acknowledged that "it is expected to be the object of intense political discussion and negotiation". The draft was rushed through an abbreviated consultation period and has been attacked bythe French Finance Minister and others who consider that the proposed draft does not go far enough, and at the other end of the spectrum by many in the funds industry who regard it as, defective, disproportionate, inappropriately political and protectionist.
It is clear that there will be spirited debate about the draft Directive in the months to come and Cayman should once again expect to be regularly referred to with varying degrees of antipathy. Although Cayman will have little influence over the outcome, the private sector and the Islands’ political leaders need to respond and adapt effectively to seize any opportunities that may arise and to keep Cayman at the pinnacle of the global investment management industry.
Category: Viewpoint
Until I read this interesting piece of writing, I was slowly coming to the conclusion that Cayman’s future must lie in encouraging the genuine physical presence of hosts of alternative investment funds to its shores. This in the face of US plans to tax Cayman brass plaque entities (which are actually run from the US and which I think is fair enough) and US plans to axe deferral of corporation tax on overseas earnings (which I think is outrageously protectionist).
Now I read that the EU is also to protect its own. If it weren’t for the passport mechanism, it would be a potentially devastating directive. I hope it fails at the outset.
It is clear that the EU is engaged in blatant economic and administrative protectionism in an attempt to cultivate a hedge fund industry at Cayman’s expense. Normally such anti competitive behaviour is challenged by lodging a strong complaint to the World Trade Organisation. As a British Overseas Territory it is unclear how Cayman could lodge such a complaint unilaterally. It would appear then, that the next best option would be to partner with affected independent countries who are not in the EU and present our position to the WTO.