This week, the European Commission published the long-awaited AIFMD Level 2 Regulation filing in the gaps in the picture sketched by the Alternative Investment Fund Managers Directive (AIFMD).
The new regulation provides the technical substance behind fifty measures marked in the directive for further elaboration.
The choice of regulation, rather than directive, as the legislative instrument for Level 2 reflects the Commission’s increasing preference for fully harmonised European law with no national discretion over minimum harmonising standards.
From a political perspective, it reflects a further step in the centralisation of legislative power in Brussels.
From a practical perspective, it means that the regulation will serve as the UK’s primary ‘rulebook’ in the field of professional funds.
The FSA’s tentative proposal to create a new FUND sourcebook for all fund managers may well entail re-ordering the regulation into a more accessible format.
The delayed timing of the Commission publication of Level 2 measures has been the cause of industry complaint.
In its defence, the Commission points to the simplification of the domestic implementation timetable that directly binding regulation achieves, so firms have a more detailed understanding than they might have anticipated at this time.
The regulation enables firms to start developing meaningful internal AIFMD-implementation projects. It provides hard and fast rules in a number of areas; thresholds for professional indemnity insurance coverage; reportable leverage triggers (three times NAV); the risk management function; asset classes that require a depositary; the (limited) circumstances in which the depositary avoids liability for the loss of fund assets; and clarity on when a manager will constitute a “brass plate” (and hence be ineligible as an AIFM).
However, for a regulation, it contains a surprising amount of high level principle more commonly associated with a directive.
For example, the regulation establishes liquidity management rules for open-ended and leveraged funds. Rather than attempting to prescribe acceptable liquidity levels across the whole spectrum, it specifies the audit trail that managers will have to create to demonstrate that they have developed, monitored, managed and stress-tested their liquidity profile against their investment and redemption profile.
This focus on audit trails is a feature of modern regulatory technique: as with a maths exam, a firm that arrives at the right answer, but cannot show its workings, will not receive a pass.
The regulation’s focus on regulatory reporting indicates that the new Financial Conduct Authority will have a lot more funds ‘homeworks’ to mark (think of ARROW as the marking pen).
In the absence of European priorities, the institutional funds sector would have ranked much lower on the UK financial conduct agenda than consumer mis-selling, client asset segregation and market transparency, but institutional investor protection has now been placed firmly on the FCA’s syllabus.
Overall, the regulation is more principles-based than prescriptive. The regulation also acknowledges the need to calibrate various compliance procedures to the nature, scale and complexity of the fund manager’s business.
However, the greater the weighting of principles against rules, the greater the uncertainty for firms and the greater the potential for inconsistent and retrospective regulation.
Because of the broad application of the directive, staying on the right side of regulatory good practice is liable to be a disproportionately costly exercise for smaller funds.
The Commission’s impact assessment confidently asserts that, despite widespread industry complaints, “it seems” that the directive attracts funds business to the European Union, so that “the benefits of the directive seem to outweigh costs by far”.
However, whilst offshore funds have the choice of opting in to directive compliance, the converse is not true of European managers and cost-conscious investors may well start investing exclusively in offshore or non-fund structures that attract a lighter regulatory regime. Only once investors have voted with their feet will we be able assert whether the investment community accepts the costs of the anti-Madoff safeguards that the directive imposes.
David Blair is head of financial regulation at law firm Osborne Clarke