Cross border regulatory implications for alternative investment managers
By Michelle Bedwin, Coremont
Published: 22 March 2021
Since the financial crisis of 2008, there has been a shift away from internationally agreed standards and principles. De-globalisation has picked up pace with COVID 19 and events such as BREXIT, resulting in regulators and policymakers becoming increasingly focussed on national legislation.
Alternative Investment Managers now have to perform a detailed analysis of the cross border implications of licensing, regulatory reporting, compliance monitoring and marketing rules, even if their sole activity is managing an offshore hedge fund. This article will consider these topics in turn and will provide clarity to Alternative Investment Managers grappling with numerous and sometimes contradictory requirements.
It makes sense that as soon as an Alternative Investment Manager plans to manage external money that they obtain the appropriate regulatory licensing in the jurisdictions in which they are located. Alternative Investment Managers located in the US will need to register with the SEC as Investment Advisors as soon as they meet the threshold AuM. Until then, reliance can be placed on applicable state registrations. It is the same situation in Hong Kong and Singapore with the SFC and MAS respectively being responsible for the licensing of Alternative Investment Managers. Also, there is an expectation by these regulators (and all major regulators) that there will be an individual located in the jurisdiction, responsible for compliance oversight.
In the European Union, it is a little more complicated. Alternative Investment Managers need to be licensed either as an Alternative Investment Fund Manager (“AIFM”) with MiFID ‘top ups’ or as a MiFID Firm. AIFMs that are responsible for portfolio management and risk management of an Alternative Investment Fund (“AIF”), which is any fund that is not a UCITS, will be currently out of scope for real time and T+1 MiFID reporting. However, Alternative Investment Managers require an AIF if they are to be licensed as an AIFM. If there is no AIF, Alternative Investment Managers need to be licensed as MiFID Firms. Interestingly, the French regulator is allowing AIFMs up to a year to launch an AIF, which may be an option for Managers who would like valuable ‘passporting rights’ that are only available to EU domiciled funds without the reporting obligations.
One of the implications of BREXIT is that Alternative Investment Managers with EU UCITS funds, who are licensed as MIFID Firms, have lost their MiFID passports, and must therefore ensure that any UCITS funds that they manage are ‘passported’ into the relevant EU country, or use a local intermediary to sell the UCITS in that country. UK Managers are no longer able to act as UCITS Management Companies and most Managers have opened an office in the EU if they did not already have an EU presence.
Alternative Investment Managers, at the same time as organising local licensing, must register as a Commodity Pool Operator (“CPO”) with the CFTC pursuant to CFTC Rule 4.7 (a) if the fund is trading more than a de minimus level of specified listed derivatives and swaps. This requirement applies if there is a single underlying US investor in the fund. Even if the manager can rely on an exemption, because initial margin and premiums and net notional value of positions do not exceed 5% or 100% respectively of the liquidation value of the fund, there is still a requirement to file a 4.13 exemption annually. It should be noted that derivatives on single name securities fall under the jurisdiction of the SEC and it is common for an Alternative Manager to be regulated by both the CFTC and SEC.
Also from a US perspective, an Alternative Investment Manager with no US presence must register as an Exempt Reporting Adviser with the SEC when reaching a certain threshold in respect of US investors and will be subject to the same US requirements on areas such as Pay to Play and the US Advisers Code of Ethics.
It should not be forgotten when considering licensing whether any trading or sales staff are working overseas during the COVID 19 pandemic as there may be licensing, legal and tax implications if staff are working overseas even for a fairly short period of time.
Regulatory Reporting and Compliance Monitoring
Alternative Investment Managers are subject to numerous regulatory reporting requirements, even to regulators in jurisdictions where they have no physical presence or investors. This includes the reporting of short and long positions to the regulator of the jurisdiction in which a security is listed, including US 13F and 13G reports. Regulators are able to sanction Alternative Investment Managers directly, or work with the home regulator in respect of any fines. These can be sizeable and also result in reputational damage. Regulation SHO, in respect of US short positions, applies to US Investment Advisors and indirectly to foreign investment advisors dealing with US Broker Dealers who are subject to these requirements in respect of marking short positions.
Depending on the instruments being traded, there may also be position limits dictated by the exchange on everything from BitCoin (with futures on some crypto assets being treated as commodity interests by the CFTC) to corn derivatives limits. These limits are at the manager level and must be aggregated and monitored closely.
Similarly, market abuse surveillance should be implemented using the relevant regulatory requirements considering the jurisdiction of listing. For example, the UK standards should be followed when trading UK listed instruments. Generally, the Alternative Investment Manager should adhere to the highest applicable standards and perform automated monitoring as per the UK rules even if there is no UK presence or UK investors.
If the Alternative Investment Manager is a CPO, quarterly CPO PQR will apply.
If the Alternative Investment Manager is an AIFM in the EU, then EMIR reporting (which is often delegated to brokers) will apply but SFTR reporting (the equivalent of EMIR for Securities Financing Transactions (SFTs)) will only apply if the UK manager has EU domiciled funds.
Form PF is only applicable to US based managers and AIFMD Annex IV is only applicable to AIFMs (even non-EU AIFMs) that are marketing funds within the EU and the UK.
Increasingly marketing needs to be reviewed on a country by country basis. Even within the EU, there are different definitions of marketing within AIFMD. The UK and the Netherlands have narrow definitions of marketing, so that marketing only takes places when providing offering documentation. Other EU countries such as Spain and Italy have much wider definitions. As well as the definition of marketing, MiFID passports, or lack of them, need to be considered before reviewing product-specific directives such as UCITS and AIFMD.
Just as the definition of marketing varies, ‘reverse solicitation’, where an investor approaches the manager of its own accord, is not recognised in some jurisdictions in Europe. Regulators are increasingly paying attention to Alternative Investment Managers who rely on reverse solicitation, which falls outside of AIFMD marketing rules. Indeed, ESMA commented recently on “questionable practices”.
As mentioned above, UK managers are having to use local intermediaries where a fund is not passported post BREXIT. It should be noted though, that in some countries such as Finland, unregistered UCITS are prohibited from being marketed irrespective of MiFID passports.
Looking across the Atlantic, US (Rule 506(c)) (part of Volcker Rule / Dodd-Frank) prohibits general solicitation of any private fund (most alternative funds) including press releases without being referenced in an ADV. Most Alternative Investment Managers rely on Regulation D in respect of funds but there are still various Blue Sky rules at the state level where filings must be made each time a fund receives a new investor.
To conclude, it looks like the situation will become even more complex in the future. Although financial services regulation did not receive significant attention during the 2020 election campaign, the Democratic control of congress is likely to bring new regulatory and enforcement priorities in respect of Alternative Investment Managers. In Europe, UK regulation will continue to diverge from the rest of the EU and it is unclear as to how regulation will evolve in Asia especially in respect of the situation in Hong Kong. Managers are advised to ensure they continue to invest time and energy in navigating an ever evolving, complex regulatory landscape. Please contact Michelle Bedwin to understand how Coremont helps its clients address these challenges.