Introduction
I am deeply honored and pleased by the invitation to present my observations regarding the European initiatives for the regulation of nonbank financial institutions to this distinguished audience. The topic confronts us with several difficulties. One is how to define nonbank financial institutions. So far there exists no agreement, what a bank is; most European legal systems operate with a definition which is considerably broader than the one used in the U.S.1 But this and other questions of drawing lines appear to be less relevant since the EU Commission in April 2009 presented the proposal for a “Directive on Alternative Investment Fund Managers,” abbreviated AIFMD.2 This proposal narrows the scope of my investigation. It explicitly excludes insurance companies, “credit institutions” and mutual funds;3 they are all subject to existing regulation4 like the UCITS-Directive;5 UCITS being the abbreviation for “undertakings for collective investment in transferable securities,” this is the official definition of mutual funds. The proposal equally excludes the management of pension funds and of “non-pooled investments” such as endowments, sovereign wealth funds or assets held on own account by credit institutions, insurance or reinsurance undertakings.6 The proposal contains a list of the institutions that should be regulated; the enumeration includes hedge funds, private equity funds, real estate funds, commodity funds, infrastructure funds, funds of hedge funds and “other types of institutional funds” like venture capital funds.7 The debates preceding and following the publication of the proposal indicate that the primary targets are hedge funds and—to a lesser degree—private equity funds.8 My paper will first present the content of the proposal. It will then give a short summary of the conflicting views and interests shaping the public debate. In a next step I shall briefly report the legislative reasons or policy objectives motivating the Commission and explained in a lengthy Commission Staff Working Document called “Impact Assessment.”9 Then we have to look at the costs that the implementation of the proposal would entail. From there we look to the other side of the cost-benefit-analysis, followed by a short conclusion.
The Proposal
The proposal is quite ambitious. The draft is designed to generate a comprehensive regulatory framework for a broad range of financial institutions.
At the same time the proposal is not final, many of its articles ask for implementation through rules to be enacted by the Commission10 using the comitology or “Lamfalussy” procedure.11 The basic features can be characterized by the notions of authorization, organization and duties of conduct. The following aspects appear to be particularly important:
The Debate
It is not surprising that this proposal has generated a lively and occasionally controversial debate. It is fueled by contributions from individual funds,40 industry associations,41 regional organizations,42 EU representatives,43 and from academics.44 The summary of these and other comments allows to draw a few general conclusions. First, it appears that among the different categories of financial institutions addressed by the proposal the emphasis is on hedge funds and—to a slightly lesser degree—on private equity and venture capital funds.45 At the same time the conflicting positions can be easily located. The UK is clearly opposed;46 the City of London, where the European hedge fund and private equity activities are concentrated, is afraid that fund managers will leave47 and relocate in places like Zurich or Singapore. Some of the continental Member States like France, Italy and Germany support the proposal48 and the French Finance Minister Christine Lagarde, has asked for even more stringent regulation.49 The main concern is that the returns, which are derived by the fund industry, imply excessive risks which will be increasingly shifted to the budgets of central banks and Member States governments. In their view there are externalities: the bonuses paid in London will in the end have to be financed by the taxpayers in the Member States of the EU. There are two documents which provide for a considerably deeper analysis. The EU Commission has explained its position in a comprehensive “Impact Assessment,” a working document produced by the Commission staff and published in the spring of 2009.50 On the other side, the Financial Services Authority as the consolidated supervisor of the British financial markets and institutions has asked Charles River Associates (CRA), a consulting firm, for an evaluation of the proposal which has been published in October of this year.51 Both documents confirm what is indicated by the mere size of the proposal. This is the fact that the Commission is not just aiming and shooting at one problem to be resolved. The proposal is motivated by several policy objectives which have to be discussed one after the other.
The Policy Objectives
The main concern of the Commission appears to be systemic risk. The Impact Assessment distinguishes two “channels” linking the behavior of funds to the stability of financial markets.52 Through the “credit channel” systemically relevant banks can be directly exposed to the failure of a large fund. This is what had happened in 1998 with Long Term Capital Management (LTCM),53 but at this moment the banks, which had lent several billion dollars to the fund, had sufficient liquidity to rescue LTCM by transforming their loans into equity positions. Even if it is true that there is no evidence that hedge funds were the cause of or contributed to the most recent financial crisis through the “credit channel,”54 the LTCM case illustrates the possibility that a large fund could fail in a moment when the banking system is under stress and thus increase the burden for the central banks and the governments who have to provide liquidity and additional equity in order to prevent the collapse of the financial system. The other link between fund behavior and systemic risk runs through the “market channel.”55 When large hedge funds follow common patterns of leveraging by investing in the same or similar opportunities—this is often called “herding” behavior—and they come under stress, the unwinding of large and similar positions can trigger a vicious circle of a continuing decline of asset prices which requires more and more fire sales into a permanently deteriorating market. It appears to be uncontested that this has happened between 2007 and 2009. The Charles River Associates study concludes a comprehensive analysis56 by stating that the “extent of this selling does appear to have been sufficiently non-trivial to have contributed to a vicious circle of declining prices and for this selling to have had an impact on overall financial markets.”57 The potential of various types of funds to contribute to systemic risk has institutional or “micro” implications. The staff working document comes to the conclusion, that the management of liquidity risks has posed a serious problem for the AIFM sector. In particular for hedge funds and funds of hedge funds the combination of illiquid investments and pressures for deleveraging and for investor redemption has exposed a severe mismatch which has contributed to the present crisis.58
A second concern motivating the EU Commission is investor pro-tection.59 The working document60 refers to a number of studies which document dissatisfaction of institutional investors with the information they receive from hedge funds and with the resulting intransparency of fund behavior and policies.61 The Commission staff is aware that hedge funds do not make public offerings and are rarely selling their securities to retail investors. Even if it is to be assumed, however, that institutional and wealthy individual investors are generally able to look for themselves, the harmonization of a basic set of disclosure and transparency rules could be an improvement. They would relieve the investors from the need to bargain for information and thus allow reduced transaction costs. At the same time a more homogeneous system of transparency might have a beneficial effect on the governance of the fund business; it could reduce conflicts of interest and improve valuation and custody procedures.
Another concern motivating the EU Commission is the efficiency and integrity of financial markets. Hedge funds and private equity funds have been blamed for making excessive use of strategies like “naked” short selling which can undermine the stability of financial markets or may be detrimental to other stakeholders in companies targeted by the funds.62 The staff working document, however, mentions correctly that short selling and other questionable market strategies are not the exclusive preserve of the AIFM sector; regulation requiring more transparency or imposing stricter controls should be addressed not only to the fund industry but to all market participants.63 With regard to the market for corporate control, however, the proposal takes a different position. As mentioned before, the Directive would require a fund which has been designed to acquire controlling shares in companies to inform management, the other shareholders and the representatives of the employees whenever the fund acquires 30 percent or more of the voting rights of a listed or non-listed corporation domiciled in the EU. It is unclear why such a rule would be imposed only upon a specific category of AIFM and not upon other purchasers as well; mandating acquisition transparency should be a rule not only of fund regulation but of the general capital market law dealing with mergers and acquisitions. At the same time it is equally unclear why the threshold triggering the disclosure obligations should be only 30 percent. Laws of Member States provide for a staggered approach, starting at a threshold of 3 percent64 or even 2 percent.65 In addition, the proposal does not appear to take into account that the acquisition of a controlling block of the voting rights triggers the mandatory bid under the Take-Over-Directive;66 it can be argued that this rule provides sufficient protection at least for the other shareholders. The staff working document admits that these issues should be examined and addressed not only for specific institutions, but on a market-wide basis.67
A final problem mentioned by the proposal68 and discussed by the staff working document69 is the corporate governance impact of AIFM after the acquisition of control of a target company. The main concern is that the controlling funds will try to retrieve the liquidity spent for the acquisition by using the assets of the target company to the detriment of creditors, minority shareholders and in particular of the employees who risk to lose their jobs. This can be illustrated by the example of ProSiebenSatl, the second largest commercial television company in Germany. It had been part of the Kirch media empire which failed years ago. The Kirch shares were acquired by two hedge funds. They owned already a Scandinavian television company which they sold to ProsiebenSatl; the acquisition was exclusively financed by debt. The resulting interest liabilities appear to be higher than the profits made by the combined television firms. Therefore ProSiebenSatl dismissed more than a third of its employees, mostly those producing television programs; the own productions are replaced by mostly older films and series bought at low cost on the international market. The viewer rates declined; and there have been questions if the TV license should not be revoked. Cases like these have triggered emotional reactions. Horst Köhler, the German Federal President and former Managing Director of the IMF, has publicly blamed the “monsters” operating on the globalized financial markets. Franz Müntefering, a former Federal Minister of Labor Relations, has famously equaled hedge funds to “locusts”: they come, they eat, they go, and nothing is left. This populist language is inspired by the stakeholder approach which has traditionally dominated the theory and practice of corporate law on the European continent. This tradition, however, is fading: the Regulation introducing the European Stock Corporation70 and the case law of the European Court of Justice71 have opened up the rigid corporate law systems of most of the Member States. Increasingly, business firms enjoy the freedom to chose the Member State and the law of incorporation; if they wish they can avoid burdensome rules of legal capital or of employee participation on corporate boards, there is slow convergence with the U.S. system which emphasizes shareholder value.72 For these and other reasons I do not see the need for corporate governance regulation at the European level, this can and should be left to the Member States. And, in spite of discussing the issue, the proposal of the AIFM Directive in fact abstains from suggesting any corporate governance rules.
The Costs of AIFMD
Charles River Associates73—on behalf of the FSA—presents an estimate of the costs which would be generated by enacting the Commission proposal. This is a valuable approach to a cost-benefit-analysis; but it is not more than a first step. CRA has based its analysis primarily on interviews with representatives of the fund industry. The emphasis is on costs the various categories of funds would have to face under the proposed regime. As the fund industry is generally opposed to the draft it cannot be assumed that the figures given to CRA have been determined in a particular modest and prudent way. Starting from the CRA analysis I suggest taking the following costs into consideration:
Looking at the Other Side of Cost-Benefit-Analysis
To what extent can these costs be compensated by benefits the Directive would generate? This question brings us back to the policy objectives which inspire the proposal83 and confronts with the problem of how these can be quantified. This cannot be discussed in depth here; I have to limit my remarks to the following aspects:
Conclusion
This brings me to the end of my remarks. I have not been able to discuss all the measures suggested in the proposal of an AIFM Directive. The emphasis is clearly on the safety and soundness of the financial system. It is generally agreed that AIF are likely to enlarge the risks affecting the globalized financial markets, and this includes systemic risk. I therefore recommend to enact at least those elements of the proposal which are designed to contain systemic risk.
On the European level, this is documented by the Annex to the Second Banking Directive. It enumerates the activities “integral to banking” which in the continental European tradition constitute the core of banking services.
Commission Proposal for a Directive of the European Parliament and of the Council on Alternative Investment Fund Managers and amending Directives, COM (2009), 207 final (Apr. 30 2009) [hereinafter COD 2009/0064].
4 COD 2009/0064 art. 2 para 2. (d), (f) and (c).
See “Where as” clause (6) to the proposed AIFMD.
Council Directive 85/611, 1985 O.J. (1375/03) as amended by Council Directive 88/220, 1988 O.J. (1100) (EC).
See COD 2009/0064, “Where as” clause (5).
See COD 2009/0064, pp.2 f.
See COD 2009/0064, p.3.
Commission Staff Working Document accompanying the Proposal for a Directive of the European Parliament and of The Council on Alternative Investment Fund Managers and amending Directives 2004/39/ EC and 2009/…/EC; Impact Assessment, COM (2009) 207 (Apr. 30, 2009).
COD 2009/0064: art. 10 para.3; 11 para.5; 12 para.3; 13; 16 para.4; 18 para.4; 24 para.2; 28 para.2.; 31 para.3.
D. Vitokova, “Level 3 of the Lamfalussy Process: An Effective Tool for Achieving Pan-European Regulatory Consistency,” Law & Fin. Market Rev., 158 (2008).
COD 2009/0064 art.2, para.1.
See COD 2009/0064, p.8.
COD 2009/0064 art. 2, para.2. (a).
See COD 2009/0064 clause 6, p.13.
COD 2009/0064 art. 4, para. 1.
COD 2009/0064 art. 5.
COD 2009/0064 art. 6, para. 1.
COD 2009/0064 art. 31 para. 1.
COD 2009/0064 art. 32 para. 1.
COD 2009/0064 art. 10
COD 2009/0064 art. 11.
COD 2009/0064 art. 12.
COD 2009/0064 art. 11 para. 1.
COD 2009/0064 art. 16 and 17.
COD 2009/0064 art. 18 para. 1.
COD 2009/0064 art. 20.
Directive 2003/71/EC of the European Parliament and of the Council on the prospectus to be published when securities are offered to the public or admitted to trading and amending Directive 2001/34/EC, 2003 O.J.{1345/64}.
COD 2009/0064 art. 21.
COD 2009/0064 art. 29.
COD/2009/0064 art. 22.
COD/2009/0064 art. 24.
COD/2009/0064 art. 25, paras. 1 and 2.
COD/2009/0064 art. 25, paras 3 and 4.
See D. Vitkova (supra note 11).
COD/2009/0064 art. 26-28.
COD 2009/0064 art. 31.
COD 2009/0064 art. 33.
COD 2009/0064 art. 35.
Josephine Moulds, Hedge Fund Coupland Cardiff Asset Management threatens to quit London over EU’s Directive on alternative Investment Fund Managers, Oct. 13, 2009; http://www.telegraph.co.uk/finance/news-bysector/banksandfinance!6318583!Hedge-fund-Coupland-CardiffAsset-Management-threatens-to-guit-London-over-EUs-Directive-on-Alternative-Investment-Fund-Managers.html.
European Private Equity & Venture Capital Industry Response to the Proposed Directive of the European Parliament and Council on Alternative Investment Funds Managers (AIFM) (2009), www.evca.eu/uploadedFiles/ ‥ ‘/2009-06-26-ResponsepaperAIFM.pdf.
James Abbot, City warns against ‘narrowly protectionist’ EU AIFM Directive, Sept. 11, 2009, http://www.cityoflondon.gov.uk/Corporation/mediacentre/files2009/City+warns+against+narrowly+protectionist+EU+AIFM+Directive.htm.
Tom Cahill, European Hedge fund ‘Bogeyman’ Rasmussen Says Fees Next Target, Sept. 11, 2009, http://www.bloomberg.com/apps/news?pid=20601085&sid=a5uOy98STxA.
Lucia Quaglia, The ‘old’ and ‘new’ political economy of hedge fund regulation in the EU (2009), www.uaces.org/pdf/papers/0901/guaglia.pdf.
Quaglia, supra note 44, at 5.
Moulds, supra note 40.
As threatened by Coupland Cardiff, supra note 40.
“McCreevy caught in the middle,” Financial Times, August 29, 2009. supra note 45.
Hedge Funds, May 5, 2009, www.ft.com.
Impact Assessment, supra note 9.
Charles River Associates, Impact of the proposed AIFM Directive across Europe (2009), http://www.crai.com/uploadedFiles/Publications/lmpactofAIFMDirective.pdf.
Impact Assessment, supra note 9, at 7 and 64.
CRA, supra note 51, at 76.
CRA, supra note 51, at 88.
CRA supra note 51, at 7 and 64.
CRA supra note 51, at 79.
Impact Assessment, supra note 9, at 87.
Impact Assessment, supra note 9 at 19. The German Bundesbank has expressed similar concerns. See Financial Stability Report 2007, pp. 35 ft. and Financial Stability Report 2008 pp. 34ff. (both reports emphasize the need for more transparency and market discipline).
Directive, supra note 2, at 3.
Impact Assessment, supra note 9, at 19.
EDHEC. Hedge Fund Reporting Survey (November 2008) http://www.edhecrisk.com/edhecpublications/allpublications/RISKReview.2009020S.1125/attachments/EDHEC%20Publication%20Hedge%20Fund%20Reporting%20Survey%202008.pdf. See also, 10SCO, Hedge Fund Oversight; Con sultation Report (March 2009), http://www.iosco.org/library/pubdocs/pdf/IOSCOPD288.pdf.
Impact Assessment, supra note 9, at 21.
Impact Assessment, supra note 8, at 28.
United Kingdom, Spain, Ireland, Germany.
Italy, Portugal.
Directive 2004/25/EC of the European Parliament and the Council of 21 April 2004 on takeover bids, 20040.J. (L142). The Directive requires the Member States to provide for a mandatory bid, but leaves it to their legislation to fix the threshold which will trigger the duty to make a bid. There are more specific rules for takeovers of financial institutions; See Directive 2007/44/EC, 2007 O. J. (1247).
Impact Assessment, supra note 9, at 28.
Directive Proposal, supra note 2, at 3 fn 2.
Impact Assessment, supra note 9, at 21.
Friedrich Kübler, “The Shifting Paradigm of European Company Law,” 11 Colum. J. Eur. L. (2005), 219, 229 ff.
See generally, Case C-212/97 Centros Ltd v Erhvervs, 1999 E.CR. 1-01459. Case C-208/00 Oberseering BV v. Nordic Construction Company, 2002 E.CR. 1-09919. Case C-167/01. Kramere Van Koophandel en Fabrieken VoorAmsterdam v. Inspire Art. LTD, 2003 O.J. (C 275) E.C.J.
This is explained in more details by Friedrich Kübler, supra note 70, at 235 ff.
CRA, supra note 51.
CRA, supra note 51, at 2.
Id. at 3.
Id. at 95. for hedge funds one-off 0.3 bp and ongoing 0.1 bp; somewhat higher figures for private equity and venture capital funds.
Id. at 98 and 10l.
Id. at 99. no burden for hedge funds; 1.5 bp for private equity and 1.9 bp for venture capital funds (all ongoing).
Id. Pp. 104 ff. (20 - 30 bp) and 107 ff. (64 bp).
Kübler, supra note 70.
CRA, supra note 51, at 42.
CRA, supra note 51, at 63.
Supra, III.
CRA, supra note 51, at 43.
Supra III. 1.
Supra, IV. 1.
S. M. Ishmael, “Fitch Warns of Negative ‘Hedge Fund Effect’ on Credit,” Financial Times, June 7, 2007.
A recent example is the Carlyle Capital Corp.; See Hal S. Scott, International Finance (16th ed., 2009), p. 879.
N. Chan, M. Getmansky, S. Haas, and A. Lo, “Systemic Risk and Hedge Funds,” NBER Working Paper 11200 (March 2005).
See the figures mentioned in VI. 1.
See supra note 15.
See supra note 76.
Scott, supra note 88 at 870.
See supra IV. 3.
H. T. C. Hu and B. S. Black, “The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership,” 79 South Cal. l. Rev. (2006) at 876.
H. T. C. Hu and B. S. Black, “Hedge Funds, Insiders, and Decoupling of Economic and Voting Ownership: Equity Voting and Hidden (Morphable) Ownership,” 13 J. Corp. Fin. (2007) at 343.
See supra IV. 4.
Kübler, supra note 70.