Comment: Avoiding the tripwires
Mark Shaw details how to avoid regulatory issues when distributing non-EU funds within the EU
Establishing a full-scope fund under AIFMD is comparatively costly. So, if a manager only wants to access EU capital on a very limited basis, it might make sense to distribute a non-EU fund via private placement, known as NPPR, or possibly by reverse solicitation.
Because AIFMD is not applied uniformly across the EU, and some jurisdictions are less welcoming to non-EU funds than others, the question of NPPR distribution usually focuses on whether or not a particular non-EU fund can be distributed in each member state.
However, the regulatory issues do not end there, and managers seeking to distribute non-EU funds will have to consider several further regulatory tripwires stemming from the Cross-Border Distribution of Funds Directive (CBDF) and the Sustainable Finance Disclosure Regulation (SFDR).
Can we rely on reverse solicitation?
This is probably the most common initial question coming from non-EU managers who are looking to access the EU, hoping to skirt the regulatory burden of registration where they are only seeking to access a couple of investors. It’s a subject that has been in the regulatory crosshairs for some time and has been put to bed somewhat by the CBDF, although not completely.
The issue for non-EU AIFMs is that the Directive makes it clear that “harmonised rules on pre-marketing, should not in any way disadvantage EU AIFMs vis-à-vis non-EU AIFMs”, so while it may not explicitly prohibit reverse solicitation, the definition of “pre-marketing” is so broad and then triggers an obligation to make a regulatory notification for pre-marketing. As such, it would be all but impossible to prove a bona fide case of reverse solicitation from an EU investor that would not trip the pre-marketing rules for an EU AIFM and therefore the same should also apply to a non-EU AIFM.
That said, in a legitimate reverse solicitation situation, given that such investors would be professionals and the fact that it hasn’t been formally prohibited, some managers may still wish to accept such investments on the basis of the negligible risk of enforcement. However, they should remain mindful of the fact that member states are permitted to goldplate AIFMD and the CBDF, so a ban on distribution of a fund from a particular non-EU jurisdiction may apply regardless of the means of distribution.
A handy outcome of the CBDF is that ESMA is required to maintain the following guide for the distribution of funds across the EU and EFTA member states.
Rules on marketing communications
The regulation that accompanied the CBDF introduced specific rules on marketing communications for EU managers to safeguard investor protection. While it has not been specified that these also apply to non-EU managers, given the overarching principles of investor protection and that non-EU managers should not be advantaged, these rules should also be complied with.
Managers issuing marketing communications have a regulatory responsibility to comply with ESMA’s Guidelines on Marketing Communications. On a high-level basis, this means that they will need to ensure:
- All marketing communications must be correctly identified as such, with appropriate disclaimer language
- Risks and rewards must be described in an equally prominent manner
- All marketing communications should be fair, clear and not misleading, regardless of the target investors
- Specific rules on performance disclosures
- There must be clear cost disclosures.
Since this is a prescriptive set of rules, it creates a particular risk for managers who are actively targeting EU investors, since it would be easy for an aggrieved investor to demonstrate non-compliance in the event of a legal dispute with the manager.
The human element
The quirks of AIFMD and its interplay with MiFID as regards fund distribution catch many managers out, regardless of whether they are based in the EU or not. This was somewhat overlooked until Brexit, when the subsequent lack of MiFID equivalence and passporting for UK-based managers drew attention to the fact that fund marketing is a human activity, and those humans that are carrying this activity out within the EU need to be regulated as such.
This can be achieved by using a regulated placement agent, but managers may also wish to be more creative in terms of their hosting solutions, to allow their own sales people to skirt regulation by only having limited conversations with prospects.
Again, as member states may goldplate these rules, this approach should be considered on a country-by-country basis.
As a starting point, managers distributing funds in the EU must comply with the minimum requirements of SFDR, but there is also a risk that they could trip into the disclosure requirements for an Article 8 (light green) fund without realising.
The trigger threshold for Article 8 compliance is where a fund “promotes environmental or social characteristics, among other characteristics”. This is a relatively low bar and could easily cause the manager of the non-EU AIF to have to comply with the draconian precontractual and ongoing disclosure obligations of SFDR.
There is a further risk for managers seeking to avoid being classed as an Article 8 fund, but nevertheless make sustainable investments, as ESMA has highlights in its recent Progress Report on Greenwashing:
“This would not only be a regulatory breach under SFDR but could also give rise to legal risk of misrepresentation. This is a thorny area of risk, so managers seeking to distribute into the EU should ensure that they clearly sit on one side of the ESG fence or the other but meet the correct disclosure requirements under SFDR in any event.
“Non-EU managers seeking to access EU capital often make a rudimentary cost-benefit analysis on private placement versus passporting an EU fund. However, the true costs and risks of private placement are not always immediately clear. While establishing a dedicated EU vehicle may seem more expensive in the short term, the comparative ease of distribution via passporting versus NPPR and the risk mitigation of being able to rely on a third-party AIFM and the other service providers should, at the very least, be seen as a necessary evil.”