Quarterly Funds Update: Autumn 2014
Published on 23rd Oct 2014
Our Quarterly Funds Update looks at issues affecting fund managers, investors and advisers in the alternative asset space. In this edition, we discuss:
- The impact that the new MIFID II rules on inducements are likely to have in the sector.
- The increasing benefits of the EuVECA regime in view of the tougher private placement regimes being enacted in various EU Member States.
- The impact that a recent Supreme Court decision, which will classify many LLP members as “workers“, may have on fund managers who are structured in that way.
MIFID II: accepting payments from third parties
The revised Markets in Financial Instruments Directive (“MIFID II”) includes rules prohibiting firms which provide independent investment advice or portfolio management services from receiving payments from third parties. We look at the practical impact which this may.
The inducement and conflict of interest rules under the original Markets in Financial Instruments Directive (“MIFID I”) have been strengthened under the new MIFID II measures, as supplemented by the proposed guidance from the European Securities and Markets Authority (“ESMA”). The primary change under the new regime is that firms providing independent advice or portfolio management will be prohibited from receiving payments from third parties. This is based on the potential for such payments to create conflicts of interest by influencing manager/adviser behaviour. The UK has already gone beyond what was required in relation to inducements under MIFID I, through implementing the Retail Distribution Review or “RDR” reforms, but the MIFID II changes go beyond this, and are likely to have the most impact on portfolio managers (which are not currently subject to the RDR unless they also offer advisory services).
Under the new rules, clients must be provided with information on all costs and associated charges (including the cost of advice). As a starting point, firms providing portfolio management or independent advice may not accept or retain any payments or other monetary or non-monetary benefits from third parties. After much negotiation, some minor non-monetary benefits will be permitted to be received by firms, but only if they are disclosed to the client. In addition, no fees or benefits must be paid to anyone except the client, unless such payment enhances the service provided to clients, and does not impair the firm’s duty to act in the client’s best interests. ESMA guidance on this point suggests that “non-monetary” must be interpreted very strictly, in the sense that any benefits which are likely to influence the recipient will not be allowed. The ESMA guidance suggests specifically listing any non-monetary benefits which are permitted under the carve-out for minor non-monetary benefits: these could include training on the features of a particular product, de minimis hospitality at a seminar or training event, or information on a particular instrument (such as investment research in limited circumstances). ESMA has suggested that providing investment research (e.g. by brokers to portfolio managers) without charge may be seen as an inducement, and firms will only be able to continue providing such research for “free” in certain prescribed circumstances.
Although these rules will not apply to alternative investment fund managers (AIFMs) in the context of their fund management businesses, they will apply to those firms in the industry still operating as MIFID firms, for example those providing discretionary investment management or investment advisory services to a separate AIFM, to segregated mandates or in EIS fund structures, and also to those financial advisers or placement agents who facilitate the marketing of many funds. ESMA has also suggested the extension of these rules to cover managers of funds (under AIFMD and UCITS) in due course. Although many of the inducement rules in MIFID II are effectively already applied to firms in the UK as a result of the RDR (which gold-plated the existing MIFID I requirements), this will be the first time that such rules have applied to discretionary investment managers. The rules applicable to independent advisers will also be extended, with the biggest impact for those firms probably being on the ability of such firms to have the fees due to them from their clients for advice relating to fund investments facilitated from the fund rather than directly from the client. In a fund context, fees paid by portfolio companies to an adviser or investment manager for administrative services e.g. director services or monitoring may be impacted, as will structures (for example some EIS funds) where management or performance fees are facilitated by the portfolio company rather than the fund vehicle or investors themselves. In these instances, simply disclosing (or setting off) the fees would not suffice.
Although the text of MIFID II has now been finalised, the timeline for implementation means that the above rules will not have effect until January 2017. Various issues relating to the inducement rules have not yet been substantively addressed in the guidance, and further detail may be available in the next round of ESMA consultation, expected in late 2014 to early 2015 and/or the draft implementing measures due to be published by the FCA no later than July 2016.
For further information or assistance with any of the issues highlighted above, please contact a member of the Osborne Clarke team.
EuVECA
Many EU Member States have used the AIFMD as a trigger to implement tough private placement regimes for funds not managed by a full-scope AIFM, meaning in practical terms that it is no longer possible to market such funds in many jurisdictions. The EuVECA regime, which allows sub-threshold venture capital fund managers to obtain a passport allowing for EU-wide marketing, is therefore becoming increasingly attractive. We take a brief look at the regime, its advantages and implications and current take-up amongst venture capital fund managers.
ESMA’s database shows that 12 managers have so far registered as European Venture Capital Fund Managers under the European Venture Capital Funds Regulation (“EuVECA”). The majority of the registered fund managers are UK based. These managers form the vanguard of sub-threshold fund managers that are using the EuVECA brand and are able to market their venture capital funds throughout the European Union without opting for full compliance with the Alternative Investment Fund Managers Directive (“AIFMD”).
Under Article 3(2) of the AIFMD, alternative investment managers (“AIFMs”) managing alternative investment funds that are either (i) leveraged with assets below €100 million or (ii) unleveraged with assets below €500 million and at least a five year lock-in period, may opt to remain outside of scope of the AIFMD. The disadvantage of being out of scope is that the AIFMD passport for marketing to other EU Member States is not available.
For a long time the assumption was that sub-threshold AIFMs would be able to access markets in the European Union using national private placement regimes. However, in practice some Member States (notably The Netherlands and Germany) have abolished their existing private placement regimes and not introduced new regimes for sub-threshold AIFM whilst other Member States (such as France) have imposed tougher conditions than were in place previously or have not clarified the rules applicable to sub-threshold AIFMs. In any event the current variation between Member States and legal uncertainty surrounding the status of national private placement regimes (together with the prospect that private placement for sub-threshold AIFMs will be prohibited altogether in 2018) have meant that marketing in the EU outside the scope of the AIFMD has become a costly legal and operational exercise. Opting-in to full AIFMD compliance is considered too burdensome to be a real alternative.
For any manager wishing to raise a venture capital fund with European investors, registration under EuVECA could therefore prove an attractive option. The EuVECA regime, available to sub-threshold EU AIFMs, provides an EU-wide marketing passport broadly equivalent to that available under the AIFMD, but with a lighter touch regime in terms of required capital, conduct of business rules and reporting.
In order for a fund to qualify as a EuVECA fund, the fund must be established in the EU and invest at least 70% of its aggregate capital contributions in assets that are “qualifying investments“. “Qualifying investments” include various equity, quasi-equity and debt interests in, or relating to, “qualifying portfolio undertakings” situated in any EU Member State or a third country provided it is not listed as a non-cooperative country by the FATF and it complies fully with the OECD Model Tax Convention.
The definition of “qualifying portfolio undertaking” corresponds to the EU definition of small and medium sized enterprises. These conditions should be easily met by any genuine venture capital fund.
The obligations imposed on any manager registered under the EuVECA regime are fairly light touch, requiring for example:
- an annual report for each qualifying EuVECA fund to be sent to the home state regulator within six months of the financial year end; and
- providing investors (prior to investment) with a checklist of certain information covering the manager’s own funds, a description of the fund’s investment objective and strategy, risk profile and valuation procedure and a description of all relevant costs and how the manager’s remuneration is calculated.
In terms of marketing, the EuVECA passport is more favourable in some respects than the AIFMD passport. Managers are able to market not only to investors considered “professional clients” under MIFID, but also to certain other sophisticated investors, provided they make a minimum investment of €100,000 and provide a written statement acknowledging the risks associated with such an investment. There is also a specific prohibition in the EuVECA Regulation on individual Member States imposing additional administrative burdens which may prevent any marketing under the EuVECA passport in practice.
In terms of service providers, there is currently no requirement for a EuVECA fund to appoint a depositary (although the European Commission will consider this as part of its review before 22 July 2017).
For UK-based sub-threshold AIFMs, the FCA has published a straightforward application form to be completed in order for a firm to register as a EuVECA manager. As the realities of marketing sub-threshold funds on the basis of the national private placement rules in various Member States emerge, venture capital firms would be well advised to consider whether to make such an application and take the benefit of the EuVECA passport. The consequent impact on structuring and investment restrictions mean that this decision should be taken at the outset of any new fund project.
For further information or assistance with any of the issues highlighted above, please contact a member of the Osborne Clarke team.
LLP members recognised as “workers”
A recent Supreme Court decision has resulted in the classification of many LLP members as “workers“. Although the case in question related to whistleblowing legislation, the anticipated impact is wide-ranging in terms of protections previously thought inapplicable to LLP members. We consider the practical impact of this decision on fund managers and advisers who are structured as LLPs.
On 21 May 2014 the Supreme Court ruled[1] that members of an LLP may in certain circumstances be “workers“. The case in question concerned a whistleblowing claim brought by a partner in a law firm (the firm being structured as an LLP). The Supreme Court concluded that the claimant was a worker for the purposes of the Employment Rights Act 1996, and as such was entitled to the statutory protections afforded by that Act.
However, as well as creating safeguards for members bringing whistleblowing claims, this decision has much wider implications for LLPs and their members. In reaching their conclusion that Ms van Winkelhof was a “worker“, the Court focused on the fact that she could not market her services as a solicitor to anyone other than the LLP of which she was a member, and was an integral part of its business (they were in no sense her client or customer). Commentators have since concluded that a large number of LLP members are likely to be classified as workers as a result (although this will always depend on the particular facts).
As a result, members are now likely to have a variety of new rights which are available to “workers“, including the right to paid annual leave; the right not to be treated less favourably if they work part time; and the right to be auto-enrolled in a qualifying pension scheme. The position of LLP members under the auto-enrolment legislation is not straightforward, and in particular it is unclear whether a member’s drawings from an LLP may fall outside the definition of qualified earnings for these purposes. However, the consensus amongst practitioners seems to be that, given the definition of “jobholders” in the Pensions Act is so similar to that of “workers” in the relevant employment legislation, LLP’s taking a risk averse approach should probably include their members as well as their employees in their auto-enrolment programme.
It is important to remember, however, that this decision does not make LLP members “employees” in the wider sense, and they will, not as a result, have the benefit of employee protections such as the right to claim unfair dismissal. It is also unrelated to the new “deemed employment” rules which came into effect on 6 April 2014 and which classify certain LLP members as employees for the purposes of taxation, as discussed in our Winter 2013 Update.
For further information or assistance with any of the issues highlighted above, please contact a member of the Osborne Clarke team.
[1] Clyde & Co LLP and another v Bates van Winkelhof [2014]
