PIERRE OBERLE examines the implications and opportunities of the Alternative Investment Fund Manager Directive for managers of Shariah compliant funds in the European Union.
Several European countries have passed specific Islamic finance legislation. This is not the case at the level of the European Union, where there is no legislation relating specifically to Islamic finance. Nevertheless, most EU legislation targeting the financial sector has an indirect impact on Islamic finance business. This is especially true for the new Alternative Investment Fund Manager Directive (AIFM).
The European regulatory framework: a key driver for the growth of Shariah-compliant funds
Some European jurisdictions, such as Luxembourg, are rapidly becoming important domiciles for Shariah compliant funds. There are two main drivers behind this recent interest.
The first is that several financial groups involved in the Islamic funds business in different parts of the world have reached a certain size and want to expand internationally. Having a UCITS product can help them extend their investor base and penetrate new markets. The second driver is client demand for transparency in the aftermath of the global financial crisis.
UCITS and the distribution passport
UCITS stands for “Undertaking for Collective Investment in Transferable Securities”, and derives from a European Directive of the 20th December 1985 that introduced a single EU-wide regulatory regime for open-ended funds investing in transferable securities such as shares or bonds.
One key aspect of UCITS is the “European passport,” which makes it easy for a fund domiciled in one EU country to be sold to investors in all the others. Over the years, UCITS has become a strong global brand, and these funds are now widely accepted in non-European jurisdictions.
Luxembourg has emerged as the leading cross-border distribution center with 75% of all cross-border UCITS registrations belonging to Luxembourg funds. Today Luxembourg-domiciled investment structures are distributed in more than 65 countries around the globe, with a particular focus on Europe, Asia, Latin America and the Middle East. Ease of international distribution is a key driver in the development of Shariah compliant funds in Europe.
AIFMD: Europe’s answer to the financial crisis
The second driver is the demand for transparency and increased investor protection which resulted from the financial crisis. The trend in the financial sector is now towards high quality regulation.
This is what an increasing number of investors expect and what Europe has to offer. Indeed, a trend for relocating offshore funds onshore has been observed over the past three years and well established European domiciles such as Luxembourg have been among the clear beneficiaries of such fund migrations.
A consequence of the financial crisis is that regulators and policy makers all over the world have taken action to enforce greater transparency, better client information and ultimately better protection.
The G20 has decided that there should be no unregulated managers or products in the marketplace: the United States answered with the Dodd-Frank Act and Europe’s answer was a new Directive called the Alternative Investment Fund Managers Directive, better known under its acronym: AIFMD.
The Directive was finally approved by the European Parliament on the 11th November 2010 and was published in the Official Journal of the European Union on the 1st July 2011 after 26 months of intense debate and negotiations between the European Commission, the European Council of Ministers and the European Parliament. Member States now have a period of two years to transpose it into national law.
The new regulatory regime will therefore only enter into force on the 22nd July 2013. In the meantime, ESMA (the European Securities and Markets Authority) is working on technical advice to the European Commission on possible implementing measures.
ESMA published a 438-page consultation paper that sets out the proposed rules for the organization of firms under the AIFM regime. It also includes depository, leverage and transparency requirements, which will support the functioning of the Directive when it will be enforced.
This article will not go into the details of the Directive nor of the 438 pages consultation paper but rather focus on the point directly impacting the managers of Shariah compliant funds, i.e. the distribution aspect.
The scope for EU and non-EU managers
The scope of the Directive is pretty large. It is applicable to all managers of non-UCITS collective investment schemes “which raise capital from a number of investors with a view to investing it in accordance with a defined investment strategy for the benefit of those investors”.
Managers of non-UCITS Shariah compliant funds will therefore also be covered by the Directive. Indeed, this Directive is designed to regulate all managers involved in activities that are not compliant with UCITS rules, such as real estate, private equity and hedge funds. A large number of Shariah compliant funds invest in real estate or private equity so this Directive will have a direct impact on them.
The Directive will be applicable to AIFM established in the EU but also outside the EU if they manage or distribute funds to professional investors within the European Union. Non-European Shariah compliant fund managers targeting or looking to target a European client base should therefore be aware of the potential impact the AIFMD will have on their strategy.
The definition of a “professional investor” as used in the AIFM Directive is the definition of a “professional client” from the MiFID Directive. Investment firms, credit institutions, insurance companies, UCITS, pension funds, central banks and national governments all fit into this category. Retail clients may also be treated as professionals on request if certain criteria are met.
A new distribution passport
Currently, alternative investment funds are regulated at national level and managers willing to market their funds in the European Union have to face up to 27 different authorization regimes. The good news is that the AIFMD will put an end to this by setting up a single authorization regime.
Once authorized, the EU managers will be entitled to market the EU AIF that they manage to professional investors, using the simplified regulator-to-regulator notification mechanism established under UCITS Directive.
Just like UCITS, these funds will therefore also be granted a European passport and this passport will also, at a later stage, be available to non-European managers and funds that comply with comparable regulation. The passport will initially (from the 22nd July 2013) be accessible only to EU alternative investment fund managers managing and distributing EU-domiciled AIF within the European Union.
After a period of four years after the entry into force of the Directive, i.e. not before 2015, and dependent upon an additional decision by EU Institutions (the European Securities and Markets Authority-ESMA and the EU Commission), non-EU funds and managers may also benefit from the passport if they comply with all the provisions of the Directive.
During this period of four years and up to 2018, existing national private placement rules (with a few additional AIFMD requirements) will continue to apply to funds being marketed in the EU without a passport.
Between 2015 and 2018, non-EU funds and managers will have the possibility either of benefitting from the passport, if they comply with the requirements of the Directive, or distributing without the passport, on the basis of national private placement rules.
In 2018, three years after the granting of the passport to non-EU AIF and non-EU AIFM, the Commission will, on the basis of an opinion of ESMA, decide on the termination of national private placement regimes.
The question of the distribution passport and the treatment of non-EU AIF and non-EU managers generated a significant number of discussions. Policymakers had to balance two objectives: ensuring a level playing between local and foreign managers and avoiding the creation of trade barriers.
At the beginning of the discussions on the Directive, some expressed the concern that the industry might end up in a “Fortress Europe” and “Prison Europe” situation, whereby non-EU based alternative managers would not be able to market their funds in the EU, and EU residents would not be able to buy offshore funds.
The issue has been solved by creating a dual system that allows the existing private placement rules to continue until at least 2018, while phasing in an option for non-EU funds and managers to benefit from the passport if they meet the requirements of the AIFM Directive.
It should also be noted that the Directive does not apply to what is called “reverse solicitation” (i.e. passive marketing). Professional investors can therefore still invest in funds at their own initiative, no matter where the fund or the manager is located. In addition, the AIFM Directive also offers the possibility of delegating certain activities, including portfolio management or the risk management function, to a non-EU entity.
UCITS is, and AIFMD will be, a truly European project with a common goal: quality products made in Europe. Despite the initial concerns, AIFMD will not create a “Fortress Europe”: non-European Shariah compliant fund managers will still be able to target European investors.
The new framework that is being put in place via the Directive and its implementing measures, and in particular the distribution passport, will certainly reinforce the attractiveness of European domiciles for Shariah compliant funds and also accelerate the re-domiciliation of funds from offshore centers to European domiciles such as Luxembourg.
Pierre Oberlé is the business development manager of the Association of the Luxembourg Fund Industry (ALFI). He can be contacted at
[email protected]
.