Cross-border distribution: Ready for the next step?

This article was originally published in Agefi Luxembourg, November 2020 and is reproduced with permission from the publisher.

Introduction

AIFM and UCITS Directives largely built their success on the introduction of the marketing passport and the creation of a common regime for investment funds distribution whereby a product could be distributed across the EU market on the basis of one single authorisation.

Several years after the implementation of such regimes, despite significant progress, there is strong evidence that things are not operating efficiently. The investment funds market is still largely fragmented along national lines. According to analysis carried out by the European Commission in 2018,¹ 70% of assets under management of investment funds are sold only in their domestic markets, only 37% of UCITS and about 3% of AIFs are available for sale to more than three Member states. The analysis has further shown that regulatory barriers (namely national marketing requirements, regulatory fees, administrative requirements and notification requirements) represent a significant disincentive to cross-border distribution: the average of the regulatory costs related to cross-border distribution ranges between 1% to 4% of the overall fund expenses.

These long and deep-rooted obstacles standing in the way of cross-border distribution are inconsistent with the key objective of the Capital Market Union to build a single market for investment funds. Therefore, it comes as no surprise that the Council and the European Parliament adopted a package of reforms aimed at reducing the barriers to cross-border distribution of investment funds – which arose in large part due to differing interpretations of the rules applicable to the use of the marketing passports under the AIFM and the UCITS Directives across Member States.

The package of reforms, originally proposed by the EU Commission in March 2018, was published in the OJEU on 12 July 2019 and is comprised of Directive (EU) 2019/1160 regarding the cross-border distribution of collective investment undertakings and Regulation (EU) 2019/1156 on facilitating cross-border distribution of collective investment undertakings. The changes will largely take effect from 2 August 2021.

Setting the scene – key provisions at a glance

With the introduction of the new cross-border distribution package, the EU Commission’s objectives are multiple: enhance market efficiency, improve transparency of national requirements, remove overly complex and burdensome requirements and harmonise diverging national rules with a view to strengthen single market for investment funds while safeguarding investor protection. The intention is also to align the operation of the marketing regimes and the rules resulting from different regulatory frameworks for investment funds (AIFM, UCITS, EuVECA, EuSEF, ELTIF).

The new rules provide for a harmonized definition and conditions of pre-marketing (which will undoubtably affect the ability for managers to rely upon reverse solicitation), a new procedure for de-notification of marketing (including restrictions on pre-marketing successor funds), a greater transparency and high-level principles for calculating regulatory fees, create a central database on cross-border marketing and modify the rules applicable to marketing communication requirements.

Harmonised pre-marketing regime

A significant criticism addressed to the existing AIFMD marketing framework is the different interpretation of the term “marketing” across Member States, resulting in the inconsistent ability for managers to pre-market across the EU in order to test the investors’ appetite for an investment strategy, before establishing and finalising the terms of a fund. In some jurisdictions (which is notably the case in Luxembourg) marketing is considered to occur at a relatively late stage when the offer of interests in an AIF is capable of being accepted by investors on the basis of final form subscription document. In other jurisdictions, marketing is considered to occur at an early stage in the investment process, rendering practically impossible the possibility to approach investors to assess demand in these jurisdictions. To address this issue the new rules introduce a new harmonised pre-marketing regime into AIFM Directive (the EuVECA and EuSEF Regulations are similarly amended) – the EU Commission will report by 2 August 2023 on the merits of applying a similar pre-marketing regime to UCITS.

Pre-marketing is broadly defined as the “provision of information or communication, direct or indirect, on investment strategies or investment ideas by an EU AIFM or on its behalf, to potential professional investors domiciled or with a registered office in the Union in order to test their interest in an AIF or a compartment which is not yet established, or which is established, but not yet notified for marketing in accordance with Article 31 or 32, in that Member State where the potential investors are domiciled or have their registered office, and which in each case does not amount to an offer or placement to the potential investor to invest in the units or shares of that AIF or compartment.”

In that context, a new Article 30a will be included in the AIFM Directive setting out harmonised conditions for pre-marketing, which require that any information presented to potential professional investors by an EU AIFM must not: (i) be sufficient to allow them to commit to invest; (ii) amount to a subscription form or similar (in draft or final); nor (iii) amount to final form constitutional documents, a prospectus or offering documents of a not-yet-established AIF. Managers will be able to provide a draft prospectus or offering document to potential investors. However, this is with the proviso that it does not “contain information sufficient to allow investors to take an investment decision.” Draft documents will also need to clearly reflect that they are not an offer or invitation to subscribe, with a warning that information therein should not be relied upon because it is incomplete and may be subject to change.

Where applicable, AIFMs will need to send a notification to their local home state regulator within two weeks of beginning their pre-marketing. The notification must specify where and for which periods the pre-marketing is taking (or has taken place), with a brief description of the pre-marketing. This notification of pre-marketing is distinct from the AIFM Directive marketing process and AIFMs will not be able to accept subscriptions from investors contacted through pre-marketing activity without first completing the formal AIFM Directive marketing process. In addition, any subscription made within 18 months of pre-marketing activity will be considered the result of marketing, for which a marketing filing must be made. Consequently, commencing any pre-marketing activity will preclude reliance on reverse solicitation for a period of 18 months.

New procedure for de-notification of marketing

There has been considerable uncertainty and divergence of practices across the EU in relation to when an AIFM marketing under the AIFM Directive marketing passport may discontinue marketing. The new rules introduce a formalised procedure for discontinuing marketing. Managers will be able to discontinue marketing a fund in a particular Member State provided that a de-notification filing is made with its home state regulator and that the following conditions are fulfilled (i) making a blanket offer to repurchase or redeem units held by investors in that Member State (free of any charges or deductions) which is publicly available for at least 30 working days and is addressed individually to all investors in that Member State whose identity is known (this condition does not apply to closed-ended AIFs); (ii) publicising the intention to terminate marketing arrangements; and (iii) terminating or modifying any relevant contracts with financial intermediaries to ensure they do not continue to market those units.

Once an AIF is de-notified from marketing, the AIFM may not engage in pre-marketing that AIF, nor another AIF with a similar investment strategy or investment idea, in that Member State for a period of 36 months from the date of denotification. It is likely that this is going to raise concerns especially for closed-ended funds. In the absence of helpful regulatory guidelines on the topic, AIFMs will likely to choose not to deregister any funds in practice, and accept to continue paying the related ongoing regulatory fees in order to not be affected by the pre-marketing of a successor fund.

Regulatory fees and charges

With effect as from 1 August 2019, any regulatory fees or charges needs to be consistent with the overall cost relating to the performance of the functions of the competent authority. In addition, competent authorities must publish a list of all fees or charges or, where applicable, relevant calculation methodologies, on their websites. The European Securities and Markets Authority (ESMA) will then maintain a centralised collection of hyperlinks to those relevant pages on its website by 2 February 2022.

Central database on cross-border marketing

Competent authorities will have to publish and maintain on their websites complete information on all national laws, regulations and administrative provisions governing marketing requirements for AIFs and UCITS, and summaries thereof. Competent authorities will have to notify such information to ESMA, which will in turn be required to maintain a central database of summaries of and links to all national provisions, by 2 February 2022. By 2 February 2022, in addition to the central database it already maintains for AIFMs and UCITS management companies, ESMA will be required to publish on its website a central database of all AIFs and UCITS marketed in a Member State other than their home state, along with details of their relevant manager and a list of all the Member States in which they are marketed.

On 1 February 2021 the ESMA issued its final report on implementing technical standards under the Regulation on cross-border distribution of funds, which deals with the publication of information by national regulators on their websites and their notification of information to ESMA, as well as the publication of information by ESMA on its website. The European Commission will decide whether to adopt the final report within three months.

Marketing communication

UCITS management companies, AIFMs, EuVECA managers and EuSEF managers must ensure that all marketing communications addressed to investors are identifiable as such, describe the risks and rewards of purchasing units or shares in an equally prominent manner, and that all information included in marketing communications is fair, clear and not misleading. Statements in marketing materials must not contradict or diminish the significance of information in other communications to investors (prospectus/key investor information, Article 23 disclosures). Marketing communications will also have to specify where, how, and in which language investors and potential investors can obtain a summary of investor rights, and provide a hyperlink to such a summary that must include, as appropriate, information on access to collective redress mechanisms at EU and national level in the event of litigation. To verify compliance with marketing provisions, competent authorities will be able to require prior notification of marketing communications used by UCITS management companies, and by AIFMs, EuVECA managers and EuSEF managers where their funds are marketed to retail investors; however, this requirement for prior notification does not amount to a prior condition for marketing. A competent authority will have ten working days following receipt of notification to request that a manager amend its marketing communications.

A welcomed package generally perceived as a source of operational simplification and harmonisation.

From our experience with investment funds distributed on a cross-border basis and their managers, the new package clearly addresses some concrete operational issues relating to the possibility, and under which condition, to test the appetite of potential investors for a new product (without certainty that it will ultimately be launched) without triggering the application of the full scope of marketing rules, in particular those relating to the notification formalities to be carried out and related costs.

Before the new regime, we were regularly consulted by clients to provide legal advice and analysis aimed at clarifying the marketing and pre-marketing regimes applicable, on a country-by-country basis. Sometimes clients even needed advice in each target jurisdiction considering lack of transparency of applicable rules. Even if fund managers need to bear in mind when using pre-marketing that they should not offer potential investors the opportunity to subscribe in shares/units of the pre-marketed fund, the new regime is a source of operational simplification and harmonisation and is clearly perceived as such by the market.

However, and based on the feedback received from the market, players are not necessarily well informed about the new package and a significant level of awareness-raising still needs to be done. A lot of interest emerged in 2018 after the issuance of the proposal by the European Commission but has since dropped in light of the regulatory wave on the agenda, among which one can mention GDPR, AIFMD and MiFID reviews, or more recently the Sustainable Finance disclosure regulation and the Taxonomy regulation to name a few.

Some concerns started to emerge, from US managers in particular seeking advice in relation to reverse solicitation and how it will operate going forward.

With an application date as of 2 August 2021 for the key changes, at the middle of a summer which could see some travelling again after months of lockdown, investment funds’ industry readiness needs to swiftly move from an awareness-raising stage to an implementation one.

A far-reaching text with a number grey zones / attention points – towards the end of reverse solicitation?

The investment fund industry will undoubtedly welcome the streamlining and increased transparency of the new EU cross-border regime. The package on the table clearly has the potential to reshuffle the cards in the way players distribute their funds. But a number of points need to be born in mind, and some grey zones must be dealt with carefully.

First the new regime is restricted in its scope. The new rules do not extend to the pre-marketing of non-EU investment fund by EU AIFMs or investment funds by non-EU AIFMS, which is a very relevant restriction to Luxembourg where numerous US and Canadian fund managers operate. As such, these players – if and when acting as AIFMs – will need to deal with individual local rules, when they exist. To ensure a level playing field, non-EU AIFMs cannot be treated more favourably than EU AIFMs by Member States. Therefore, the new pre-marketing rules – and particularly the new two-week notification requirement – may possibly also apply to the pre-marketing of non-EU investment funds by EU AIFMs and investment funds by non-EU AIFMS, but individual Member States are left to determine their own position in that respect.

The new rules are also intended to constrain the route of reverse solicitation. Any subscription by professional investors, within 18 months following the start of pre-marketing, will be considered as resulting from active marketing and therefore will trigger the application of the AIFM Directive marketing rules. This irreducible 18-month period was introduced as a way to enable the national competent authorities to exercise control over pre-marketing and avoid circumvention of the rules. In practice this means fund managers will need to adequately document that they are carrying out pre-marketing activities based on the (new) definition of the AIFM Directive.

But this also raises questions around potential limitation of reverse solicitation during the 18-month period following pre-marketing and more generally about the presence of some ambiguous provisions in relation to current market practice in the package, which could negatively affect the overall intention of the legislator to facilitate the cross-border distribution of funds.

The geographic scope of this 18-month period restriction is not yet clear and Member State regulators may interpret this provision widely such that any pre-marketing in a Member State will restrict the ability to rely on reverse solicitation in all other Member States. Fund managers may therefore need to assess the practical impact of this restriction (an investment commitment based on a reverse solicitation being only possible prior to the 18-month period) before beginning pre-marketing. The European Commission has committed to evaluate the operation of the reverse solicitation regime and its impact on the passporting regime within 24 months of the cross-border Regulation entering into force.

The industry has further raised concern over the additional notification process in addition to the existing requirement and the additional related costs. 

For EU Fund managers, the package of reforms is a step in the right direction as it should help them avoid falling foul of the current diverse regimes across the EU as to what does, and what does not, constitute marketing as defined under the AIFM Directive. However, it is already clear that the new rules are not without their difficulties, especially if the actors are not fully ready in time.

¹ 2018/0041 (COD)