Financial Services Europe And International Update - December 2011

This update summarises current regulatory developments in the European Union and the UK, focussing on the investment funds and asset management and related sectors, during the past six weeks.

EU and International Regulatory Developments

The Proposed EU Financial Transaction Tax: An Update

The European Commission on 28 September 2011 published a proposal for a financial transaction tax ("FTT") in the EU. The proposed tax would be levied on financial transactions of shares and bonds at a rate of 0.1% and on derivatives at a rate of 0.01% where the transaction was conducted by a financial institution established on the EU, regardless of where the transaction took place.

On 8 November 2011 the Commission's proposal was discussed at a meeting of ECOFIN. Whilst Member States agreed that the financial sector should make a contribution in return for the bail-outs during the financial crisis, discussion has polarised between France, Germany, Spain, Slovenia and Belgium who supported the tax and the UK, the Czech Republic and Bulgaria who strongly oppose the FTT. The UK branded the discussion a waste of time as there was nowhere near unanimity and time would have been better spent tackling the eurozone crisis. A majority of Member States (Luxembourg, Malta, Italy, Finland, Denmark, Latvia, Bulgaria, the Netherlands, Slovakia, Romania, UK, Czech Republic, Sweden, Greece) raised reservations about the impact the proposal will have, which requires further analysis and discussion at a technical level, and favoured a global tax.

The proponents of the tax have argued that financial transactions should be taxed like any other goods or services and that there is a need to harmonise transaction taxes across the EU to prevent double taxation and distortion in the single market. Most appear to be prepared to proceed at a eurozone level if agreement cannot be reached among the twenty-seven Member States, as is now the case following the recent Brussels EU summit.

Germany in particular has called for the FTT to be agreed quickly and has suggested that those Member States who wish to wait for a global FTT are simply using this as an excuse to do nothing. The German Finance Minister has indicated that Germany will be prepared to see the proposed FTT proceed at eurozone level only but cautioned those member states outside the eurozone against creating differences between those in and out of the single currency zone.

France has said that whilst a global tax was the ideal, an EU wide FTT could act as a trigger for this. The French Finance Minister also said there had been significant developments at the G20, where the USA, who had been staunchly against an FTT, were now saying that they agreed that the financial sector should pay for the crisis. France saw this as a step in the right direction towards global implementation of the tax.

The opponents of the FTT have raised concerns about the impact of the tax, including:

the reduction of competitiveness of the EU in the global market; the increased cost of capital and the impact this would have on investment and growth; the increase of interest rates on sovereign debt; the significant risk of relocation; the likelihood that costs would be passed on to the customers, in particular pension funds; and the cumulative impact of the FTT and other regulatory measures (CRD4 and EMIR, for example) on the financial sector. The UK, Luxembourg and the Czech Republic have argued that it is the wrong time to introduce an FTT. They point out that the discussion has also centred on the need to promote growth and jobs and to recapitalise the banks, but now the FTT is proposed this will reduce growth, cost jobs and make bank recapitalisation more difficult. Sweden and the Netherlands said that a FAT ("financial activities tax) would avoid many of these negative effects in place of a FTT.

There appears to be no consensus on where any revenues from the proposed FTT will be spent. Proponents of the FTT have said that this discussion could wait until the technical discussions on the tax are complete. However, the UK's Chancellor of the Exchequer has argued that there should be clarity about where the money was going as the revenues under the Commission's proposal (assuming any significant amount is actually collected after relocation of the financial services industry outside the EU) had already been proposed to be spent four times over — on the EU budget, member states' national budgets, fighting climate change and tackling poverty.

(Media reports that have subsequently appeared suggest that even if a FTT is imposed on eurozone members only, as it will still affect transactions passing through the UK and could be challenged by the UK as contrary to at least two of the EU Treaty articles).

Further Commission Proposals on Credit Rating Agencies

The EU introduced regulations in 2009 and 2010 in order to regulate the credit rating industry in the wake of the financial crisis. This required credit rating agencies ("CRAs") to be registered and supervised by ESMA and set out various conduct of business standards.

On 15 November 2011 the European Commission published a draft Directive and draft Regulation to regulate credit rating agencies in order to deal with outstanding weaknesses in the framework which have become apparent during the current euro debt crisis.

The key changes in the proposed Directive and Regulation are:

in order to reduce over-reliance on credit-ratings, there will be a general obligation for investors to do their own credit assessments; both CRAs and rated entities will be required to disclose more information underlying ratings; CRAs will have to consult issuers and investors on any intended changes to their rating methodologies; EU Member States will be rated every six months and investors and Member States will be informed of the underlying factors and assumptions made in each rating; issuers will have to rotate every three years the agencies that rate them and complex structured financial instruments will require ratings from two rating agencies; ESMA will publish a freely available European Rating Index of all available ratings in respect of a debt instrument; and CRAs will be liable in cases where they infringe, either intentionally or with "gross" negligence, the EU's CRA regulations. The notion of allowing ESMA to suspend sovereign ratings in exceptional circumstances, which Commissioner Barnier had been pressing for, has now been dropped from the proposals in the face of considerable opposition from other Commissioner. (However, it is to be given further consideration at a later stage).

The proposal will now pass to the European Parliament and the Council for negotiation and adoption.

ESMA's Final Advice to the European Commission on the AIFM Directive's Implementation Measures

Readers will recall that the Alternative Investment Fund Managers Directive ("the AIFM Directive") was the subject of a record of several thousand amendments during its legislative process in Brussels before being finally adopted and published in the Official Journal in July 2011. During this process, on 9 November 2009, the UK's Treasury Minister Lord Myners stated:

This is a very dodgy Directive that's been poorly constructed. It was produced in a hurry. It's a process that makes those who support the European Union embarrassed.

Patrice Berge-Vincent of the French financial regulator, the AMF, stated a month earlier on 9 October 2009 that:

Almost all of the Directive's provisions need to be redrafted to make them appropriate, proportionate and adequate.

Against this background, on 23 August 2011, ESMA published a further consultation on possible Level 2 implementing measures under the AIFM Directive which related to the rules for alternative fund managers ("AIFMs") and the treatment of third-country entities, the Commission having in December 2010 sent a provisional request for technical advice on the Level 2 measures to the former Committee of European Regulators (ESMA's predecessor). ESMA consulted on its draft advice in two stages. In July 2011 a consultation focused on the general provisions, authorisation, operating conditions, the depositary, transparency requirements and leverage. In August 2011, as indicated above, ESMA produced a further consultation. This focused on supervision and third-country entities.

ESMA's final advice, released on 16 November 2011, will be the subject of a separate more detailed DechertOnPoint, but covers the following matters.

General Provisions, Authorisation and Operating Conditions

Amongst other things, ESMA:

clarifies the operation of the thresholds that determine whether AIFM is subject to the AIFM Directive; proposes to require AIFMs to have additional own funds or professional indemnity insurance ("PII") to cover risks arising from professional negligence; and notes that many of the proposals (in areas such as conflicts of interest, record keeping and organisational requirements) are based on equivalent provisions in MiFID (2004/39/EC) and the UCITS IV Directive (2009/65/EC). Depositaries

The advice from ESMA sets out the criteria for assessing whether the prudential regulation and supervision applicable to a depositary established in a third country has the same effect as the provisions of the AIFM Directive. The advice identifies a number of criteria for this purpose, such as the independence of the relevant regulator, the requirements on eligibility of entities wishing to act as depositary and the existence of sanctions in the case of violations. The advice also covers the liability of depositaries.

Notably, ESMA proposes three conditions, at least one of which has to be fulfilled for an asset to be considered "lost" (which impacts on whether a depositary must subsequently return an asset) namely:

that a stated right of ownership of the AIF is uncovered is unfounded if it either ceases to exist or has never existed; that the AIF has been permanently...