EUROPE IS GETTING IT WRONG ON FINANCIAL REFORM / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

Europe is getting it wrong on financial reform

By Jacob Rothschild

Published: April 20 2010 22:23

Sometimes the most opaquely-named measures can carry great significance. This is the case with the European Union’s proposed Alternative Investment Fund Managers directive. It is due to become EU law by July and negotiations are in a crucial phase.

This ambitious directive was conceived as part of a wide-ranging plan by the European Commission to extend regulation to all who could pose real risk to the financial system. They were not the cause of the crisis, but fund managers, and particularly those with high leverage, are perceived to have contributed to the Lehman crash. Lesson: regulate them.

The big EU targets are hedge funds and private equity firms. They are seen as high-risk, often secretive, and thus suitable only for professional investors. Greater transparency and accountability are always good things. The snag, however, is that the draft AIFM directive has cast its regulatory net so wide that it captures other investment vehicles, in Germany, the UK and elsewhere.

Consider Britain’s investment trusts. The first investment trust was established in 1868. Many of these trusts have existed for over a century, which makes it hard to describe them as “alternative”. These are publicly quoted companies led by boards of directors who are appointed by, and owe tough legal duties to, their shareholders. Their shares are freely traded, just like shares of Siemens or Carrefour. They are subject to a high degree of existing regulation at both UK and EU level. They are subject to detailed disclosure requirements and extremely high standards of corporate governance. They tend to adopt a cautious approach to investment, seeking to deliver growth but with a lot of safety. Their outlook is long-term.
Which is why they appeal very much to private investors. Some 1m of them, mostly from the EU, have money in investment trusts. Our RIT Capital Partners trust alone has 12,000 shareholders; I report asset value to them regularly, report in detail twice a year, and the whole board meets them every summer.

This highly accountable structure of investment trusts was barely reflected in early Brussels drafts of the AIFM directive. Some provisions would actually dilute prudence by transferring responsibility from the board to third-party managers (some investment trusts, including RIT, are self-managed, so do not even employ such a manager). Other clauses – such as the requirements for a redemption policy, valuations, and capital adequacy – are inappropriate for quoted companies from which investors cannot redeem, instead being able to buy or sell shares every trading day.

Further problems relate to the requirement to appoint a single depository responsible for receipt of investor funds, safe custody of the fund’s assets, and oversight of its valuation procedures, as it is not obvious there will be providers willing or competent to perform all these functions at once.

A good question arises, and it has an interesting answer. Given that there has been no suggestion that investment trusts have posed any threat to the financial system or played any part in the financial crisis, why have they been included in the AIFM directive at all?

The worry among EU politicians and regulators is that exempting any one type of fund from the AIFM directive would invite creative hedge fund managers somehow to call themselves trusts and thus avoid regulation. But this should not be a concern. The more hedge funds might be tempted to see investment trust status as a loophole through which they would like to jump, the happier regulators should be. The moment a hedge fund morphed into an investment trust, it would be forced to operate a fundamentally different structure, and meet new investment restrictions. They would be subject to more regulation, increased transparency and greater accountability to their investors: which is why few (or none) of them would do such a thing.

Intelligent amendments to the directive are being proposed. But these attempts at “proportionality” are a second-best solution, and they risk being watered down during negotiations between the European parliament and Council. The reality remains that the AIFM directive is an inappropriate regulatory framework for investment trusts.

The best solution is to exclude investment trusts from its scope altogether. Tinkering, well meant, usually ends up achieving the reverse of what is intended. At best, the outcome will be increased administrative and compliance costs with no obvious benefit. At worst, it will lead – as an impact assessment commissioned by London’s Financial Services Authority warned – to the demise of the industry. Those who will bear this cost will be the very investors the directive is intended to protect.

Lord Rothschild is chairman of RIT Capital Partners

Copyright The Financial Times Limited 2010.