A New European Regime for Venture Capital

Ref. Ares(2011)1001117-21/09/2011 A New European Regime for Venture Capital Response of the Law Society of England and Wales ETI Registration number: 24118193117-34 The Law Society of England and Wales 113 Chancery Lane London WC2A 1PL 1

DG Internal Market and Services Staff Working Paper: A New European Regime for Venture Capital Response of the Law Society of England and Wales Introduction 1. This response is from The Law Society. The Law Society is the representative body for approximately 140,000 solicitors in England and Wales and negotiates on behalf of the profession and lobbies regulators, governments and others. 2. This response has been prepared by the Society's Standing Committee on Company Law and is supported by the Law Reform Committee of the General Council of the Bar. 3. The Law Society welcomes the opportunity to comment on D.G. Internal Market and Services Consultation Document A New European Regime for Venture Capital ( the Consultation Document ). General Comments 4. As a general observation, we do not consider that cross-border fund raising by venture capital funds is presently materially constrained by the lack of a European private placement regime for venture capital. Most Member States have private placement regimes which permit the raising of capital from sophisticated and professional investors and which can generally be readily used by venture capital fund managers without undue cost in terms of local advice. 5. We do, however, support the principle of creating an EU internal market for venture capital funds in view of the fact that Member States may be required under the Alternative Investment Fund Managers Directive (AIFMD) to withdraw their private placement regimes in 2018 and the risk that certain Member States may seek to withdraw or narrow the scope of their private placement regimes in advance of that date as a response to the marketing regime introduced by the AIFMD. If this were to occur, then this is likely to significantly constrain cross-border fund raising by venture capital funds (the majority of which are likely to be under the 500 million AIFMD threshold), since their managers would have no alternative but to opt into the AIFMD regime in order to undertake cross-border marketing and this would add significant administrative and operational burdens and costs to fund raising activities and fund operation. 6. We question though whether the approach of creating an EU internal market only for venture capital funds is unduly restrictive. The point made in the Consultation Document that venture capital funds are not likely to either pose important systemic risk to the financial system or create specific investor protection concerns can equally be made for other types of fund which are below the 500 million AIFMD threshold. We consider that there is a case for creating a framework for cross-border marketing - with tailored, less onerous requirements than those imposed by the AIFMD - which could be utilised by 2

venture capital funds and also by other types of investment fund which are below the AIFMD threshold. 7. This alternative approach would have the advantage of facilitating greater access to capital by SMEs whilst avoiding issues associated with attempting to define venture capital funds and venture capital investment strategies. It would also have the advantage of limiting the complexity involved in having multiple regimes for cross-border marketing. Under the approach in the Consultation Document, there would be three marketing regimes: one for funds and their managers which are required to be authorised under the AIFMD, one for venture capital funds and their managers and a third (based on Member State private placement regimes) for funds which do not qualify as venture capital funds and are below the 500 million AIFMD threshold. Responses to Consultation Questions Section 1: Venture capital and SMEs Question (a): Do you think that encouraging Member States to a process of mutual recognition of venture capital funds, based on the direct enforcement of the Treaty freedoms, could facilitate the cross-border activity of these funds? 8. We have no specific comment to make in relation to this question. Question (b): Do you believe that the main impediment preventing cross-border venture capital fundraising and investments is the absence of a passport for activities under the AIFMD thresholds; or the fact that the AIFMD is not tailored to venture capital in general? 9. As indicated above, we do not consider that there is currently a material impediment to cross-border venture capital fundraising. In the event, however, that Member State private placement regimes are narrowed or removed, the AIFMD is likely to be a significant impediment - for both venture capital funds and other smaller funds - unless a tailored, more suitable regime is created. 10. We believe that the principal impediment to cross-border investment for venture capital funds is not the absence of a passport for fund management activities but is, rather, the need to put in place potentially costly structures to avoid the imposition of local taxes on capital gains and withholding taxes on dividends and interest in the Member States in which investments are made. The proposals in the Consultation Document do not address these taxation issues and will not therefore, in our view, alleviate the difficulties for venture capital funds in making cross-border investments. Question (c): Is a targeted modification of AIFMD rules for venture capital or a standalone initiative in this area the more appropriate tool to increase venture capital activities? Please specify. 11. We are of the view that a single regime, modified as appropriate for different types of fund, would be preferable to stand alone regimes. A single regime would be more integrated and should offer less scope for inconsistencies. We consider therefore that a targeted modification of AIFMD rules would be the better approach. However, as indicated above, this would only assist in addressing issues associated with cross- 3

border fund raising by venture capital funds in the event that Member State private placement regimes are narrowed or removed and will not assist in addressing issues associated with cross-border investing unless the taxation issues which arise in that context are resolved. Question (d): From your experience, could you provide concrete examples where you encounter additional administrative or regulatory hurdles when raising or investing funds across the EU? 12. As indicated above, as a general matter, we do not think that, currently, there are material hurdles to raising funds on a cross-border basis (although, as noted, this will change in the event that Member State private placement regimes are narrowed or removed). The exceptions to this general rule are France and Italy, which do impose significant hurdles in relation to the marketing of non-domestic funds. In Italy, for example, the marketing of interests in foreign non-ucits funds is subject to prior authorisation of the Bank of Italy, which has been rarely (if ever) granted. There are no private placement or professional investor or high net worth exemptions. Question e): Do you believe that an initiative on cross-border operations of venture capital could contribute to eliminating the cross-border tax problems encountered and if so, how? 13. We consider that it would be helpful to eliminating cross-border tax problems to have agreement amongst Member States as to a form, or forms, of vehicle which are regarded as transparent for tax purposes. Question (f): How could a possible passport for venture capital operators facilitate targeted tax incentives in favour of cross-border venture capital investments? 14. If a passported operator were to be treated as not establishing a permanent establishment for tax purposes in the host Member State, this would assist significantly in enabling operators to simplify the structuring - and reduce the costs - required in order to invest cross-border. In such circumstances, it would not be necessary for the operator to establish a separate advisory company in the Member State in which investment is to be made (if a presence in that Member State is required). Section 2: Elements of a European legislative framework for venture capital 1) Voluntary registration with a competent authority Question (a): Do you agree with this approach? If not, what alternative approach would you suggest? Could you then briefly outline the pros and cons of such an alternative? 15. We agree that the approach should be a voluntary opt-in approach. However, we are of the view that, in common with the approach to EU passporting in other contexts, the benefit of the passport should require compliance with certain harmonised standards. In this context, we consider that a minimum harmonisation approach would be appropriate. We think that this could be achieved by suitable tailoring of appropriate requirements in the AIFMD. 4

Question (b): Do you consider such a voluntary regime to have any major cost implications for the key stakeholders? (Investors, competent authorities, venture capital business). Please specify. 16. This will depend upon the nature and extent of any requirements applicable to venture capital managers who opt-in to the regime. Question (c): Based on your experience, could you provide qualitative and/or quantitative assessment of potential cost savings that the European 'Passport' would bring about? 17. In terms of cross-border fund raising, our experience is that the cost of taking local advice in individual Members States in relation to the inward marketing of a fund is typically in the region of 2,000-2,500 per Member State. A passport would avoid the need to incur such costs, although those savings would need to be weighed against the cost of compliance with the passporting regime. To make the regime beneficial in this respect, it would be important that compliance costs are kept to a minimum. We note that this is recognised in the discussion on operating conditions in section 2(5) of the Consultation Document. 18. If the passport takes into account the information requirements under the European Money Laundering Directives, particularly for beneficial ownership, there will be cost savings in terms of anti-money laundering compliance for both venture capital funds and the various financial institutions and professionals who provide services to such funds. Question (d): What information should the manager provide to the competent authority? 19. We see no reason why the information to be provided should not mirror that required under the AIFMD. However, we would advocate that, for smaller funds, it would be appropriate to permit filing on a post-event basis rather than requiring filings to be made pre-event. 20. Should the proposed passport regime proceed, we recommend that the requirements of the European Money Laundering Directives be taken into account when considering the scope of information that a venture capital fund manager should provide to the competent authority for registration. Question (e): What option would you favour: registration with the national authority or with ESMA? Alternatively, ESMA could hold a European register of venture capital managers and funds with the information provided by national authorities. Would you favour this solution? 21. We would favour registration with the national authority. 2) Simple notification procedure Question (a): Do you agree with this approach? If not, what alternative approach would you suggest? 22. We agree with the approach, which has the benefit of being straightforward. 5

Question (b): What should be the content and timeframe of the notification? Should the notification cover both, the places where the manager intends to invest in SMEs and the places where it intends to raise funds? 23. We have no specific comment to make on the content and timing of the notification. The notification should cover the places where the manager intends to conduct its management operations (which may not necessarily be the same as the places where the manager intends to invest) as well as the places it intends to invest funds. Question (c): Do you consider such a procedure to have any major cost implications for the key stakeholders? (Investors, competent authorities, venture capital business). Please specify. 24. We cannot see that such a notification procedure would have cost implications for the key stakeholders. 3) Restriction for retail investors Question (a): Do you agree with this approach? If not, and in case you believe venture capital should be accessible to retail investors, what kind of measures would you recommend to ensure their protection? 25. We agree with the approach but we consider that it would be important for individual Member States to be able to permit venture capital funds to be offered to retail investors under conditions determined at a Member State level, as is the case under the AIFMD. Question (b): What are the restrictions (if any) on participation of retail investors in your country within the fund structures used for venture capital investments? 26. In the United Kingdom, funds used for venture capital investments may be structured as listed investment companies. Retail participation in such investment companies is unrestricted. In relation to other types of typical fund structures (e.g. limited partnerships) retail participation is restricted, in broad terms, to the following categories of nonprofessional investors: 1. high net worth individuals (i.e. individuals with an annual income of 100,00 or more or with net assets, excluding primary residence and pension benefits, of 250,000 or more); 2. sophisticated investors (i.e. persons who are treated as being sufficiently knowledgeable to understand the investment risk involved or who are assessed by an FSA authorised firm as being capable of making their own investment decisions and understanding the risks involved); and 3. clients of an FSA authorised firm for whom the firm considers a fund to be a suitable investment. 4) Reporting obligations 6

Question (a): Do you agree with this approach? If not, what alternative approach would you suggest? 27. We agree with this approach in principle, however, we are of the view that the reporting standard should be a contractual matter for the fund documentation. We would note that a requirement to report on a consolidated basis under IFRS/UK GAAP has significant cost implications for venture capital managers. In addition, professional investors, whilst typically imposing demanding reporting requirements, generally do not want reporting on a consolidated basis because of the associated cost and the fact that it its not possible using consolidated accounts to track the position in relation to underlying investments. Question (b): Do you agree with the need to require an annual report for each fund? 28. See above. Question (c): Do you agree that the annual report should reflect the annual financial accounts and a report of the activities of the financial year? 29. See above. Question (d): Do you agree with the obligation to audit the financial information of the annual report? 30. See above. Question (e): What reporting requirements/obligations exist within the fund structures used in your country for the purpose of venture capital investments? Would you consider that the proposed information requirements would constitute a significant administrative burden? Please specify. 31. We have no specific comment to make in relation to this question. Question (f): Do you think that more information requirements should be imposed on venture capital managers? If so, please specify 32. We do not think that more information requirements should be imposed. 5) Operating conditions for venture capital entities Question (a): Do you think there is a need to specify any operating condition for venture capital entities? If yes, what would you consider as sufficient EU level framework for venture capital managers in this area and what level of compliance cost would this entail? 33. As indicated above, we are of the view that any passport regime should be based on compliance with certain harmonised minimum standards. These should be tailored appropriately for venture capital funds with a view to compliance costs being proportionate. We think that any minimum standards should include certain operating conditions. For instance we would see the conditions in articles 12 and 18 (General Principles) and article 14 (conflicts of interest) of the AIFMD as being appropriate. In contrast, we consider that other operating conditions specified in the AIFMD, in 7

particular, the requirements in relation to risk management, remuneration, liquidity management, valuation and depositaries as being disproportionate in the context of the size and risks posed by venture capital funds and the nature of their investment activity (i.e. relatively infrequent investment in unquoted securities). Question (b): Do you think that it should be specified that venture capital entities should comply with rules of conduct when dealing with their investors? If yes, to what extend? 34. See above. We think that appropriate rules of conduct would be covered by the application of requirements based on article 12 of the AIFMD. Question (c): Do you think that it should be specified that venture capital entities should comply with specific organisational requirements? If yes, to what extent? 35. See above. Question (d): Do you think that it should be specified that the persons effectively conducting the business should have good repute and experience? If yes, to what extent? 36. Yes. We consider that such persons should be of sufficiently good repute and should be sufficiently experienced in relation to the investment strategies to be pursued by the venture capital fund manager. Question (e): Do you think that it should be specified that the significant shareholders should be suitable? If yes, to what extent? 37. Yes. We consider that significant shareholders should be suitable taking into account the need for sound and prudent management of the venture capital fund manager. 6) Legal form of the venture capital funds Question (a): Do you agree with this approach? If not, what alternative approach would you suggest? 38. We agree. There seems no reason to limit the legal forms which can be used to constitute venture capital funds. Question (b): Is it convenient to specify in the legislative proposal the legal forms that the venture capital funds might adopt? 39. We have no specific comment, save to note that if any such reference were not to be limiting, it would need to make clear that any legal form could be adopted. Question (c): Is there any other aspect relating to the legal form of the venture capital entities that the proposal should take into account? 40. Any regime for venture capital funds should recognise, as does the AIFMD, that such funds may be internally managed, rather than having an external manager. 8

7) Investment focus on SMEs Question (a): What, if any, investment criteria determine your existing national fund structures used for purposes of venture capital investments? 41. Fund structures are driven largely by tax considerations, including the need to ensure that there is no tax at the fund level. For this reason, in the UK, structures typically used are limited partnerships (which are transparent for tax purposes) and listed investment companies, which can benefit from a tax regime under which there is no tax charge for the investment company on capital gains and tax advantages can be offered to investors Question (b): Do you think it is worth specifying any investment rules for venture capital funds? 42. As indicated above, we question whether the approach of creating an EU internal market only for venture capital funds is unduly restrictive and we consider that there is a case to be made for creating a passporting regime which could be utilised by venture capital funds and also by other types of investment fund which are below the AIFMD threshold. If a regime is to be limited to venture capital funds then we consider that the only investment restriction should be that an investee entity is an SME at the point of initial investment. Question (c): Do you think there is a need to define a compulsory investment percentage of assets that the venture capital fund should invest in SMEs? If yes, what compulsory investment percentage would you propose and how should it be calculated? 43. No. We do not consider that it would be necessary to be prescriptive as to the percentage of assets that should be invested in SMEs. This is a matter which should be left to the venture capital fund manager, subject to any limitations or requirements imposed by investors in the fund. Question (d): Do you agree with the need to envisage a flexible application of the principle described? 44. Yes, we consider that the principle should be flexible to allow managers to accommodate differing investor requirements. 8) Determination of the scope of the activities of venture capital funds 1. Description of the activity Question (a): How do your national rules capture (if at all) the definition of venture capital funds? 45. There is no specific definition of a venture capital fund. However, the rules of the Financial Services Authority use the expression venture capital investment in the context of the categorisation of firms for prudential purposes and the imposition of limitations on the scope of activities which firms can undertake. This expression is defined as being: a[n investment] which, at the time the investment is made, is: (a) in a new or developing company or venture; or 9

(b) in a management buy-out or buy-in; or (c) made as a means of financing the investee company or venture and accompanied by a right of consultation, or rights to information, or board representation, or management rights; or (d) acquired with a view to, or in order to, facilitate a transaction falling within (a) to (c). Question (b): Should the temporary nature of the venture capital investment activity in SMEs constitute a criterion that should be reflected? 46. No. We consider that this should be left as a matter to be negotiated with investors and reflected in funds constitutional documents and rules. We are of the view that a venture capital manager should have sufficient flexibility, within applicable fund rules as negotiated, in relation to the timing of investment and divestment. Question (c): Do you think it should be specified any temporal limit (minimum and maximum) to the participation of the venture capital fund in the capital of the SME (i.e., from at least 2 to 10 years)? 47. No. See above. Question (d): Are there any other means of finance that venture capital funds provide to SMEs that should be reflected (e.g. loans)? 48. Loan finance and finance provided through non-equity share capital (e.g. nonparticipating preference shares) should be reflected. Question (e): Do you think that there is a need to specify that the manager should be actively involved in the development, growth and success of the SME? Or should the passive investment in an SME also be considered by the proposal as venture capital investment? 49. Many venture capital investments are made on a passive basis. We do not therefore consider that it would be helpful, or reflect the approach taken by many venture capital fund managers, for managers to be required to take an active approach. Question (f): What other criteria would you consider appropriate to capture the venture capital activity? 50. We would comment that it will be important for the criteria to be sufficiently flexible in order to maximise the opportunity for SMEs to access capital. An overly prescriptive approach may hinder the overall objective to address the funding deficit for SMEs set out in the Consultation Document. 2. Description of the venture capital investment strategy Question (a): To what extent does your national regime capture the above definitions of typical venture capital strategies? 51. The legal and regulatory regime in the UK does not define or otherwise capture the various stages of investment. To the extent used in various contexts, reference is generally made to the industry definitions referred to in the Consultation Document. 10

Question (b): Do you agree that the special rules on venture capital should only apply when funds invest in the seed, start-up and expansion stages of SMEs? If not, do you believe that SMEs in a restructuring phase should also benefit from venture capital? What other alternative approaches would you suggest? 52. We do think that venture capital should be defined sufficiently widely to include replacement capital since it may be important for an existing venture capital fund investor in an SME to be able to participate in a restructuring in order to preserve its investment. Question (c): Would you propose other definitions to define the permitted portfolio of venture capital funds? 53. We have no additional comment to make in this regard. Question (d): Do you agree that venture capital funds do not/should not use leverage? 54. We agree that venture capital funds do not tend to use leverage. However, funds should not be restricted from using temporary finance for bridging purposes. In addition, any restriction on the use of leverage by venture capital funds should not extend to leverage used by portfolio companies, since borrowing at a portfolio company level is essential in the context of the development of the businesses of portfolio companies. 3. Definition by exclusion of certain types of investments Question (a): Do you agree with the list of entities described as not being proper investment targets for venture capital funds? 55. We agree that it does not seem consistent with the concept of venture capital to permit investment in companies that have their securities traded on a secondary market since such companies typically have other means of accessing capital. We would note though that secondary markets take many different forms, with varying degrees of formality and liquidity. If there is to be a restriction on investment in traded companies, we think that whether or not a company is regarded as having its securities traded on a secondary market should be defined by reference to secondary markets which are regulated markets or multilateral trading facilities for the purposes of the Markets in Financial Instruments Directive. 56. We are also of the view that companies which are investment entities rather than trading entities should not be proper investment targets. 57. We do not agree that there should be a restriction on investment in other funds which are venture capital funds. Any regime for venture capital funds should recognise the possibility of funds of venture capital funds and venture capital feeder fund structures, both of which are a means through which capital can be provided to SMEs. Investment in another fund or funds should be permitted provided that that other fund or funds are venture capital funds (however defined for the purposes of the regime). 11

Question (b): If not, what types of companies would you specify as eligible investment targets? 58. See above comment in relation to funds of venture capital funds and feeder funds. Question (c): Do you think that the EU should draw inspiration from the criteria set by the SEC to define the target companies of the venture capital funds? 59. We do not think that the SEC criteria are helpful in relation to the issues raised by the Consultation Document. We note that the criteria were prepared for a different purpose and would be limiting in the sense that they would seemingly not permit an investment comprising a debt element (see criterion (b)) or an investment in the context of a restructuring (see criterion (c)). Nor would they permit funds of venture capital funds or feeder funds. For the reasons indicated above, we do not think that such limitations would be appropriate or helpful to achieving the objective referred to in the Consultation Document. 9) Third country entities What could be an appropriate regime for third country venture capital funds? 60. Although this is ultimately a policy issue, we do not think that there should be any restriction on non-eu venture capital funds from raising capital from EU investors or investing into the EU since, as the Consultation Document acknowledges, venture capital funds do not pose systemic risks or specific investor protection concerns. We are also of the view that such fund should be able to opt into any EU passporting regime for venture capital funds provided that they are subject to the same standards and are subject to supervision for compliance with those standards by a Member State acting as home Member State. 10) Impact on other pieces of EU legislation Question (a): Do you agree with this approach? 61. See response to question 10(b), below. Question (b): Would you support the first (exemption for entities below the AIFMD threshold) or the second option (exemption independently from the threshold)? Would you suggest an alternative approach? 62. The first option seems more aligned with the stated systemic risk control and investor protection objectives of the AIFMD. If the AIFMD threshold denotes the level at which funds are regarded as sizeable enough to be subject to the controls and protections imposed by the AIFMD, it seems contradictory to treat venture capital funds which are over the threshold differently to other funds. In our view, the second option would be inconsistent with the scheme and objectives of the AIFMD. Question (c): Are there any particular elements from the AIFMD that in your view should also apply to the venture capital managers? 63. See response to question 5(a), above. 12

11) Supervision and sanctions Question (a): Do you agree with this approach? If no, what alternative approach would you suggest? 64. We do agree with this approach. Question (b): What supervisory powers should be granted to the competent authorities for the supervision of venture capital funds and managers? 65. We do not have any specific comment to make in relation to this question Question (c): What type of sanctions should be envisaged? 66. We do not have any specific comment to make in relation to this question 13

For further information, please contact: Catherine Howdle Internal Market EU Policy Advisor The Joint Brussels Office of the Law Societies 85 Avenue des Nerviens, Box 10 B-1040 Brussels, Belgium Tel (+32-2) 743 85 85 Fax (+32-2) 743 85 86 http://www.lawsociety.org.uk 14