A Regulatory Road Map For The UK

Reform of the hedge fund industry

Originally published in the May 2006 issue

The rapid growth of the hedge fund industry has attracted considerable regulatory attention over the last two to three years. Regulatory requirements have already been imposed on hedge fund managers in the United States under amendments made to the Investment Advisers Act 1940. The International Organisation of Securities Commissions has been looking at hedge fund regulation and at the same time the European Commission's Green Paper on UCITS has looked at what the relationship should be between hedge funds and European retail funds.

It is not surprising therefore that in the UK, the FSA has also been actively reviewing the UK's regulation of hedge funds. The FSA has focused on two broad areas. The first of these is the retailization of hedge funds and product regulation. In this respect the UK seems to be behind the curve. Other European countries have already taken steps to retailize hedge funds. For example, the German Investment Act which came into effect in January 2004 has significantly liberalised the German hedge fund market by enabling retail customers to be offered interests in a fund of hedge funds. The second area of the FSA's regulatory focus has been on the broad regulatory risks that hedge funds pose.

Recent FSA action has put down a marker that the FSA is committed to addressing regulatory risks that it considers are posed by hedge funds. In March 2006 the FSA reported that the Chief Executive of Regents Park Capital Management LLP had given an undertaking to the FSA not to undertake any controlled function relating to regulated activities for three years. This matter appears to have been connected with alleged inaccuracies in valuations of assets of certain offshore funds. The press has also reported on FSA action involving Philippe Jabre, which relates to market integrity issues.

The FSA's proposals for reform in this area are therefore vitally important given that they appear to be backed up by a real prospect of action. Although regulatory risks for hedge fund managers may increase, in the long term the focus on and engagement with the industry should remove the regulator's fear of the unknown and hopefully lead to intelligent regulation.

In June 2005 the FSA published its Discussion Paper (053) "Wider-Range Retail Investment Products" which considered investor protection issues applying to retail investment products. The FSA's Feedback Statement (063) on this was published in March this year.

The focus of these papers has been on increasing the range of investment products available to the retail market. The retailization of hedge funds has been one aspect of this.

The debate on the retailization of hedge funds has been driven in part by the discrepancy in treatment of hedge funds and other unregulated funds, when compared with other financial products, such as structured notes and listed investment trusts, which provide an equivalent financial exposure. Unlike other asset classes, funds are subject to product regulation and authorisation. Without this authorisation they cannot be freely offered. Other financial products can be offered without authorisation of the product itself, even though the product provides substantially the same exposure as a fund. In the UK, regulated firms are subject to a prohibition on promoting investments in unregulated funds, which means that such funds cannot be widely marketed and sales are subject to a suitability assessment, which carries legal and regulatory risk.

A further driving factor in this area has been investor choice. The FSA is concerned to ensure that investors are not unnecessarily denied access to certain products. This was a particularly important factor before the recent equities bull run, although hedge funds are also now recognised by the regulator as being an important portfolio diversification tool.

Liberalising regulations in this area isnot entirely new. The FSA's Qualified Investor Schemes were aimed at providing the ability to offer FSA authorised funds with hedge fund-like qualities. These schemes have not been especially successful. The UCITS III Directive in any event broadened the investment powers of authorised funds, thereby detracting from the benefits of Qualified Investor Schemes.

The FSA's response to these concerns has been to propose a new category of authorised fund. The FSA's proposals involve broadening the existing category of Non-UCITS Retail Schemes ("NURS") to permit firms to offer authorised funds of hedge funds and other unregulated collective investment schemes. As these funds will be FSA authorised, the restrictions on the promotion of unregulated collective investment schemes will not apply. At present NRUS may only invest up to 20% of their assets in unregulated collective investment schemes. This restriction would clearly need to be removed. "Quality criteria" will, however, be imposed on the types of unregulated funds in which NRUS will be able to invest.

The FSA appreciates that in order to make this structure commercially viable, consideration will need to be given to the tax regime that will apply. The FSA are in discussions with HMRC as to the tax treatment of NURS.

The FSA has also come out with proposals for the reform of the listing regime which will allow hedge funds to be listed and their securities offered more broadly to the public. This has been considered as part of the FSA's Listing Review and in particular the work that the FSA has been carrying out on Investment Entities.

The proposals for the reform of the Listing regime will allow the establishment of listed hedge funds. This is a key distinction from the proposed expansion in the range of NURS and the current listing regime which both provide for fund of hedge funds. The FSA has put forward proposed revisions to the Listing Rules which relate, amongst other things, to the spread of investment risk and investment activity requirements. Presently a listed investment entity is permitted to invest no more than 20% of the entity's total assets in a single investment, the purpose of this being to ensure there is a spread of investment risk. The FSA proposes to remove this restriction and replace it with a principles based approach, which will allocate responsibility for ensuring spread of investment risk to the Board. As a result of moving from a mechanistic to a principles based approach the FSA will permit firms to employ wider-range investment strategies and, for example, to engage in short selling and the use of synthetic instruments.

The liberalisation of this area is a step forward. However, a principles based approach can lead to ambiguities as to how to achieve regulatory compliance, and the increased flexibility that will be given to investment entities will come with responsibilities for the board to ensure that there is compliance with FSA requirements. Listing investment entities will need to state in their annual report and accounts how they are achieving their objective of spreading investment risk and notify any significant changes in their risk profile.

The reforms described above should be introduced in the course of 2007 and 2008.

Regulatory risks

The other dimension to the FSA's work has been on the regulatory risks posed by hedge funds and the way these risks could be mitigated.

Issues surrounding these risks were cited by the FSA in Discussion Paper 0504 "Hedge Funds: A discussion of risk and regulatory engagement" and the feedback to this in Feedback Statement 0602.

In broad terms, the principal issue posed by the FSA in these papers was whether hedge fund managers should receive special regulatory treatment given the particular risks that they pose to the FSA's regulatory objectives. In this regard the FSA had proposed establishing a new regulated activity of undertakinghedge fund management and also specific permissions for prime brokers. Alternatively, notification requirements had been suggested for persons proposing to carry on activities relating to hedge funds. The FSA has decided not to proceed with these specific measures but has determined that in many respects the hedge fund industry does warrant particular attention.

One element of this has been the imposition of FSA relationship management on high impact firms to be conducted by the Hedge Fund Managers Supervision Team. This team has been established as a specialist resource within the FSA to assist its supervision of hedge fund managers. The FSA states that its purpose will be to ensure that hedge fund managers adhere to and comply with the FSA's Principles for firms and approved persons, the rules on Senior Management Arrangements, Systems and Controls, the Code of Market Conduct and COB rules.

Going forward, the hedge fund industry is likely to come under increasing regulatory scrutiny from the FSA. The FSA will continue to scrutinise the role of prime brokers in the hedge fund industry and has also identified particular areas of concern to them. These include issues such as asset valuations and conflicts. In respect of conflicts, the FSA has in particular focused on the use of side letters and the preferential treatment of some investors over others. The issue of conflicts is also related to valuations and the remuneration of managers by reference to performance.

In many respects the risks posed by hedge fund managers are no different to those posed by other asset managers and arguably, therefore, hedge fund managers should not be singled out for different treatment. Even UCITS funds under UCITS III investment powers are able to engage in hedge fund like strategies and distinctions are becoming blurred. Nevertheless, the debate on this point has moved on and the industry can expect increased regulatory attention. The key will be to ensure that new requirements are proportionate and do not stifle the industry.