An Attempt at Realpolitik or Schizophrenia?

The FSA's approach to hedge fund regulation (or how to beta regulator...)

Angela Hayes, Partner, Financial Services Group, Lawrence Graham LLP
Originally published in the June 2006 issue

In a discussion paper in June last year ("Hedge funds: a discussion of risk and regulatory engagement"), the UK Financial Services Authority (FSA) painted a bleak picture of the riskspresented by the hedge fund industry: poor control infrastructure; limited operational support; valuation weaknesses; a tendency to market abuse and fraud. Much of that risk profile was derived from looking across the pond at the SEC's experience; in the UK the FSA remains on a steep learning curve about practices in the sector and there has yet been little FSA enforcement activity focused on hedge funds. On this down-beat note the FSA resurrected a debate about whether there should be greater regulation of hedge fund managers and prime brokers based in the UK. These are, after all, the only players that the FSA has a hope (as it directly regulates them) to control in the short term, unlike the funds and their administrators that are mainly offshore.

In tandem, the FSA consulted on whether retail investors should be given greater access to funds with underlying alternative investment styles. On the face of it this looked like an uneasy juxtaposition, why talk down the sector when at the same time discussing widening the investor base? It is explicable, however, if we recognise that the FSA is in "catch-up" mode. It recognises market pressure to widen investor access but if access is widened at a time when the industry lacks transparency, is poorly understood by regulators and where the regulator continues to have little control, this is a disaster waiting to happen not just for less sophisticated investors but for the FSA itself. It needs therefore to send some strong messages to the sector about spring cleaning.

Since regulators exist to regulate, you might have expected the FSA to embrace at least some of the regulatory measures it speculated about in its paper last June, not least because there has been continued interest in hedge funds at EU level. For example, the FSA considered whether fund managers should be required to obtain a distinct FSA permission before they could commence managing hedge funds, which would imply specific, and in some way different, standards. However, at the same time that the FSA has been saying some pretty unflattering things about hedge funds and their managers, it has also been trying not to frighten the very lucrative hedge fund management business away from London by the threat of heavy handed regulation. So the joint response of the UK Treasury and the FSA to the EU Commission's green paper on regulation of asset management made it very clear that the UK authorities do not believe that a case has been made for the harmonised EU regulation of hedge funds. In markets characterised by rapid and significant innovation, the dead weight costs of regulation are likely to be large. Instead, regulators should look to the distribution channels not the funds themselves.

The UK desire to maintain relatively light regulation of the sector in the EU has been reaffirmed by the approach in the Treasury Select Committee's report on its enquiry into European financial services regulation published on 8 June 2006. The purpose of the enquiry was to examine the impact on the UK of European financial services legislation generally. The disparity in approach to investor access to hedge funds across Europe was a key example drawn upon by John Tiner of the FSA in his evidence to the Select Committee. Although this Select Committee report has missed the opportunity to comment specifically on hedge fund regulation, the thrust of the conclusions is consistent with a lighter EU regulation agenda. Although in the UK the FSA has opened a debate about whether there should be greater retail access to products with hedge fund type characteristics, a single market in European Financial Services, with comparable products and services available to consumers across borders, is not seen as a realistic proposition in the near future. Going forward, new EU regulation would have to be shown to have a clear benefit to the European economy. Is it the EU that is best placed to act? For the hedge fund industry with its diffuse global reach and the commercial reality that the weight of management and broker expertise is in London and New York, the answer to that is likely to be a resounding "No". For this industry, EU regulation is unlikely to be anything more than a minor side show and, if imposing any kind of strait jacket, an obvious disincentive. It is to be hoped that the report of the Commission's expert working group on alternative investment funds, due to issue around the beginning of July, will show the FSA's realpolitik prevailing at EU level.

In its Feedback Statement on hedge fund regulation published in March this year the FSA has dropped all of its "hard" proposals for enhanced regulation and some of the soft ones. No specific permissions or notifications will be required to act as a hedge fund manager; no enhanced investor due diligence will be imposed; no increased stress testing will be required; nothing new will be initiated by way of cross border cooperation between regulators or work on industry codes of conduct. But the FSA has introduced measures to enhance its monitoring and supervision of the sector. The FSA recognises that without knowledge it has little hope of constructive engagement or effective action in the future.

So where is the schizophrenia? It lies in the fact that, after all, there has been no outbreak of peace and love in the FSA's approach to hedge funds and those who serve them. Alongside the "soft" regulation, the FSA also came out fighting in its Feedback Statement with some very hard warnings. Wrongful valuations, the use of side letters favouring particular investors with enhanced liquidity, and weaknesses in operational risk management remain areas of close supervisory focus. More strongly the FSA has stated, without any qualification, that managers involved in wrongful valuations and use of side letters in this way are in breach of Principle 1 of the FSA's high level Principles for Businesses, which provides that FSA regulated firms must conduct their business with "integrity". That means the FSA will be obliged to take disciplinary action against those managers it finds transgressing. As a practitioner regularly involved in defending firms in FSA enforcement action, the author considers that the FSA has certainly set the bar too high. To lack "integrity" equates to "dishonesty" which is not a position that any fund manager should be prepared to concede and it is hard to prove. The FSA is setting itself up for some very hard fought enforcement cases indeed. For the FSA, therefore, alongside the partly emollient language the stakes have just been raised even higher.

In the market conduct area the FSA has not backed down either; although the Feedback Statement is very low key on the issue, we hear anecdotally that the FSA's direct rhetoric to managers and brokers is much more brutal and that more enforcement cases affecting the sector are in the pipeline.

For UK based hedge fund managers, it really is time to be seen to act on the FSA's pronouncements if you want to avoid becoming embroiled in protracted enforcement action rather than concentrating on generating alpha.