Changing Rules

The regulation, taxation and distribution of hedge funds around the globe

Originally published in the July 2009 issue

The reduction in worldwide securities markets coupled with net redemptions over the last nine months have resulted in industry assets under management falling significantly – estimates suggest some 30% from their peak. Some hedge funds have closed, some have restructured and some fund managers have gone out of business. The business environment remains extremely challenging yet the regulatory consequences of the credit crunch and their potential impact on the marketplace are only beginning to emerge. At the end of April 2009, the European Commission published a draft proposed European Directive that will apply to all Alternative Investment Fund Managers established in an EU member state. In their current form the proposals in the draft Directive will affect not only the managers of hedge funds but also private equity, real estate, infrastructure and some traditional long only managers. Although there is bound to be much debate and lobbying to change the proposals, history shows that a lot of the original text will remain. The changes proposed would have far reaching effects on the European non-retail asset management industry and quite probably, a number of unintended consequences. All industry participants will need to monitor developments carefully as the new rules emerge.

Changing rules
In September last year, the consequences of the credit crunch accelerated. Coupled with the demise of Lehman Brothers and the intervention of governments to “bail out” banks, the sub prime crisis became a banking crisis and then a macro crisis. For the sector, the deleveraging by financial institutions and flight to cash by all investor classes caused significant redemptions and, together with the falls in securities markets worldwide, is estimated to have reduced assets under management in the industry to about 30% of the position at December 2007.

Last year we were predicting that more institutional money would be allocated to hedge fund strategies and that this money would fuel a focus on operational risk – both by investors and managers. We anticipated that the larger hedge fund managers would need to embrace the published Best Practice Standards and Practices (both of the Hedge Fund Standards Board and the US President’s Working Group on Financial Markets) to demonstrate robust controls and processes. We also commented that compensation strategies would need to be modified and aligned to achieve adherence to a strong operational control framework and avoid bias to risk and short term thinking.

That was then. Whilst these issues remain valid the extreme financial market dislocation over the last nine months has caused every financial institution to reappraise its business model. Necessarily, the emphasis has been on survival and trying to get some vision on the future business environment – a tough challenge given the huge upheavals in financial markets. But just as managers have started to see a slow down in redemptions and started to achieve some positive investment performance, they are being faced with a new challenge – a challenge from the regulators.

The draft EC Directive

It is fair to say that since the European Parliament approved the Rasmussen report in July 2008, it has been known that the European Commission would have to draft proposals to address the recommendations of this Parliament approved report. However, it was not expected that the draft Directive published at the end of April 2009 would be so wide in scope and released with such limited consultation. The draft Directive is proposed to apply to alternative investment fund managers (AIFMs) established in an EU member state and who provide management services to alternative investment funds (AIFs). The definition of an AIF includes all non-UCITS funds and therefore also covers – for example – real estate funds, infrastructure funds, exempt unauthorised unit trusts and UK investment trusts.

Issues with the Directive
Not only was the scope much broader than expected, but also the provisions in the draft Directive were much more extensive. For the hedge fund industry, it is proposed that EU hedge fund managers with assets under management of €100 million or more will be subject to a minimum level of capital of €125,000 plus a further 0.02% of the value of assets under management in excess of €250 million. There are also detailed reporting requirements for the AIFM to both the home state regulator (e.g. information on governance structures, internal risk management systems, valuation procedures and risk management systems) and to investors (e.g. descriptions about valuation procedures, liquidity risk management, redemption rights, identity of the AIF’s depository, the third party independent “valuator”, when the AIF may use leverage, any investors who benefit from preferential interests etc.).

More fundamentally, the draft Directive seeks to change some of the existing relationships and infrastructure within the industry. Underthe proposals, it will be necessary for each AIF to appoint an independent valuer to value the assets and then the units/shares of the AIF each dealing or subscription/redemption day and at least annually. It is unclear whether there is sufficient supply of expertise in the EU marketplace for such an independent valuation process, especially when it comes to hard-to-value assets. In addition, the AIF will need to appoint a depository. The depository needs to be an EU credit institution and this will exclude most existing prime brokers – it is thought that there are only four prime brokers who currently have EU credit institution status. Consequently, an EU credit institution will need to be appointed as a depository to a hedge fund and in turn sub-delegate to a prime broker. This is feasible except that the draft Directive also requires the depository to take the liability risk for breaches of the Directive, irrespective of the sub-delegation arrangements which probably makes such arrangements uneconomic and possibly unworkable. The Directive also requires disclosure about leverage to both the investors and the regulator. The definition of leverage is unclear but it appears that the regulatory authorities including the Commission itself will have the power to impose limits on leverage.

The reaction of the industry

Reactions have largely have been negative and reflect the perception that only limited consultation has taken place. Clearly, the draft Directive will be subject to much lobbying and negotiation and it must be remembered that it only represents Level 1 principles under the Lamfalussy process and the fine detail is yet to be worked out; however, most commentators believe that the basic thrust of the Directive will remain.

US regulatory developments
The US is moving at a different pace. At the time of writing, a US House Sub-committee had just finished a hearing on “Perspectives on Hedge Fund Registration”. There is a bill proposing an amendment to the Investment Advisors Act of 1940 which would lead to a mandatory registration regime for all US investment advisors and non-US investment advisors if they have US clients. This registration requirement differs to the proposed European AIFM model (where registration is required if the AIFM operates from a place of business in the EU) because the US model, by virtue of linking the registration requirement to clients, makes it extra-territorial.

The US appears to be moving at a slightly slower pace than the EU and although registration would bring obligations under the proposed rules, there does not seem to be the appetite yet for such a “root and branch” rewriting of the rules. This could lead to serious competitive disadvantage for EU managers.

Business implications
What is clear is that the financial environment in which hedge funds operate has changed fundamentally. The regulators are rewriting the rules. Therefore, hedge fund managers need to start re-thinking what this means to their business and operating model. Although the new rules are not yet completely clear, there is enough information in the proposed Directive to start working through the issues, considering their impact and then potential solutions. We have set out an action plan (see Table 1) of the key areas to consider.

Hedge fund managers need to get up to speed quickly with the proposed new rules. Even discussion and debate is causing additional transparency and it seems even more likely than at this time last year that managers will need to demonstrate a robust governance, infrastructure and controls framework to regulators and investors. There is potential for a seismic shift in the industry and managers must both address the challenges but also seek the opportunities for achieving real competitive advantage.


Regulatory developments
The hedge fund industry has been the focus of significant attention over the past year in light of the recent global economic crisis.

• EU Directive
Following the G20 recommendations regarding the financial crisis and pressure from the European Parliament, on 29 April 2009, the European Commission issued a draft European Directive to establish a regulatory framework for AIFMs. It aims to “…create a comprehensive and effective regulatory and supervisory framework for AIFM in the European Union.” The proposed Directive will require all AIFM within scope to be authorised and to be subject to harmonised regulatory standards on an ongoing basis. The executive summary comments on some of the issues arising from this proposed Directive.

• EU supervision
Jacques de Larosière, the former head of the IMF, reported to the European Commission on cross-border supervision in the EU to remedy flaws in the current patchwork of national supervision. His report stated that there was a risk of “major dislocation” in the markets if significant hedge funds ran into financial difficulties. His approach was for a European Systemic Risk Council (ESRC) with an effective risk warning system so that if a national regulator was not deemed to be taking adequate action to deal with risk, the ESRC would take immediate action.

• Lehman Brothers
The impact of the Lehman Brothers administration on investment managers has focused attention on operational issues around settlement, the holding and use of collateral and pricing, and also upon segregation arrangements for client money and custodied assets, particularly through the use of cash and margin prime brokerage accounts.

• FSA view
Nearly 85% of European hedge fund managers are based in the UK so it is worth considering the UK regulator’s observations. Lord Turner, chairman of the UK’s FSA, gave a regulatory response to the global banking crisis. It made reference to the “shadow banking system” – investment banks, mutual funds and off balance sheet vehicles – performing credit intermediation and maturity transformation functions whilst not being subject to adequate capital and liquidity constraints. The FSA does not consider that there is any evidence that hedge funds have made a significant direct contribution to the underlying causes of the current economic crisis. However, it does say that the effective regulation of the potential systemic impacts of hedge funds, or clusters of hedge funds, should be considered as an important part of the future regulatory framework, both globally and nationally. Key components of such a framework would include the mandatory authorisation and supervision of hedge fund managers, an effective enforcement regime and transparency/disclosure requirements. The FSA has also been focusing upon remuneration and internal capital adequacy assessments.


Summary of some specific country regulatory changes

• France

In France, since October 2008, the regulations or by-laws of hedge funds may provide for a ceiling above which redemptions may be limited. Contractual funds are not subject to rules relating to diversification of holdings or limits on the amount of leverage they may employ, and since 24 October 2008, they have been able to invest in assets other than securities or financial instruments such as aeroplanes, boats, works of art and real estate, provided that they comply with specific requirements set out by regulations.

• Guernsey
In Guernsey, from 15 December 2008, a new regime of investment fund regulation was implemented, applicable to both open-ended and closed-ended funds. All Guernsey funds are now classified as either “authorised funds”, subject to ongoing regulation by the Guernsey Financial Services Commission (GFSC), or as “registered funds”, subject to limited ongoing supervision by the GFSC. There is no restriction with respect to the type of activity undertaken by afund designated as either an authorised fund or a registered fund, although registered funds cannot be offered to the Guernsey public. The GFSC introduced a fast track registered closed-end fund regime, where the turnaround time is normally 10 days or less, subject to the administrator satisfying the GFSC that its due diligence is complete and the promoter has a favourable track record in an established jurisdiction.

• India
The Securities and Exchange Board of India removed the restrictions on indirect investment via Participatory Notes (“P-Notes”) from October 2008, effectively allowing hedge funds to invest either directly by seeking registration as a Foreign Institutional Investor sub-account or by obtaining indirect exposure by investing via P-Notes.

• Isle of Man
The Isle of Man has seen considerable change and consolidation in the regulations applicable to collective investment schemes and those persons providing services to them. The Collective Investment Scheme Act 2008 and Collective Investment Schemes (Definitions) Order 2008 have replaced the provisions of the Financial Services Act 1988. The CIS Act identifies three classes of scheme: authorised schemes, international schemes and recognised schemes. Authorised schemes are established in the island and offered to the general public; international schemes, which are not authorised or exempt, cannot be offered to the general public in the Isle of Man, and Recognised schemes are managed or authorised under the law of another country or territory outside the Isle of Man and cannot be promoted to the general public until they have been recognised by the Isle of Man’s Financial Supervision Commission.

• US

The US congress is currently considering changes to the SEC hedge fund registration regime that may have an impact on offshore managers. At the time of this publication, however, there are no new details regarding the extent of the proposed changes and whether they will actually impact offshore managers.

• UK
The UK’s FSA has introduced the requirement to disclose short selling, specifically that firms must report all net short positions in excess of 0.25% of companies’ issued shared capital. The FSA has also published a number of papers based upon effective risk management and the need for more extreme stress testing and scenario analysis, given that their regulatory reviews indicated many firms’ testing is not as robust or embedded in senior management as they would expect. The introduction of the Funds of Alternative Investment Funds (FAIF) regime into the UK, in which retail investors could be sold funds of hedge funds, has been deferred by the FSA in light of market sentiment, with the likelihood that it will not go ahead.

Taxation Developments
Over the past 18 months a number of hedge funds and their managers, have closed their doors. With lower returns and greater investor demands for liquidity, and hence redemptions, a large proportion of funds have seen AUM fall drastically. The result of this impact for many managers is that their mass is now half or even a quarter of its size in 2007. While the hedge fund industry works its way through the current crisis, some forecasts indicate that recovery is coming and some commentators believe that by 2013 the industry should be thriving again. It is important to realise, however, that the new, recovered, hedge fund industry will have metamorphosed from what we currently know and expect, to something new and different. So the question right now has to be: What are the tax challenges facing the remaining players and how will the landscape shift in response to the huge upheaval of the financial markets?

Offshore versus onshore funds

One of the key questions facing not only hedge fund managers but traditional fund managers is the “offshore versus onshore” debate when dealing with fund domicile. There are a number of advantages to operating in an onshore regulated market rather than in an offshore centre such as Cayman. But one of the key drivers to fund location is tax. Have the onshore jurisdictions got it right and made it attractive from a tax perspective to domicile funds in their territory?

The Undertakings for Collective Investment in Transferable Securities Directive (UCITS III) has produced a flexible fund model for asset managers to utilise as it has wide ranging investment powers which include the use of derivatives and indices.

The UCITS brand has been successful not only across EU borders but also in the Asian and South American markets. A common misconception is that UCITS means a product that is marketed to retail investors, however, this is not accurate. UCITS funds are very flexible and allow for institutional as well as retail investors. Over the last 12 months we have seen a number of hedge fund managers enter the regulated UCITS market as a new way of raising capital in difficult times.

Turning specifically to the EU onshore fund domiciles there has been an explosion of funds being set up in Luxembourg and Dublin due to their favourable regulation and the exempt tax status of funds located in these jurisdictions. That said, the management of these funds still resides largely in the UK where the investment professionals are located. More recently the UK authorities have tried to improve competitiveness of the UK funds market by giving UK funds greater clarity on the distinction between what constitutes trading versus investment. There is now a white list of transactions for UK AIFs which mirrors the list of “investment transactions” that qualify for the UK Investment Manager Exemption (IME). Given that onshore products can now be managed as tax efficiently as offshore products, it could mean that the convenience of locating the fund, as a regulated onshore fund offering, in the same territory as the manager will be more of a driving factor. Post the UK Budget 2009, we are already seeing interest from the industry in establishing tax efficient onshore funds as a complementary offering to an existing offshore fund range.

United Kingdom
There has not been the same success around the introduction of the FAIF regime in the UK, largely because there is not an efficient tax treatment to go hand-in-hand with the regulatory regime. This vehicle was heralded as facilitating UK retail investment in hedge funds and was intended to provide a model which spread risk by using the fund-of funds model. The difficulty in agreeing the tax treatment, however, has resulted in delays to any product being launched.

Tax Havens
Following the 2009 G20 meeting, and the draft European Commission Directive for Alternative Investment Fund Managers, political agendas across the globe are weighing heavily on hedge funds, and this has created an increased focus on tax havens and a consequential call for there to be full tax information exchange. We understand that the Cayman Islands and certain other offshore territories have already and will continue to sign up to these agreements which should afford them “white list” status and they should therefore remain as an offshore fund domicile of choice.

Other territories
Interestingly, the Asian and South East Asian regions are pushing forward with their plans to attract more fund managers. We have seen the implementation of an independent agent exemption for fund managers operating out of Japan. This is a welcome change for fund managers operating in Japan as the need for the work around solution, whereby decision-making takes place in Hong Kong, has been removed. In addition Singapore, which had already introduced a domestic exemption, has relaxed some of its requirements this year in order to stay competitive with Hong Kong.

Other territories are seeing increased lobbying for similar exemptions to be introduced in their jurisdiction. These territories include Australia and New Zealand and it will be interesting to see how this progresses, and whether there is an actual desire from the local governments to build their financial service centres and attract hedge fund managers to these locations.

Capital Profits
Capital profits treatment continues to be debated across the world, with the US Obama package still pushing on how the treatment of the taxation of carried interest or performance fees might be amended. Germany has introduced a flat rate of tax for income and gains for individuals which means that there is no longer an advantage in receiving one over the other (although there is grandfathering in relation to investments held prior to 1 January, 2009). There is a 95% exemption on tax on dividends and capital gains for corporate investors holding hedge funds, as long as the fund provides additional reporting to German investors.


From the changes outlined above, it is clear that regulatory bodies and tax authorities have hedge funds firmly in their sights but there is still opaqueness on the nature of the regulation requirements in the new environment of hedge funds. However, we can be certain that tax information exchange from the offshore territories will be a must. There is no question that onshore funds will play their role in the new world, and offshore funds will remain in play, and it will be interesting to observe which becomes the preferred choice, and that, of course, is in the hands of investors and politicians. THFJ

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