Code of Conduct

An alternative for the regulation of hedge funds

Originally published in the December 2007/January 2008 issue

Arising from many discussions and the obscurity that surrounds hedge funds, the industry is contemplating an institution of a Code of Conduct. Hedge funds have fallen under watchful eyes recently in response to concerns that risky strategies could cause insolvency or illiquidity of institutions that would worldwide render financial markets unstable. The up to €1.5 to €2 trillion hedge fund industry is hoping that a Code of Conduct might help alleviate some of the stress that investors and market participants experience in the last couple of month. Activists of the currently unregulated industry also believe that a Code of Conduct will be an alternative to actual and future national regulation.

Is this the right approach? First of all, it is important to understand the legal environment of the establishment, administration, sales activities and brokerage of the world wide hedge fund industry.

Regulation Alternative 1: Seat of corporation

The choice of the seat or jurisdiction is an important aspect in the structuring process of a hedge fund. Once the jurisdiction has been chosen, a decision has also to be made on whether to base the fund domicile in that jurisdiction or, if permitted by law, establish it there and receive the administration of the fund from a hedge fund manager in another jurisdiction. Most hedge funds are established as limited companies or limited partnerships according to the law of an offshore location such as the Cayman Islands, British Virgin Islands, Bermuda, Guernsey, Isle of Man, and Jersey.

The laws and regulatory requirements governing the funds, confidentiality laws, banking secrecy laws, local tax and double tax treaties makes such jurisdictions especially attractive for the hedge fund industry. Although, no jurisdiction is likely to satisfy all requested criteria, hedge funds will weigh the aforementioned factors against each other.

Additionally, the local management company might be established in this jurisdiction which is not controlled by outside regulators. Typically, the local management company will then delegate the daily investment management function to an external investment adviser. Furthermore, such domiciled companies are not regulated by any European or US company or capital markets laws, and it is very doubtful that such offshore states want to introduce severe regulation.

Regulation Alternative 2: Sales activities

Another possible regulation is the restriction of their sale activities. Units of hedge funds are predominantly sold within the United States and Europe and in this regard are legally embedded into European or US regulations.

German regulations

In January 2004, the Investment Act (Investmentgesetz, InvG) and the Investment Tax Act (Investmentsteuergesetz) came into effect in Germany. The Acts opened the German investment market for hedge funds, whereby both single hedge funds and funds of hedge funds have been introduced. The Investment Act describes hedge funds as funds with additional risks or funds of funds with additional risk and gives some specific rules in relation to hedge funds and their distribution in Germany. According to the InvG, hedge funds must not be offered to the public pursuant to sections 112-115 of the Investment Act) and only shares of so-called “Dachhedgefonds”, funds that invest in units of target hedge funds, are allowed for public distribution.

But the scope of sections 112-115 InvG is limited, referring only to domestic investment assets pursuant to section 1, clause 1 InvG. Thus the regulation applies only to funds administered by a German investment management company (Kapitalanlagegesellschaft) in terms of section 6 InvG or those sold as shares of an investment stock corporation (Investmentaktiengesellschaft) pursuant to section 96 InvG.

Besides this, public marketing of foreign hedge fund shares in Germany is subject to the regulations of sections 135-140 InvG. Public sale of units of foreign hedge funds is thus prohibited pursuant to section 135, clause 1, sentence 2 InvG. It has to be considered that the term public is legally defined in section 2, clause 11 InvG and includes sale through public offer, public advertisement or the like. However, it has to be noticed that a private placement is not regulated in Germany and the units can be sold to private and institutional investors.

UK Rules

In principle, the UK also prohibits the sale of hedge fund shares as ‘unregulated collective investment schemes’ within British territory. But this does not apply if the investor himself addresses to the fund. The sale is also allowed insofar as so-called ‘certified high-net-worth individuals’ are concerned.

Additionally, so-called ‘high-net-worth partnerships’, which dispose of a net asset of at least GBP 5 million, are excluded from the prohibition. Furthermore, the aforementioned exemptions are completed by the Conduct of Business Source Book (part of the FSA Handbook, which summarises the rules of conduct for authorised persons). According to this source, ‘unregulated investment schemes’ can be offered to other investors; eg. those who are classified by agents as an ‘intermediate customer’ or ‘market counterpart’.

US Regulations

In the United States, hedge funds comply with the definition of an investment company and are therefore in principle regulated by the Investment Company Act of 1940. The Investment Company Act requires such investment companies to be registered with the SEC and regulates their activities. Pursuant to its section 7(d), all companies whose shares are sold within the United States must be registered and comply with all requirements in the Act. However, there are some exemptions regarding the regulation pursuant to US capital market law. Funds are freed of the duties of the Company Act pursuant to section 3(c)(1) if they (i) not publicly offered, and (ii) have fewer than 100 investors, where foreign investors are not considered. Furthermore, they are excluded pursuant to Rule 206(4) section 3(c)(7) if they (i) not publicly offered, and (ii) addressed only to so-called ‘qualified investors’, individuals who dispose of an asset of at least US$5 million. Furthermore, it is a precondition that the fund does not sell its products publicly. Most funds fulfil one of these exemptions and therefore do not have to be registered.

In addition, sale of hedge fund units in the United States is regulated by the provisions of the Securities Act of 1933. In essence, the Act requires publication of a prospectus and application to the US Securities and Exchange Commission (SEC) to be distributed. If a sale does not take place through public offering, the Act provides an exemption in Rule 506 section 4(2). In principle, there is a 35-investor limit for private placements, but this does not include ‘accredited investors’. Besides the more defined companies, private investors also are regarded as such investors if they meet one of the following conditions: Either they dispose of, alone or together with a spouse, an asset of more than US$1 million, or they achieve, alone, an annual income of more than US$200,000 or, together with a spouse, of more than US$300,000. Consequently, a hedge fund can sell units to an investor who is considered accredited without being bound by the limitation of 35 investors.

Furthermore, private placements of fund units to US investors are generally made in accordance with the exemption from registration pursuant to Rule 506 of Regulation D of the Securities Act 1933.

Regulation Alternative 3: Domicile of hedge fund management

A further link for state regulation and monitoring is the domicile of the management. Hedge fund managers in Europe and Asia already operate under the full authorisation and supervision of leading international regulatory authorities such as the BaFin, FSA, the Autorité des Marchés Financiers in France, SEC and the Securities and Futures Commission in Hong Kong. Additionally, European managers already must comply with a multitude of Europe-wide regulations such as MiFID and CAD2. In particular, MiFID regulates risk management;fair, clear and not misleading communications; conflicts of interest; and the aspects of outsourcing which are directly relevant to a hedge fund’s management.

In the UK, for example, hedge fund management must apply for an allowance, according to the British Financial Service and Markets Act of 2000, for its activities, so hedge fund managers are regularly registered with the FSA. The FSA verifies whether the relevant person has sufficient experience with assets administration and direct access to market information. But again, it has to be considered that the FSA cannot regulate a hedge fund corporation itself, only its management.

Introduction of a Code of Conduct in UK

Does possible development of a voluntary Code of Conduct therefore have any relevance or meaning in this context of existing regulations?

On 10 October, the Hedge Fund Working Group, representing 14 leading hedge fund managers based mainly in the UK, published a consultation paper on hedge fund standards. The best practice standards in the consultation paper include disclosure, valuation, risk management, fund governance and activism. In terms of disclosure, managers should especially consider whether commercial terms are disclosed in sufficient detail to enable investors to make informed investment decisions. Managers should ensure that the methodology for valuing complex assets is transparent and should develop an appropriate approach to deal with risk, with particular emphasis on liquidity. Furthermore, managers should ensure that adequate structures are in place to handle potential conflicts between managers and investors and to comply with corporate governance principles. Finally, it recommends that regulators should, as a general rule, require all investors to disclose their interest in companies through holding derivatives such as contracts for differences (CFDs) and should not vote on matters concerning borrowed shares where they have no underlying economic interest.

The consultation paper also proposes establishment of a board of trustees to supervise the standards. It remains to be seen how large an impact the Code of Conduct proposal, if implemented, will have on the hedge fund industry. Especially the question regarding the enforcement in case of any wrongdoing or misbehaviour has to be discussed.

US rules

The situation in the United States is similar. Hedge fund managers must register in accordance with the Investment Advisers Act of 1940. The SEC regulates investment advisers pursuant to such Investment Advisers Act. The Act defines the term ‘investment adviser’ generally in such a way which includes any person (or entity) who for compensation is engaged in the business of providing advice to others or issuing reports or analyses regarding securities.

Accordingly, advice on investment in bonds or other financial resources must be registered with the SEC unless specifically excluded or exempted under the Investment Adviser Act. In this regard there is an exemption for ‘private fund advisers’, who are not subject to regulation if they (1) had fewer than 15 clients during the preceding 12 months, (2) do not pose as an ‘investment adviser’ in public and (3) do not advise companies registered as investment companies under the Investment Company Act, as is the case with managers who advise funds resident abroad and those who, as mentioned above, are not obliged to register as an investment company. It must be taken into account that the Investment Advisers Act does not consider the client himself as an investor, but the hedge fund, so that an adviser may advise even 14 different hedge funds without being obliged to register.

Regulation Alternative 4: Banking regulation

The fundamental risk caused by hedge funds activities is the systemic threat to the stability of national and global capital markets. Thus, particular risks arise for banks doing business with hedge funds. As a consequence, one other way to regulate and monitor hedge funds is to indirectly monitor the acting banks as prime brokers, lenders or counterparts in derivative transactions. This monitoring could be done in such a way that, within the existing regulatory control of the risk management of the banks by the respective regulatory authorities in the domicile countries of the banks, so that the activities of the involved banks in the hedge fund industry would be analysed more precisely. During the meeting of the European Finance Ministers on 8 May 2007, this indirect supervision was considered the preferred method of controlling hedge funds.

However, the indirect approach raises the question of appropriate responsibility criteria. As mentioned earlier, hedge funds are established in one country, they market their shares in another country, their investment managers or investment advisers are located in a third country and they possibly do forward or derivative transactions in a fourth.

Consequently, it is difficult to determine which state should regulate a fund or in which country monitoring shall be executed. A starting point would be to execute regulation and monitoring where the risk from a hedge fund deal could arise.

Additionally, there is the problem that national financial regulators are able to monitor only a part of the borrowing or the derivates business activity of hedge funds. Hedge funds usually operate with banks in different countries and use forward trading or derivatives with banks from different nations for protection. Besides this, it has to be taken into account that national financial regulators have no handle on the funds but simply monitor banks doing business with hedge funds. Furthermore, it is problematic to determine which country regulator is responsible for the regulation and monitoring of a hedge fund. Pursuant to the country-of-origin principle, regulators could look first of all to the residence country or the country where the most investors are resident. Such a principle, however, cannot now be internationally realised.


The German, British and US capital market regimes do already have regulations to protect investors considering hedge fund investments. This regulatory protection does not apply, however, if hedge fund units are placed privately or addressed to institutional or wealthy individuals, who intentionally have been regulated in all countries in such a way.

Ultimately, it is important to regulate hedge funds as long as they introduce specific risks but it should be avoided to regulate the more general systemic risk. Therefore, a cooperation of different countries in different regions of the world is essential to achieve effective area-wide regulation, hinder any arbitrage opportunities for the hedge funds industry and for the monitoring of market related risks. In addition, transparency rules should be implemented to improve the overall standing of the industry.



Dr Andreas Fillmann’s practice has focused exclusively on banking and capital markets. He advises on financial regulatory issues, structured finance, project and acquisition finance, derivatives and acts for hedge fund and banks regarding their respective capital markets transactions. His experience with derivatives includes advising investment banks and hedge funds on swaps and hedging transactions based on various master agreements. He also has advised on a large number of equity and debt capital market transactions, acting for underwriters and issuers, including primary and secondary equity placements, stand-alone and structured bond issues and MTN programs.