Hedge Funds and Side Letters: Where Next?

Where does the FSA stand?

Kate Wormald, OESA

Until recently, the FSA seemed to accept that it had no jurisdiction over offshore hedge funds and offshore managers. Then in 2006, it made statements concerning acceptable market practice concerning the issuance of side letters.

To the extent that side letters are issued by offshore funds and offshore managers, this seems to require the exercise of an extraterritorial power to regulate – the very power it had earlier expressly conceded that it lacked. Somewhat surprisingly, AIMA, an industry body, has issued 'guidance' on the subject of side letters to flesh out the FSA requirements, without apparently considering the question of the authority of the FSA to impose requirements on offshore entities. This article discusses some important points arising from these developments.

A regulatory obligation?

In February 2006 the FSA asserted that acceptable market practice requires the disclosure of side letters and managing any conflicts that arise. This was required under Principle 1 (acting with Integrity). But there was no explanation by how this applied to investment advisers in the UK. Investment Advisers do not have a contractual relationship with the investor. The offshore entity is not regulated by the FSA and neither is the manager. So it is difficult to see how this gives rise to a regulatory obligation of a regulated firm.

Principle 8 deals with conflicts of interest and treating customers fairly. If the FSA had grounds for making this disclosure a regulatory obligation, then it should have done so under Principle 8. But it was unable to do so because the investors are not the retail clients of the investment manager. They are the customers of the hedge fund. The hedge fund is an intermediate customer of the firm. The firm is not under an obligation to look through the hedge fund to the investor. In any event the investors are high net worth individuals or institutions. So why is the disclosure even necessary? What does it achieve?

Side letters are used by hedge funds. The commercial rationale is to encourage investment and seed capital from large investors who are often financial institutions who are unlikely to invest without the side letter. This market is a professional market with barriers to entry to retail due to regulatory constraints and minimum investment levels. So is it not easy to understand the FSA's concern.

The FSA also warned that a failure to comply might give rise to market abuse, if a hedge fund adviser dishonestly conceals the existence of a side letter. In most cases it is unclear how such a risk could arise? So it seems a very tenuous peg on which to hand such a disclosure requirement. Therefore, it is surprising to see the authority making such a significant statement without providing any justification. Dare one say that even the FSA does not think through all the statements it makes? But it might well scare investment advisers and their professional advisers to fall into line.

AIMA's role

It is interesting to consider AIMA's role. Last autumn they issued Industry Guidance and this raises some more questions. Industry bodies that give Industry guidelines firstly identify and discuss the issues with their members and address any concerns. Then they formulate the best possible solutions and provide alternatives if possible. This process takes a long time if properly observed. They do not get together a small group of people and issue written guidance to their members. The risk of doing so means that important matters are not addressed.

AIMA developed and expanded the original FSA requirement. This resulted in Industry Guidance on side letters and supplementary guidance being issued. However AIMA did not consult its members nor did it canvass their views before finalising either of the guidance notes.

AIMA's guidance states that the disclosure only applies to side letters that contain "material terms", and it applies "where the firm is a party to the side letter or is aware that a fund of which the firm or an affiliated firm of the investment manager is a party to them". But the guidance did not define what "aware of" means. Nor did they justify how a regulatory obligation could be bestowed on an investment adviser where no contractual relationship existed between it and the investor. The requirement seems to arise from a tenuous connection through awareness. But how much does one need to know before the obligation is imposed. This is a dangerous concept. The investment adviser is meant to make a disclosure and manage the conflicts that arise. But whose conflicts are they? The conflicts are not the investment advisers but the hedge fund's. The board of the hedge fund would be better placed to address these concerns. The investment adviser has the delegated power to manage the portfolio, not the conflicts that arise. So the scope of the disclosure is confusing and the guidance did not clarify matters. Whilst you can see what this is driving at, the simple fact of the matter is that the analysis does not work. It is stretching concepts and Principles to their limits.

So now a difficult question arises concerning the status of the guidance. Following the recent publication by the FSA on industry guidance,4 it seems it could fall into one of two categories. Sturdy Breakwater Guidance, which will be binding on the FSA and require an explicit recognition of its status, or Implicit Recognition that will not be binding on the FSA. The FSA is under an obligation to consult the industry in relation to the former and to follow due process but not with the latter.

Implicit Recognition Guidance is guidance issued by the industry because it is assumed the industry has found itsown solution to a deficiency in a market practice. However as a practical matter regulatory rules cannot be made under Industry Guidance if the FSA could not make them under its own powers . So it begs the question as to whether the Industry Guidance on side letters has any status at all.

Everyone wants to be a good citizen but it is difficult to ensure cooperation when a regulator acts beyond its powers as demonstrated by Mr Goldstein. Investment Advisers in the UK are now faced with a dilemma. They are expected to follow the Industry Guidance. But it has no regulatory status. It does not bind the FSA so they could still be subject to regulatory scrutiny. But what happens if they do not follow it? They could still be subject to regulatory scrutiny.

Now the FSA is continuing its review of the hedge fund industry and on 11 Dec sent a thematic questionnaire to investment advisers. But it only gave them three weeks to reply. One of the questions asked was whether the investment manager had followed the AIMA guidance on side letters. So what happens if the answer is No? Why did the FSA not undertake this investigation before if made the industry comply with this disclosure? Then the FSA would have consulted the relevant parties. Is this a case of the cart before the horse?

Learning from others' mistakes

The uncertainty this requirement and the process are causing is unhelpful and confusing. Whilst you can understand the FSA's concerns with the industry as a whole their approach is inconsistent with their own policies. On the one hand it asserts that the hedge fund and its manager are offshore and outside of its regulatory scope. But then on the other hand it treats the business as though it is onshore and applies retail standards.

Hedge funds are predominantly a wholesale business which should affect how the FSA deals with issues that arise. It looks as though the FSA's first steps have faltered. So the FSA should be mindful of the fact that Regulators as much as the Regulated are required to act within the law and the powers bestowed upon them. Just last year the SEC learnt the same lesson.