Is the time right for a code of conduct?

Originally published in the February 2008 issue

2007 saw pressure build in Europe for greater regulation of hedge funds, including calls from Germany for a global code of conduct for hedge funds. Simon Bennett, Partner, Capco, takes a look at this trend and also asks whether hedge funds current proposals for self-regulation can stave off regulatory intervention.

In 2007, Germany's presidency of the G8 put hedge fund regulation firmly in the spotlight, with German Chancellor Angela Merkel trying to win backing from fellow G8 members for a code of conduct for hedge funds. Although at the time Germany eventually had to back down from these plans, the question of greater regulatory supervision continues to hang over the hedge fund industry.

For an industry often (mistakenly) considered 'unregulated', the hedge fund sector in Europe already has to comply with good deal of regulation. Take the UK, for example. While a fund may be located in an offshore jurisdiction the individual running, if based in the UK, must comply with the FSA's Principles for Business and the guidelines set out in its Handbook. Across Europe, EU regulation is already having an impact on hedge funds through the introduction of MiFID and other directives. Indeed, as the Datamonitor 'Hedge Funds in Europe 2006' survey underlines, Europe is gradually moving towards a pan-national set of investment regulations, albeit slowly. Given that regulation already exists, where do the concerns of national authorities and regulators lie?

What the regulators say

Turning first of all to the UK, the financial regulator, the FSA, remains concerned that hedge fund activity could lead to serious market disruption and erosion of confidence. To combat this, the FSA has taken a variety of steps, including, in 2004, the introduction of its six monthly prime broker survey. There are fears, too, over market abuse, insider trading and manipulation. In its Market Watch newsletter, October 2007, the FSA branded hedge funds "complacent" in their attitude towards insider trading. As a result, the FSA is to visit more hedge funds in the first quarter of 2008 and managers that fail to meet best practice guidelines could be subject to fines. Other important areas of focus are control and operational issues, preferential treatment of investors, mis-valuation of complex illiquid instruments and fraud, as is 'retailisation' – the possibility of the retail market opening to a wider range of alternative investment products.

Oversight of hedge funds is clearly moving up national authorities' agendas in other European countries, particularly as retail investors seek greater access to alternative investments. In France, for example, the Autorité des Marchés Financiers (AMF) set up a working group in April 2007 to evaluate and recommend adjustments to the French regulatory framework for funds of hedge funds (FoHFs). The AMF sought to ensure the regulatory framework was both competitive and provided investor protection. In the selection of underlying funds, the working group recommended a move towards principles-based regulation encompassing "operational and organisational procedures of target hedge funds, their legal status, rules for segregating and valuing assets, and external controls."

A further pressure on hedge funds to act has come from the Financial Stability Forum, which, responding to a request from G7 Finance Ministers and the European Central Bank Governors, updated its report on highly leveraged institutions, recommending, in May 2007, that the global hedge fund industry should review and enhance existing sound practice benchmarks for hedge fund managers.

In response to the Financial Stability Forum's suggestions, the Hedge Fund Working Group, made up of fourteen of the largest London-based hedge funds and chaired by Sir Andrew Large, a former deputy governor of the Bank of England, was set up. On 10 October 2007, the HFWG issued a consultation document, outlining a series of best practice standards for the industry. A final report will be issued in January 2008. The main standards to protect investors include: disclosure of holdings of complex, hard-to-value securities and the methods used to value them; clear risk management plans, including plans to address liquidity risk and the danger of running out of cash; clear policies on dealing with conflicts between investors and managers. The group also called for rules to help companies identify hedge funds and others holding significant stakes via derivatives and voting blocs where funds have no economic interest. As part of the agenda, hedge funds would have to 'comply or explain', agreeing to meet certain standards or tell investors why they were not meeting them. A Board of Trustees would be 'guardians of the standards'.

The creation of the working group was welcomed by the European Central Bank and Peer Steinbrück, the German Finance Minister. The Financial Stability Forum, commenting in October, said that the issuance of draft best practice standards was a "notable step towards improved transparency and discipline" and "recognition by the sector of its responsibilities". Hector Sants, Chief Executive of the FSA, speaking on 20 November, 2007, commented that the FSA was "pleased that the UK managers have taken this initiative." But, he noted, "It is, however, important that such an initiative, if it is to work, receives general industry support and is seen to be adding to the existing code of practices."

Response to the HFWG

So how have the proposals of the HFWG been received? A brief overview of recent press commentary suggests that some in the industry believe the proposed standards will need tightening if they are to be effective. There have been suggestions that the standards are too woolly, whilst doubt has also been cast on the effectiveness of the proposed 'Board of Trustees', given that the only power it would have would be to comment publicly on non-conformity with standards.

Other voices in the industry suggest that the proposed best practice standards do not take investors firmly enough into account. One adviser to institutional investors, Albourne Partners, was reported (in the Financial Times, 3 January 2008), as having written to the HFWG, suggesting that the standards needed to be added to in order to protect institutional investors. According to the Financial Times, the firm called for hedge funds to have proper governance, with a majority of non-executives, face-to-face board meetings and experienced directors, as well as replacing the 'boilerplate' that makes up most prospectuses with proper descriptions of what hedge funds do. The firm also called for the provision of performance targets to investors, preferably in a standard format.

Nevertheless, the HFWG acknowledges that its report includes gaps and that these need to be filled. It also recognises that to be truly effective, the standards would need to be global. To this end, the HFWG has already come into contact with industry bodies such as AIMA and the President's Working Group on Financial Markets (Asset Managers Committee), set up in September 2007, in the US, to examine practices for hedge fund managers.


While certain national authorities, for example, in Germany, appear keen to rein in hedge funds, regulators elsewhere appear more cautious. In the UK, commenting in late November 2007, Sants underlined that the FSA remained "broadly content with its approach to the regulation of hedge funds." He added, referring to the recent turmoil experienced by financial markets, the "FSA's view, which may be contrary to the expectations of some commentators, is that hedge funds were not the catalyst or drivers of the summer's events." Indeed, with governments in the UK, Europe and beyond focusing on banks – consider, for example, the recent proposal by the UK chancellor to give the FSA greater powers to step in where a bank is found to be failing – it may be that present circumstances allow hedge funds a temporary respite as regulators turn their attention to more immediately pressing matters.