Regulation of Hedge Funds in Capital Markets Law

A never ending story

Originally published in the October 2007 issue

The debate on the regulation of hedge funds is once again in the news because of turbulence in the sub-prime mortgage markets in the United States after several hedge funds failed with their investments partly or entirely. The reason for the failures was that in the US mortgage market this spring, default rates for loans to debtors with lower credit scores ('sub prime') increased significantly, leading to the collapse of more than 20 institutions that had specialised in this market segment.

One cause of the precarious situation of these and other hedge funds is that, because of the large number of hedge funds (now approximately 9,000 to 11,000) and the volume of investment being managed (approximately US$1.6 to US$2 trillion), it is becoming increasingly difficult to find investments that can match the high yields achieved in the past (returns on investments of 10% to 25%). To meet such targeted returns on investments irrespective of the current market (absolute return), funds may employ risky investment strategies or use borrowed money to leverage investments. If the interest payable on borrowed capital is below the expected return on the investments, the result can be increased equity yield. If, however, the investment yield is lower than the interest rate for borrowed capital, leveraged investments also can deplete equity.

In the current debate demanding increased regulation of the market, it is already becoming apparent that, because of the increased volume of invested capital being managed and the investments in hedge funds being made by institutional investors, future investments in hedge funds are destined to achieve lower yields and the activity of hedge funds may probably more come into line with the activities of established financial institutions. This implies that risk management systems applicable to hedge funds will need to change to accommodate the greater magnitude of risk.

Importance and risks

The need for and extent of increased regulation should be driven by hedge funds' importance to the financial markets and the risks such funds pose.

When debating increased regulation, one must not overlook the positive overall economic aspects of hedge fund investments. For example, although made primarily with the intention of exploiting inefficiencies in information, some event-driven investments made by hedge funds in the past proved the salvation of ailing companies in Germany, such as the 'Ihr Platz' drugstore chain. Hedge fund investor participation in these companies guaranteed that unprofitable corporate structures could be dissolved and then adjusted to the existing competitive situation. This did lead to short-term loss of jobs, but in the long run, allowed distressed companies to achieve financial stability, giving them the ability to create new jobs – which, incidentally, they are doing.

Hedge funds also provide needed capital to high-risk industries. While companies in these industries often are unable to repay conventional installment loans, hedge funds can provide loans to solve their short-term cash flow problems and provide additional working capital. This capital is, of course, expensive because the loans bear high interest rates.

The risks for the banking sector associated with hedge funds can be categorised as:

  1. Credit risk of loans;
  2. Investment risk of invested capital in hedge funds; and
  3. Trade risk from trading in derivatives on the OTC markets with hedge funds.

In participating in these markets banks often are subject to conflicts of interest. On the one hand, they provide loans to hedge funds, and on the other, they participate in the credit derivatives market as credit default swap providers. In case of buying back mortgage loans, such transactions could result in a manipulation in the credit derivatives market. Many hedge funds had speculated using credit default swaps and now believed they had been defrauded as a result of the bank's activities.

In order to reduce risks like these, some propose that hedge funds' activities be regulated indirectly through stricter government regulation of prime brokers. Hedge funds typically collaborate with banks and specifically with prime brokers specialised in working with the hedge fund business. These entities loan capital to hedge funds and act as lender of securities during short sales. The US investment banks Morgan Stanley, Goldman Sachs and Bear Stearns currently dominate the worldwide prime brokerage business. Indirect regulation of hedge funds through prime brokers is unlikely fully to achieve the intended purpose, because the larger hedge funds regularly collaborate with numerous prime brokers, so no one prime broker would have a comprehensive overview of a hedge fund's risk situation.

Regulation in other countries

The debate over increased regulation of hedge funds is not limited to Germany. While Germany (where hedge funds already are regulated based on the German Investment Act – Investmentgesetz) is advocating increased regulation internationally or at least mandatory self-monitoring of the industry, the United States and the United Kingdom, where most hedge funds are based, do not favour strict international regulation, even if stricter German regulations apply to individual funds.

In the United States a recent regulatory change aimed to improve regulation of hedge funds. In the aftermath of the LTCM crisis, although the SEC's main focus remains protection of the financial markets from systemic risks, the agency also has an interest inimproving protection for hedge fund investors, who may include inexperienced investors.

The new regulation therefore obligates hedge fund investment advisers to register under the Investment Advisers Act as of February 2006. Under the new regulation the SEC expects to prevent cases of fraud and to be able to obtain more detailed information on the hedge fund industry, to guard against conflicts of interest through the required appointment of a compliance officer, and to keep less-experienced investors from directly investing in hedge funds through the act's prohibition on profits-related payments to persons other than qualified clients. Under the new regulation, investment advisers must take each individual client into account and can no longer treat entire funds or investment companies as one client for purposes of the 15-client exemption. However, the Investment Advisers Act generally only obligates an adviser to be registered if it has investment capital of at least US$30 million. (An adviser with less investment capital might still be required to be registered under individual state securities regulations.) The act and regulation impose reporting and disclosure requirements and authorises the SEC to conduct regular monitoring as well as individual inspections.

Aspects of the new regulation have been strongly criticised, at times even from the ranks of the SEC itself. Critics assert the new regulation would not have prevented most of the cases of fraud cited and that, in any case, the number of fraud cases in the hedge funds sector was comparatively small. According to the critics the new regulation provides only specious security for investors, while imposing significant costs and creating implementation problems.

In England, the British FSA is considering tightening the legal framework for hedge funds. The regulatory authority is giving particular attention to the influence of the hedge fund industry on the stability of the financial market and suspected attempts to manipulate the market, but also is considering stricter rules to protect investors. In order to obtain a better understanding of the industry, the FSA has begun regular monitoring of 25 of the most important hedge funds. The authority emphasises that it will only consider moderate changes so as not to give the industry reason to migrate elsewhere. Furthermore, the prohibition on public sales also is being reviewed. How corporate policy is influenced by shareholders acting aggressively is, on the other hand, not considered to be a hedge fund industry-specific problem, but instead will be discussed in a more general setting.

Regulatory approach

In the approach to regulate the prime brokers already discussed, this would mean that the prime brokers would have an important role as quasi-regulators. This indirect control mechanism would combine monitoring efficiency and monitoring effectiveness. Under this approach, governmental oversight, if any, should take the form of better protection and monitoring of implementation of risk-control mechanisms by banks and prime brokers. In fact, at this writing many banks and prime brokers already are satisfying their indirect control function by demanding extensive information about risks from their hedge funds within the scope of their own internal control systems.

The overall objective of any change in regulations should be minimising the risk of market disturbances while providing appropriate protection for investors, without taking away the incentives for market participants or even negatively impacting the effectiveness of market mechanisms. For the most part, those currently debating the subject are in agreement that this kind of regulation only makes sense on an international level and that offshore financial centres also must be included in the discussion, because increased regulation by individual countries would only lead the industry to migrate to the area of least restrictive regulation and would not create greater stability in the internationalfinancial markets.

In principle, a variety of regulatory approaches could be taken:

  • Regulations could be imposed on the economic activity of hedge funds, for example, by putting restrictions on short sales or introducing limitations on shareholder voting rights for short-term investments.
  • Regulations also could require hedge funds to disclose the investments they have made, including for example information about separate positions, netted overall investments and investment leverage. This approach would require specifying the form of the disclosure and the party or parties who would be entitled to receive the information or benefit from the increased transparency: the financial market regulatory authority, the prime brokers, investors themselves, or all of the above?
  • Finally, increased regulation also could take the form of stricter corporate governance provisions, to protect the other shareholders and the companies' management.

Following the events concerning Deutsche Börse AG, an additional registration threshold below the 5% limit stated in § 21 WpHG [=Wertpapierhandelsgesetz; German Securities Trading Act] was already implemented, bringing the threshold to 3% to improve transparency as to a fund's most important investments and to allow companies whose shares had been purchased by hedge funds to react accordingly. The proposal to reduce from 30% to 25% the threshold for the obligation to submit a takeover offer (§§ 29, 35 WpÜG [=Wertpapier Übernahmegesetz; German Securities Acquisition and Takeover Act]) has a similar slant, especially in view of the sinking attendance numbers at annual general shareholder meetings. Instead of reducing this threshold, however, the more appropriate focus would be on acting in concert as per § 30, paragraph 2 WpÜG (or rather § 22, paragraph 2 WpHG), and the efficiency of the imputation rules (which have proven problematic, even in the example of Deutsche Börse AG), especially since the adjusted threshold corresponds to the rules in many other European countries. This proposed action might even have the result of discouraging investors oriented toward long-term investments.

An alternative proposal in the regulation debate calls for hedge funds to be evaluated on a voluntary basis by recognised rating agencies. Here the financial markets would fall back on the proven expertise of rating agencies, which would need to expand their offerings somewhat to be able to provide these services. The larger rating agencies already are in the process of creating rating approaches specifically for hedge funds. There are, however, limits on the ratings process in the hedge fund environment. Unlike traditional corporate credits, the composition of a hedge fund's assets, and with it risk potential, can change significantly within a short period if the fund is in active operation, as would be typical. Rating agencies are thus unable to assess the exact position of a hedge fund in real time, with the result that deterioration of asset value can be recognised only after it's too late. The rating proposal being debated would thus seem in need of improvement and is in any case not at a stage at which international consensus can be reached. Moreover, the data to date predicts that most funds will not seek to be rated as long as the scheme is voluntary. In fact, a German proposal calling for a voluntary code of conduct aimed at greater transparency fizzled without any international consensus when it was presented informally during the G8 Summit.

Finally, another possible approach would be to stipulate mandatory basic principles for hedge funds (guiding principles) such as those planned by the Central Bank in The Netherlands. In this proposal, the regulatory authority will stipulate specific principles aimed at managing the risks of retirement funds, insurance companies and financial institutions. At a later date an analysis would be performed to determine whether adequate risk management systems had been put in place. Banks in particular would have to ensure that their risk plans satisfied the regulatory authority.


It remains to be seen whether combining components of these proposed measures can lead to a workable international solution agreeable to all concerned. Regulation of prime brokers, which could be obligated to officially disclose to the respective regulators their loans or other activities seems preferable to direct oversight of hedge funds by governmental bodies.

In addition to greater efficiency, a primary argument for this approach is that the real concern is the effects of hedge fund insolvency on the banking sector, not hedge fund investment strategy. Moreover, this kind of indirect approach seems less likely to drive hedge funds to relocate to offshore financial centres. Furthermore, regulating hedge funds in view of their leverage activities and the ability to circumvent regulations is to be recommended, however only to such a degree that it has to do with the specific risks from their investments and not with general risks of the financial market system itself.

In contrast there is no reason why hedge funds should be subjected to any special regulations under company law, especially since those hedge funds which have the objective of following event-oriented strategies make up only a part of the industry and since the active tracking of shareholder interests is in many cases also to be found in the asset management sector. It thus seems questionable to use additional regulations to intervene with regard to market investment strategies.

Dr Andreas Fillmann is Partner in the Frankfurt office of international law firm Squire, Sanders & Dempsey. He is the author of several articles on bank finance and capital markets-related issues and is a frequent speaker on the topic.