The New Regulatory Environment

An expert panel considers the future of hedge fund regulation

Originally published in the April 2009 issue

On 9 March 2009 a high profile panel was convened at the 10th Annual International Conference on Private Investment Funds (a conference co-presented by the Private Investment Funds Subcommittee of the IBA Investment Funds Committee and the Subcommittee on Hedge Funds of the Committee on Federal Regulation of Securities of the American Bar Association Section of Business Law, and supported by the IBA European Regional Forum) to discuss the pressing issue of the New Regulatory Environment. It was a difficult task, given that the panel was meeting less than a month before the G20 summit in London was likely to hatch its own plans for just this question.

The panel was chaired by Michael P. Harrell of Debevoise and Plimpton in New York, and consisted of Andrew Baker (Alternative Investment Management Association, London), Andrew J. Donohoe (US Securities and Exchange Commission, Washington DC), Stuart J. Kaswell (Managed Funds Association, Washington DC) and Kenneth M. Raisler (Sullivan & Cromwell LLP, New York).

A future model for hedge fund regulation
Starting with the UK, the issue before the panel was whether hedge funds would require more regulation, and if so, how pervasive was this likely to be? Baker quickly came to the fore as an advocate of the system already in place in the UK, supervised by the FSA, as well as arguing for a best-of-breed approach to regulation – i.e. use those models that work, that are effective, rather than re-writing the rule book from scratch, much as that might be tempting for G20 finance ministers and others.

Manager authorisation works well in the UK, Baker said, as well as in other European countries and in Asia. The manager authorisation process is an onerous one, requiring submission of a business plan, and the putting aside of capital, as well as a request for permission from the regulator to manage a particular strategy. It also includes an approved persons regime, in which senior staff have to submit to scrutiny, and be appointed to specific roles within the organisation. If an individual does not have the qualifications to man a given post within a firm then the regulator has the power to disqualify him/her from doing so. Add to this a specialist supervisory team that maintains strong relationships with the top hedge funds in terms of size, and a solid regulatory framework is already in place, Baker argued.

“In the case of the UK industry, somewhere between 30 and 40 of the top funds are what’s called ‘relationship managed’,” Baker explained. “That means that there is a regular dialogue on issues which are of topical interest, whether it’s counterparty risk issues, whether it’s crowded trades, whether it’s to conduct a quick survey on short selling, there’s a ready mechanism to tap into the top firms without having to crank up a wide piece of machinery.”

In addition, the FSA also regularly polls the UK prime broking community, focusing particularly on the levels of leverage being extended, in order to assess systemic risk. In Baker’s words, “it is a good and regular snapshot.”

What is missing, however, is a more formalised approach to direct supervision of the larger managers and funds, but this will require more formal definitions of issues like systemic risk, and where organisations are sufficiently large to pose a risk in that respect.

Up for discussion right now in the UK is how this reporting should occur: do the managers or the funds report to the regulator, and what sort of information would be most useful to the FSA in its duties? Risk concentrations within portfolios, leverage, and redemption provisions are all fair game in this debate.

The US model is slightly less onerous of course. US hedge fund managers only need to register with the SEC if they have more than 14 clients, and clients have been defined essentially to mean a fund, unless individualised investment advice is given to the investors as well. Obviously, efforts to register hedge funds in the US have been defeated in the courts in the past, but now the wind is blowing from a different direction, particularly with Congress considering the registration of fund re-sales, and the Obama administration re-opening the issue of adviser registration.

“The handwriting on the wall is pretty clear,” said the MFA’s Stuart Kaswell. “There’s a very great likelihood that there will be regulation of hedge fund advisors, and that’s something that we’re not necessarily thrilled about, but we understand that’s going to be part of the landscape.”

The MFA is keen to be closelyinvolved in the US regulatory debate, and also professes that hedge funds were, at worst, a transmission function for the financial crisis. According to Kaswell, it is now less a case of, if hedge fund registration will come into force in the US, and more a case of when.

However, the US regulatory tapestry is a complex one. For starters, it is the victim of Congressional arm-wrestling over the future of the country’s financial infrastructure, how that should be overhauled, and which Congressional committees should be involved in helping to define that. Kaswell emphasised the jurisdictional divides that exist within Congress, including the desire by Barney Frank, Chairman of the House Financial Services Committee, to focus on the need for a risk regulator within the US.

Kaswell’s view is that hedge fund registration will arrive as part of a broader package of regulatory reforms. “The Senate side is a little less clear,” he explained. “They’re going to start hearings as to what’s likely to take place, and the order is a little bit less defined. But both lobbies are going to be looking at all of these issues, and the outcome is likely to be for some change in the regulation of hedge fund advisors.”

Of course, there is still a large question mark hanging over the role the SEC would play in all this, and how regulation and reporting would work in practice. Should reports by registered firms be made publicly available, or just to the regulator? And are regulators equipped to handle and effectively assess and act on that data?

“Their bias is to make it public,” said Raisler. “Making a level of information available to the public in various forms is a heartfelt issue in the hedge fund space. Disclosure is obviously an obligation.”

But what should be disclosed? This is another pressing issue for lawmakers to consider. Raisler, however, was confident that the larger, more sophisticated firms would be equipped to deal with most of the disclosure requirements Congress is likely to throw at them.

The bigger threat, he said, comes in the so-called “second tier”, i.e. the instruments Raisler describes as “the life-blood of the industry.” This includes the already controversial topic of short selling, then moves on to the more esoteric climes of the CDS and broad OTC markets. “This is really very different from hedge fund regulation per se, because it covers a whole swathe of businesses; but I think if you want to attack the business of the hedge fund, and undermine its potential for success, it would be substantive regulation or, in fact, prohibitions of some of these other kinds of activity.”

He pointed to last year’s short-selling bans as an example of how regulatory intervention could be destructive. “The issue of regulation of hedge funds really is only the tip of the iceberg, it’s really what’s below the surface that we have to get focused on.”

The SEC’s Andrew Donohoe accepted that the US regulator is navigating a different path from the FSA, one based on disclosure and an overriding fiduciary duty. The focus is on ensuring that the free enterprise system continues to work well. It is still a principles based regulatory system, however, and could still be called light touch.

The 14 or fewer clients exemption goes back to the 1940 Advisers Act. At the time, the issue was not viewed as being of sufficient significance to warrant federal government intervention. That is something that has obviously changed. “When you have funds that are hedge funds, with billions of dollars in assets under management that are not registered, and you have an adviser with 15 clients and US$50 million who is, that doesn’t necessarily make sense from a regulatory standpoint,” Donohoe says.

Speaking personally, he said the likely approach Congress will take is to focus on the issues of risk and strategy. Because of a lack of a clear legal definition of what a hedge fund is, the SEC is currently forced to lookat funds which benefit from an exemption clause from the definition of an investment company. This therefore covers not only hedge funds, but also private equity and venture capital vehicles.

Donohoe seemed alive to the fact that hedge fund registration, if introduced, will bring with it massive new volumes of work for his division. What is needed, he argued, is an established mechanism for defining a hedge fund, and clearly quantifying the numbers of hedge funds operating in the US. At the moment, without sufficient data, it becomes harder for Congress to make informed policy judgements, but on the other side of the coin, the need for data is not the raison d’être for regulation.

“In the US regulatory system, even if you’re not registered as an adviser, you’re still subject to all the requirements,” Donohoe said. “It’s not as if you’re outside the regulatory regime, but you’re not subject to inspection by us, [and] you’re not subject to many of our rules regarding record-keeping. I do think that we’ll see a form of registration, but it’s not actually going to be up to us.”

The question is, what is driving the demand for greater regulation of hedge funds? Is it investor protection? If so, can this be fulfilled by putting out reams of new data on hedge funds into the public domain? Alternatively, structural issues could be addressed, perhaps defined attributes like how much leverage can be used, or additional capital requirements. Independent custody or exemption from a framework of law, frequency of reporting or fidelity bonding are all other options that could be considered.

“You could pick and choose some of the things that go into the structure of investing companies,” said Donohoe. “I think better funds already do much of that. But then what is the expectation once you’re in that structure, about what role we want? Once you’re there, increasingly, as time goes on, people will want us to do more.”

Best practices and their role in the regulatory template
No discussion of the current state of play in US hedge fund regulation would be complete without touching on the President’s Working Group (PWG) of course. The PWG has been focusing on transparency, disclosure, and investor protection, and could form a starting point for future US hedge fund oversight. It dealt in particular with the way in which hedge funds manage their affairs internally in order to provide the investor community with more confidence that they were acting in a responsible manner.

In short, its findings argued for a best practice code that funds could adhere to. This has also been captured by AIMA and the MFA, as well as the broader investment community, but sadly may not now be enough to stave off the inevitable burden of additional regulation.

“I think what you’re always worrying about when you develop best practices is that you’re writing a script for the regulators to adopt by way of legal requirements and perhaps juice-up a bit,” Sullivan & Cromwell’s Kenneth M. Raisler said. Many of the findings in the MFA, PWG, and Investors Committee reports will hopefully form a code for responsible hedge fund managers to follow, and potentially be part of a future regulatory package, be it direct regulation or the future inspection and supervisory structure likely to be put in place in a number of jurisdictions.

“I think there will be convergence here, in terms of the various requirements, and it’s not that hard to figure that out in terms of where you go,” Raisler added.

Indeed, the MFA and AIMA, as well as the Asset Managers Forum, have been working together to try to achieve just such a consensus ahead of the G20 summit in April. This includes AIMA’s launch of, a website it has built in collaboration with the MFA, PWG, and the Hedge Fund Standards Board, which houses the current body of work in the field of industry initiatives.

“We’ve put them all side-by-side sothat we can focus the debate on what these standards have in common, rather than trying to always diverge by saying where they differ from each other,” said AIMA’s Andrew Baker. “The fact is that they have got a very substantial body of work in common.”

The two key areas of convergence remain in the fields of the appointment of third party service providers and governance. The Financial Stability Forum has been tasked with bringing about a degree of harmonisation or convergence of these standards as part of the delegated work it has been carrying out in the lead-up to the G20 summit.

In the European Union the level of enthusiasm for more regulation seems to be increasing on a monthly basis. The European Parliament adopted a report in September 2008 which called for capital requirements to be imposed on hedge funds, along with increased disclosure, limitations of leverage, and prohibitions on reasonable asset stripping.

As with Washington DC, hedge fund regulation has been caught up in political grand standing. While Charlie McCreevey, the EU’s Internal Markets Commissioner, said he felt further regulation of hedge funds was not required, he was overruled by José-Manuel Barroso, the European Commission President, moving at the behest of France and Germany. Indeed, Jean-Claude Trichet, President of the European Central Bank, warned the hedge fund industry to expect further regulation.

Speculation remains over the exact wording of an EU directive covering hedge funds, including whether it will be aimed specifically at the hedge fund community, or encompass private equity firms as well. Capital requirements is one popular prediction, as is some kind of additional layer of regulation for funds that pursue “shadow banking” activities, possibly even being treated as banks, and having to hold core capital like banking institutions in Europe.

“The risk is that either puts a large chunk of the industry out of business or brings it onshore in a diluted format, because some of the strategies employed would no longer be operable in an onshore regulatory format,” said Baker. “Equally, the industry could be pushed offshore, so that it becomes a contract between the institutional investors and the institutional advisors based in offshore locations. We’re not convinced that’s necessarily a desirable outcome. We could have the direct opposite of what the directive is trying to achieve.”

Passing the regulatory buck
Who will be doing all this regulating? In the case of the US, Michael Harrell wondered whether systemic risk was the best benchmark to use for a regulatory framework. It would have obstructed the creation of money funds in the 1970s, for example. Such a remit should not be given to an existing regulator either: according to Raisler, the Federal Reserve already has enough on its plate. It is an issue of confidence, he argued. “The perception is that systemic risk is at the heart of the problem, ergo, there is a need for a systemic risk regulator.”

“You could argue that you shouldn’t put a systemic risk regulator in place until you’re got through the stimulus process and figured out what the problems were, and then try to have the regulator actually solve those problems,” Raisler commented.

At the moment, however, the Federal Reserve is the only agency with the resources and skills to tackle systemic problems of this nature in the US. It already has jurisdiction over the banks, including the likes of Goldman Sachs and Morgan Stanley now that they have commercial banking status. In Raisler’s view, it is not a huge stretch for that remit, from a systemic viewpoint, to be extended to hedge funds, as well as insurance funds, with direct close supervision of the biggest players.

Can some form of international regulatory system really be achieved? Donohoe recognised that there are some useful standards in place outside the US that could potentially be co-opted into a new hedge funds regime, but advisedthat from a cultural perspective, something that works well in one jurisdiction, may not be suitable for transplanting wholesale to another. A good example is third party administration – taken for granted in Europe, but less embraced in the US, where administrators themselves are not regulated entities.

However, regulators still co-operate to a great degree behind the scenes, perhaps more closely now than ever before, particularly with enforcement cases. “There’s a lot of information sharing that goes on between them,” Donohoe explained.

Despite the fact that funds can be global in nature, and frauds can be similarly international, countries like the US are unlikely to waive their investor protection responsibilities, although awareness of the views of other regimes is definitely more pronounced now.

“In a world where there’s got to be more co-ordination, there’s obviously got to be more dialogue, and there’s got to be more mutual understanding as to what the regulations in different parts of the world are trying to achieve and what the limitations are to achieving a greater level of convergence,” said AIMA’s Baker.

He called for some kind of communication mechanism that would help with the exchange of information, and the supervision of cross-border institutions. This would still need a primary owner of the relationship, i.e. the home regulator, but close coordination with other parts of the “empire” would necessitate the involvement of other regulators.

There was also an intense awareness on the panel that the push for hedge fund regulation in Europe is being largely driven by the French and German governments, and that private equity funds could be caught up in this. It is already difficult, however, to clearly define private equity as opposed to hedge funds, particularly as some hedge fund firms now pursue longer lock-up periods and more illiquid investment strategies. Putting a knife between the two worlds is becoming harder, and there is less confidence that Brussels will be able to do this as skilfully as Washington DC. In addition, as Donohoe pointed out, hedge funds are agile, and once a definition is out in the open, can adopt new structures and ways of doing business more quickly than governments can legislate. Sometimes it is easier to simply adopt a broad-brush approach.

“If there was regulation, if there was a law that tried to capture hedge funds, it would capture hedge funds, private equity funds, and probably venture capital funds, just because of the way that laws were written,” Donohoe said.

Raisler agreed that the line was very blurred: “The stations between the two are dulled down to the point where you don’t have a good definition of hedge funds, you don’t have a good definition of private equity, but in both cases they represent large pools of capital that need, from a confidence perspective, to be overseen in some way. To say that somehow hedge funds are subject to some scheme, but there’s no need to deal with private equity, will create some asymmetric responses.”

Short selling
On the short selling issue, Andrew Baker said that managers could expect some kind of global template or agreement on what short selling is good for, and what it is bad for. Bans and restrictions are being rolled over as regulators await recommendations from a task force commissioned by IOSCO. From an industry point of view, disclosure is likely to form part of a global template: “The key issue for us is that any reporting of positions is done in the aggregate of the marketplace, not at the individual manager level,” he commented.

He expects that regulators will try to thrash out a common level for items like disclosure thresholds, frequency of reporting, delays to reporting, information that can be shared on cross-listings, and use of derivatives. “We are very troubled by the FSA approach, which has been to acquire disclosure of the individual positions of shorts,” Baker said. “Wethink it’s one thing to require reporting, but it’s another thing to require public disclosure. We think that actually has harmful effects rather than something you don’t like. We think there are negative effects to it, even though everybody starts with the assumption that some disclosure is good, more disclosure is better.”

On the one hand, the hedge fund industry is concerned about too much insight being granted into their strategies, whilst on the other there is a public – and political – perception that short selling is a bad thing. There is also a danger that disclosure of short positions to the general public will create the impression that the hedge fund industry is singling out a particular company as a loser, when this might not be the case. In Raisler’s words, “there could be a million different reasons” to go short.

“We’d welcome some sort of circuit breaker which can stand between ‘anything goes’ and an absolute ban during difficult times, because that’s no way to engineer a car, just have a top gear and a brake, and nothing in between,” Baker added.

The role of industry associations
What role do industry associations like AIMA and the MFA have to play in the ongoing regulatory debate? They, and the firms they represent, have been forced by last year’s events to move from the original industry stance of ‘no further regulation required, thanks’ to one where various conduct codes, best practice guides, and self-regulation formats have been coughed-up. Can much more be added, now that, in Harrell’s view, “the political train has left the station?”

Kaswell argued that such initiatives still have a role to play, in particular in helping to inform the regulatory and legislative process. Part of the effort has to be to persuade legislators that hedge fund firms can behave in a responsible manner. “The best practices hold up extremely well if you’re concerned about customer abuse,” he said.

Raisler added that such guidelines have proven an enormous help to investors, as they provide a benchmark they can ask the managers they invest with to adhere to. They have also had a material impact on the way hedge fund firms conduct themselves, and helped to focus energies and resources amongst the bigger firms in ensuring that they operate in a professional manner. This can only be a good thing from the perspective of regulators.

Interestingly, there has been divergence between the US and Europe on opinion regarding retailisation, with the European community giving retail distribution more serious consideration, and the US industry remaining largely opposed.