The New Regulatory Landscape

What next for hedge funds?

ROBERT FINNEY AND EMMA RADMORE, DENTON WILDE SAPTE

Where are we now?
Influential regulators and groups have already suggested or taken initiatives that give clues on the future for hedge funds. Internationally, the G20, G30 and IOSCO are active. In Europe, the European Commission has plans, and change is coming in major individual jurisdictions, including the UK and US. All the plans propose greater regulatory oversight, but the degree of oversight and the methods regulators will use are not common to all.

Are hedge funds to blame?
Most criticism of hedge funds’ role in the financial turmoil has been a two-pronged attack: they are not regulated and so acted unsupervised and constrained by few rules; and much of the short-selling that allegedly damaged banks and many other companies was their fault. Less sensational commentators give little or no credence to these arguments. They say although the hedge fund vehicle itself is typically unregulated, its manager and key intermediaries invariably are (at least in Europe and specifically the UK), and required standards of conduct should curb irresponsible behaviour. The EU’s February’s de Larosiere report recognised hedge funds were not alone responsible for the frantic short-selling activities. That said, there is widespread support from all levels, including from FSA at UK domestic level, for regulating entities depending on their economic effect. A hedge fund is not a bank and cannot be subject to all the same regulation, but a proportionate regulatory approach must take account of the effects of a fund’s actions. FSA will outline its plans in the review by its Chairman, Lord Adair Turner, due in mid-March.

Also, while few hedge funds were individually big enough to present a systemic risk to the market if they failed, in hindsight regulators took too little account of the systemic risks of the sector as a whole.The criticisms and suggested remedies raise almost as many questions as they answer:
• Can regulators agree a common approach on short selling when their views of the practice diverge enormously?
• How will onshore regulation deal with offshore funds? Alongside the focus on hedge funds is a multilateral attack on offshore centres;
• Will legislators and regulators really address only the issues that have caused concern, or apply their “one size fits all” approach or try to shoehorn hedge funds into existing regimes? – “Lite” touch regimes are out, but will heavy handed be in?

European plans
The European Commission will use the results of its recent consultation in its discussions with the G20. The Commission had believed the combination of EU and national measures and industry codes, with fully regulated service providers, together gave enough safeguards. But now it plans a European regime to regulate hedge funds in the light of risks they pose to the financial system. The Commission attempts a definition of hedge funds as collective investment vehicles which have:

• a focus on absolute returns;
• a relatively high and systematic use of leverage; and
• institutional or other sophisticated investors

Regulators have not imposed strict requirements on hedge funds because of their non-retail investor base, saving more protections for retail fund investors. Can they resist introducing measures to protect investors rather than merely the financial system?

The Commission sought feedback on:

• Systemic risks: Do regulators have mechanisms to monitor and react to risks originating in the hedge fund sector?
• Market integrity and efficiency: Do hedge fund activities threaten the efficiency and integrity of financial markets?
• Risk management: Should authorities worry about how hedge funds manage risks, value asset portfolios and manage potential conflicts of interest?
• Transparency and investor protection: Do hedge fund investors get the protection and information they need?

The UK response
In response, Treasury and FSA stressed the importance to the UK of the hedge fund industry and how high-profile political debate should not obscure fundamental issues. While regulators could do more to oversee all entities (including hedge funds) that might contribute to “macroprudential” risk, many dangers hedge funds pose could equally arise in other market participants, so any regulatory response should not cover hedge funds alone. It is critical to look at the behaviour that causes concern rather than assume hedge funds in themselves cause problems. But there is a case for effective disclosure, diversification and risk management tools, especially if the retail market can access hedge funds via funds of funds.

FSA’s current Financial Risk Outlook and Business Plan underline its intention to regulate proportionately, based on economic effect and desired outcomes.

Trade bodies such as the IMA, HFSB and AIMA responded. IMA believes regulation of hedge funds as a product will fail because defining hedge funds is too difficult. Anyway, it says, the hedge fund product does not need fixing and the Commission is chasing a chimera, the “unregulated European hedge fund”. Rather, the way forward may lie in further asset class regimes building from the UCITS regime and a good pan-European private placement structure. The HFSB similarly feels UK regulation does not need fundamental change.

One part of the UK’s new Banking Act now gives Treasury power to make rules about “investment banks” (using a definition wide enough to capture any broker dealers who hold client money). This power, driven by issues arising from Lehman’s demise, could be used to set up a protection scheme for funds posting client money and custody assets with prime brokers – possibly with early pay out along lines of compensation scheme for bank depositors.

The US
There are proposals in the US that, if passed, would greatly increase the supervision of hedge funds, venture capital and private equity funds and similar vehicles. Previous attempts to regulate have focussed on managers but the proposed Hedge Fund Transparency Act would subject hedge funds themselves to registration and disclosure requirements. Hedge funds would need to become “investment companies” under the law, although they would be exempt from most provisions of the Investment Company Act. Larger funds would have to register and file certain information with SEC. A separate proposal would close a current loophole that exempts investment advisers from SEC registration if they meet the definition of “private adviser”. By removing the exemption, the new laws would bring advisers under SEC oversight.

Conclusion
It is not yet clear how hedge fund regulation will change. What is clear is that the major regulators in the US and Europe will at least impose greater transparency and information requirements in relation to funds and probably introduce new registration procedures for funds not just managers. In many countries the changes will be greater, and include prudential regulation (such as capital requirements) and conduct rules, and asset protection and fiduciary requirements for funds, managers and other services providers such as prime brokers and custodians/depositories. Banks seem likely to suffer major changes to the newly introduced Basel 2 regime which may indirectly, or even explicitly, affect their exposures to hedge funds.

Also there will be cross-market reforms in areas such as cross-selling. And FSA has warned firms will generally experience more intrusive regulation. The challenge for regulators is to understand and police the industry better without stifling it, and to complement the industry’s own initiatives in doing so.

ABOUT THE AUTHORS

Robert Finney (Partner) and Emma Radmore (Senior Associate), Financial Markets and Regulation Group, Denton Wilde Sapte LLP, London