Voluntary Governance Standards

Signing up: what are the legal and regulatory consequences?

DUNCAN BLACK, FIELD FISHER WATERHOUSE LLP

We should be grateful for the effort which has been put into the preparation of the Matrix of the various different standards. It demonstrates that there is a good deal of consensus between the creators of the different rules and it will accelerate international harmonisation of best practice. But what are the legal and regulatory consequences of these rules?

The legal consequences
Hedge Fund Standards Board: The January 2008 Final Report of the Hedge FundStandards Board discussed the legal consequences of the Standards. The Report argued that, for purposes of legal liability of funds and their managers, it is preferable to have clarity as to what the standards are for those hedge funds which choose to sign up, and for those who explicitly opt out to give reasons for their non-compliance.

The Report points out that managers have no contractual duties to investors and can only be sued in tort, but this does not, in my view, answer the argument that the existence of the Standards might assist Claimants wishing to sue in negligence. How could the existence of the standards help a Claimant? Because the Standards, for the first time in the UK, set out in detail and in the words of the managers themselves what the norm should be. It will, therefore, be difficult for any hedge fund or its manager, faced with a claim under English law, to argue that failure to comply with standards set out by a peer group was not negligent. In the words of the HFSB: “..the purpose of the Standards is to promulgate best practice in the UK hedge fund management industry at a benchmark level reflecting the standard of reasonable skill and care we consider is likely to be applied by the English court in civil negligence claims.”

The HFSB differs from the other voluntary standards because it contemplates a sign-up/opt out procedure. If a firm does not wish to comply with some of the Standards, it should announce publicly which parts it does not comply with and why. If it can demonstrate that reasonable efforts were made by the firm to bring its non-compliance with the Standards to the attention of the Claimant, then the Claimant will find it hard to argue that the firm should be judged according to the Standards. Most firms have not yet signed up. For the reasons above, those firms still risk that an English court would hold that the HFSB sets out the minimum standards with which they should comply.

Other standards: US PWG, AIMA, IOSCO and MFA
These guidelines do not have an express sign-up/opt out system, although all are drafted in the hope and expectation that firms will comply. For example, the US PWG says: “What is critical is that managers are able to explain to investors how they have implemented and adopted the practices in this Report.”

As with HFSB, a legal claim which relies in part upon non-compliance with one or more of these standards will be troublesome to resist on grounds that it was not necessary for the firm to comply. There may be some room for escape if there is a good reason why, in a particular instance, compliance was unnecessary or impractical. For example, some of the standards originate from outside the UK (although it is difficult to see why that should matter when determining the legal duty of care). Better still, if there is a discrepancy between one set of rules and another, it will be easier for the Defendant to argue that there is no consensus as to the minimum standard, or that standards will vary according to the circumstances.

Practical consequences
Does any of this matter in practice? Much of the content of the different standards is generalities, uncontroversial and/or a repetition of the FSA’s rules. To that extent, the existence of these rules should make no substantive difference to the standard of care likely to be required by the English courts. But in matters of detail, it is likely that a firm’s failure to follow a specific procedure recommended by some or all of the rules will make imposing negligence liability easier for a Claimant.

A practical way of minimising this risk is for firms to state in prospectuses and/or other communications with investors (after a fund is launched) that they do not comply with a particular standard. Alternatively, a more attractive way of doing it would be to make a positive statement describing in reasonable detail what process a firm does follow in any particular instance (e.g. valuation of assets),and couple this with a general statement that the firm is aware of the various voluntary standards, but for the avoidance of doubt makes no representation that it complies with them. (Perhaps adding for good measure that the firm believes that its bespoke processes are most suited to the firm’s characteristics and the interests of its investors).

The regulatory consequences
HFSB: In the HFSB Final Report, it discussed whether there was a risk that the Standards could effectively become mandatory regulatory rules which might bind UK regulated entities such as London-based asset managers. Care was taken at the time to make sure that the Standards be classed as unconfirmed (by the FSA) guidance. If the Standards had been classed as confirmed guidance by FSA, it would mean that FSA would not take action against any regulated firm which could show it had acted in compliance with them.

Why did HFSB decide not to seek classification as confirmed industry guidance? The two reasons given are (i) because HFSB rules are intended to be best practice as opposed to minimum regulatory standards (albeit not to comply with HFSB might be negligent) and (ii) the opportunity to opt out would not sit well with it being confirmed guidance. Hector Sants of the FSA recently said: “FSA sees the HFSB Standards as a very constructive addition to the wider regulatory architecture. It should be noted that the FSA will take compliance with these standards into account when making supervisory judgements, although, of course, our focus remains on ensuring compliance by hedge fund managers with our own regulatory requirements.”

Other standards: US PWG, AIMA, IOSCO and MFA
Only one of these is UK originated (AIMA). Whilst FSA will be aware of these standards, it is HFSB which comes closest to being a regulatory standard which FSA will impose.

Despite the low sign-up rate, the reality is that HFBS are becoming the yardstick, at least in the UK. Firms need to disclose their non-compliance or alternatively sign up to the scheme.