NEWS FOCUS: US gears up to regulate hedge fund industry

During the last quarter of 2008, the impact of the economic crisis was visibly pronounced on the hedge fund industry as redemptions and liquidations reached record levels.

Since then public sentiment against private funds and shadow banking entities has been on the rise with revelations of high profile securities frauds in the asset management sector, although many of the implicated companies are not hedge funds.

In a US Congress that is apparently divided along party lines on most issues, the issue of hedge fund regulation easily garnered bi-partisan legislative proposals. The most likely conclusion is that regulation of hedge funds and other private funds appears to be imminent in the US.

There are currently multiple US regulatory reform proposals that would directly impact hedge funds. Many of these proposals are still in a state of flux and there is no certainty of what legislative proposal will emerge from the political process.

However, a consistent pattern in these proposals is the elevation of disclosure, reporting and regulatory audit as key pillars of any reform. A pertinent question is whether the scale of the disclosure, reporting and regulatory audit responsibility and the cost of the required compliance infrastructure would be sustainable for vast majority of small and medium sized hedge funds.

Such funds collectively account for less than 10% of assets under management (AUM) in the industry.

Finding the right balance will be the most important challenge regulators will face in the search for a regulatory regime that curbs systemic risk, protects investors and preserves a viable hedge fund industry. A one-size-fits-all approach is unlikely to achieve that balance.  

Pre-crisis paradigm
There is no prototype hedge fund. Hedge funds vary in structure depending on several factors, including the interests and domicile of investors, investment strategies, objectives and risk parameters. There are patterns or features that are commonly identified with hedge funds.

Prior to the economic crisis hedge funds were often credited with contributing to the enhancement of systemic stability by providing needed liquidity in otherwise illiquid markets, by eliminating market inefficiency and by absorbing opaque risks from the financial system.

These funds thrived on the efficiency of a business model that extracted value for its investors at each level of execution. These funds were characterise by a lean operational infrastructure, with many services outsourced to a clearing agent and third party service providers, beneficial financing arrangements with creditors that were often based on net value-at-risk (VaR) financing terms and cross product margining and a fluid investment execution and risk management process.   

At the end of 2008 the aggregate amount of assets under management in the global hedge fund industry was estimated to be about $1.5 trillion, down by about 30% from a previous high. Of that figure the 100 largest hedge funds accounted for about $1.125 trillion (75%) of assets in an industry estimated to have about 10,000 hedge funds.

Further consolidation at the top is predicted as operational and regulatory compliance costs rise. Could those lightly regulated hedge fund managers that constitute the vast majority of fund managers, but account for significantly less than one-third of the amount of total industry assets, pose the same amount of systemic risk as the top tier funds?

Disclosure, reporting and audit
At the height of the economic crisis, financial markets witnessed an unprecedented level of de-leveraging. Some of these were attributed to hedge fund redemptions and liquidations. The Obama administration has expressed the view that de-leveraging by private funds contributed to the strain on financial markets and may have had a pro-cyclical impact on markets that were already in decline.

The administration believes because many affected funds were not required to register with regulators, the government lacked reliable, comprehensive data necessary to monitor and access any potential risk they posed to the market.

The US Treasury has proposed the Private Fund Investment Advisers Registration Act of 2009 to address what it perceives as a regulatory gap. Competing proposals include the Private Fund Investment Advisers Registration Act of 2009 (Representative Kanjorski), Hedge Fund Transparency Act (Senators Grassley and Levin), Hedge Fund Study Act”= (Representative Castle), Hedge Fund Adviser Registration Act (Representatives Castle and Capuano) and Private Fund Transparency Act of 2009 (Senator Reed).

In addition to private fund regulation proposals, many of the current financial reform proposals would directly or indirectly impact hedge funds. The private fund regulation proposals do not reflect the entirety of potential new regulations that hedge fund managers may have to comply with.

While the fate of most of the proposals is uncertain, there are common themes that are noteworthy and that can be summarised as disclosure, reporting and regulatory audit. For example, based on the current forms of these proposals, the obligations of a hedge fund manager that manages over $30 million of assets would include an obligation to register with the Securities and Exchange Commission (SEC) and, if registered with the Commodity Futures Trading Commission (CFTC), be subject to a dual, but harmonised, regime of disclosure, reporting and regulatory audit of the SEC and CFTC.

SEC reregistered fund managers would be obliged to comply with any periodic or unscheduled request of the SEC for systemic risk information; an obligation to comply with any expanded reporting and disclosure to investors, creditors and counterparties as the SEC requires. They would also need to submit to surprise audits by independent public accountants and procure SAS-70 reports for assets held in the custody of an affiliate.

In addition such fund managers would need to establish internal anti-money laundering compliance programme similar to those in effect for financial institutions as well as an obligation to submit to regular examinations of the SEC.

A hedge fund manager whose funds fall within the threshold set by the SEC and CFTC for becoming a major swap/security-based-swap participant would have an additional obligation to execute over the counter (OTC) derivatives trades on exchange-like facilities, clear such trades through a regulated central clearing organization, report such cleared as well as non-cleared trades and to comply with other prudential regulations. A fund manager that uses shorting would be required to comply with any short sale price test restriction and disclosure requirement.

Striking the right balance
A compliance infrastructure designed to meet these obligations is likely to be large and significantly expensive. Based on the scale of these responsibilities, such infrastructure may be comparable in size and cost to compliance programmes at highly regulated large securities companies.

There is a serious question whether such cost or scale of responsibility would be sustainable for small and medium sized hedge funds. Ironically, these funds which account for the vast majority of the industry, may not (individually or collectively) pose a systemic risk to the financial markets. 

Striking the right balance requires a regulatory regime whose maximum impact on curbing systemic risks and protecting fund investors can be done with the least incremental cost to investors and funds.

There are multiple approaches that can be adopted, including using a deminimis dollar threshold exemption to separate non-risky classes. However, there is a compelling argument that an arbitrary threshold is likely to be either too low or too high or that it may be open to abuse if it is the sole determinant of whether to regulate or not.

A logical conclusion could be drawn that the right balance cannot be attained unless the regulatory approach, in a bottom-up fashion, differentiates between funds on a combination of relevant factors (such as size, use of leverage, liquidity of assets, structure of fund) and imposes regulation accordingly, strengthening investor protection where needed and curbing systemic risk where it actually exists.

This article was written by Chinedu Ezetah, formerly the deputy general counsel of Old Lane.

Comparative framework of hedge funds

Investor protection reform proposals
Registration of fund manager
Proposed legislation: Private Fund Investment Advisers Registration Act of 2009
Managers of “private funds” (3(c)(1) or 3( c)(7) funds)) that are either US registered funds or non-US funds with US investor ownership of at least 10%, will be required to register with the SEC. Deminimis threshold for SEC registration will be AUM over $30 million. Certain foreign private fund managers will be exempt.

The European Union’s proposed directive on alternative investment fund managers originally seemed to take a more territorial and protectionist approach by prohibiting fund managers that are not licensed by an EU member state from offering fund interests or carrying on fund advisory business in member states. This is expected to be modified in subsequent drafts.

The draft legislation would eliminate the provision in the Investment Advisers Act that exempts certain fund managers that are registered with the CFTC from SEC registration. SEC and the CFTC would be required to work together to harmonise and develop joint proposals for the regulation of fund managers that are registered with both the SEC and the CFTC.

The version of the legislation recently approved by the House Financial Services Committee would exempt venture capital funds.

SEC registration would impose disclosure, reporting, recordkeeping, SEC audit and the internal controls and compliance requirements of the Investment Advisers Act (including with respect to disclosing and resolving conflicts, preventing misuse of material non-public information, ensuring a fair allocation of investment opportunities and independent approval of certain transactions and personal trading, code of ethics and standards of business conduct, among others). The legislation would expand SEC’s regulatory authority and require regular SEC examinations of fund managers.

Registration of funds
Proposed legislation: Hedge Fund Transparency Act
Funds with over $50 million of AUM would be required to register with the SEC as investment companies but will be exempt from the substantive regulation of The Investment Company Act if they satisfy certain conditions. In addition to compliance with any disclosure, reporting, audit and books and record requirements of the SEC, funds would be required to disclose the identities of limited partners and beneficial investors and to establish anti-money laundering compliance programs that are substantially similar to those in effect for financial institutions.

Oversight of custody of fund’s assets
The SEC’s proposed amendment to the custody rule under the Investment Advisers Act requires fund managers to under-go an annual surprise exam by an independent public accountant to verify existence of clients’ assets. Affiliates of a fund manager that are custodian of fund’s assets will be required to obtain SAS-70 reports (independent confirmation of existence of assets as well as to assess supervisory controls that are in place to protect assets).
The amendment would require Custodians to deliver custodial statements directly to the advisory clients as opposed to through the fund manager.

Say-on-pay rules
Proposed legislation: Corporate and Financial Institution Compensation Fairness Act of 2009
Fund managers (among other covered financial institutions) with AUM over $1 billion would be required to disclose to the “appropriate federal regulator” (for fund managers, this is likely to be the SEC) the structures of all incentive-based compensation arrangements. The disclosure is to enable the appropriate regulator to determine and prohibit compensation structures that are not aligned with sound risk management of the fund, that provide an incentive for taking inappropriate risks that could threaten the “safety and soundness” of the fund or that could have serious adverse effects on economic conditions or financial stability.

The proposed legislation provides that (other than in respect of compensation arrangements that were in effect prior to the enactment of the legislation) claw-back of incentive-based compensation under any other applicable law shall not be limited by the legislation.

Providing SEC with additional authority to protect investors
Proposed legislation: Investor Protection Act of 2009
Fund managers who are also registered broker-dealers will be restricted from holding more than $10 million of fund's assets in street name. Fund managers would be required "to act in the best interest" of their clients without regards to their own interests. The legislation would limit the use of arbitration clauses to prevent clients from seeking relief from law courts, authorize the SEC to provide FINRA with rule-making authority over registered advisers, and expand the extra-territorial authority of the SEC under anti-fraud provisions, among other measures.

Systemic Risk Reform Proposals and other Regulations
SEC Registration and Disclosure
Proposed legislation: Private Fund Investment Advisers Registration Act of 2009
Detailed disclosure to the SEC required as determined by the SEC to be necessary or appropriate in the public interest and for the assessment of systemic risk by the board of governors of the Federal Reserve and the financial services oversight council.
At the minimum, required disclosure would include reporting of amount of AUM, use of leverage (including off-balance sheet leverage), counterparty credit risk exposures, trading and investment positions, and trading practices. Although the disclosure is made on a confidential basis, US Congress and federal agencies will be able to access the information.
The draft legislation eliminates the subsection of the Investment Advisers Act that currently prohibits the SEC from requiring fund managers from disclosing the identity, investments, or affairs of any client, except in connection with an enforcement proceeding or investigation. SEC would be required to conduct regular examinations to monitor compliance.
The SEC has recently signalled that it favours a disclosure regime under which hedge funds make detailed systemic risk disclosure to the SEC on a confidential basis in addition to the public disclosure required by the Investment Advisers Act and securities laws.

Say on pay rules
Among the considerations for the required disclosure is to enable the appropriate regulator determine and prohibit compensation structures provide an incentive for taking inappropriate risks that could have serious adverse effects on economic conditions or financial stability.

Regulation of Systemically Important Financial Companies
Proposed legislation: - Bank Holding Company Modernization Act of 2009 and Resolution Authority for Large, Interconnected Financial Companies Act of 2009
Any financial company (including hedge funds) may be designated as “Tier 1 financial holding company” if the Federal Reserve determines that, based on its size, leverage, interconnectedness with the financial system, it could pose a threat to US or global economy or financial stability in times of stress. Such designated “Tier 1 financial holding company” will be subject to higher prudential standards, Federal Deposit Insurance Corporation's (FDIC) resolution authority, the corrective intervention powers of the Federal Reserve and will be required to fully conform its activities to those permitted for Bank Holding Companies within five years of designation (including restrictions on non-financial activities or so called “merchant banking” investments).

Limitation on off balance sheet lending
Proposed legislation: Bank Holding Company and Depository Institution Regulatory Improvements Act of 2009
Banks’ exposures to Clients under OTC derivatives and repos would be treated as extensions of credit for purposes of bank lending limits.

Regulation of OTC Derivatives
Proposed legislation: Over-the-Counter Derivatives Markets Act of 2009
Exchange (or exchange-like) trading of “standardised” OTC derivatives and clearing through regulated central clearing organisations or agencies. Funds with outstanding swap positions that exceed thresholds established by the SEC and CFTC for becoming “major swap participants” or “major security-based swap participants” would be required to register with the CFTC and SEC, respectively, and to comply with regulations established jointly by the SEC and CFTC, including, among others, trading of standardized OTC derivatives on exchange-like facilities and clearing same through regulated clearing organizations or agencies, increased margin and capital requirements, position limits and trade reporting.
The draft opens the door for synthetic ownership of exchange listed equity securities to be reportable under securities laws governing disclosure of large beneficial ownership of publicly listed companies. 

Proposed legislation: Comprehensive Derivatives Regulation Act of 2009” (Senator Reed) and the bill to enact the Over-the-Counter Derivatives Markets Act of 2009 (Representative Frank)
These proposals differ from the US Treasury’s draft in some material respects but impose similar robust disclosure and reporting requirements on major participants in the OTC derivatives market.

Regulation of shorts
Regulation SHO – pre-borrows or hard locate
Rule 204 currently requires that a broker-dealer must close out any failure to deliver on a short sale within T+4 and Rule 10b-21 of the Securities Exchange Act targets short sellers who deceive broker-dealers into believing that they have their own source of borrowable shares. SEC is exploring tightening these short sale regulation further by imposing a pre-borrow or hard locate requirement.

Proposed uptick rule
SEC is exploring several alternatives including a market wide price test restriction and/or a halt circuit breaker or a temporary short sale price test that would apply only to securities that trip a circuit breaker (a severe decline in the price of the relevant security). Under consideration as benchmarks for the price test include using the last sale price, using the current national best bid or using an alternative price test that would allow short selling at a price above the current national best bid.

Regulation SHO – disclosure of short positions
SEC is exploring additional disclosure of short positions such as adding a short sale indicator to the tapes to which transactions are reported for exchange listed securities or requiring public disclosure of individual large short positions. Aggregate short selling volume data on individual securities as well as all exchange listed securities is currently publicly disclosed on FINRA’s website.

Regulation of securities lending
SEC is exploring new rules on securities lending markets, including in respect of pricing, potential conflicts and transparency of securities lending transactions.

CFTC’s Statement on Speculative Position and on Eliminating Bona Fide Hedge Exemption for Swap Dealers
CFTC is exploring applying speculative position limits to the energy futures markets (and potentially across all markets and participants) and eliminating or restricting the bona fide hedging exemption from speculative position limits for persons using the futures markets to hedge risks other than risks arising from actual use of a commodity.

Offshore Tax Evasion
Proposed Legislation: Foreign Account Tax Compliance Act of 2009
The proposed legislation is directed at foreign financial institutions (which would include offshore funds) that have US investors, subject to some exceptions including investors that are US tax exempt entities, regulated investment companies and public companies. Based on the proposed legislation, a non-US fund that has US accounts/investors would be required to report certain information (including identity of account holders, account balance, withdrawals) about the US accounts to the Treasury department in order to avoid a 30% withholding tax on its US source income, dividend and proceeds.