New Regulation And How It Will Affect The Hedge Fund Industry - An Administrator's Perspective
Good afternoon ladies and gentlemen,
My first topic is the EU Savings Directive
So what is it
Well firstly it is nothing to do with savings. It is not, as the name might suggest, a Brussels inspired moral inducement to persuade EU citizens to save and create wealth, rather than indulge in a credit financed spending splurge.
The EU savings directive, which I am just going to refer to as the Directive, was expected to come into force on the 1st January next year, but that was delayed as a result of predictable international and intra-national bickering, both within and without the EU. In the end the Directive was ratified at the end of June this year and, as I understand it, it will come into force next year.
It was originally supposed to come into effect as of 1st January 2004 with the original reporting deadline being March 2005 for the period from the 1st of January 2004 to 31st December 2004. Because of the delays it was expected to defer the initial reporting period. Frankly what I am not clear about yet is whether the initial reporting period is going to be for the period from 1st January 2005 until the 31st December 2005 with that report currently due in March 2006 or whether it is in fact now going to start from, say, the 30th June 2005 and have all other dates deferred accordingly.
The Directive was created with the stated objective of countering money laundering which frankly I think is absolute poppy cock and and this is the main thrust of the Directive preventing the evasion of tax payable by EU resident individuals on interest income earned on their offshore investments.
To achieve this objective the EU requires that the last payment or paying agent - that is the company that arranges an interest payment to be made to an EU resident investor - to provide information about the payment, to the tax authorities of the State where the payment agent is resident. Those tax authorities will then pass on the information to the tax authorities in the EU member state where the individual investor resides.
Three EU countries have opted out of reporting and have been allowed to levy a 25% withholding tax rather than exchange information. These jurisdictions are Austria, Belgium and Luxemburg and, by 2011, the tax rate will increase to 35% of the interest payments made to EU investors.
Certain non-member states have also joined in to the agreement including the Channel Islands, British Virgin Islands and the Cayman Islands and it is likely that they will elect to impose a withholding tax rather than comply with the exchange of information arrangement. Ironically Bermuda does not fall under the Directive and I understand that is another example of an EU cock up. Under the original Directive, it was agreed that certain states, other than EU member states, would also sign up to the Directive if it was going to work. These certain states include places such as Andorra, Lichtenstein and Switzerland and also the British Dependent Territories of the Caribbean, which left Bermuda out of the net. I dont know if you have ever described a Bermudan as being a member of the Caribbean community, but it is not something that I would advise.
Some jurisdictions have refused point blank to join the club and these include Singapore and Norway. Therefore if a fund has a payment bank in either of those two jurisdictions then the information will not be passed on by the paying agent in those jurisdictions to any tax authorities anywhere. I think that it is unlikely that the rest of the world will be able to pressurize either Norway or Singapore to change their mind, but I do think Bermudas freedom in this context is limited time wise.
In the context of all funds and indeed hedge funds the Directive offers some exemptions, which means that the funds paying agent need not report distributions or payments to what are called beneficial owners the EU individual investor.
For example interest payments would include any distribution made by a fund to its investors if that distribution is derived from interest received by the fund for example a typical money market fund or distributing fixed income fund. Normally the paying agent would ascertain what proportion of the distribution derives from interest received by the fund and that sum is the sum that would be reported. If the paying agent is not able to determine the proportion then it is required to treat the whole of the distribution as an interest payment.
One exemption in this regard is one that is actually given to the EU member state rather than the Fund in as much as the EU member states have the discretion to determine that the distribution is not an interest payment if the fund in question has invested not more than 15% of its assets in income generating instruments. The UK in particular has adopted this 15% rule in its domestic legislation we have yet to see how many other member states and the independent territories I referred to will do the same.
The sale or redemption of shares or units of an investment fund may also be deemed an interest payment if the fund invests directly or indirectly (i.e. into other funds) more than 40% of its assets in these instruments. Thus a non distributor fund one that rolls up all its revenues into the net asset value maybe exempt from reporting requirements if less than 40% of its assets are invested in interest generating instruments. On the face of it that will exempt most hedge funds, except those investing directly into one of the fixed income strategies or funds that trade futures or derivatives on a margin basis, because such funds actually hold most of their net assets in cash at any one time.
However for the more traditional hedge funds there are still two problems with regard to the 40% exemption rate. Firstly the 40% threshold is expecting to be cut to 25% on January 1st 2011 that is tomorrow problem, not todays.
The real problem is knowing how to calculate the 40%. The Directive actually states that the 40% threshold can be determined by the investment policy as laid down in the funds rules i.e. statuary documentation or presumably the offering document. Unfortunately many hedge fund managers retain the flexibility to change their investment strategy and indeed go liquid if the manager deems that to be the appropriate stance to take in the market. In such cases where it is not possible to rely on the offering document, it will be necessary to review the actual assets of the fund and determine whether or not more than 40% of the assets are invested in debt instruments. This does not sound a very difficult job, but what the Directive has not made clear is whether that calculation is to be made:
i) at a single point in time for instance on the last trading day of the financial year of the fund;
ii) at the calendar year end; or
iii) based on an average of the positions at the end of each month or even a daily average.
So the first thing that has to be done and usually this would be required of the administrator, is to ascertain whether the fund itself falls into the Directives net. And if it does, as is likely to be the case with any futures fund for example, the administrator then has to ascertain how many of its investors are Beneficial Owners as defined in the Directive and how many of those Beneficial Owners are EU resident investors.
Under the Directive a Beneficial Owner must be an individual. As a result interest payments made to corporate or institutional investors should not be within the scope of the Directive, but that may be modified by local regulation. What is not clear, although this may be clarified in some jurisdictions by the enabling legislation passed by the relevant EU member state, is how should an administrator treat a financial institution that is acting as a nominee for an individual beneficial owner. One way would be to claim (and I think it could be a valid claim) that the nominee, which is usually a bank, is the final paying agent with regard to any Beneficial Owners for whom they act as nominees. As such the reporting requirement passes from the administrator of the fund to the nominee paying agent.
However that does not relieve the administrator of the job of analyzing the funds portfolio and determining what proportion of any redemptions or distributions paid to an investor are interest payments. This is because the nominee, as the final paying agent, will need to have that information in order to fulfill their obligations to their local tax man and if they are unable to give that detailed information the break down then they will be required to treat the whole payment, whether a distribution or a redemption, as an interest payment (or, if they are from one of the withholding territories, withhold tax on the total payment).
Thus administrators are going to have to be sure that they operate systems that will not only trigger a warning if more than 40% of the funds assets are invested in debt instruments at any one time, but will also enable them to calculate the proportion of any redemption proceeds or distributions that relate to interest payments at the time they are paid to the recipient. This is not necessarily going to be an easy task, depending on the system that the administrator is currently using and it is almost inevitably going to require some software programming.
The next question is can you avoid the Directive. I suppose the simple answer is Yes, if you appoint a Bermudan, Norwegian or Singaporean paying agent but that may be an expensive option and it is also possible that in some jurisdictions the tax authorities may deem the sudden appointment of a Norwegian, Singaporean or Bermudan paying agent as an attempt to avoid the Directive, which of course it is. Assuming that its an attempt to avoid the Directive then they may deem the final paying agent to be the administrator regardless of the actual legal position of the bank situated in a non-Directive territory.
So much for the EU Savings Directive.
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Some comments on the SECs proposal that Hedge Fund Managers (HFM) should be registered as investment advisors in the US under the Investment Act (the Act) and how that proposal will affect non-US managers.
Firstly, let me say that, I am not against regulation per se in fact, I think that it is quite extraordinary that, in the US, HMFs have not been regulated in the past. For those of us in Europe and particularly Ireland and the UK, of which I have some experience, there has been a requirement for anyone managing third party money to be regulated for years.
No, my basic complaint with regard to the SEC proposal is that it is so blatantly a political proposal and furthermore it will not, in fact, protect all investors, which is what their brief is and is what they claim they will be doing.
The SEC claim that they will be able to prevent fraud and cite some 46 indictments for fraud in the hedge fund industry. Some of those indictments are, probably, duplicates, because the accused has been indicted more than once, for example, by the SEC, which is a federal agency and by the Securities regulator in their home State. Also included in their 46 indictments are several where mutual fund managers have been indicted for permitting HFMs to carry out the now infamous market turning trades. I have no doubt that the mutual fund managers have stepped out of this in a big way but the HFMs did nothing illegal (unless they were last which included only a couple of the 46 cases) but to make them care the SEC have tarred the whole hedgefund community with the same brush.
This, of course, raises the obvious question is the SEC capable of stopping fraud or even identifying it One wonders if anyone, including the SEC would have yet heard of market timing or after-hours trading if some little bird, the now familiar ex-employee of the Canary Fund hadnt squawked to Elliot Spitzer.
I think it is fair to say that the amount of fraud in the hedge fund industry is, in fact, if not negligible, certainly not material in the context of fraud in other industries. There is, of course, an argument that I fully subscribe to that, if somebody wishes to commit a fraud, then no amount regulation is of going to stop them.
One of the other reasons why I think that the contention that the SEC Investment Advisor registration will be protecting hedge fund investors is false, is that they still intend to retain the thresholds of 15 clients and US$25 million. If a hedge fund manager has only 14 clients, then he still wont have to be registered, or, if he has less than US$25 million in assets under management, he still doesnt have to be registered. I cannot see why some poor benighted investor in Middle America, who is one of only 14 clients of a particular manager, should be unprotected, whereas if a 15th client was to join, then they all become protected. That doesnt seem to me to reasonable and, as I have already said, in the UK and Ireland, this would not be the case.
To be frank, in this context, the SEC has widened the net with regard to the number of investors, in as much as they are no longer going to accept a fund client as being just one of the 14 clients of the manager. The HFM will have to look through the fund and include those investors in the fund in their 14.
Similarly, I think that the US$25 million limit is farcical not only would you have to register if you were managing just a few thousand Dollars for third parties in the UK and Ireland, but also, several numbers of the cases of fraud cited by the SEC area over the years were for sums of less than US$5 million and a number of them were committed by people who had less than US$25 million under management.
Having got that off my chest, I would now say that the other major complaint I have with regard to this proposal is the inevitable US desire to regulate the world and to try and impose extra-territorial jurisdiction. This the SEC is trying to do by stating that any investment manager who acts for more than 14 US investors will have to be registered under the Act. Again, I would not object to this if it was the case that the manager had set up business in the US or was directly marketing in the US. But I do object to the fact that a UK or other non-US hedge fund manager, who is properly and effectively regulated in their own jurisdiction and who is managing an offshore (i.e. non-US) fund, just because a number of US investors wish to invest in this fund, should have to register and incur double compliance costs.
The proposed regulations, do have the concept that funds that are regulated and publicly offered outside the US and do not have their principal office or place of business in the US would not be deemed a private fund and therefore subject to regulation. This would include UCITs. I think the crucial words here are publicly offered and I say this because most hedge funds are deemed Professional Funds or, in some cases, Private Funds, which means that they are definitely not offered to the public, but distributed to either Professional investors or, in the case of Private Funds, to a private list of clients, most of whom should be existing clients of the Manager.
The proposals also allow a non-US manager to ignore non-US investors when calculating the 14 clients accordingly, the requirement for the non-US manager to register will only come into force if the non-US manager has more than 14 US persons as clients. In addition, the non-US investment advisors who do fall under the Advisors Act, because they exceed 14 US clients, would only be subject to the anti-fraud positions of the Advisors Act and would not be required to comply with the books and records and the custody and clients rules applicable to US based investment advisors. Apart from the fact that this seems unfair to US advisors who are obliged, as I understand it, to count non-US investors within their total, it also doesnt mean that, once the SEC has non-US managers on its books, that they wont change these concessions at a later date.
There are other aspects to the Act, which give cause for concern, particularly as it is not clear whether non-US managers will be exempt.
For example, a qualified client in the US is an investor with a net worth of more than one and a half a million dollars or with at least US$750,000 of assets under management with the HFM. Again, the SEC is proposing to grandfather existing clients of an HFM, but new clients would have to meet this qualifying requirement. What is not clear is whether that would be the requirement that a non-US registered advisor would have to comply with, with regard to all their clients or just their US clients.
Outside the US, it is generally accepted that a Professional Sophisticated accredited investor, whatever you like to call it, is one with net assets, jointly with their spouse, or, in this day and age, their partner, of US$1 million, excluding their home and a requirement that the minimum investment level into a fund be US$100,000. If the non-US manager is required to comply with the US threshold rule, then I suspect that, unless they are a very large HFM already applying high minimum investment levels, they would just ignore the US market as being too burdensome. On the other hand, of course, many of the HFMs are may already be registered under the Act.
I, personally, think it is quite likely that many non-US managers and, particularly, the smaller ones, will decide to avoid dealing with US clients, just because the hassle relating to regulation and the accrediance compliance cost would be too much of an additional burden to bear. There appears to be a belief in the US that the non-US hedge fund world needs the American hedge fund investors, but, of course, although this may be true for some managers, there is sufficient money outside the US to fund the smaller non-US managers and all the more so, given the recent decline in the value of the Dollar.
As a final comment, I would like to present another possibility (although I stress that it is only a possibility), namely that some jurisdictions may decide that, if the US is not prepared to accept reciprocity with regard to giving full exemption to properly regulated HFMs resident in properly regulated jurisdictions, then some of those jurisdictions may turn round, like the proverbial worm and require US managers to become registered and authorised in their own jurisdictions, if they wish to act for investors in those non-US jurisdictions.
Thank you Ladies and Gentlemen.