Offshore Hedge Funds Structuring - Global Initiatives For Alternative Investments
You will have read in your programmes that I am supposed to be speaking to you today about AIMAs submission to the SEC in response to the SECs proposed registration requirements under the US Investment Advisors Act, for hedge fund managers. This specific topic is presented under the rather grand title of
Global Initiatives For Alternative Investments
Given that many, if not most, of you will have seen AIMAs response to the SECs proposal and the fact that the real point of interest today is how the SEC proposes to impose their rules extra-territorially i.e. outside the United States it would, in fact, be difficult for me to stick to my brief. This is because we dont yet know, (and wont know for sure) what the situation is until the SEC publish their rules, which, I may say, were originally promised to be published within two weeks of the announcement of their decision on 26th of October i.e. by 10th or 11th of November. In fact, of course, they released the regulations late last Thursday after I had prepared this presentation.
In passing, I must say it seems extraordinary to me that major governments, or their agencies, will often introduce quite draconian legislation, such as this SEC Investment Advisor Registration Regulation or the USA PATRIOT Act or, indeed, the EU Savings Directive (about which I will comment more later) anyway, all of this legislation has been passed into law or ratified and yet we have no clear idea how we are supposed to implement the law.
For example, the USA PATRIOT Act was passed on 26th October 2001 and now, over three years later, we still await the rules as to how the Act will apply to Hedge Funds and Hedge Fund Managers, even though, I believe, the Act has been reauthorized recently in the US.
It does seem to be an extraordinary way to run a railway.
I should make it quite clear that the comments that I will be making today are my own personal opinions and should not be taken as the official AIMA stance, although in some cases, they may coincide.
AIMA did respond to both the original SEC comments issued in September 2003 and to the new proposals issued at the end of the summer. I should make it quite clear that AIMA is not against regulation per se. And for the record I totally support that stance. Indeed, we would both contend that some regulation is positive and necessary it is an incontrovertible fact that many jurisdictions out side the US have regulated Investment Managers, including Hedge Fund Managers for years and the industry has thrived.
I would go so far as to say that I have been continually surprised that US Hedge Fund Managers have not been regulated up to now.
However, my main objection to the SEC proposals - and this is my objection not AIMAs is that it is clear that the decision to regulate the Investment Managers has primarily been done for political motives and not, as has been claimed, with any well thought out intent to protect investors.
Why do I say that
The way that the SEC has amended existing rules to allow them to force Hedge Fund Managers to be registered was in itself quite clever. The existing rules exempt anyone who has less than 15 clients from registering. Hedge Fund Managers took advantage of this rule by forming funds who would be deemed to be a single client. Until the SEC changed the rule this year they didnt have to look through the Fund. Now they have to look through the Fund and count all individual investors in the Fund and, as such practically, every Hedge Fund Manager who has a fund falls under the 15-client rule. But those with less than 15 clients still escape the net.
There is also another exemption which is that if they have less than US$30 million under management in total, then they do not have to register. They are permitted to register once they hit US$25 million, but they do not have to register until they hit US$30million.
I have a philosophical problem with both of these exemptions.
How can the SEC justify the fact that if a Hedge Fund Manager has only fourteen clients then he does not need to register, but if he signs up a fifteenth client then he does.
What is magic about that fifteenth client
And why does the SEC allow the first fourteen clients to be thrown to the crocodiles and only send in Mick Dundee when the fifteenth client appears on the scene
I also have a problem with the US$25 / 30 million thresholds.
What makes a small manager less likely to run off with the clients money, just because he has less than US$25 million under management
If you review the SECs lists of 46 criminal indictments, which they used to justify their attitude to fraud, you will find that a high proportion are relatively small, for sums substantially less than US$25million many less than US$5 million. Therefore why the limit
I will come back to fraud in a second.
I am not familiar with Canadian regulations, but I do know that if you manage the assets of one single third party investor in the United Kingdom, or in Ireland then you have to go through the full registration rigmarole. And indeed, as you will no doubt hear in our panel later this afternoon most if not all of the popular offshore domiciles for hedge funds have regulation, albeit it stronger in some jurisdictions than others.
With regard to fraud the SEC has claimed on the one hand that there has been substantial fraud in the Hedge Fund industry, which frankly I consider to be a huge exaggeration. On the other hand they claim that, by having the ability to visit and inspect the Hedge Fund Managers books and records, they will be able to reduce fraud because Managers will be looking over their shoulder to see if Big Brother is watching them.
In my opinion this is hogwash the threat of Big Brother has never stopped the dedicated crook and nor has regulation. But that is another matter.
The SEC cannot claim a particularly good track record at identifying, or preventing, fraud, either by positive action or implied threat. It was, after all, not the SEC who discovered market timing and late trading in the mutual fund industry. That was only discovered when an ex-employee of the Canary Fund stamped his little feet in a fit of pique and told Elliott Spitzer in New York. It was the very capable Mr. Spitzer who opened the can of worms and, I would suggest, it is probable that if the Canary had said nothing, then these practices would still be going on today.
It also has to be said that the SEC was responsible for overseeing Enron, WorldCom and Tyco, each of which individually, have probably perpetrated frauds that exceed the total value of all the frauds in the Hedge Fund Market over the past ten years or so.
I have yet to hear a convincing argument as to how the SEC expect to acquire and apply the resources to adequately regulate up to 7,000 US hedge funds, let alone any offshore managers about which more in a minute. But this is another subject.
I would also point out that the implication of some of the comments of the SEC staff and the Commissioners who voted for registration, was that Hedge Funds were involved in market timing and this was an illegal practice. In fact market timing in itself was not illegal, and certainly it was not illegal for Hedge Funds to take advantage of the inefficiencies provided in the market place. I accept that late trading was illegal, but only a couple of the Hedge Funds involved in market timing have been shown to be utilizing late trading techniques. The fact is that, for most mutual funds, market timing was illegal because many of the mutual funds had published procedures in their prospecti for prohibiting market timing trades and then blatantly ignored those undertakings. Hedge Funds that took advantage of the opportunity to do market timing, whilst some may think they were morally lax, were certainly doing nothing illegal.
There is another aspect of the SECs approach, which I find objectionable. The SEC claims that because of the growth in the institutional interest in Hedge Funds and because many of those institutions are large pension plans, which look after the assets of a plethora of retail customers, then the Hedge Fund Managers of the Hedge Funds that the pension plans have invested into, should be regulated, in order to protect those retail investors.
There are a couple of points I would make about this:
Firstly, the SEC makes it clear that many large hedge fund managers are already registered because of institutional investor pressure, which is, undoubtedly, true. In fact, I would suggest that most institutions would not place money with a hedge fund manager, unless the manager was registered. So the argument is largely self-defeating, because the managers that the retail pension plan participants needs protection from are, in all likelihood, already registered and the perceived protection is, thus, already provided.
The SEC also, rather ingenuously, suggests that, because many hedge fund managers are already registered, then registration is obviously not a burden to any hedge fund manager. I would suggest that those hedge fund managers that are already registered have chosen that route because they wanted the institutional money and wouldnt get it otherwise, so registration for them was a necessary evil. Many of the smaller hedge fund managers who are not yet targeting institutional investors will find the cost and hassle of registration a substantial burden.
The other point I would make here is that the managers of pension plans are, themselves, heavily regulated and it seems to me that the SEC has ignored the responsibility, experience and qualifications of those managers, with whom the investors have placed their monies. Is the SECs suggestion, by implication, that these managers are incompetent Or that they are not fully and properly regulated
So far I have been discussing the SECs new regulation from a general point of view and how it will effect US hedge fund managers.
Moving offshore I find the SECs insistence to regulate non-US hedge fund managers just because they act for 15 US persons, is excessive and this was one of the planks of AIMAs submission namely, that if a non-US hedge fund manager is regulated by a competent regulator, such as the FSA in London or IFSRA in Ireland or, indeed, I would suggest, perhaps the Ontario Securities Commission, then, providing there is equivalence in the regulation of the hedge fund manager, there should not be any need for that hedge fund manager to register as an investment advisor in the US, just because he manages money for a US person.
The SEC has rejected this because they claim that they do not have the resources to maintain oversight of all non-US jurisdictions regulations.
Ironically, even when the US hedge fund managers register under the Investment Advisors Act, there will not be equivalence, because it is generally accepted that most offshore i.e. non-US regulation is much tougher than the US Investment Advisors Act.
I would accept that, if a non-US hedge fund manager sets up a place of business in the United States and starts operating out of the United States, then, just as in any other jurisdiction, they should fall prey to the local regulatory authority. But if they are approached by US persons, outside the US, then I feel that they should not be required to be registered in the US.
As the last bullet point on this slide indicates, it seems that the regulations will permit some relief for offshore managers who do manage money for some non-resident US Persons. Ironically, this many mean that an offshore hedge fund manager may have a lighter form of regulation, if they manage a Cayman Island partnership that accepts US persons than they would if they had a Delaware partnership that accepted US persons, because the Cayman Partnership is outside the US. I think the old phrase watch this space applies here.
The other area of regulation that I wanted to comment on and which some of you may and others may not have any knowledge of, is the EU Savings Directive. As with all things associated with the EU, this is a muddle.
The EU Savings Directive was designed with the initial intention of identifying individual investors, resident in EU member states, who were opening up non-resident bank accounts and not disclosing the interest earned on those accounts and, thus, evading tax.
After much to-ing and fro-ing, the EU Savings Directive was created. From a hedge fund point of view, this requires the final paying agent of a hedge fund to report on any portion of payments made to EU residents, which represents interest. That report has to be made to the local tax office of the administrator or paying agent who, in turn, will inform the tax office of the investor.
The EU Savings Directive, of course, would not work if the regulations only encompassed the member states of the EU and, therefore, there has been a concerted effort over the past few years to persuade many of the offshore or international centers, such as Caribbean and Channel Islands, as well as the United States, Switzerland and Lichtenstein to sign up to the Directive. This, many (but not all) have done but, in the process, have elected to withhold tax, rather than make the report.
Life gets more complicated.
The EU has made a number of exemptions available and, in the context of hedge funds, the main exemption is that, if the fund has less than 40% of its assets invested in interest investments, then it does not fall foul of the directive and need not report the payments made to EU residents.
As a result, it is probable that most hedge funds will avoid the EU Savings Directive and, therefore, you may ask why Im making such a fuss about it. May I suggest you just think of futures, commodities and currency funds, each of which hold virtually all, if not all, of their assets in cash and, therefore, fall under the Savings Directive.
What do we have to do
Well, first of all, we have to go through the analysis to see if the fund is exempt or not. If it is not exempt, then we have to check each investor to see whether they are EU resident individuals. Then we have to analyse the revenue of the fund to ascertain which portion of any payments made to the EU resident investors represents interest income and then we have to report that to the taxman.
One of the problems with the 40% exemption rule is that we do not yet know:
- whether that 40% is to be calculated on the day of the redemption or payment;
- whether it is meant to be an average over the life of the fund; or
- the year to date;
- whether it is to be the position as at the 31st of December of the previous year; or
- whether it is a rolling monthly average.
It is quite likely that what is deemed to be the correct method in Ireland is unacceptable in Luxembourg.
It is a fact that, once the EU has issued a directive, it is left up to each individual government to introduce legislation that complies with that countrys interpretation of the law. Imagine the conflict this produces just between the UK (communal law) and France (Code Napoleon). Be that as it may, the administrator of the fund has to prepare all this information, not only for their own uses, but also, for example, for a private bank that has invested as a nominee on behalf of a number of individual clients, several of whom may be individual EU residents. Therefore, in this case, it would, of course, be the Luxembourg bank that has to make the report but, in order to make that report, they would have to rely on the information given by the Irish administrator and, if Luxembourgs interpretation of the directive is different to Irelands interpretation, who does what to whom and where
Luxembourg, by the way, is I believe one of the countries that have elected to withhold tax. The interesting thing about the withholding tax option is that the jurisdiction that elects to withhold tax keeps, I believe, 20% of the tax withheld and pays the other 80% across to the tax jurisdiction of the EU resident investor, without disclosing whom the tax is being paid on behalf of.
The more I think about this exercise, the more I think the SECs problem with staffing is going to be miniscule next to the problems that will be encountered by the tax offices and all of the EU member states. If you think that there are close to 50 administrators in Dublin, most of whom act for mutual funds. Some of these administrators will have 50-100,000 shareholders, many of whom will be EU residents. Can you imagine the chaos that will be caused in the Irish tax office when thousands of reports descend upon them shortly following every dividend payment date.
Luxembourg will probably be worse, because a high proportion of Luxembourg funds are money market type funds designed specifically for EU resident investors.
The only good sign on the horizon is that everybody has not yet signed up to the directive and it may yet fall by the wayside.
The mind boggles with the ingenuity of modern government.
Thank you.