An Introduction to AIMA and Some Thoughts on "Regulatory Creep"
Speech given by Dermot S. L. Butler
at the 3rd Annual Conference, Caribbean Group of Securities Regulators
27th October 2006
Good morning Ladies & Gentlemen
I am standing here today with the intention of wearing two hats.
My first hat is that of Deputy Chairman of AIMA, the Alternative Investment Management Association, which many of you will know. However, for those who are not familiar with AIMA, I think I can say, without fear of contradiction, that it is THE Global Professional Trade Association of the alternative investment industry and, specifically, of hedge funds, managed futures funds and managed currency funds.
AIMAs objectives are, on the one hand, to:
- Increase institutional investor education;
- Encourage transparency; and
- Provide due diligence and related sound practice guidelines.
and on the other, to work closely with regulators and interested parties in order to promote the responsible development of alternative investments.
AIMA has nearly 1,100 corporate members, based in 46 countries, spread across 5 continents and we service some 3,800 individuals at these companies.
Membership covers the whole gamut of the industry, including, inter alia, single strategy hedge fund managers, CTAs (managed futures fund managers) and both fund of fund and multi-strategy fund managers, as well as administrators, prime brokers, lawyers, auditors, risk management consultants, pricing agents, pension consultants and insurance brokers.
In addition and very importantly everything that AIMA produces of an educational or research nature is made available to some 250 regulators and to over 600 institutional investors around the world on a complimentary basis; regulators may also have access to AIMAs website.
AIMA members have established chapters in several regions, including Australia, Canada, Hong Kong, Japan, Singapore, South Africa and, most recently, the Cayman Islands, with, I am very glad to report, the sterling support of Gary Linford, who is, I believe, still the Cayman regulator, although many of us will be sad to see him leave at the end of this month.
Our aim is to provide a unified professional voice of the hedge fund industry to enhance understanding, sound practices and the growth of the hedge fund industry worldwide.
I would like to start by commenting on the efforts that AIMA has made with regard to education and sound practices, an area close to my heart, as I am Chairman of AIMAs Sound Practices Committee.
Over the past three years, we have produced, in addition to the AIMA Journal, which comes out several times a year and which contains non-commercial information and education in the form of reports and papers written by industry practitioners.
In addition to this, AIMA has produced several guides to sound practices for:
i. Asian hedge fund managers;
ii. Australian hedge fund managers;
iii. Canadian hedge fund managers;
iv. European hedge fund managers; and
v. Hedge fund administrators;
vi. as well as the AIMA Offshore Alternative Fund Directors Guide and
vii. just recently, a Guide for Business Continuity Management for Hedge Fund Managers.
We are currently reviewing and updating the Guide for European Hedge Fund Managers, as well as our Due Diligence Questionnaires for investors seeking hedge fund managers, CTAs and fund of fund managers and for managers seeking administrators, prime brokers and custodians, which I am glad to say are gradually becoming the industry standard.
AIMA has produced several independent research papers, including:
i. A Report on Asset Pricing and Fund Valuation, with Recommendations (2005). This was intended to be the first of an ongoing series of such research papers on valuations and pricing and so you can expect regular updates;
ii. A guide to Fund of Hedge Fund Management and Investment (edited by CMRA);
iii. The Benefits of Managed Futures (Schneeweis);
iv. Alternative Investment in the International Institutional Portfolio (Schneeweis); and
v. Market Neutral Hedge Fund Strategies by HFR (Hedge Fund Research).
AIMA is the co-sponsor with CISDM (the Center for International Securities and Derivative Markets) of the CAIA (Chartered Alternative Investment Analyst) Post Graduate Qualification, or designation - the industrys first and only specialized education standard. This is a true commitment to education and, since it was launched four years ago, the CAIA programme has attracted over 4,000 candidates from more than 50 countries, in six continents.
On the regulatory front, AIMA has been very active in many jurisdictions and, in no particular order of importance, these activities have included:
i. Publishing a survey on the state of the Italian hedge fund market, which was presented to the Banca DItalia.
ii. Working closely with the AMF (French regulator) in developing its regulations on single strategy hedge funds and the role of the prime broker and depositories in the context of the new contractual funds in France.
iii. Specifically, AIMA has asked the French regulator to accept that the manager or advisor of a hedge fund, who is already regulated by the US CFTC, should be recognized under the regulatory supervision of a relevant regulatory authority a term within the French regulations. I will comment on the need for this sort of equivalence later.
iv. In Luxembourg, AIMA works closely with the Luxembourg Funds Association.
v. In Spain, AIMA members participated in consultation with the Spanish Government and regulator in the development of regulations for creating and marketing hedge funds in Spain.
vi. AIMA and its members are in regular contact with the regulatory authorities in Switzerland, including the powerful Swiss Federal Banking Commission.
vii. In Dubai, AIMA representatives have taken an active role in working with the Dubai Financial Services Authority (DFSA), including submitting a response to the DFSA Consultation Paper No. 25 The Proposed Regime For Collective Investment Funds.
viii. Referring back to the regional Chapters I mentioned earlier, these chapters have, themselves, been very active and each works closely with their regulators, as well as producing local guides and the like. For example, the Canadian Chapter has produced, in addition to the Guide for Canadian Hedge Fund Managers I mentioned just now, a Hedge Fund Primer.
ix. AIMA is developing its relationship with the CBRC and the CSRC in China and has held meetings with the Chinese regulatory bodies and is, at their request, providing information to them on the global hedge fund industry.
x. In the UK, AIMA works extremely closely with the FSA on a wide variety of topics, although recently this has been targeted at Valuations and Side Letters which has lead to AIMAs recently issued Guidance Note on Side Letters.
xi. AIMA has also published a Matrix based guidance note to help members prepare for the introduction and implementation of MIFID (Market in Financial Instruments Directive).
All of this may sound as if AIMA works in a rather parochial or regional mode, but this is not true. AIMA is THE international hedge fund industry association and, as many of you here today know, AIMA has promoted several international initiatives with regard to regulatory related matters, including:
a. Playing an active role in the EU expert group on hedge funds, which reported to the European Commission in July on the suggestion to facilitate the development of the European market for hedge funds;
b. AIMA members, including several who helped produce the AIMA paper on asset valuation and fund pricing in 2005, are actively participating in the IOSCO Standing Committee 5s work on accurate valuation and pricing of hedge fund assets; and
c. Several of you here today joined us a year ago for AIMAs 3rd International Regulatory Forum. Over 100 representatives of national and international regulatory authorities joined industry executives at the Mansion House in London for discussions on specific issues and developments concerning the management and regulation of alternative investments around the world.
These forums are held under what are known as the Chatham House Rules, which means that nobody present at the meeting may report on what was said by any individual party, although AIMA is entitled to report on the topics in broad terms.
d. The first similar Pan Asian Regulatory Forum, which took place in Hong Kong on 17 October, saw representatives of all the main national regulators in the region and some from elsewhere plus IOSCO gather privately with leading industry practitioners.
I am reliably informed that the Forum was regarded by the regulators who attended as an extremely valuable opportunity to meet and discuss matters on which their views and perspectives converge and, sometimes, diverge.
I would suggest that the delegates here today will leave this afternoon with very similar sentiments about the success of this conference.
I appreciate that it may appear that I have today shown what AIMA can do and what it has done for almost everybody else, except the Caribbean. I would point out, in our defence that, firstly, what we do on an international front (for instance, AIMA last month had a very successful visit to Washington, which was more of a meeting between the industry and legislators, rather than regulators, which are very different groups) can and does have a knock-on effect in all parts of the world.
This year AIMA has developed two initiatives firstly, to strengthen our Regulatory and Tax resource and create a new proactive Media and Press department to try and mitigate the bad image that is so often portrayed about hedge funds and, of course, if you think about it, there is a direct relationship between these two areas.
Negative media influences politicians, who have their inevitable knee-jerk reactions, such as Sarbannes Oxley and it is the politicians who drive the legislators to pass the laws and it is then the regulators who have to implement and regulate those regulations. Without wishing to sound sycophantic, I often think it is unfair to attack and complain about regulators well, most of them anyway the problem is usually the regulations too often it is a case of shooting the messenger.
Secondly, AIMA is a not-for-profit organization with limited resources. We try and keep membership fees in the reach of all prospective members worldwide, so we do not have unlimited cash for lobbying, research and the like. In fact, our main and most valuable resource is our members. At risk of sounding xenophobic, I would cite the Irish member group, who were almost single-handedly responsible, with the Dublin Fund Industry Association, for the Guide to Sound Practices for Hedge Fund Administrators and were also largely responsible for the Valuation and Pricing Research Paper.
Thus, I repeat, our most valuable and productive resource is our members and the formation of the Cayman chapter is very good news, not only for the Cayman members, but for the whole of the Caribbean. Naturally, of course, we would welcome more members for the whole region and I would point out that all these gems of information that I mentioned the Journal, research papers, guides, etc., etc., etc., can be sent to all of you who give me your card, providing you are either a registered regulator or a registered member of AIMA. If not, I can arrange for you to receive an application form so you can join.
That is the end of my commercial, so I am now going to switch hats to that of the Chairman of Custom House Administration & Corporate Services Ltd. I would stress that the comments I now make are being made in my private capacity, not as Deputy Chairman of AIMA.
Recently, I was asked to speak on the subject of how hedge fund managers and Administrators can resist or respond to Regulatory Creep.
So what do I mean by Regulatory Creep In simple terms, I mean the growth of regulations, specifically targeted at hedge funds, or elsewhere, for that matter, but which nevertheless, have a tangential affect on hedge funds.
The majority of these new regulations originate in the corridors of power of the United States and the European Union but they still can affect hedge fund managers and their funds, even if they are based in the Bahamas, the BVI, the Cayman Islands, Bermuda, or elsewhere.
The pattern is much the same. The authority planning to introduce the regulation, flags its intention quite well in advance and usually, but not always, seeks some comment on the proposed regulations, from interested parties. Once that consultation process has been completed and industry comment has been received and reviewed, the regulators finalise the legislation.
For the most part, the only way that either fund managers or administrators can resist any proposed legislation that could affect them is to participate in the consultation process, prior to the finalization of the new laws. In this regard, organizations such as AIMA will prepare responses and submit them to the relevant authority, in the hope of trying to influence or, perhaps, tone down the more aggressive or intrusive parts of the legislation.
A lot of work goes into these submissions, For example, AIMA made two submissions, in 2004, to the SEC concerning the proposal to register Hedge Fund Managers under the US Investment Advisors Act. Although both letters were only 15 or 16 pages long, including appendices, they took an extraordinary amount of work for AIMAs staff and several dedicated members who had to survey the whole membership, collate their responses and then pull the whole lot together into a concise submission.
All of this effort is absolutely necessary, but I cannot honestly say that I recall any occasion when proposed legislation has been withdrawn as a result of these efforts, although it is not so rare to have amendments introduced.
Once the regulations are in place, there is little anyone can do, whether they are fund managers or administrators, to resist, as such, although in some cases, managers can avoid legislation by restructuring their product, the fund - as I will describe in a few minutes. Having said that, I might add that, although neither AIMA nor its members can claim credit for this, one determined manager was successful, in June, in overturning the SECs hedge fund registration rule that came into effect in February this year. I will come to this later.
So what sort of legislation are we considering and how do managers and administrators respond to the new regulations, once they come into force
In the past few years, we have seen numerous pieces of legislation and regulations introduced, which, as I have suggested, are either targeting the hedge fund industry, or effect hedge funds and their managers, because the legislation is so wide that it takes in a broad spectrum of the financial industry. These include, in the US, New Issues and revised ERISA regulations and, in Europe, MIFID and continually revised anti-money laundering regulations. And, of course, Sarbannes-Oxley and the new International Accounting Standards are perfect examples of this. But, more specifically, I would cite the EU Savings Directive.
Before I discuss this, I cannot resist the opportunity to make a personal comment on the anti-money laundering regulations in the context of funds (hedge or other). I believe there is a need for only one anti-money laundering regulation in the context of funds, which is that when a subscription is received, details of the bank account used to pay (which must be an account in the investors name) must be recorded and then, upon redemption, the proceeds of the investment MUST be paid back to that original remitting bank account out of which the original subscription was paid.
If that happens, the money cannot be laundered or used for terrorist financing, while it is in the fund. What happens before or after the money goes into the fund is the responsibility of the Bank so why waste resources getting the fund, the manager, the administrator and/or the custodian to duplicate the due diligence already carried out by the remitting bank
Back to the EU Savings Directive, which was introduced in order to stop EU resident taxpayers avoiding paying income tax on their investment income thats dividends and interest income by investing in offshore bank accounts (where no tax was deducted), or investing in roll up funds the classic example used is the Belgian Dentist with an account in Luxembourg. On the face of it, it is difficult to argue against the ambition of the tax authorities in the European Union to try and ensure that they are able to get their slice of, what they thought was, their own cake.
However, in drafting the laws designed to catch these errant tax payers or tax evaders, if you will the legislators succumbed to a common disease in the European Union imprecise or lax drafting of the laws. As a result, practically any investment vehicle that could produce interest income, which, itself, was an ill defined term within the legislation, could be deemed to fall under the Directive or be in scope.
Of course, the main problem here was that many investment funds are established in jurisdictions that didnt fall under the regulatory umbrella of the European Union. Hedge funds and many other offshore funds, including long only, roll up and money market funds, are established in many jurisdictions, including the Channel Islands and the Caribbean, Bermuda, etc., etc. the list goes on.
To the surprise of many, the EU managed, largely with the help of the UK Government, to pressurize many of these offshore centers, which were UK dependant, so that, after some political horse trading, they agreed to pass legislation that would enable the EU Savings Directive to be effective on an almost worldwide basis. Even so, there were some notable exceptions, including Singapore, Norway and, ironically, Bermuda. I understand that this latter exception was a perfect example of the casual or lax drafting of laws in the EU.
Correct me if I am wrong, but I am told that the Directive specified Caribbean tax havens, which, of course, specifically excluded Bermuda, because that is not in the Caribbean. Perhaps this is a sad reflection of the modern educational attitude to geography. And then, of course, the Bahamas, being independent, could not be bullied by the UK, but enough of that - this is a topic we could spend all day debating.
So the net result was that regulations were introduced under the Directive, but as with all things in the EU, the interpretation of those regulations was left up to individual member states. In the context of hedge funds, whether the particular fund was considered in scope or out of scope was dependant upon a number of factors, including some exemptions, such as the fact that, if less than 40% of the funds assets were in interest bearing instruments, then the fund could be exempt or out of scope. In some jurisdictions, it was deemed that, if the fund could not be defined as a UCITs fund, under EU definitions of that EU animal, then that fund would also fall out of scope.
I dont propose to comment on the actual requirements and problems of administering funds that fall in scope or, for that matter, out of scope, other than to say that the hedge fund administration community spent many hours and many Euros and Dollars developing, or modifying their systems so that they could comply with the Directive. The irony is that it has been reported that the whole exercise has been a dismal failure, with negligible amounts of tax actually raised or paid.
Frankly, this would be rather funny in my opinion, except when one considers the huge waste of resources spent by Governments all over the world, including, of course, many of you here today, and by the whole investment industry, including the hedge fund industry, who were not the original focus or target of the legislation.
Systems had to be modified and, in some cases, quite dramatically, in order to comply with the Directive and more information had to be collected by administrators, such as the TIN or Tax Identification Number, for all European Union residents. The system modifications, inevitably, cost money and who is going to have to pay for that in the end Inevitably, it will be the investor, because the administrator cannot afford to eat these sort of costs ad finitum without passing them on to the customer.
The other major regulatory fiasco in the last couple of years was the SECs attempt to regulate HFMs. New legislation or regulations, which were based on an opportunistic reinterpretation of regulations that had been in place for years and which affected many hedge fund managers, required any hedge fund manager who had more than 14 US clients, to register under the US Investment Advisors Act. (It was a little more complicated than that, but in simplistic terms, this was the situation.)
With Americas usual tact dare one say arrogance - they determined that they had the extraterritorial right to require that offshore managers, with more than 14 US investors, must also register, regardless of the standard of regulation that they may have domestically. Ironically, there is little doubt that the regulations imposed by, for instance, the FSA in the UK and, I would suggest, the Irish Financial Regulator, are very much stronger than the US Investment Advisor legislation. However, this is not recognized by the SEC and all qualifying hedge fund managers were supposed to have registered by the beginning of February this year so much for equivalence.
On the face of it, it seemed to be a lot of fuss about relatively nothing, because the US regulations were fairly mild. But the fear, which some believe has already been justified, was that, once the SEC had got their claws into the hedge fund managers, they would start to impose more regulations. The SEC claims this was not their intention, but since the change in regulations went through, the SEC did indicate that they propose to introduce more regulations.
Again, as with the EU Savings Directive, there were exemptions and ways to avoid registration. The obvious one was not having any US investors, but also a fund that had a lock up of two years or more was exempt. The reason for the two-year lock up exemption was that the SEC did not think that it was appropriate to restrict, or require, the registration of private equity fund managers, whose funds would have an absolute minimum two-year lock up.
I dont know whether it is more than just a coincidence that recently, the hedge fund community has been entering the private equity market. The reason given is the growth of hedge funds, which has, to some extent, outstripped the capacity of the markets in which they have historically invested and, therefore, the private equity market has become interesting to them but I have a sneaking suspicion that a private equity component in a hedge fund may have been included by some managers because it justified the two-year lock up.
Of course, all of this is now somewhat academic because, as I have already mentioned, as a result of the stand taken by one stalwart US hedge fund manager Phil Goldstein the US Appellate Court in Washington has thrown out the SEC legislation and the SEC has decided not to oppose it. Therefore, hedge fund managers no longer have to register. Unfortunately, Mr. Goldsteins success did not come before many managers had registered and, before many tens, perhaps even hundreds, of millions of Dollars had been spent in legal fees. Huge resources, both human, in terms of compliance staff, and financial, have, again, been wasted, because of what one can only assume, was bad law, or even arrogance in the face of the law, imposed by the SEC.
A report published two weeks ago showed the compliance officer with US hedge fund managers are the highest paid, behind the actual manager with salaries averaging close to US$250,000 p.a. And, again, I ask who is going to reimburse the investors, who, of course, will ultimately bear the burden It certainly isnt going to be the US regulators.
Although many will, I think quite understandably, enjoy the SECs moment of humiliation, we must remember that some of the SECs staff will be angry and are now dangerous, like a wounded elephant, and I suspect that, for many of the staff teaching the hedge fund industry, a lesson is high on their list of priorities. So we can expect some sort of legislation in the near future probably before the end of 2007. And, of course, they will see the high profile Amaranth debacle as a heaven-sent example of the need for controls of the industry. Ironically, if Phil Goldstein had lost, Amaranth would not have been regulated anyway but little details like that never interfere with political rhetoric.
This is why AIMAs initiative to try and develop contacts and positive relationships, in Washington, with legislators on the Hill, as they say is so very important. We must all remember that, although we may not like it or approve it, the recent travails of on-line gaming industry has clearly demonstrated that decisions made in Washington can have far reaching effects outside America not that that is news to any of you here today.
Please dont think that I am against regulation. Good regulation is essential and, personally, I think that hedge fund managers should be regulated as, indeed, they are in Europe and, in fact, in most offshore jurisdictions. It is almost only in the United States that they arent regulated and I am at a loss to understand why that is still the case. I think it is inevitable that the SEC will call for legislation - and that will have to go through the due process to become law. What I desperately hope is that, when formulating this legislation, it is done with an eye towards the practicality and usefulness of the regulation and in the actual interests of the investor and not as a political knee-jerk reaction to bad press. As we know, press reports are often absolutely ignorant when they are discussing hedge funds, or any other emotive subject, for that matter.
In closing, I would like to express two other personal opinions I stress personal not AIMA opinions. Whilst I can accept the idea of retail investors in a well-structured and diversified fund of hedge funds, I am not comfortable with the general idea of opening single strategy hedge funds to the retail investor. So what is a retail investor Presumably we can say anyone who does not qualify as an accredited, sophisticated or professional investor, which leads to the second point should the minimum investment threshold be raised for accredited investors It seems logical to me perhaps US$250,000 would be in line with growth and inflation
Another change that I would like to see is a push for some of the more reluctant regulators to recognise each other and accept the concept of equivalence obviously this comment does not apply to either the CGSR or IOSCO, who are, in my opinion, making great strides in this context.
Finally, to end on a positive note, I was very encouraged by a report in the Financial Times a month ago today that Christopher Cox, the SEC Chairman, had said that regulators in the US and Europe had established important ground rules that will ensure that no market is exposed to undue extraterritorial reach by regulators on either side of the Atlantic. This statement was made in the context of the cross border Stock Exchange mergers, but, nevertheless, it is a very positive statement, particularly if it is accepted as a basic principal and one which I am sure many of you in this room here today welcome.
Thank you.