What Fund Managers Can Do To Resist And Respond To Regulatory Creep
Good morning Ladies and Gentlemen.
This is quite a broad topic and I think I will start by describing what I consider to be ?Regulatory Creep?.
In simple terms, I mean the gradual, or perhaps not so gradual, growth of regulations specifically targeted at hedge funds, or elsewhere, for that matter, but which have a tangential effect on hedge funds.
The majority of these new regulations originate in the corridors of power of the United States and the European Union ? but still they can affect managers and their funds, even if they are based in the Cayman, other Caribbean Islands, Bermuda, or elsewhere.
The pattern is much the same. The authority planning to introduce the regulation flag their intentions quite well in advance and usually, but not always, seeks some comment on the proposed regulations as published from interested parties in the effected industries. 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 (the Alternative Investment Management Association, of which I am Deputy Chairman) and the MFA (the US Managed Funds Association) will usually 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 part of the legislation.
A lot of work goes into these submissions, but I cannot honestly say that I recall any occasion when proposed legislation has been withdrawn as a result, although it is not so rare to have amendments introduced as a result of these efforts.
Once the regulations are in place, there is little that 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.
So what sort of legislation are we considering and how do managers and administrators respond to these new regulations, once they come into force?
In the past two to five years, we have seen numerous pieces of legislation and regulations introduced, which, as I have suggested, are either directly targeting the hedge fund industry or affect hedge funds and their managers, because the legislation is so wide that it takes in a broad spectrum of the financial industry.
As an example of the latter type of legislation, I would cite the EU Savings Directive. This was proposed by the EU in order to stop EU resident taxpayers from avoiding income tax payable upon their investment income (dividends and interest) from investing, for example, in ?offshore? bank accounts (where no tax was deducted) or investing in ?roll up? funds. These do not distribute any income, but absorb it into the Net Asset Value, so that investors received a gross return when they sell their shares. On the face of it, it is difficult to argue with the ambition of the tax authorities in the European Union to ensure that they were able to get their slice of this particular cake.
However, in drafting the laws designed to catch these errant taxpayers - or tax evaders, if you will ? the legislators succumbed to a common disease in the European Union ? imprecise drafting of the laws. As a result, practically any investment vehicle that could produce ?interest income?, which, itself, was an ill-defined expression within the legislation, could be deemed to fall under the Directive.
Of course, the main problem here was that many investment funds are established in jurisdictions that did not fall under the regulatory umbrella of the EU. Hedge funds and many other offshore funds, including long only, roll up and money market funds are established in such jurisdictions as the Channel Islands, the Caribbean, Bermuda, etc., etc. ? the list goes on.
However, to some people?s surprise, the EU managed, largely with the help of the UK Government. to pressurize many of these offshore centers, 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 noticeable exceptions, including Singapore, Norway and, believe it or not, Bermuda. This latter was a perfect example of the casual or lax drafting of laws ? the Directive included ?Caribbean? tax havens, which, of course, specifically excludes Bermuda, because that is not in the Caribbean ? an obvious reflection on the modern educational attitude to geography, let alone history!
That result was that some regulations were introduced by the Directive, but, as with all things in the EU, the interpretation of those regulations was left up to individual members. In the context of hedge funds, whether a particular fund was considered ?in scope? or ?out of scope? was dependent upon a number of factors, including the 40% rule. This said that, if less than 40% of the fund?s assets were in interest bearing instruments, then the fund would be exempt or ?out of scope?. In other jurisdictions, it was deemed that, if the fund could not be described as a UCITs fund under EU definitions of that EU animal, then that also would fall out of scope.
There are other exceptions and other ways of defining vulnerable funds, but suffice it to say, the net result of all of this was that the managers and, particularly, the administrators, had their work cut out in trying to, first of all, identify whether the fund was ?in scope? or ?out of scope? and, if it was ?in scope?, then determining if any of the shareholders were, in fact, EU resident taxpayers.
Another component of the EU Savings Directive is the requirement that the personal entity responsible for ensuring that the Directive was followed was the final payment agent of the fund. This is normally the administrator, who would be responsible for arranging payment of dividends or redemptions to shareholders. However, many shareholders in funds are, in fact, themselves, banks acting as institutional nominees on behalf of shareholders.
Therefore, the administrator of the fund would not necessarily know who the ultimate shareholder is and, therefore, that nominee bank would become the final payment agent. One might imagine that this shouldn?t present much problem, because that payment agent merely assumes the responsibilities of the administrator. However, in order to meet the requirements of the Savings Directive, in most jurisdictions the final paying agent is required to report the earnings of the taxpayer to their own domestic revenue service. For example, at Custom House, we have to make such reports to the Irish tax authorities. These reports contain a breakdown, if we are able to ascertain it, of the interest element of their earnings. In other jurisdictions, the requirement may be to retain an agreed level of withholding tax on that interest element.
Again, this may just seem a fairly simple and analytical mathematical task. However, imagine the situation where a Fund of Funds has invested in an underlying fund, which is not prepared to or, perhaps, not able to give the breakdown of the interest component of any revenue generated by that fund ? in such a case, the total profit on the investment is deemed to be ?interest?.
In any event, it can be seen that the administrator of a fund which is in scope, may still have to carry out the analytical and reporting process, even if it doesn?t have any direct EU resident taxpaying shareholders, just because some of its institutional investors may themselves be acting as a nominee.
As another quirk with regard to the Savings Directive ? Swiss institutions have taken the view that the Swiss clearing house, Telekurs, must determine whether the fund is within or out of scope. Thank God Telekurs work on the UCITs definition and very few hedge funds would qualify as UCITs funds.
But enough on the Savings Directive.
The other major legislation that was passed in the last couple of years that has affected many hedge fund managers has been the requirement by the SEC that any hedge fund manger who has more than 14 clients who are US persons (as defined under US law) must register under the Investment Advisors Act.
With America?s usual tact ? dare one suggest arrogance - they have determined that they have the extra territorial right to require that offshore managers must also register, regardless of the standard of regulation that they may have domestically. Ironically, there is little doubt that the regulations imposed by the FSA in the UK and, I would suggest, the Irish Financial Regulator in Ireland, are very much stronger than the US Investment Advisor legislation.
However, this is not recognised by the SEC and all qualifying hedge fund managers were supposed to have registered by the beginning of February this year. On the face of it, it seemed 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 claim this was not their intention, but since the Act has gone through, the SEC has indicated they propose to introduce more regulations.
Again, there are ways to avoid registration ? the obvious one is not having any US investors, but also a fund that has a lock up of two years or more is also exempted under the current law. There is some doubt whether this exemption will remain in place, but in the meantime, many managers have resisted, or avoided, registration by changing their funds or launching new funds and closing old ones that have this two-year lock up.
I attended a conference early in 2005, or perhaps late 2004, at which a then senior SEC lawyer said that introducing a two-year lock up would not be allowed to fly very long, however, that lawyer no longer works for the SEC and so one still doesn?t know what the future holds, although my own belief is that the evangelistic nature of the SEC legislators will not welcome this loophole, nor let it exist for long, even though they created it.
The reason the two-year legislation came in was because the SEC did not think it was appropriate to restrict or require the registration of private equity managers whose funds would have an absolute minimum two-year lock up.
I don?t 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.
It is, of course, also a fact that the private equity market has been a booming market in its own right and hedge fund managers are nothing if not entrepreneurial and it would not be long before they started to dabble in this area. The other point, however, is that, if a hedge fund starts to invest in private equity, then it has a greater ability to justify the two-year lock up than if it was merely a long-short, equity, or other arbitrage strategy.
Systems have had to be modified and, in some cases, quite dramatically, in order to comply with the EU Savings Directive and more information has to be collected by administrators, such as the ?TIN? ? Tax Identification Number ? for all European Union residents. These systems modifications inevitably cost money. On the other hand, the administrator has not had to do too much to comply with the SEC registration requirements, other than to, perhaps, identify how many investors are US persons.
In this context, a very large percentage of offshore funds already have precluded investment by US Persons because of the requirement to establish a Master Feeder Fund structure and give US taxpaying investors K1?s. However, many of those funds that would not allow a US taxpayer into the fund have accepted US tax exempt investors, such as US endowments, pension plans, or whatever.
Some managers, who, for whatever reason, have no desire to register as an investment advisor in the US, have taken the step of refusing to accept any more US investors (although, if my memory serves me correct, they are able to ?grandfather? existing US investors in their funds). In an event, already Subscription Forms for almost every offshore fund will require investors to identify whether they are a US Person or acting for a US Person and this information will already be analysed by the administrator, on behalf of the manager, for tax reporting requirements or ERISA reporting, which I will come on to in a minute.
The cost of amending existing systems to enable the monitoring of the EU Savings Directive has varied from expensive to very expensive, depending on the system used by the administrator, but it is not only for that legislation that the administrators have had to spend both financial and human resources to amend their systems.
For example, the German market has opened up for hedge funds, but the Germans have imposed quite complex tax reporting requirements, which are similar to the K1 reporting required in the US for taxpayers. However, they require to have the information as of each valuation date and, of course, the information that they want is not exactly the same as K1s, so, again, the system has to be refined and tweaked and those refinements and tweaks have to be paid for.
I mentioned ?ERISA? reporting requirements, which have been in place for some time. Under American regulations, a fund manager who has more than 25% of assets under management subscribed by ERISA or similar plans, has to comply with some, quite Draconian, regulations, which do not apply to any other managers. The complexity of calculating this 25% and monitoring it is much more than you would imagine. The problem is that, once you have one ERISA plan, then all other US pension plans, which are not ERISA are deemed to be ERISA plans under the legislation and the total number of these various plans, in aggregate, cannot exceed 25% of the total assets managed. This just means more detailed monitoring by administrators and managers and, of course, many funds limit the acceptance of American pension plans or perhaps, exclude them altogether.
I am glad to say that there is a move afoot in the US, although I am not sure if the final legislation has yet been passed, but there is a move afoot to modify this legislation. The two main planks, which I believe have been approved in the Senate are to increase the limit to 50% and/or eliminate the inclusion of non-US pension plans within the calculation. This would make life much easier for offshore managers if, or when, the legislation goes through. My understanding was that the Senate had passed both amendments, but I am led to believe that this might be tampered with when it goes through Congress ? we will have to wait and see.
Another quite important US regulation, which itself, was an amendment of existing regulations was the introduction of New Issue laws in the past couple of years. These were a modification of the old ?Hot Issue? laws and there is a definite relaxation within these regulations. Nevertheless, resources have to be devoted to monitoring subscriptions into the funds in order to enable the manager or the administrator to identify whether the fund falls under the regulations that remain in place.
In simple terms, the old Hot Issue regulations required any fund that is investing in IPOs or other ?New Issues?, to ensure that none of the investors in the fund were ?insiders? or people who could be deemed to be insiders under the American legislation. This would include people involved with broker dealers, whether or not they were actually trading on a daily basis and various other qualifications.
The change that came about in the revised New Issues laws was that, not more than 10% of the subscribers could be what were called restricted investors, with the other investors being deemed unrestricted. Identifying which shareholders are restricted or unrestricted is, in itself, quite complex, because it has been necessary to get a legal opinion that the fund is not tainted and this, of course, requires the administrator to get substantial disclosure from all of its shareholders. I?m sure many of you will appreciate that shareholders are not always cooperative.
The major hassle in all of this for the average administrator is for Funds of Funds that may suddenly find that they are investing in a fund that has decided to invest in IPOs and requires the Fund of Funds, or rather its administrator, to contact all of its shareholders to ensure that they are not deemed to be a restricted investors.
Again, none of this analysis is rocket science, but it is science and does require systems modifications and those are always expensive. It also requires the application of human resources to maintain the records.
The main point I am making about this Regulatory Creep and there are many other areas where regulations are creeping in, including continual revision of AML legislation and guidelines, the introduction of MIFID by the EU and MAD ? perhaps the most enjoyable acronym, Soft Dollar commissions and many more. For example, legislators are currently looking at Side Letters.
The clear result of all of this legislation is that it adds considerably to the compliance cost of both managers and administrators and particularly with regard to administrators, to the cost of ensuring that the information required with regard to a fund is available and available in a usable format.
This, as I have said so many times already, requires considerable effort in systems modifications, amendments or additions and the application of quite substantial resources, both financial and human, not only in the development of those systems and the creation of an environment whereby the legislation can be complied with, but also with regard to the ongoing application of the systems and compliance.
I opened up this presentation by saying that the majority of regulations that managers and administrators had to put up with originated in the US or the EU. Whilst I would stick by that statement, there are also regulations coming in from individual countries with regard to hedge funds and these are obviously of concern to the managers but, inevitably, the policing or monitoring of those regulations will, in all probability, always fall under the administrator. I have already mentioned, as an example, the tax reporting requirements for hedge funds sold in Germany. Of course, Germany is not the only country in Europe that is introducing its own hedge fund regulations, each of which will, no doubt, have differing restrictions that have to be monitored or complied with by the hedge fund manager of the fund and, therefore, the administrator.
As an aside, I think this is a strong indication that the EU itself will find it very difficult to introduce community wide regulations, because each of the countries that have now introduced their own, which includes, inter alia, Italy, Spain, Germany, France and the UK, will have a vested interest in maintaining their particular regulatory quirks. As an example, the most recent regulations to have been published are those in Spain, which now permit hedge funds, subject to certain restrictions, including, for example:
- Maximum leverage of five times NAV, although there appears to be no restriction on exposure to derivates;
- Minimum investment of ?50,000; and
- Minimum of 25 investors per fund.
And with regard to Funds of Hedge Funds, the restrictions include:
- Minimum investment of 60% in other eligible funds. In this context, an ?eligible fund? is a hedge fund set up in an OECD country or a hedge fund whose management company is set up in an OECD country;
- The Fund of Funds cannot invest more than 10% of its assets in any single hedge fund, although it is possible to invest up to 60% in hedge fund indices or hedge fund derivatives;
- There is no minimum investment requirement.
It is notable that the single manager hedge funds may only be sold to qualified investors, whereas no such restriction appears to apply to Fund of Funds.
As can be seen, these Spanish restrictions or requirements are different from regulations in other countries and, therefore, will require additional monitoring and the inevitable system amendments by administrators.
I have not spent much time talking about anti-money laundering, because, for the most part, this subject has been beaten to death, but it still strikes me as ironic that, despite introducing the USA PATRIOT Act in October 2001, within six or seven weeks of the horrendous attack on the twin towers in New York, the Americans have still not introduced regulations that enable the hedge fund industry to apply the USA PATRIOT Act to hedge funds.
This is particularly ironic because quite Draconian anti-money laundering legislation has been passed by the European Union and many other jurisdictions, including most, if not all, of the offshore centers, including in the Caribbean, Bermuda, Channel Islands and elsewhere.
Although there is quite a lot automation that can be applied and modification of systems that will enable crosschecking of names on lists of bad boys, anti-money laundering procedures still require a high degree of manual labour, chasing up information from investors. The requirements with regard to carrying out due diligence on prospective investors and their clients have become more Draconian and more intrusive with each revised set of guidelines.
I think that, perhaps, it is the anti-money laundering regulations that imposes the most demands upon administrators, who take on the task of being the anti-money laundering agent for most funds that they act for, because of the extreme penalties that could be incurred if a mistake was made. Those penalties could be criminal if the mistake was negligence or an intentional flaunting of the law, but in any event, any prosecution or criticism under the anti-money laundering regulations could have disastrous effects on the most innocent of administrators, in the context of reputational risk. This problem is exacerbated by the fact that it is not always as straightforward as it may seem. I will tell you three stories in this regard before I sign off.
The first involves a well known British bank, which was competing to get the account of a major Swiss watch manufacturer, whose name we all know. The bank, as we all know, had to obtain full KYC information on the owners of the watch manufacturer. This presented no problem, except that a large chunk of the equity was owned by a Trust. The bank needed to know who was behind the Trust and that is where it became problematic. Not only was the bank possibly asking the Trustees to infringe Swiss secrecy laws, but more importantly, the very structure of a Trust could mean that the actual beneficial owner is not yet known to the Trustees. Obviously, most Trustees have a pretty good idea of who the beneficiaries are going to be, or who the beneficiaries would be today, but they may not be able to give a confirmation of that until they decide to distribute some part of the Trust and thereby identify a beneficiary.
Anyway, the bank was unable to get the details they thought they needed and so they had to withdraw. There is no doubt that everything regarding this potential client was as clean as a whistle, but the list of procedures could not all be ticked, so the bank had to forego the opportunity to take on this business.
The next story relates to the question that I posed at a recent regulatory forum, trying to illustrate my own concerns about administrators having to make decisions on behalf of the regulators.
The two areas that worried me (and still do) are the requirement, not the ability, but the requirement to report anything that may be deemed suspicious. Although I recognize that making such a report is indemnified under law, that doesn?t mean that, if an investor is mistakenly reported as having done something suspicious, that investor wont take legal action. Be that as it may, that is something that we live with every day.
The other area that concerns me is the so-called Politically Exposed Person regulations, which require administrators to identify anybody who is ?politically exposed? and carry out greater due diligence on those persons. Now I suppose that we know that Mrs. Mugabe is politically exposed and Cherie Blair is politically exposed, but we don?t necessarily know the names of other people who might be friends or associates of these politicians who would fall in under this category.
Anyway, I posed the question, which I pose to anybody in the audience here, of the following hypothetical situation. At the time that I made this comment, Ireland was President of the EU and the Friday following this particular discussion, Bertie Ahern, the Taoiseach, was due to hold a dinner for the other EU Prime Ministers or Presidents. I posed the possibility that we might be acting for a fund that had received subscriptions from four people:
- The first one is Teddy Kennedy ? we know at least (and I think that it is generally accepted) that his father made a lot of money out of bootlegging and, therefore, the source of his money was originally criminal. Would you prohibit his investment in the fund? Probably not, because there is no suggestion that he had personally committed any AML crime, so he is in.
- The second investor was Helmut Kohl. Again, I don?t think he ever went to jail and I am not sure anything went to Court, but it was definitely proved that he had manipulated contributions to his political party, albeit for the benefit of his political party. Nevertheless, he had done a naughty and we probably would be justified in saying no, we cannot accept money from him, although we might be on our own.
- Let us now assume that the other two subscribers are Sylvio Berlusconi and Jacque Chirac. My recollection at the time was that, certainly, Sylvio Berlusconi and, I believe, also, Jacques Chirac, had both been instrumental in arranging for laws to be passed that prohibited the prosecution of Prime Ministers and/or Presidents in their two countries for any misdeeds, financial or otherwise whilst they were in office.
Now, nothing has been proved against either of these two gentlemen, although there has been some, no doubt they would claim, scurrilous, accusations bandied about in the popular press. However, I have to say that, given these scandalous, scurrilous, unproven allegations, it still would appear to me to be suspicious that these two gentlemen had changed the law to avoid their own prosecution. Should I report them?
I never got a satisfactory answer to that one and I hope that I and my company are never put in the position of having to make a decision.
Finally, on a slightly lighter note, as you probably know, we are required to obtain the street address of any shareholder and to get copies of utility bills, passports, etc. The street address is always a problem in the Middle East, because they don?t have street addresses. Their postal addresses are PO boxes, much as it is here in Bermuda, however, at least you do have street addresses, as well as the PO box number.
Anyway - and this is a true story:
We had an application to invest in one of our funds from a Prince in one of the Middle Eastern countries. The fellow handling the anti-money laundering for this particular fund sent in a standard request for copies of his passport and utility bills. We received a copy of the passport without any problem, however, the Prince wrote back and said that he was having difficulty in providing a utility bill but he owned the only utility company ? would that help?