By: Dr. Ranjan Bhaduri, CAIA, AllAboutAlpha.com Editorial Board and Hannah Wendling, AlphaMetrix Alternative Investment Advisors.
As recently examined here on AllAboutlpha.com, hedge fund regulation is a topic that has been discussed frequently throughout the past decade, with little material change in the United States. Triggered by the 2008 financial crisis, however, hedge fund legislation seems imminent, and with hedge fund regulation pending in legislative bodies of the United States, European Union, and elsewhere, some experts anticipate an outflow of capital to countries with less stringent regulations. In light of this, it may be useful to examine some of the current and pending regulatory laws in the US and beyond:
One Small Paragraph
The United States is reacting to calls for greater regulation through proposed bills to more closely monitor activities of alternative investment fund managers (AIFMs). Based on the bills which have been proposed thus far, the consensus on Capitol Hill seems to be that SEC registration (to increase transparency) is the preferred method to keep private advisors in check.
Current policies were put in place in the Investment Advisers Act of 1940, nine years before A.W. Jones created the first hedge fund, and few legislative changes have occurred in the past six decades to keep pace with the evolving financial industry. Most hedge funds are exempt from regulation due to one small paragraph: Section 203(b) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(b)) states that an adviser need not register if he has fewer than 15 clients, and “client” can be interpreted to mean “fund.”
Notably, this provision, known as the “private adviser exemption” was upheld in 2006 in Goldstein v SEC, a lawsuit brought against the SEC in 2005 for its attempt to re-interpret the meaning of “clients” to mean “investors,” out of accordance with the rest of the 1940 Act. This provision in particular has been targeted by proposed legislation.
Regulatory flood gates opening
From the Oval Office is the proposed Private Fund Investment Advisers Registration Act of 2009. If enacted as proposed, it would eliminate the “private adviser exemption” and require registration with the SEC by investment advisors to private funds with $30 million or more assets under management. It contains an additional caveat which would allow the SEC to define a “client” however it wishes, effectively overruling Goldstein v SEC.
Of the bills introduced in Congress, the Senate’s Private Fund Transparency Act of 2009 (introduced by Sen. Jack Reed (D-RI)), closely mirrors the Oval Office proposal. It reflects it almost word-for-word, notably with the same elimination of the private adviser exemption and broadened power of the SEC to define terms, including “clients,” how it wishes.
A second Senate bill, the Hedge Fund Transparency Act (Sens. Levin (D-MI) and Grassley (R-IA)), focuses on private fund registration, as opposed to adviser registration. Under this proposal, any private fund with more than $50 million would be required to register with the SEC. Funds would be required to file annual disclosure statements which would be made publicly available, and which would identify investors and state the current value of assets in the fund.
The House of Representatives’ Hedge Fund Adviser Registration Act of 2009 (Reps. Capuano (D-MA) and Castle (R-DE)), is a no-frills proposed amendment to the 1940 Act. It deletes the private advisor exemption from the Investment Advisors Act of 1940, Section 203(b).
Most recently, three legislative discussion drafts were introduced in the House (Rep. Paul Kanjorski (D-PA), with similar regulatory aims, though exempting venture capital firms from its scope.
A flight to Switzerland…
Europe is facing similar legislative pressure. The Directive on Alternative Investment Fund Managers is an EU-wide bill which would, if enacted, tighten regulations on managers with assets greater than 100 million Euro. It has a similar emphasis on transparency, containing registration requirements, detailed reporting, and capital minimums for AIFMs. Proponents of the bill point to the 2008 financial crisis and argue that increased regulation is necessary: that hedge funds have become so entwined in the financial fabric of our society they could pose a systemic risk to the global economy.
However, the Directive is receiving strong resistance. The tougher rules which could result have led managers and industry experts to predict a move to Switzerland, which is not an EU member state, offering softer rules and lower taxes. There is a particular focus on potential flight from London, based on the combination of stringent regulation from the Directive and an unappealing proposal to implement 50% income tax.
…with stops in Jersey and Monaco.
An alternative would be Jersey, the British Crown Dependency, which would not be subject to the EU Directive and which offers regulatory exemptions to funds with solely institutional or professional investors. In addition, Jersey is a low tax location, where the maximum personal income tax rate does not exceed 20%.
The difficulty with relocating to avoid EU regulation, however, is that the Directive contains provisions which would inhibit outside funds from accessing the European market. One solution is EU microstates: Monaco, for example, may become particularly attractive by virtue of being a French protectorate, and so will not be shut out by the EU directive but still has the benefit of 0% income tax.
Alternatively, managers may look to move funds to Asia, and may benefit from the ongoing competition between Asian nations to attract new funds. Regulatory standards vary between countries, but many are offering incentives to lure new managers following the 2008 financial crisis. Asian countries were hit particularly hard—assets managed in Hong Kong shrank from $90 billion in early 2008 to $55 billion today.
The landscape is changing in Taiwan, in which historically tight regulation from the Financial Supervisory Commission is gradually being supplanted in a bid to expand the country’s regional presence. As of October 12th, for instance, Taiwan will now allow the trading of both stock futures and stock index futures.
In Japan, funds are required to register with the Financial Services Agency, the Japanese equivalent of the SEC. Under a 2008 amendment to the Financial Instruments and Exchange Law, however, the reporting requirements are much reduced for funds which are limited to professional QEP investors.
In China, massive overhaul of investment fund regulations is currently underway, intended to see the China Securities Regulatory Commission’s power expanded to include supervisory oversight of China’s private funds.
Elsewhere in Asia, regulation in Singapore is governed by the Monetary Authority of Singapore, under which managers can be exempt from regulation if they have 30 or fewer clients, all of whom are financially sophisticated. In addition, managers are not required to maintain a physical presence in Singapore, and can instead offer their funds through private banks.
Some managers have estimated operations’ costs in Singapore at one-third the level of London. In contrast, in Hong Kong lawmakers prohibited exemption from licensing when the Securities and Futures Ordinance came into force in April 2003. Since that time, all hedge fund managers engaging in regulated activities must be licensed by the Hong Kong Securities and Futures Commission.
Few places to hide
Whether we will see new legislation cause a migration of managers to less-regulated countries is still uncertain, but it is clear that in regions all over the world, the hedge fund industry is moving toward increased transparency.