K&LNG
MAY 2006
Alert
Hedge Funds
FSA Consultation on Hedge Fund Regulation
Hedge fund managers doing business in the UK may
be interested in the content of three recent
publications from the Financial Services Authority
(“FSA”). Published at the end of March 2006, two
feedback statements set out the responses received by
the FSA in connection with discussion papers
(“DPs”) published in July 2005. The first DP set out
the FSA’s assessment of the risks posed to the FSA’s
statutory objectives by the investment techniques and
legal structures of hedge funds, and the other
considered, among other things, the effect of changes
to FSA rules, which have resulted in some onshore
retail products being permitted to use trading
techniques similar to those used by hedge funds. The
feedback statements summarise the consultation
responses received, set out the FSA’s further policy
considerations and outline the FSA’s proposed next
steps. In addition, a new FSA consultation paper on
implementation of the EU Transparency Directive
has some potential impact on the availability of
hedge funds to the UK retail market. The principal
issues that have arisen in the feedback statements are
discussed below.
HEDGE FUNDS AND UK REGULATION
At this stage, the FSA has no plans to change any UK
regulatory rules relating to hedge fund managers and
has shelved its proposals to identify hedge fund
managers as a distinct and separate category of FSA
authorised firm. It has, however, recently established
a dedicated team of regulatory staff to monitor and
supervise the hedge fund sector on an ongoing basis,
with particular emphasis on those managers it
considers to be “high-impact.” The comments
received by the FSA as a result of the DPs will be
used by the hedge funds team to develop its
monitoring program. Given that London has become
a major centre of hedge fund management activity
over recent years (second only to New York in terms
of the number of managers), the FSA can be expected
to keep the hedge funds industry under increasing
surveillance.
ASSET VALUATION
The FSA has noted that valuing the investments held
by a hedge fund is highly technical, and regulation of
such activity is extremely difficult given that
valuation oversight is ultimately a responsibility of
the (offshore-based) board of a fund. The FSA
believes that this is an area where further analysis
and investigation should be undertaken as (1) there is
some scope for fund managers to overstate fund
assets given that net asset value is the basis upon
which their performance fees are calculated, and (2)
investors might be prejudiced by false valuations.
Fraudulently false valuations could result in a breach
of the first of the FSA’s “Principles for Businesses”
being the basic principles upon which all FSA
regulation is built - the principle that all regulated
firms must conduct their business with integrity.
Criminal sanctions may be invoked in serious cases
where a valuation is proven to be intentionally
inflated. The FSA will be conducting thematic work
on hedge fund valuations as a matter of high priority.
SIDE LETTERS
It is becoming increasingly common in the United
States for institutional investors in hedge funds to
negotiate preferential terms. Indeed, it is often the
case that large potential investors use their leverage
to insist on preferential terms.
Reprinted with the permission of MFA Reporter (June/ July 2006 edition), for whom this Client Alert was first written
as an article.
Kirkpatrick & Lockhart Nicholson Graham LLP |
MAY 2006
Investment in a hedge fund is governed by the fund's
underlying organisational documents, and any
variation to these established terms must be done by
way of a written agreement or side letter. Each side
letter is entered into between the fund and an
individual investor, and the FSA believes that
entering into such side letters with some but not all
investors of the same class may be to the detriment of
other investors in that class who should be aware that
side letters can affect the risk profile of their hedge
fund investment. This lack of transparency and a lack
of disclosure regarding side letters deprives the other
investors of access to comprehensive information.
The FSA warns that failing to disclose the existence
of side letters to every investor in a particular class
could, as with false valuations, amount to a breach of
Principle 1 by the FSA-regulated manager—i.e., it is
not conducting its business with integrity.
Although there are no specific SEC rules on side
letters, the SEC staff has stated informally that the
unequal sharing of information with investors in a
hedge fund may be improper in certain circumstances.
As a consequence, many U.S. hedge funds now
disclose in their offering documents that certain
investors may be provided more detailed information
and/or that certain investors may be given preferential
terms. In any event, if material information is
provided to some investors, the hedge fund may be
forced to share that information with other investors
in a timely manner. There are also no specific UK
rules at all on side letters beyond the general
principles, but the FSA has stated that as a minimum
it would expect acceptable market practice to be for
managers to ensure that all investors are informed
when a side letter is granted (but not the nature of the
individual agreement). The FSA has also indicated
that it will review a sample of firms' practices to
further inform its policy thinking on side letters.
RETAIL INVESTMENT PRODUCTS
The second FSA feedback statement mainly concerns
the risks posed to the UK’s financial markets by
investment products that have some of the
characteristics of hedge funds. In response to the
comments it has received from the financial services
industry, the FSA has proposed that, with regard to
such “complex” investment products, it will reinforce
its existing consumer information and awareness
work, look more closely at the question of product
provider responsibility, and potentially extend the
range of products available to the retail market.
2
In particular the FSA has been considering whether it
should introduce a new unlisted authorised fund of
hedge funds product which could be marketed to the
UK general public. The FSA has suggested that
investor protection in relation to these proposed
products should, in part, be provided by requiring
that the fund manager be domiciled in the UK, and
hence subject to FSA rules. The FSA is further
considering investor protections in this area by
assessing whether concentration and risk spreading
restrictions would provide sufficient control and
protection for consumers. The FSA has stated that it
will issue a consultation paper on this matter
although as yet no date for the consultation has been
published.
In addition, a new FSA consultation paper published
on 30 March 2006 (concerning how the FSA
proposes to implement the EU Transparency
Directive) contains a further proposal to extend the
range of products available to the UK general public.
The suggestion is that for the first time, investment
entities using a wider range of investment strategies,
such as hedge funds, would be able to list their shares
on a UK exchange and market to the UK general
public. (N.B. Funds of hedge funds are, subject to
listing rule restrictions, already able to be admitted to
listing on a UK exchange and similarly marketed).
Although the details are not yet available, and the
FSA has stated that a further consultation paper will
be issued on this subject in the near future, it seems
likely that the first hedge funds that will be listed will
be those that follow a single strategy. The FSA has
stated however that listed hedge funds would be
subject to a “robust listing regime” with “enhanced
disclosure requirements.”
The FSA states in the consultation paper that “there is
an inevitable trend towards increased variety of
products” and the FSA’s regulatory response to this
will be to rely on consumer education and awareness as
the principal tool for the protection of consumers,
rather than attempting to restrict the variety of products
available for investors. Provided there is sufficient
disclosure to shareholders of the risks associated with
investing in an investment entity exposed to a particular
asset class or investment strategy, and entities continue
to satisfy the requirement to spread investment risk,
then the FSA sees no reason why shareholders should
not be free to invest.
Kirkpatrick & Lockhart Nicholson Graham
LLP
|
MAY 2006
For investors, if single strategy hedge funds were
eligible to be listed, a greater degree of liquidity
should result. Hedge fund shares are usually illiquid
investments, and to the extent that, in the future,
listed, closed-ended hedge funds are established, this
could increase the level of liquidity in the industry,
creating perpetual vehicles that investors can trade in
and out of more easily.
The Feedback Statements can be downloaded from:
http://www.fsa.gov.uk/pubs/discussion/fs06_02.pdf
http://www.fsa.gov.uk/pubs/discussion/fs06_03.pdf
The Transparency Directive consultation paper can
be downloaded from:
http://www.fsa.gov.uk/pubs/cp/cp06_04.pdf
The FSA will consult further on these proposals in
the course of 2006 and 2007.
Philip Morgan
+44.20.7360.8123
pmorgan@klng.com
Neil Robson
+44.20.7360.8130
nrobson@klng.com
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202.778.9107 cmeer@klng.com
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