AUGUST 2005
Hedge Funds
FSA Consultation on Hedge Fund Regulation
Hedge fund managers who do business in the UK
will be interested in the content of two discussion
papers published at the end of June 2005 by the
UK's financial regulator, the Financial Services
Authority ("FSA"). These papers invite debate on
the possibility of more stringent regulation of
hedge fund activities and products within the UK.
One paper sets out the FSA's assessment of the
risks posed to the FSA's objectives by the investment techniques and the legal structures of hedge
funds, and the other considers a range of matters
including the effect of recent changes to FSA rules
which will result in some onshore (i.e., UK-domiciled) products that use certain trading techniques
similar to those used by hedge funds being made
available to the UK general public. It also considers whether offshore hedge fund products should
be capable of being marketed to a wider range of
persons in the UK than at present.
HEDGE FUNDS AND UK REGULATION
Hedge fund managers based in the UK are
required to be authorised by the FSA. The funds
themselves, however, are generally domiciled offshore (i.e., outside of the UK) and are accordingly
not themselves directly regulated by the FSA.
They are only affected by FSA regulation indirectly through their UK-based hedge fund manager (if
there is one), or through trading activities in the
UK through other UK FSA authorised firms.
Hedge funds control over $1 trillion (£546 billion)
of assets globally and are responsible for up to half
the daily turnover in the New York and London
stock markets, and as a result they have an increasingly important role in financial markets, enhancing market liquidity and market efficiency. The
FSA produced the discussion papers because it
was concerned that the growth in the global hedge
funds industry might give rise to new risks.
The risks identified by the FSA as being inherent
in the hedge fund sector include erosion of confidence (if a fund were to collapse), liquidity disruption (which might be caused if several hedge
funds were to dispose of a large volume of investments in a particular market segment at the same
time), control issues (reflecting the fact that some
hedge fund managers do not have the optimal skill
set to create an effective control infrastructure),
operational risk and potential weaknesses in asset
valuation methodologies.
In addition to these particular risks, the FSA has
also drawn attention to hedge funds' evolving
investor base with increased investment by funds
of hedge funds and pension funds, both of which
spread the risk of investing in hedge funds into
the wider community.
Furthermore, the FSA believes that some hedge
funds may have been testing the boundaries of
insider trading and they suspect that some funds
may engage in market abuse under the current UK
regulatory rules as a result of their trading activities.
The FSA has considered several risk scenarios.
One of these concerns the potential impact upon
the stability of the financial markets of failure, significant distress or collapse of a group of hedge
funds. Whilst the risks are currently small, they
are perceived to be growing, and the FSA cites the
1998 example of the near collapse of Long-Term
Capital Management, which, at one stage, had
$1.4 trillion in gross exposures and a leverage ratio
of 50 to 1. The FSA cannot be certain that other
hedge funds do not have similar exposure at present because of the limited disclosure obligations
imposed upon hedge funds in the UK.
Kirkpatrick & Lockhart Nicholson Graham
LLP
In order to tackle these issues, the FSA has stated
that it will establish a centre of hedge fund expertise to “relationship manage” the 15-25 high impact
UK-based hedge fund managers (out of 350 active
in the UK). It will also increase surveillance of
market conduct within the hedge fund sector, and
has proposed that it may require firms to identify
the hedge fund manager rather than the hedge
fund itself as the counterparty to a trade for transaction reporting purposes. The FSA intends to
engage in greater dialogue with other international
regulators concerning hedge funds.
management systems of the UK firms launching
those products should be reviewed and a clearer differentiation of different products be made than at
present.
CONSULTATION
The FSA has asked that the hedge fund industry
give their views on a number of issues, including
whether:
■
a distinction should be drawn between hedge
fund managers and other types of investment
managers or investment advisers for the purposes of FSA regulatory oversight;
■
prime brokers should be distinguished more
clearly as a separate category of regulated entity;
■
additional data should be collected from hedge
fund managers to assist the FSA in its supervisory oversight of high impact firms;
■
the FSA should encourage industry initiatives
to improve investor due diligence and hedge
fund disclosure;
■
the FSA should work to promote the development of industry codes of practice to encourage
improvement in the accuracy of hedge fund valuations.
RETAIL INVESTMENT PRODUCTS
The FSA is also concerned about onshore (i.e.,
UK-domiciled) products that have some of the
investment characteristics of hedge funds—shortselling, economic leverage and the use of derivatives for investment purposes—and the consequential volatility, illiquidity and complexity of
such products.
The FSA has considered a suggestion that the
existing FSA regime for investment products may
not be adequate to cover such new products in the
UK. They have been considering ways of responding so as to bring greater coherence to the current
regime for investment products that may be marketed to the general public in the UK.
In parallel with the consultation on hedge fund
regulation, the FSA has asked for industry comments to try to decide whether to encourage or
discourage wider access to such onshore products
and also whether the current restrictions on the
marketing in the UK of offshore collective investment schemes (such as the typical offshore hedge
fund) should be lifted or eased. At present offshore hedge funds may only be marketed in the
UK to a limited class of professional or otherwise
sophisticated investors, and may generally only be
marketed by FSA authorised firms.
If you wish to comment on any of these issues you
should make your submissions to the FSA by 28
October 2005. Alternatively, please contact the
authors who will be happy to collate all comments
and submissions received and forward them to the
FSA. The FSA will publish feedback in early 2006.
The discussion papers can be downloaded from:
http://www.fsa.gov.uk/pubs/discussion/dp05_03.pdf
http://www.fsa.gov.uk/pubs/discussion/dp05_04.pdf
The FSA sees three main risks for investors:
(1) that the greater risks associated with products
that have hedge fund characteristics may not be
apparent to potential investors; (2) that investors
might be confused by the range of products; and
(3) that different regulation for different products
may inhibit investment. The FSA has suggested
that, to reduce the risks associated with onshore
products with hedge fund characteristics, the risk
2 AUGUST 2005
Philip Morgan & Neil Robson
Kirkpatrick & Lockhart Nicholson Graham LLP
Financial Services Group, London Office
Telephone: +44.20.7648.9000
Email: pmorgan@klng.com or nrobson@klng.com
August 2005
KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP
Kirkpatrick & Lockhart Nicholson Graham has approximately 1000 lawyers and represents entrepreneurs, growth and
middle market companies, capital markets participants, and leading FORTUNE 100 and FTSE 100 global corporations
nationally and internationally. Members of the Hedge Fund Practice Group and their telephone numbers and e-mail
addresses are listed below. For more information you may also visit our website at www.klng.com, or send general
inquiries via e-mail to hedgefunds@klng.com.
BOSTON
Michael S. Caccese
Philip J. Fina
Mark P. Goshko
Thomas Hickey III
Nicholas S. Hodge
George Zornada
LONDON
Philip J. Morgan
Neil D. Robson
LOS ANGELES
William P. Wade
617.261.3133
617.261.3156
617.261.3163
617.261.3208
617.261.3210
617.261.3231
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pfina@klng.com
mgoshko@klng.com
thickey@klng.com
nhodge@klng.com
gzornada@klng.com
+44.20.7360.8123 pmorgan@klng.com
+44.20.7360.8130 nrobson@klng.com
310.552.5071 wwade@klng.com
NEW YORK
Robert J. Borzone, Jr. 212.536.4029
Jeffrey M. Cole
212.536.4823
Ricardo Hollingsworth 212.536.4859
Beth R. Kramer
212.536.4024
Richard D. Marshall
212.536.3941
Keith W. Miller
212.536.4045
Scott D. Newman
212.536.4054
rborzone@klng.com
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rhollingsworth@klng.com
bkramer@klng.com
rmarshall@klng.com
kmiller@klng.com
snewman@klng.com
SAN FRANCISCO
Jonathan D. Joseph
David Mishel
Timothy B. Parker
Mark D. Perlow
Richard M. Phillips
415.249.1012
415.249.1015
415.249.1042
415.249.1070
415.249.1010
jjoseph@klng.com
dmishel@klng.com
tparker@klng.com
mperlow@klng.com
rphillips@klng.com
WASHINGTON
Clifford J. Alexander
Diane E. Ambler
Catherine S. Bardsley
Arthur J. Brown
Deborah A. Linn
Cary J. Meer
R. Charles Miller
Charles R. Mills
Jean E. Minarick
David Pickle
Theodore L. Press
Robert H. Rosenblum
William A. Schmidt
Donald W. Smith
Martin D. Teckler
Robert J. Zutz
202.778.9068
202.778.9886
202.778.9289
202.778.9046
202.778.9874
202.778.9107
202.778.9372
202.778.9096
202.778.9029
202.778.9887
202.778.9025
202.778.9464
202.778.9373
202.778.9079
202.778.9890
202.778.9059
calexander@klng.com
dambler@klng.com
cbardsley@klng.com
abrown@klng.com
dlinn@klng.com
cmeer@klng.com
cmiller@klng.com
cmills@klng.com
jminarick@klng.com
dpickle@klng.com
tpress@klng.com
rrosenblum@klng.com
william.schmidt@klng.com
dsmith@klng.com
mteckler@klng.com
rzutz@klng.com
www.klng.com
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Kirkpatrick & Lockhart Nicholson Graham (K&LNG) has approximately 1,000 lawyers and represents entrepreneurs, growth and middle market companies, capital markets participants, and leading FORTUNE 100 and FTSE 100 global corporations nationally and internationally.
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