OSC eyes hedge fund curb

Date: Friday, November 18, 2005
Author: Wojtek Dabrowski- Financial Post

Post-Portus reflection: Regulator may pull exemption for principal protected notes
Wojtek Dabrowski
Financial Post

The Ontario Securities Commission is considering changing a key rule that could disrupt the flow of small-investor dollars into Canada's $30-billion hedge fund industry.

"We're very much aware that this would be a dramatic, but perhaps appropriate, step," OSC vice-chairman Paul Moore said in an interview.

The commission is looking at whether to remove a regulatory exemption that lets hedge funds sell their products to ordinary retail investors, instead of just the wealthy, by using something called principal protected notes, or PPNs.

PPNs guarantee the return of an investor's principal, plus the return obtained through exposure to one or more underlying hedge funds. The exemption from the provincial securities laws that hedge-fund firms use to sell PPNs is called the "bank-debt exemption," which lets large banks or financial institutions issue debt without filing a prospectus.

Because of the bank-debt exemption, PPNs also aren't subject to accredited-investor rules that normally have to be followed by hedge funds. Those rules state hedge funds can be sold only to affluent individuals who can understand and cope with their complexities and volatility.

Failed Toronto-based firm Portus Alternative Asset Management Inc. -- its collapse affected 30,000 investors -- used a purported PPN guarantee by Societe Generale, a large French banking group, to sell its product to ordinary investors.

"We just have a concern that the bank-debt exception was never designed to allow hedge funds to be sold," Mr. Moore said.

"We are examining whether or not that is an appropriate exemption or whether there should be a rule change to take that exemption away with respect to PPNs," he said.

Mr. Moore is heading an OSC committee looking at changing the way hedge funds are regulated after the Portus scandal this year. The Financial Post first reported the regulator's review in August.

The OSC committee is co-ordinating its work with other Canadian jurisdictions.

No decision on the exemption has been made.

He said if the OSC was to pull the exemption, "it would be in a focused way and it would be after public consultation."

Canada's hedge-fund industry has ballooned to more than $30-billion from $4-billion in the past five years, according to OSC chairman David Wilson. Principal-protected notes have been among the key drivers of the growth, analysts say.

However, sales of PPNs have cooled drastically in wake of the Portus scandal.

Still, "we think well over half of the retail exposure to hedge funds is in the form of PPNs," Mr. Moore said.

Removing the bank-debt exemption would make hedge funds subject to regulation that is more exhaustive than the set of rules they must obey today. Mr. Moore also acknowledged the move could effectively kill PPNs as an asset class altogether.

Mr. Moore emphasized that no decision has been made. Aside from exemptions, the OSC's review of hedge-fund rules is also focused on areas such as registration, suitability obligations of financial advisors, compliance and enforcement.

Toreigh Stuart, chief executive of Toronto-based BluMont Capital Corp., said he doesn't believe the regulators have made up their minds about the issue yet.

"I don't know if they're going to pull it," he said. "I think they're just trying to figure out what the rules should look like."

However, he added, "I can't tell you I'd be thrilled about it."