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Hedge fund managers need to pay closer attention to details of regulation to avoid...

Date: Tuesday, May 1, 2012
Author: Margie Lindsay, Hedge Funds Review

Hedge fund managers need to pay closer attention to details of regulation to avoid compliance pitfalls

Hedge funds need to pay more attention to the fine detail of regulation of the industry. The in-house general counsel or chief operating officer needs to keep on top of laws to avoid non-compliance.

Hedge funds are in danger of missing important compliance criteria if they do not keep on top of the fine print of regulation, according to Marie Defalco, vice chair of the investment management group at US law firm Lowenstein Sandler.

“You almost have to have someone in the house that’s focusing on [just regulation]. If you’re a smaller fund and you can’t afford in-house general counsel, you have to have someone that is doing the co-ordination with outside counsel, staying aware,” advises Defalco.

She advises hedge funds have at least one person focused on keeping abreast of legislative and legal changes to avoid nasty surprises. Pointing to some aspects of Dodd-Frank, for example, Defalco says although a fund may qualify for an exemption under the act, it still has reporting requirements. “I’m not sure all of those smaller funds are aware of that.”

Another area where funds may need to take more care concerns Form PF. This reporting requirement “requires a tremendous amount of information gathering”. Defalco says it is ”very important that [funds] start way in advance” because they may have to modify their subscription agreements or collect more information from their investors in order to comply with the form.

Funds are caught not just under the Securities and Exchange Commission (SEC) filing but also need to keep an eye on Commodity Futures Trading Commission (CFTC) rules.  “If they are trading any commodities, whether in the US or not, and have at least one US investor, they may be required to register as a commodity pool operator,” advises Defalco.

She is sceptical that managers based in Europe are prepared for the scope of US regulation. The SEC’s extraterritorial reach appears unquestioned, particularly if it thinks a manager’s contact with the US is sufficient to merit its attention.

“[European managers] are aware of Dodd-Frank but they may automatically assume they qualify for an exception from registration, for the private adviser exemption. That’s not necessarily true because if they have sufficient US investors, then they don’t qualify for that or may qualify for something else. If they qualify under the private fund exemption, they still have to do reporting,” notes Defalco.

Many rules and regulations are still to come, despite the fact the SEC has issued much since its rules on registration. “We haven’t seen much in the way of rule-making with respect to the funds themselves and registration since last June when the SEC came out with the private funds definition.”

The rule-making has slowed down partly because there is so much to do and as the SEC itself has already produced a large number of rules since July 2010. Defalco believes some recommendations may be simplified but warns there is more to come.

Looking internationally, Defalco believes there will need to be some attempt at co-ordination of the different regimes. This, however, may be some time in coming. “Fund managers have to be aware of the rules wherever they’re marketing or investing, especially if they are soliciting in the EU as rules there are changing with the AIFM directive. There’s a lot to be aware of,” she says. “It increases the cost of running a hedge fund. Just having the chief operating officer, which is necessary if you’re a registered adviser, and keeping up to date with all the compliance is costly."

While there has been a lot of regulation over a short space of time, Defalco thinks many investors have found increased oversight comforting. The fact that managers are registered and are reporting information has benefited investors as well as increase transparency overall.

“I think we’ve seen with the very long lag times and excessive due diligence that the more information that is available, the better,” she states. “The fact that [hedge funds] are a little more transparent is a good thing because it gives everyone confidence. However I personally I think over the long term it’s a negative first as it just increases costs.”

A second negative is the barrier to entry for new funds. “It used to be if you were a good trader you could set something up in your garage and, if successful, grow from there. That is not now the case. You have to have the compliance professionals and the whole operational risk infrastructure from day one. That’s a bad thing,” she concludes.