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HEDGE FUNDS UNDER REGULATORY SCRUTINY
 

By Antoine Bernheim, Publisher. This article appeared in the November 2002 issue of Hedge Fund News?.

The popularity of hedge funds has attracted the attention of legislators and government regulators and the impact of the current scrutiny will undoubtedly have more lasting effects than the earlier reviews which followed the blow-up of Long Term Capital Management. In the U.S., the SEC is "concerned about the implications flowing from the growth in these private investment funds", particularly incidents of fraud, conflicts associated with managing hedge funds alongside mutual funds, pricing and marketing of hedge funds directly or indirectly to retail investors. The SEC is conducting a large scale fact-finding investigation seeking information from hedge funds and broker-dealers. The Treasury Department is in the process of issuing rules applicable to hedge funds under the USA Patriot Act to prevent them from being used to launder money or finance terrorist activities (see HFN May 2002 issue). While the SEC and the Treasury have very different motivations and interest, the information they collect could provide significant ammunition to future government actions, leading perhaps to require hedge funds to register with the SEC as investment advisers. Finally, the IRS is looking into the growing number of hedge funds setting up insurance companies in Bermuda and offering potentially significant tax advantages to U.S. taxpayers.

In the UK, on the other hand, the Financial Services Authority ("FSA") is looking to be responsive to investors' interest in hedge funds and is searching for new avenues to open up hedge fund investments to the retail sector.

In September, the Treasury's Financial Crimes Enforcement Network ("FinCEN") proposed to amend Banking Secrecy Act ("BSA") regulations to require hedge funds to implement anti-money laundering programs substantially similar to those applicable to mutual funds under a rule issued last April. Implementation of the rules, currently subject to a 60 day comment period, will take place in 2003, 90 days following publication of a final rule. As proposed, U.S. hedge funds would be subject to the anti-money laundering rules unless they do not allow investors to redeem any portion of their investment within two years of purchase. Offshore funds would be subject to the anti-money laundering regulations if they were selling ownership interests to U.S. persons or organized, operated or sponsored by a U.S. person. Hedge funds must designate an individual or a committee with responsibility for overseeing the anti-money laundering program. While hedge funds are likely to delegate some elements of the compliance programs to independent service providers who have typically been given responsibility to review subscription documents and money transfers, the hedge funds remain responsible for the effectiveness of their program and to ensure access by federal examiners to information and records related to those programs. Hedge funds would also be required to identify themselves by filing a notice with FinCEN including their name, address, phone number and e-mail address, as well as that of their investment adviser, the amount of assets under management as of the end of their most recent fiscal year and how many investors they have.

In July, FinCEN and the SEC issued a joint notice of proposed rulemaking applicable to mutual funds, pursuant to the USA Patriot Act, regarding reasonable procedures to (i) verify the identity of any person seeking to open an account; (ii) maintain records of the information used to verify the person's identity; and (iii) determine whether the person appears on any list of known terrorists or terrorist organization provided to investment companies by any government agency. In addition, the identification records would have to be kept on file for five years after the investor has closed his/her account. It is likely that similar rules will be applicable to hedge funds and a number of them have already incorporated these provisions into amended subscription agreements.

In the UK, the FSA released a discussion paper in August to address issues related to the selling and marketing of hedge funds in the UK and the regulation of UK-based hedge fund managers. These normally require authorization since 1986 and most achieve this by joining the Investment Management Regulatory Organization ("IMRO"), a self-regulatory organization. The IMRO application is a relatively extensive process, including an interview, and focuses on business viability, "fitness and properness" as well as competence of the principals. It does not, however, concern itself with the risk profile of the fund or its suitability for investors who may be introduced to it outside the UK. The discussion paper recognizes that given the FSA's objectives, powers and risk-based approach, "the small scale of operations of most hedge fund managers, and the lack of impact on retail consumers, mean that most such firms are assessed as low impact" and therefore do not receive much supervisory oversight. The FSA's paper almost reads like a seal of approval for hedge funds and the FSA views hedge funds as a desirable product that should be made more available to the general public. The FSA paper examines the different routes that a UK investor can take in order to make investments in offshore hedge funds (since there is virtually no UK-domiciled hedge funds as they would be subject to corporation tax). The FSA is inclined to support the idea that certain types of hedge funds can be suitable products to be marketed and sold to the retail sector within the Collective Investment Scheme Sourcebook. With respect to anti-money laundering regulations, UK-based hedge fund managers have been required by law, since 1994, to "know their customers", including customers introduced to them by intermediaries. The Guidance Notes of the Joint Money Laundering Steering Group aim to promulgate good practice in countering money laundering and detail how obligations under the UK Money Laundering Regulations are to be met.

These developments may not affect the ability of hedge funds to operate profitably, but the cost of doing business will go up and could, in the future, slow down the creation of new hedge funds in the U.S. In addition, the application of new U.S. laws and regulations to offshore hedge funds could raise thorny issues. In particular, the requirement to identify aspects of a fund’s operations vulnerable to money laundering or terrorist activity has been interpreted differently by different people and led certain hedge funds to demand more representations and disclosures than many banks or investors are willing or able to make. u

 
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