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United States of America (USA)
Hedge funds are typically organized by professional investment advisors that manage investments for hedge funds. Hedge funds distribute securities in private offerings, traditionally “marketing” their interests through word of mouth and the personal relationships with the hedge fund’s advisory personnel. Broader marketing, including use of the Internet, has become more frequent in recent years.
Hedge fund advisors typically receive, as compensation, a management fee based on the amount of hedge fund assets (commonly 1-2 percent), plus a share of the capital gains and capital appreciation (commonly 20 percent) or some other allocation based on the fund’s investment performance. Hedge funds typically agree to repurchase their own interests from investors on a limited, periodic basis, such as quarterly, often following an initial “lock-up period” during which time investors are not permitted to liquidate their investments.
Because hedge funds are not registered investment companies, they generally are not required to meet prescribed disclosure requirements. Hedge fund advisors, however, typically provide potential hedge fund investors with a private placement memorandum that discloses information about the investment strategies the hedge fund is permitted to use and an overview of how the hedge fund operates. The private placement memorandum also generally provides the adviser with the maximum flexibility in selecting, shifting and modifying its strategies. In addition, the private placement memorandum often provides the hedge fund adviser with broad discretion in valuing the hedge fund’s assets.
Hedge fund investors generally receive some ongoing performance information, risk analyses and portfolio profiles from their hedge fund advisors. Although not required, most hedge funds retain an auditor to conduct an annual independent audit, which, if certified, is prepared using generally accepted accounting principles (GAAP).
For tax and other considerations, some hedge fund advisors create one or more “offshore” hedge funds that are organized in a foreign jurisdiction, in addition to maintaining U.S. based hedge funds.
Hedge funds do not register the offer and sale of their interests under the Securities Act. As such, hedge funds may not offer their securities publicly or engage in a public solicitation. Instead, hedge funds generally sell their interests in private offerings.
Investment Company Act 1940 and hedge fund
Most hedge funds have substantial investments in securities that would cause them to fall within the definition of Investment Company under the Investment Company Act, 1940. Hedge funds, however, typically rely on one of two statutory exclusions from the definition of Investment Company, which enables them to avoid the regulatory provisions of that Act.
Section 3(c)(1) of the Investment Company Act, 1940 excludes from the definition of investment company any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 investors and which is not making and does not presently propose to make a public offering of its securities.
Section 3(c)(7) of the Investment Company Act, 1940 excludes from the definition of investment company any issuer whose outstanding securities are owned exclusively by persons who, at the time of acquisition of such securities, are “qualified purchasers, and which is not making and does not at that time propose to make a public offering of its securities. A hedge fund relying on Section 3(c) (7) may accept an unlimited number of qualified purchasers for investment in the fund.
Qualified purchasers are defined by SEC to mean “accredited investors”. “Accredited investors” is defined to include individuals who have a net worth with their spouse, above US $ 10,00,000 or have 17 however, most funds relying on Section 3(c)(7) have no more than 499 investors in order to avoid the registration and reporting requirements of the Securities Exchange Act of 1934 (“Exchange Act”).
The principals of hedge funds normally have no interest in encouraging resale of interests in their funds. In the usual case, therefore, transfers of the interests are prohibited without the written consent of the general partner or other manager, and there is limited liquidity of the interests through sales and redemptions by the hedge funds.
The Exchange Act and hedge funds
The Exchange Act contains registration and reporting provisions that may apply to hedge funds. Section 12 of the Exchange Act and the rules promulgated there under govern the registration of classes of equity securities traded on an exchange or meeting the holder of record and asset tests of Section 12(g) and related rules. Section 12(g) and Rule 12g-1 there under require that an issuer having 500 holders of record of a class of equity security (other than an exempted security) and assets in excess of $10 million at the end of its most recently ended fiscal year register the equity security under the Exchange Act.
Registration of a class of equity security subjects domestic registrants to the periodic reporting requirements of Section 13, proxy requirements of Section 14 and insider reporting and short swing profit provisions of Section 16 of the Exchange Act. Although hedge fund interests fall within the definition of equity security under the Exchange Act, most hedge funds seek to avoid Exchange Act registration by having fewer than 500 holders of record (which in the case of hedge funds are also generally the investors).
Due to the power a hedge fund’s adviser may exercise over the equity securities held by the fund, both the hedge fund and its advisor generally will be deemed to beneficially own any equity securities owned by the hedge fund. The beneficial ownership reporting rules under sections 13(d) and 13(g) of the Exchange Act generally require that any person who income above US $ 20,00,000 in the previous two years (or joint income with their spouse above US $
30,00,000). Institutional investors with assets exceeding US $ 5,000,000 are considered “accredited investors”.
In addition, hedge fund advisors also may be subject to the quarterly reporting obligations of Section 13(f) of the Exchange Act, which apply to any “institutional investment manager” exercising investment discretion with respect to accounts having an aggregate fair market value of at least $100 million in equity securities. An “institutional investment manager” includes any person (other than a natural person) investing in or buying and selling securities for its own account, and any person exercising investment discretion with respect to the account of any other person.
Section 16 applies to every person who is the beneficial owner of more than ten percent of any class of equity security registered under Section 12 of the Exchange Act and each officer and director of the issuer of the security (collectively, “reporting persons” or “insiders”). Upon becoming a reporting person, a person is required by Section 16(a) to file an initial report with SEC disclosing the amount of his or her beneficial ownership of all equity securities of the issuer. Section 16(a) also requires reporting persons to keep this information current by reporting to SEC changes in ownership of these equity securities, or the purchase or sale of security based swap agreements involving these securities. Hedge funds are also subject to the short swing profit provisions of Section 16(b) of the Exchange Act.
The Commodities Exchange Act and hedge fund
As a result of recent CFTC rule options, many hedge fund advisors can now qualify for exemptions from Commodity Pool Operator (CPO) and Commodity Trading Advisor (CTA) registration. Regulations under the Commodity Exchange Act (CEA) provide an exemption from registration to CPOs operating pools that engage in limited commodity futures activities and sell interests solely to certain qualified individuals. Regulations under the CEA also provide an exemption from registration to CPOs that operates pools that sell interests to certain highly sophisticated pool participants.
Investment advisors to hedge funds that operate in reliance upon Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act may be able to rely upon one of these CFTC exemptions. In addition, the CEA provides a de minimis exemption from CTA registration that is similar to the Investment Advisors Act’s de minimis exemption from investment adviser registration. Consequently, hedge fund advisors that are exempt from registration as an investment adviser also are usually exempt from registration as a CTA. Hedge fund advisors that meet the definition of CPO or CTA, but that are exempt from registration as such, are required to keep books and records, but are not subject to disclosure, periodic reporting or audit requirements that apply to a registered CPO or a registered CTA.
Other Regulations and hedge funds
Pursuant to authority granted by the Exchange Act, the Treasury Department has adopted rules that govern the reporting of large positions in U.S. Treasury securities by persons who participate in the government securities market, including registered investment advisors and hedge funds. Pursuant to these rules, the Treasury Department periodically provides notices of Treasury security issues for which large position information must be reported (“reportable position”) and the applicable large position threshold for that issue. Hedge funds that have a reportable.
United Kingdom (UK)
Assets in the European hedge fund industry increased by around 40% last year to reach $64bn by end-2001. Last year, $11bn of the inflows in Europe went to existing funds, while new start-ups attracted $6.6bn. The number of hedge funds managed in Europe rose significantly during 2001, from 317 to 446.
The main investor in hedge funds have been and still is, high net worth individuals and private endowment funds, pension funds and insurance companies are also a significant source of inflows to hedge funds.
Almost all hedge funds are located in offshore jurisdictions. The UK is not a domicile of choice for hedge funds, primarily because the tax regime is unfavourable. A UK-domiciled hedge fund would be liable for corporation tax on income and capital gains. This provides hedge funds with strong incentives to set up in offshore jurisdictions to benefit from favourable tax regimes. The administration of funds is also usually based offshore. Many of these offshore funds are structured with onshore managers and advisors to inform investment strategy and provide other defined services to the offshore fund. There are significant numbers of hedge fund managers in the US and the UK. Many of the investors in hedge funds, both institutional and individual, are also located in onshore jurisdictions.
FSA does not have legal responsibility for, or oversight of, the operation of a hedge fund established and operated outside the United Kingdom, even if a fund employs one or more UK investment managers. However, while the funds themselves are outside the FSA’s jurisdiction, they oversee the marketing of hedge fund products in the UK and the regulation of UK based hedge fund managers.
There is no specific regulatory regime for the marketing of hedge fund products in the UK. Where a hedge fund is structured as a limited partnership or as an open-ended investment company, it would usually be classified as an unregulated collective investment scheme for regulatory purposes. This does not allow the free marketing of these funds to the general public. But it does allow funds to be marketed to intermediate customers, market counterparties or to private customers where a firm has taken reasonable steps to ensure that the fund is suitable.
Firms that are authorised and which may give advice to their clients on the merits of hedge fund investment will need to consider the requirements of COB and in particular the restriction on financial promotion. The vast majority of hedge funds have minimum investment amounts, typically of US$100,000 or more. This requirement, which the industry itself chooses to apply, would be an insurmountable hurdle to many private customers and is itself a barrier to retail investment in hedge funds. Again, FSA requires regulated firms to undertake thorough due diligence before taking such action.
A hedge fund manager must meet the threshold conditions for authorisation as set out in the Act, both at the time of authorisation and on an ongoing basis. Above and beyond this, the firm must also comply with other regulatory requirements relevant to its business. FSA regime puts particular emphasis on systems and controls, which firms are required to put in place and maintain adequate systems and controls appropriate to the business it conducts. When considering an application for permission from a hedge fund manager, the FSA will focus on its resources and competence to manage the assets of funds in line with its mandate from the operators of the underlying fund.
Other features of the authorisation process include checks on whether a hedge fund manager has adequate procedures in place to show compliance with UK regulations. FSA also require hedge fund managers to keep clear records of any marketing material distributed along with a clear audit trail showing how they meet the criteria laid down in the relevant regulatory regime.
Authorised hedge fund managers, as with all regulated firms, are required to satisfy the threshold conditions for authorisation on a continuing basis and comply with FSA rules, including requirements on systems and controls as well as training and competence. FSA takes appropriate action against any authorised firm, including hedge fund managers, which causes significant risks to its statutory objectives. It must be clarified, that authorisation of hedge fund managers by FSA does not imply any oversight of the underlying hedge fund or funds.
Other financial institutions have exposures to hedge funds that arise through several transmission mechanisms, including counterparty trading, derivatives activity, the provision of brokerage services, direct equity investments, and (very occasionally) direct lending. A number of UK-24 authorised firms offer finance to hedge funds, most commonly as a prime broker, although the number of UK owned firms providing finance in this way is relatively small. The FSA seeks to ensure that, following Basel and IOSCO guidelines, credit providers to hedge funds follow appropriate risk management practices.
FSA continues to monitor trends in the hedge fund sector, and developments in counterparty risk management arrangements. Both market surveillance and periodic discussions with hedge funds and credit providers help to inform our assessment of the risks. FSA also meets periodically with hedge fund trade associations and industry analysts to help inform its views of the market.
Hedge fund managers or operators based in the UK have been subject to the Money Laundering Regulations 1993 since 1994, even if the assets that they manage are held overseas. The Regulations oblige them by law to know their customers, including indirect customers introduced to them by intermediaries.
The market impact of the few hedge funds that are both large and leveraged is a global issue. As stated above, it was analysed in considerable depth following the collapse of Long Term Capital Management at the end of 1998, by a number of bodies including the Financial Stability Forum (FSF) Working Group on Highly Leveraged Institutions (HLIs).
Some concerns have been raised recently about the effects on markets of short selling by hedge funds and others. FSA’s position on this important issue can be summarized in its own words: “If we were to introduce regulatory provisions to deal with concerns about short selling, we would have to consider their costs and benefits. Indeed, there are good reasons why we would not wish to constrain short selling.” FSA noted in its latest assessment that it can be “an equilibrating and efficiency-enhancing market practice”. Short selling can provide the market with two important benefits; market liquidity and pricing efficiency. FSA therefore sees no case for any outright ban on short selling, a practice which in its judgment a necessary and desirable underpinning to the liquidity of the UK market.
From time to time, allegations are made by market participants about collusion among hedge funds to manipulate markets. Like all other market participants, hedge funds are covered by both the criminal and civil regimes that outlaw various forms of market manipulation and abuse. The FSA also takes steps to investigate evidence of any such collusion.
Switzerland
The Swiss Investment Funds Act introduced the concept of ‘other funds with special risks’, which enables Swiss and foreign based hedge funds to be licensed by the Federal Banking Commission (FBC). There is no statutory minimum investment level but, the minimum investment has never been below Sfr 10,000 and is normally considerably higher. Only funds domiciled in a recognized jurisdiction with ‘equivalent supervision’ can be sold in Switzerland – the FBC has deemed that member states of the European Economic Area, the USA, Guernsey and Jersey meet the standard.
Although it is the hedge fund that is authorized, much of the regime focuses on the actions and competence of the hedge fund manager. For example, the decision on whether to license a hedge fund is based on a qualitative assessment of managers, risk management systems and internal controls.
Germany
The Investment Modernisation Act was approved by the German Parliament on November 7, 2003 and became effective from January 1, 2004. One key measure under the Modernisation Act is the admission of 26 hedge funds as the alternative investment vehicle. So far only hedge fund certificates (products with payout linked to the performance of hedge funds) were allowed to be distributed in Germany. The act is expected to catalyze the development of German hedge fund industry and is a response to the interest in hedge funds among institutional and retail investors.
Following the approval of the new investment act, the Baffin will issue guidelines that will outline the issues related to setting up a hedge fund or a fund of funds. The new regulations will stipulate that KAGs may now launch “investment funds with additional risks” or “fund of funds with additional risks” (i.e. funds of hedge funds). There are a few additional requirements for existing KAGs to comply before establishing such funds, for example, due expertise of an asset manager and risk assessment models must be in place. Hedge funds and fund of hedge funds may also be launched by the newly introduced investment stock companies with variable capital.
The German market, to a certain extent is now open to foreign hedge funds and provides the opportunity to admit public distribution of certain foreign hedge funds. The Investment Act stipulates that only foreign funds of hedge funds may be publicly distributed in Germany. The single hedge funds still remain barred from public distribution, although it is possible to distribute them by private placement. As regards investment policy, foreign funds of hedge funds must largely follow the same regulations as German funds of hedge funds under the Investment Act.
Offshore Centers
(Bahamas, Bermuda, The British Virgin Islands and the Cayman Island)
Offshore administrators assist a hedge fund adviser to set up an offshore hedge fund in accordance with applicable foreign laws and also assist the fund in complying with such laws on an ongoing basis. They also provide accounting, record keeping and reporting services, as well as assist in calculating fees and accruals. Certain offshore jurisdictions regulate offshore hedge fund administrators operating within their borders. The regulation of offshore hedge fund administrators subjects them to licensing, auditing and record keeping requirements. For example, many offshore hedge funds are domiciled in the Bahamas, Bermuda, The British Virgin Islands and the Cayman Islands.
These jurisdictions generally apply certain laws regulating the operations and conduct of investment pools and investment pool administrators to hedge funds and hedge fund administrators : The Bahamas Mutual Fund Act, 1995 (June 2001 Revision); Bermuda Monetary Authority Act 1969; Bermuda Companies Act 1981, Part XII A (Mutual Fund Companies); Bermuda Monetary Authority (Collective Investment Scheme Classification) Regulations 1998; British Virgin Islands Mutual Funds Act, 1996 (as amended 1997) and Cayman Islands Mutual Fund Law (2003 Revision).
These laws generally require fund administrators to be licensed and three of the four jurisdictions (except Bermuda) require licensed fund administrators to have their accounts audited by an auditor approved by the regulator. Each of these jurisdictions also subjects licensed fund administrators to antimony laundering provisions. These provisions set forth client identification and record keeping requirements in addition to obligations to report any suspicious activity with respect to the funds they administer to the relevant authority in that jurisdiction.
Ireland
Hedge fund managers setting up an offshore fund can seek a listing for the fund’s shares on the Irish Stock Exchange. This does not generally extend the categories of investor with whom shares of hedge fund can be privately placed. But often a listing is sought because it is believed that institutional investors can invest a larger proportion of their assets in listed (as distinct from unlisted) shares. Hedge funds seeking a listing must impose a minimum investment amount per investor of US $100,000, unless the hedge fund is set up under the law of EU member states, Hong Kong, the Isle of Man, Jersey, Guernsey or Bermuda. The investment manager must show that the fund has adequate and appropriate expertise and experience in managing investments; in practice this means the manager must already be managing $100 million in third party funds on a discretionary basis. Hedge funds seeking a listing must also have appointed a custodian with responsibility for the safe keeping and custody of the fund’s assets.
Singapore
In response to interest expressed by the financial industry, The Monetary Authority of Singapore (MAS) issued in June 2001 guidelines allowing hedge funds to be sold to the public.
The rationale is, according to the MAS, is: “to provide more investment choice for those who understand the higher risks associated with the prospect of significantly higher returns from such funds”. The key requirements for public offerings of hedge funds are a minimum initial subscription of $100,000 per investor, adequate and prominent disclosure in the prospectus of the high risks of investing in hedge funds, and investment managers must have expertise in managing such funds.
Hong Kong
In October 2001 the Hong Kong Securities and Futures Commission (HKSFC) issued a consultation paper on the offering of hedge funds, which considered various different approaches. The consultation exercise has concluded and, from 17 May 2002, funds seeking authorization as hedge funds need to comply with several new provisions. Under these guidelines, managers of single hedge funds and funds of hedge funds will be required to be managing assets of at least US $100 million, and have five years’ general experience in “hedge fund strategies”. The minimum individual investment in single hedge funds is US $50,000, and US $10,000 for funds of hedge funds. No minimum subscription level applies to schemes providing 100% capital guarantees. Hedge fund offering documents must display warning statements on the front cover, noting the special risks associated with these investments.
Taiwan
There was no guideline/regulation/rule to regulate hedge funds existing within Taiwan’s regulatory framework, even though hedge fund issue was the top priority concern to SFC, Taiwan’s regulator. SFC used to apply a self declaration like form to screen hedge funds from Foreign Institutional Investors but it did not seem to be so effective. SFC turned around the policy toward hedge funds, when it eventually approved two hedge funds’ application a month ago after one-month review and consideration.
SFC has now given a guideline to the Taiwan Stock Exchange (TSE) that, other than those internationally recognized “unfriendly” hedge funds, those which meet the certain criteria shall be in principle allowed to obtain a foreign institutional investor (FINI) status for investment in Taiwan’s securities market.
The hedge fund provides, in its application for FINI, memorandum and articles of association or agreement for establishment of the fund, and explanation of its investment or trading strategies which can sufficiently prove that the fund is not engaged in market manipulation. The fund shall also declare that it will not use unjust measures to affect the fairness or order of the financial/securities market.
The SFC feels that as long as hedge funds can provide true and accurate information in their applications and follow local regulations, and that the exchanges can monitor and track their activities effectively, hedge funds shall not create adverse impacts on the local securities market.
There are no specific guidelines or rules to restrict overseas hedge fund to invest in Thai capital market. However, overseas hedge funds who wish to invest in Thai Stock of Exchange need to subject to SEC laws, in particular, in chapter 8, regarding unfair securities trading practices and acquisition of securities for business Takeovers. SEC, Thailand treats hedge fund equal to ordinary investors in Thai Stock Exchange Market. The regulator does not have special checking on any hedge funds but checks for unusual transactions of all categories of investors equally by.
- Checking unusual movement in SET (stock exchange) which may cause by unfair securities trading in the market.
- Checking through investors report submitted to SEC for the disclosure of the holding of securities above the threshold (5% of total number of securities). The impact of these changes on fund location and investment profiles has, to date, been small when compared to the size of the global hedge fund market. However, the changes above are recent developments and funds operating under these regimes may, over time, account for a greater proportion of the industry’s funds under management.
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