I-1.14 The Future of Hedge Fund Regulation: A Comparative Approach, United States, United Kingdom, France, Italy and Germany

Introduction

Hedge funds are important actors in the global economy that managed 1,7 trillion dollars in 2009, a 13% increase compared to 2008 and down from 2,1 trillion in 2007. It is estimated that 9 400 hedge funds are operating worldwide, a reduction of more than 1 000 funds from the 2007 peak, due to the financial crisis during which three quarters of hedge funds suffered an average 15,7% loss[1].

Although the industry has faced some difficulties over the past two years, hedge funds play an important role in the global financial system. They assure efficiency in capital markets, they are a significant source of liquidity, and they absorb financial risks. The benefits these investment vehicles bring to the markets are essentially made possible by flexible and light regulatory regimes. Unlike registered investment companies, they escape most of the disclosure, reporting and leverage requirements.

Hedge funds didn’t cause the current crisis, yet there seems to be a consensus among regulators around the world for more regulation. One may wonder why that is and whether regulators are not confusing targets. The rationale behind this desire to take action is twofold. The first concern is systemic risk, which we define here as the risk of chain reactions of failures. The current crisis has shown, if it still needed to be shown, that markets are deeply interconnected and rely on one another. The size and complexity of hedge funds may make some of them systemically significant and likely to provoke chain reactions that could lead to a generalized collapse of financial markets.

In light of the failures of Long Term Capital Management in 1998 and Amaranth Advisors in 2006, the question of whether hedge funds pose a systemic risk needs to be asked and the potential remedies need to be evaluated. Carrying out such assessments can be challenging for regulators if they do not have the tools to evaluate risks. Some entities may escape their oversight, which has become a justification for more regulation. The second concern that according to regulators justifies hedge regulation is the need to achieve greater transparency and cure informational asymmetries in order to guarantee an appropriate level of investor protection.

This paper examines in its first part the relevance of these two arguments. It provides an comparative overview of legal regimes applicable to hedge funds in five jurisdictions. It focuses primarily on the United States and explores four European Union member states’ hedge fund regulations. The United Kingdom, France, Germany and Italy have been chosen, for these countries are representative of the variety of legal frameworks that coexist within the European Union. It concludes that although systemic risk may be a legitimate concern, the investor protection argument is questionable.

Part II explores what the future of hedge fund regulation could look like based on the different proposals that have been sketched out in the past few months[2].

The European Union[3](“EU”) has introduced the controversial Directive on Alternative Investment Fund Managers (“AIFM”) in April 2009 and the U.S. House of Representatives has enacted the Private Fund Investment Advisers Registration Act of 2009[4](“PFIARA”).

These recent proposals introducing more regulation are presented and discussed in Part II in which a lack of global coordination in attempts to reform hedge funds is also identified.

Part III develops the idea that hedge funds do not need more but better regulation. The paper proposes a framework to assess whether more regulation is the answer and makes several suggestions as to what elements legislators should take into account in the costs/benefits analysis that should precede any attempt to introduce regulation.

Finally, I develop the idea that national particularisms must be transcended in order to establish an effective legal framework on a global scale. I suggest the creation of a global database for regulators’ use. The database would bring together financial information concerning all systemically-sensitive financial entities, including hedge funds. This system would favor an ex-ante monitoring, which would help reduce the likelihood of a systemic crisis.

Definition

There is no formal legal nor universally accepted definition of the term “hedge fund”. It generally refers to a broad category of pooled investment vehicles, privately organized, administered by professional investment managers, and not widely available to the public but rather to wealthy and sophisticated individuals or institutional investors.

Hedge funds can be defined by their characteristics as private investment partnerships or investment corporations that use a wide variety of trading strategies in order to seek absolute returns such as position-taking in a range of different markets. They employ an assortment of trading techniques and instruments, often including short-selling, derivatives and leverage[5].

Strategies and instruments vary a great deal from one hedge fund to the other. William Donaldson underlines that “these pools of capital may or may not utilize the sophisticated hedging and arbitrage strategies that traditional hedge funds employ, and many appear to engage in relatively simple equity strategies”[6]. Another way to distinguish hedge funds from other investment vehicles is their particular compensation system, generally consisting in a management-based fee of 1 to 2% and a performance fee of 20% in average, which is quite unique.

From a legal perspective, hedge funds in the United States, are investment vehicles that are not regulated as investment companies and that rely on various exemptions offered by federal securities laws. This relative lack of regulation can also be observed in the European Union, although approaches on how to deal with hedge funds vary between the United States and the European Union, and even among European Union member states themselves.

The term hedge fund appears to be is a “catch-all classification”[7]  and therefore a preliminary remark needs to be made. It seems that regulating such a large range of investment vehicles, with different strategies, different structures, different sizes in an uniform manner may be a questionable call. Indeed, it carries the risk of inappropriate, too vague or counterproductive regulation depending on the characteristics of each hedge fund. The heterogeneity that exists within the hedge fund industry must be kept in mind when discussing further regulations. 

It is equally important to remember that hedge fund regulation actually designates different realities and that it may take three forms. It may refer to regulating the fund itself, regulating the fund adviser/manager or regulating the fund’s operations. The way hedge funds are regulated and the degree to which they are regulated varies from one jurisdiction to another.

Some regulate hedge fund advisers, whether partially (USA) or completely (UK), some regulate the funds directly (Germany) and some regulate both (France).

This paper challenges the idea that hedge funds need more regulation. It argues instead that they need more effective regulation that is flexible and tailored to their specific characteristics and risks. Trying to develop a better regulatory framework starts with a better understanding of what hedge funds are, of what their role in the financial markets is, of what risks they may entail for the stability of the global financial system and of what the impact of current regulatory frameworks on hedge fund performances is. Such an analysis is necessary in order to understand the issues at stake and to properly assess the impact of future reforms.

PART I : HEDGE FUNDS, MARKETS AND LEGAL ENVIRONMENTS: AN OVERVIEW OF CURRENT HEDGE FUND REGULATIONS IN THE UNITED STATES AND IN THE EUROPEAN UNION

It is commonly assumed that hedge funds are lightly regulated investment vehicles that play an important role and tend to make markets more efficient (1) although they are not exempt from several critics which has led various jurisdictions to consider reforms (2).

1. Hedge funds are important market players, already regulated to a certain extent

1. 1 The benefits of hedge funds for the financial system

Hedge funds offer investors, fund managers and the markets in general several benefits and inmany respects look more attractive than traditional vehicles.

To investors, first of all, hedge funds provide a potential for substantial returns that are not necessarily correlated with the market by using a wide range of strategies. “As such, hedge funds may be an important diversification tool in an investor’s overall investment portfolio because they minimize overall volatility and provide access to sectors and strategies not otherwise available”[8]. Thus, for investors who are willing to risk large sums of money in order to get greater returns, hedge funds are an interesting alternative to traditional investment vehicles. The exhibit below illustrates this diversification benefit based on data from 1995 to 2006. Overall, an investor with 100% of hedge fund interests in her portfolio had an average return of 13,6% for 7,4% risk. This yield is substantially better than an investor with a 96% traditional portfolio whose average return was lower (9,3%) and whose percentage of risk was higher (8,5%).

To managers, hedge funds offer an easy-to-set-up structure for minimal costs. In addition, the compensation mechanism, generally a 2% management fee and a 20% performance-based allocation is very attractive. Some banks actually blame hedge funds for investment bankers’ high expectations in terms of compensation.

John Mack, Chairman at Morgan Stanley believes that the reason investment bankers are overpaid is that investment banks “fear a brain drain to better-paying hedge funds” and need to compete by raising their compensation packages”[9].

Moreover, hedge funds are structured and localized to take advantage of tax regimes. In the United States for instance, they are structured so as to benefit from a “flow through” tax treatment which allow them to avoid income tax at the entity level[10].      Managers are then taxed only on their capital gains, at a 15% rate , which is substantially less than for regular income taxes. 

To the mark ets finally, they are said to increase liquidity and enhance efficiency. For instance, hedge funds help provide   efficiencies in pricing of securities in all market conditions thanks to their extensive research and willingness to make investments. Moreover, it has been shown that by providing a counterparty to institutions which wish to hedge their risks, they often help dispersing risk[11]and lowering volatility[12]. Surprising and rare enough to be worth mentioning coming from a French essay, Godeluk and Escande further argue that hedge funds have dynamized the corporation world. Even activist hedge funds, they claim, have accelerated the regeneration of the economic system[13].

1.2 Legal regimes applicable to hedge funds in the United States and in the European Union[14]

Hedge funds first appeared a little more than fifty years ago and have developed in the United States and in the European Union thanks to favorable legal environments. They are often referred to as “unregulated” and “unsupervised” investment vehicles but to the term “unregulated” I prefer the term “lightly regulated” and I shall explain why. Before turning to American and European legal frameworks, the word “regulation” itself needs defining. Are we referring to the registration of the fund and its adviser with a regulatory body that exercises an active oversight or to limitations on transactions and special requirements on hedge fund activities? Indeed, in the United States, one often associates registration and regulation, which is a legitimate thing to do.

Most of the time registration implies regulation and vice-versa. In the European Union, however, hedge funds are registered almost everywhere, yet these funds are still said to be unregulated. The reason is that there are no or very few restrictions on their activities. It is important to acknowledge that registration doesn’t necessarily mean regulation of activities.

That is the European case. Conversely, the absence of registration doesn’t necessarily mean that hedge funds are completely unregulated. This is the case of the United States.

1.2.1 The United States

The United States is both the most popular onshore location with nearly two-thirds of global onshore hedge funds whether structured as Limited Partnerships or Limited Liability Corporations. It is also the leading center for location of management, with 68% of the global assets among which 41% in the state of New York. The majority of U.S domiciled assets are managed from New York (60%), followed by California (15%), Connecticut, Illinois and Florida (about 6% each)[15].

The American legal framework doesn’t offer any legal definition of what a hedge fund is. In its 2003 report on the implications of the growth of hedge funds, the Securities and Exchange Commission (“SEC”) regards this structure as a “pool of securities and perhaps other assetsthat does not register its securities offerings under the Securities Act and which is notregistered as an investment company under the Investment Company Act”[16].

As Robert Jaeger points out: “hedge funds are designed to take advantage of various

exemptions, exclusions and safe harbors that are explicitly provided within the regulatory framework”[17]. SEC Commissioner Troy Paredes also emphasizes the fact that the resulting light regulation of hedge funds is not the product of “shenanigans or of the exploitation of loopholes”[18]. Quite ironically, hedge funds must comply with many laws and regulations as described below in order to qualify for those exemptions and safe harbors[19].

The investment Company Act of 1940

Unlike other investment companies, hedge funds may avoid registration with the SEC if they comply with the requirements of one of the two statutory exemptions set out in the Investment Company Act of 1940 (“ICA”) known as 3(c)1 and 3(c)7[20].

Section 3(c)1 provides an exemption from the definition of an “Investment Company”[21]to an issuer whose outstanding securities are beneficially owned by not more than one hundred persons and who does not hold himself out to the public.

This provision actually enables hedge funds to have a lot more investors since beneficial ownership by a company or another fund counts as beneficial ownership of one person, provided that they are not set up to circumvent the provisions of the Act[22].

For example, let’s assume that investment company A has 50 investors, pension fund B has 150 investors and hedge fund C has 90 clients. If A, B and C invest in hedge fund Z, hedge fund Z will be deemed to have 3 clients when really 290 investors will be exposed, provided that A, B, or C do not hold more than 10% of the outstanding voting securities of the issuer.

This method used to determine beneficial ownership for the purpose of qualifying for the 3(c)(1) exemption has some exceptions. In a 1994 No-Action letter[23], the SEC stated that a defined-contribution plan cannot be counted as a single investor if its participants get to make investment decisions. If participants play an active role in the plan then one must “lookthrough” and each plan participant must be counted as one towards the 100 investors limit.

The second exemption, Section 3(c)(7) was introduced in the National Securities Markets Improvement Act of 1996 and has become very popular since it allows hedge funds to offer their securities to an unlimited number of “Qualified Purchasers”[24].

One caveat should however be mentioned. Even though Section 3(c)(7) doesn’t set a maximum number of qualified purchasers, Section 12g of the 1934 Act imposes registration and reporting requirements if the fund has more than 500 investors. So as not to lose the benefit of the exemption, in practice, hedge funds have a maximum of 499 investors.

The look-though issue was also raised for 3(c)(7) funds, in order to determine whether a benefit retirement, for instance, could be a qualified purchaser or if a hedge fund had to lookthrough to determine whether each participant was qualified. The SEC concluded that a defined benefit retirement plan is deemed a qualified purchaser if plan participants cannot make investment decisions and if the decision to invest in a 3(c)(7) fund is made solely by the plan fiduciary[25]. In this instance, if plan participants had been able to direct their investments to specific alternatives, then the 3(c)(7) fund would have had to look-through and evaluate each participant’s level of sophistication.

The Investment Advisers Act of 1940

The alternative way to regulate the hedge fund industry is to regulate hedge fund advisers. In the U.S., investment advisers are regulated by the Investment Advisers Act of 1940 (“IAA”). The IAA imposes fiduciary duties. One of the most important duty was developed by the Supreme Court in 1963 in SEC v. Capital Gains Research[26]which established an “affirmative duty of utmost faith and full and fair disclosure”. Equally important is the duty of best execution. Advisers must seek the best execution for their client. They also must disclose conflicts of interest, report personal transactions[27], keep records of their trades[28], establish maintain and enforce a code of ethics[29] and must not engage in transactions which operate as a  fraud[30]nor make untrue statements of material facts[31] to investors or in their ADV form filed with the SEC[32].

In order to make sure that hedge funds comply with the various legal requirements imposed upon them, the SEC introduced Rule 206(4)-7 which requires each investment adviser registered or required to register with the Commission “to adopt and implement policies and procedures reasonably designed to prevent violation of the federal securities laws, review those policies and procedures annually for their adequacy and the effectiveness of their implementation, and appoint a Chief Compliance Officer (CCO) to be responsible for administering the policies and procedures”[33]. Rule 206(4)-7 took part of the compliance burden off the SEC’s shoulders which was lacking resources to examine thousands of registered investment advisers, to place it on the industry’s with the costs that come with this responsibility.

Besides additional costs, internal compliance may lead to internal conflict of interests. For instance, it is the responsibility of the CCO to establish procedures to detect and prevent violations but if these procedures are too stringent, it may handcuff the regular course of business. One may also raise the question of the conflict of interest a CCO may be confronted with when she detects a fraud. Should she report it at the risk of losing her position? There seems to be an incentive from a CCO’s point of view to stay quiet.

In this regard, the SEC’s enforcement cooperation initiative launched on January 13, 2010 similar to the DOJ’s should be applauded as it “establishes incentives for individuals and companies to fully and truthfully cooperate and assist with SEC investigations and enforcement actions, and provides new tools to help investigators develop first-hand evidence to build the strongest possible cases”[34].

Hedge fund advisers meet the definition of an “Investment Adviser”[35]and should technically register[36]under the IAA and report to the SEC through Form ADV.

 a matter of fact, today a large majority of hedge funds advisers are registered. Yet, some escape this regulatory oversight. Indeed, Section 203(b) of the IAA provides a list of exemptions from the registration requirement. The exemption hedge fund advisers rely on is the de minimis exemption of Section 203(b)(3). Under this provision, investment advisers who have fewer than fifteen clients during the preceding twelve months, do not hold themselves out generally to the public and are not advisers for a registered investment company need not be registered although some advisers choose to do it on voluntary basis.

The fifteen clients limit is often regarded as artificial. Under this exemption for instance, 14 other funds each representing up to four hundred and ninety nine investors may invest in a hedge fund without triggering a registration requirement on its adviser because the clients would be the funds and not each individual investor behind these funds.

In 2004, the SEC challenged the term “client” and introduced Section 203(b)(3)-2(a), the socalled “Hedge Fund Rule”. It argued that “client” referred to “investor” and that one should look-through in order to calculate the number of clients. In our example, if 14 funds representing 499 investors each invested in one hedge fund, this would imply that 6 986 investors would have to be taken into account. The consequence was that all hedge fund advisers had to register with the SEC by February 1, 2006. In June 2006, the District of Columbia Court of Appeal ruled against what it judged an “arbitrary” provision in Goldstein v. SEC[37].

Yet, as part II analyzes in greater detail, the mandatory registration of all hedge fund advisers is very likely to become a reality if the Private Fund Investment Adviser Registration Act is enacted. The Act gets rid of the fifteen clients exemption and compels all investment managers to register under the IAA.

The Securities Act of 1933

Interests in a hedge fund are securities under the definition of Section 2(a)(1)[38]and under the Howey[39] test, which technically makes hedge funds fall under the scope of the Securities Act of 1933 (“the 1933 Act”).

As previously mentioned, hedge funds cannot hold themselves to the public[40], engage into general solicitation, nor advertise in the absence of a pre-existing relationship[41].

Therefore, the only way in which they may offer securities is to use the private offering exemption under Section 4(2) of the 1933 Act[42]. Hedge funds typically use Regulation D’s Rule 506 safe harbor to carry out their offering.

Using this safe harbor is not mandatory provided that the conditions of Section 4(2) are met although advisers usually prefer Rule 506. It allows them to offer securities in a private offering to a maximum of 35 sophisticated purchasers and an unlimited number of “accredited investors”, as defined by Rule 501(a) of the 1933 Act.

The Securities Exchange Act of 1934

Hedge funds typically do not need to register under the Securities Exchange Act of 1934 (“The 1934 Act”) because they are regarded as traders. If they were treated as dealers[43]they would have to register under Section 15b of the Act. The Exchange Act is extremely important because it contains antifraud provisions (Section 10b and Rule 10b-5) that apply to all investment advisers whether registered or not which impose a fiduciary duty to disclose material facts and prohibit material misstatements and omissions. Moreover registered funds are subject to periodic requirements under Section 13[44], proxy rules under Section 14, and insider reporting requirements and short swing profits transactions rules under Section 16 of the 1934 Act.

Other regulatory requirements

Hedge funds are further regulated by the Commodity Exchange Act even for a singletransaction on commodity and subject to the CFTC rules[45], by the National Association ofSecurities Dealers (“NASD”) rules and therefore must comply with five sets of principles, orby the Employment Retirement Income Security Act (“ERISA”) which makes them subjectto the restrictions of an ERISA fiduciary if more than 25% of the value of any class of equityis held by an employee benefit plan[46].

They are also subject to several Department of Treasury’s regulations. For instance any large position in U.S Treasury securities are reportable with the Federal Reserve Bank of New York, and foreign currencies positions above certain thresholds must be disclosed.

Moreover hedge funds are financial institutions that are subject to anti money laundering requirements set out in Section 352 of the U.S. Patriot Act of 2001[47]which compels them to develop internal control programs, to designate a compliance officer, to set an ongoing employee training program and to have an independent audit function to test the program[48].

Finally, hedge funds may also be subject to state regulations also known as “Blue Sky laws”.

State laws do not regulate hedge funds’ operations but may regulate advisers, offers, sales of interests and may impose additional and stricter antifraud provisions[49]and notice filing requirements[50]. For instance, the state of Connecticut is currently contemplating the possibility to impose new reporting requirements on hedge funds based in the state[51].

1.2.2 The European Union

Investment funds in the European Union are classified within two categories. The first one is the so-called UCITS funds (Undertakings for Collective Investment in Transferable Securities) that meet and follow the requirements set by the UCITS Directive[52]and are authorized to sell to the retail market. The second category is a broad and default category encompassing all non-UCITS funds including hedge funds, private equity funds, commodity funds or real estate funds that are regarded as entailing a level of risk that makes them unsuitable for retail investors. Access to these funds is therefore limited to sophisticated, professional and institutional investors[53]. In addition, they do not benefit from the EU passport that would allow them to market throughout the internal market.

The graph below illustrates the evolution of the assets under management in Europe in UCITS, in non-UCITS funds and within the non-UCITS category, in hedge funds.

With 1 400 hedge funds, it is estimated that hedge funds’ assets managed in the European Union amount $382 billion[54](23% of the global market share) while assets domiciled in the EU roughly amount $75billion[55]. This can be explained by the fact that the U.K. is a major hub for hedge fund managers but that their funds themselves are often located offshore, for tax reasons. These figures give indications as to what regulation should target in the EU.

Hedge funds are regulated on a national level, and the way hedge fund regulation is dealt with varies a great deal from one country to the other. The United Kingdom approach focuses on regulation of investment advisers only. Germany on the other hand only regulates funds, while France and Italy regulate both investment advisers and the funds themselves. Although some convergences may be observed on the types of documents required[56], for instance, the features of hedge fund regulation[57]itself differ from one EU member state to another.

In terms of investor access, for example, Italy imposes a minimum subscription of € 500,000, France has various thresholds depending on the type of fund as well as on qualitative considerations[58], and Germany has no such requirements.

1.2.3 The United Kingdom

London is the second largest center for hedge fund management after New York and the leading center in Europe. In 2009, the sector employed around 40,000 people and managed 21% of global hedge fund assets and 76% of European hedge fund assets totaling around $382billion[59].

Hedge fund regulation in the U.K refers mainly to the regulation of hedge fund managers who must, prior to commencement of business, seek the authorization of the Financial Services Authority (“FSA”) pursuant to Section 19 of the Financial Services and Markets Act of 2000.

As mentioned above, the U.K is not a domicile of choice for hedge funds themselves because of its tax regime[60], although hedge funds are not inexistent in this jurisdiction[61].

Very different from the American rules-based and hedge fund-specific approach, the Financial Services Authority has a principles-based and wide scope approach to regulation.

Simply put this means that every regulated entity must follow the eleven “Principles for Business” of the FSA Handbook of Rules and Guidance. These principles are not intended specifically for hedge funds but for all FSA-regulated entities. This has led to the creation of the Hedge Fund Working Group whose goal was to provide guidance to the industry on what the FSA Principles should mean for hedge fund managers. Provided that these principles are properly enforced, hedge fund managers are relatively free to carry out any type of strategy as there is no particular constraint on investments.

Notwithstanding the above, U.K hedge fund advisers are however subject to Mifid[62]capital adequacy rules based on its activities while hedge funds themselves are not[63].

The FSA’s approach to supervision of hedge fund managers is risk-based. It consists in periodic risk assessments through a process called ARROW II during which the FSA examines various elements such as management, governance, financial reports or the amount of capital held, or targets a specific issue[64]. Enforcement follows an outcome-based approach where the FSA assesses ex post the decisions made by managers and take enforcement action if needed.

Finally, like in other jurisdictions, there is a general prohibition on the marketing of unregulated collective investment schemes and regulated “Qualified Investor Schemes” to the general public[65]which may only be promoted to eligible investors after making sure of the investor’s wealth and sophistication.

1.2.4     France

In France, hedge funds are known as fonds spéculatifs or fonds alternatifs. Hedge funds were introduced in France with funds investing in futures, Fonds Communs d’Intervention sur lesMarchés à Terme (FCIMT).

In 2003, the Financial Security Act[66]set up a legal framework by creating two additional legal schemes: OPCVM ARIA[67] whether leveraged or unleveraged (undertaking for collective investment in transferable securities with simplified investment rules) and OPCVMcontractuels[68](contractual undertaking for collective investment in transferable securities).

Hedge funds may operate through these legal forms[69], that are regarded as non-UCITS funds under European Law. The sale of hedge fund units or shares are subject to a general prohibition of solicitation[70]and they cannot be accessed unless various criteria are met, especially in respect to “qualified investors”. These criteria are defined by decree[71] and codified in Article D.411-2 of the Code monétaire et financier (Monetary and Financial Code).

Natural persons may invest in hedge funds whatever their legal form, if allowed to, by being registered on records by the AMF or if at least two of the following criteria are met (i) the size of the investor’s financial instruments portfolio exceeds € 500 000, (ii) the investor has carried out transactions which amounted  €600 each at an average frequency of at least ten per trimester over the previous year or (iii) has worked for at least one year in the financial sector in a position that requires knowledge of securities investment.

Retail investment to hedge funds, though limited is not impossible under certain

circumstances.

The following chart summarizes the French legal framework and aims at providing a clearer picture of a quite complex environment.

[72] [73] [74] [75] [76] [77] [78] [79]

In addition to these provisions, French hedge funds, like those in the United States, are subject to antifraud provisions, pursuant to the European Directive 2003/6/EC of 28 January 2003 on insider dealing and market manipulation. They are also subject to national provisions detailed in the AMF General Regulation. The AMF also introduced Conduct of Business rules for portfolio management companies which are enforced by its Commission des sanctions whenever a breach occurs. Such rules address conflicts of interests, due skill, care and diligence, and integrity of the market, to name a few examples.

Though not as regulated as other investment vehicles, hedge funds in France have to register and are regulated to a certain extent. Although the control exercised by the AMF appears to be a good thing from an investor protection point of view, it may also be one of the reasons for the lack of competitiveness and dynamism of the French hedge fund market.

1.2.5 Italy

In Italy, hedge funds are referred to as fondi speculativi and may be open or close-ended. Italyis a dynamic market for hedge funds and was one of the first jurisdictions to adopt specifichedge fund rules in a Treasury Ministry Decree in May 1999 that was modified in 2000, 2003,and 2005[80] and developed through regulations of the Bank of Italy. By 2005, the Italian hedgefund market consisted in 161 funds and was worth € 17,5 billion[81].

This dynamism may be explained by the flexible legal environment hedge funds benefit from.

As in France, Italy requires investment advisers to be authorized by the Bank of Italy, and hedge funds themselves cannot be distributed unless they have received the authorization of the market regulator, the Commissione Nazionale per le Società e la Borsa (“CONSOB”).

While advisers are subject to capital requirements, hedge funds themselves are not. Foreign non-UCITS funds that want to distribute in Italy must comply with the same authorization requirements.

Typically, hedge funds are managed by Società di Gestione del Risparmio (“SGR”), which until June 2007 had to be speculative SGRs. This requirement has been removed.

Consequently common SGRs may now manage hedge funds.

In order to secure authorization, funds are required to disclose specific warnings and information such as the class of asset which will be owned by the fund and the procedure related to the investors’ access. But unlike France, once this authorization is granted, they are free to invest in any type of financial instruments and use any investment strategy and are not subject to the supervision of the Bank of Italy nor to portfolio diversification requirements[82].

Italy also imposes a prohibition on marketing to the general public. An investor cannot invest in a hedge fund if her initial subscription is below a threshold of € 500 000. Up until recently, Italian law also provided that hedge funds could not have more than two hundred investors but this provision has been repealed. Therefore, as of today there is no restriction on the maximum number of investors[83].

Consequently, Italian hedge funds are very lightly regulated and may carry out any investments they want, provided that they find investors who can satisfy the € 500,000 initial investment requirement.

1.2.6 Germany

Sondervermögen mit zusätzlichen Risiken (“hedgefonds”) (special investment schemes with additional risks) have a new legal framework since the Investmentgesetz (InvG)[84] which governs German collective investment schemes came into force in 2004.

German law, unlike any other jurisdiction, provides its own legal definition of the term hedge fund: “a fund is considered a hedge fund if it uses either leverage or short selling strategies or both and is not restricted in the choice of its assets”[85].

German hedge funds may take two legal forms. They can either be structured as investment funds (contractual form) managed by an investment management company[86]or as investment stock corporations (corporate form). In Germany, hedge funds need to obtain the written license of the regulator Bundesanstalt für Finanzdienstleistungsaufsicht (“BaFin”) prior to taking up any business[87].

Whether contractual or using the corporate form, hedge funds may only market and distribute through a private placement and they must follow the rules applicable to prospectuses which must be written and contain the fund rules and a warning for the possible total loss.

The terms of contract must be approved by the BaFin. Similarly, foreign funds can only be sold to German investors in a private placement.

German hedge funds are subject to minimum capital requirements[88]but advisers are not. The rationale behind capital requirements is the same as for banks. It provides a “cushion against existing obligations when asset values sharply decline”[89]. Like any fund they must comply with the principle of risk diversification, although no formal limits are imposed upon them, like it is the case in France for instance.

They also enjoy a very flexible legal environment in terms of investment strategies, the use of leverage is not controlled, nor is derivatives-based transactions, which is quite similar to the Italian legal framework. Plewka and Schmid note however that the InvG empowers the Ministry of Finance to restrict the use of leverage and short-selling transactions by an executive order to prevent abuse and protect the integrity of capital markets[90].

Moreover, unlike Italy, there are restrictions as to the type of assets German hedge funds may invest in. For instance they may not invest in raw materials nor in real property. They may not invest more than 30% of the value of the fund in equity interests in business which are not listed on a stock exchange and more than 50% of its net assets in another hedge fund in which not more than 10% are held by a single fund[91].

Finally, there is no qualitative requirement or quantitative threshold restricting access to hedge funds in Germany, unlike other jurisdictions.

As this quick overview and the following chart demonstrate, there is no common approach between the European Union and the United States. The current legal regimes applying to hedge funds are determined on a national level, even within the European Union from which one could expect an uniform approach.

[92]

If there is one common feature of regulators and politicians on each side of the Atlantic it is the idea that hedge funds are potentially problematic entities because they are not regulated enough.

Yet even in this trend, disagreements have emerged and two blocks seem to exist. The USUK approach on the one hand and the France-Germany axis that is dominant in the European Union on the other hand.

The idea that hedge funds should be regulated comes, in my view, from critics that may be excessive as well as from valid concerns about market stability.

2. Critics and concerns in the context of the current crisis have led governments to take Action

2.1 Hedge funds are criticized investment vehicles

There is a global consensus to acknowledge that hedge funds didn’t cause the recent financial crisis. According to the IFSL only around 5% of hedge fund assets were invested in mortgage-backed securities in September 2007[93]. But although they were the victims, not the perpetrators, hedge funds are often demonized and end up being treated as scapegoats.

From misleading but widely distributed undocumented essays based on no legal nor scientific facts describing hedge fund’s activities as “criminal activities” based on insider trading[94], to political leaders incriminating hedge funds, the industry suffers from bad press and prejudices.

Hedge funds are often associated with volatility, short selling[95], empty voting[96], shorttermism, activism, tax avoidance[97]and risky behaviors that potentially affect market stability.

Although some of the above-mentioned critics are not unfounded, the way hedge funds work and their role in the markets are often misunderstood and reduced to their shareholder activism role. Indeed, the general public has become aware of the existence of hedge funds essentially through their takeover attempts extensively reported in newspapers.

This contributed to the development of a generalized anti-hedge fund sentiment and has led the general public in other words voters in the United States or in Europe to call for more regulation. As a result, the industry is under heavy fire from global leaders.

Thus, this call for stricter rules to govern hedge funds may result more from a political fear of being criticized than from an actual need. More generally, there seems to be a structural divergence between what political agendas dictate and what the markets and economic growth require. Politicians have a strong incentive to adopt populist measures because by doing so, they increase their chances of getting reelected in the short term. Markets and growth however, require pragmatic and long term-oriented measures that may not always look appealing from a political perspective. This is particularly true in the present context where electors call for action and for moralization of financial markets. As John C. Coffee identified “historically, bubbles are followed by crashes, which in turn are followed by punitive legislation”[98].

In the aftermath of the 2007 crisis, hedge funds are no exception to this statement. President Barack Obama called them “speculators” who were “refusing to sacrifice like everyone else” and who wanted “to hold out for the prospect of an unjustified taxpayer-funded bailout”[99] when it is known that not a single hedge fund was bailed out.

The President’s comments were criticized, by Congressman Scott Garrett, for instance, for whom it showed a fundamental misunderstanding of just who hedge fund managers represent as well as the fiduciary responsibilities these managers have to their investors[100]. German Chancellor Angela Merkel and French President Nicolas Sarkozy have also joined forces combating these “predators”.

Given the lack of restrictions for retail investors to invest in hedge funds in Germany, one could understand the Chancellor’s concerns, although hedge funds do nothing else but what they are legally allowed to in this jurisdiction. Nicolas Sarkozy who urged for more regulation in an already heavily regulated environment, said that one “can't tolerate hedge funds buying a company with debt, firing a quarter of the staff and then enriching themselves by selling it in pieces. We didn't create the euro to have capitalism without ethics or morals”[101].

Particularly in Europe, there seem to be a sociological pattern to regard hedge funds as a major threat, as the symbol of wild capitalism and greed. Such passionate and intransigeant positions focusing only on hedge fund as activists could be avoided if the industry along with political leaders properly educated the public to understand what hedge funds do and what their role in the financial crisis really was. As Troy Paredes well noted “the abuses and collapses that have punctuated the industry are not indicative of widespread hedge fund behavior, (…) the vast number of hedge fund managers are disciplined traders who make informed, although risky, trades”[102].

In fact, according to International Financial Services London Research hedge funds suffered from the collapse of banks in the United and in Europe, from the falls in equity markets, from bans on short-selling and pressure to liquidate positions to meet margin and redemptions calls.

Yet, despite these market conditions, they outperformed many of the underlying markets such as the S&P index which saw a 38% drop and the 2009 global return is back to 19% from -13,9% in 2008[103].

Gareth Murphy from the Bank of England noted that the sector was free of moral hazard in the sense that the crisis had not resulted in the public bailout of a single hedge fund[104].

This being said, one cannot deny that some of the critics and concerns addressed to the hedge fund industry are fair and may, to a certain extent, justify that some action be taken.

2.2 Systemic risk

Hedge funds may raise concerns in terms of systemic risk

The first of these concerns is that some hedge funds may be a source of systemic risk and lead to chain reactions beyond the hedge fund industry, potentially creating a threat to the entire financial system. Although one often draws a parallel between the size of the fund and its potential impact in terms of systemic risk, it should be kept in mind that “the absolute size ofan institution is not the predicate for systemic risk; it is rather the size of its debt, itsderivatives positions, and the scope and complexity of many other financial relationshipsrunning between the firm, other institutions, and the wider financial system”[105]that must beevaluated in order to determine to what extent the fund poses a systemic risk. Indeed, thefailure of LTCM, a hedge fund worth $4 billion posed a systemic risk because of its exposureto banks, while the failure of Amaranth, which was worth more than the double ($9,5billion)had no systemic impact[106].

Most of the risks that arise from hedge fund operations and strategies are hedge fund-specific[107]such as operational risk, or fraud. It should be careful not to draw hasty conclusionsas not all risks present systemic risk characteristics. Indeed, “if, for example, a hedge fund ispursuing a high risk contrarian strategy, then it is probably lowering systemic risk”[108].

As the Bank of France noted in a study on hedge funds in 2007, since only sophisticated investors are exposed to these types of risk, strong regulation is not needed to address them from an investor protection perspective. However, hedge funds may affect financial stability through different channels, as the European Central Bank analyzed in its occasional paper on hedge funds[109].

The first of these channels is the credit channel, in other words the repercussions of hedge funds’ failures on exposed banks. This was illustrated by the LTCM debacle in 1998. A study carried out by the Bank of France estimates that 17 banks would have collectively lost 3 to 5 billion dollars if LTCM hadn’t been bailed out[110]. Several elements may explain the failure of this hedge fund among which derivatives use, questionable investment decisions, a leverage ratio of 25, and poor disclosure to its counterparties which weren’t aware of the full size and the riskiness of the portfolio[111].

Sometimes such an exposure and risk come from internal hedge funds as the $3,2 billion rescue of two hedge funds owned by Bear Stearns in 2007 illustrates[112]. In such cases, the failure of the fund is likely to have enormous and direct repercussions on the bank that owns it. If such event may always occur, some, like CRA, note such a failure would be less likely to occur today because leverage levels are quite low and because counterparties consider that they have more information and are capable of assessing the risks[113]. CRA adds that other hedge fund failures have had a lesser impact on the markets.

Amaranth, for instance, did not have a destabilizing effect because counterparties to these funds held sufficient collateral.

Hedge funds may also destabilize the markets through is their transmission and dissemination role. In other words, by reacting to a bank failure for instance, they may amplify the effects ofa crisis and/or spread it.

Although in this assumption, they are not the source of the problem,they may worsen its consequences by reacting to it. In the midst of the worst crisis of thecentury, financial stability was not affected by the hedge fund industry, whose role waslimited to transmission through massive selling of shares and short-selling transactions asJacques de la Laroisière, Chairman of the High-Level Group on Financial Supervision in theEU concluded in his report[114].

The Issing Committee in charge of preparing the London G20meeting illustrated this statement in its report by noting that “hedge funds played a role incrisis transmission, due to their strong reliance on bank financing and maturity mismatch. Inthe crisis, these characteristics contributed to pro-cyclical behaviors, in particular to deleveraging and asset sales, which had a negative impact on market liquidity”[115].

Systemic risk may also originate from herding[116]behaviors. The idea is simple and may be illustrated by an example. Let’s imagine that hedge fund A knows that a stock is overvalued, due to a bubble for instance. The rational decision to make would be to short these stocks.

However, hedge fund A has a strong interest in achieving tremendous returns, especially because of its compensation system that is largely based on performance. Shorting a stock that is skyrocketing would carry the risk to be outperformed by other funds which would choose to ride the bubble. Even if hedge fund A knows that the stock is overvalued, it may ultimately decide to follow the herd to take advantage of the potential returns while the bubble lasts.

Being part of the herd protects the fund from suffering competitive disadvantages and also imply that if the bubble bursts the entire herd will suffer from the same consequences. Based on that example, one can immediately identify the potential risk posed these herding behaviors in terms of procyclicity and legitimately admit that such behaviors may be source of systemic risk.

Finally, some of the specific hedge fund features may be problematic for markets stability.

The first one that needs to be mentioned is this inherent the conflict of interests that is posed by valuation. There is indeed a natural incentive to provide inaccurate, inflated valuation of the portfolio because the compensation of hedge fund managers are directly calculated based on this value. This can lead to distorted assessments by counterparties and clients and generate risk. Another feature is the redemption system. Hedge funds are typically structured in a way that doesn’t allow daily liquidity by setting up quarterly or annually redemption only, usually after a lock-up period. This feature limits the impact of nervous and risk averse behaviors that often amplify the effects of bad market conditions.

In the current crisis, hedge funds have mainly suffered from redemptions coming from risk-averse investors who brutally withdrew their money. This has led to a generalized market volatility through massive selling of shares due notably to redemptions. IFSL estimates that hedge funds had to return 13,2% of investors’ assets[117]in 2008, which had a procyclic effect on the generalized liquidity crisis.

Thus, it seems that some hedge funds, like many other financial institutions, may be a source of systemic risk important enough to justify that action be taken to mitigate it. The current approach to systemic risk is often an ex post “too big to fail” bail-out policy. This can be explained by the fact that regulators experience difficulties in anticipating the impact of defaults mainly because of a lack of visibility and lack of relevant indicators on the structure of the financial system[118]. This calls, as it shall be discussed below, for the development of tools to allow an ex ante monitoring.

2.2.2 Mitigating systemic risk

Before turning to the question of how systemic risk may be mitigated, one should first and foremost seek to determine whether getting rid of systemic risk is even possible. The answer, I believe, is that although limiting systemic risk is feasible, it can never be entirely eradicated.

Ben Bernanke made a similar statement and noted that trying to do so “would stifle innovation without achieving the intended goal”. He specified nonetheless that “authorities should try to ensure that the lapses in risk management of 1998 do not happen again”[119].

Andrew Lo wrote that “financial crisis may be an unavoidable aspect of modern capitalism, a consequence of the interactions between hardwired human behavior and the unfettered ability to innovate, compete, and evolve. But even if crises cannot be avoided, their disruptive effects can be reduced significantly[120]. This raises the interesting question of the arbitrage that needs to be made between preserving market dynamics and mitigating systemic risk. Differently put, a balance has to be struck between economic efficiency considerations and arguments in favor of financial stability. Finding this right balance is one of the main challenges legislators must confront.

Bearing this challenge in mind, one must look for ways to improve the current situation in order to limit the contagion effect and prevent market instability.

As the proverb says it is difficult to manage what one cannot measure, and this is particularly true for hedge funds. Indeed, hedge funds have limited obligations to disclose information that may be regarded as important by regulators in order to assess potential systemic risk. In the giant puzzle of trying to understand how markets and financial players are intertwined, hedge funds are often the missing piece.

Indeed, it is hard to deny hedge funds are relative opaque. However it should be noted that the amount and the nature of information disclosed vary depending on whether the disclosure is made to investors, counterparties or regulators. While unregulated advisers may not have to disclose anything at all to regulators, regulated advisers are subject to disclosure requirements and may be investigated by regulators at any time.

The nature and the amount of periodic disclosure due to investors is mainly defined

contractually and remain a private matter between two parties. If investors deem the amount of information they are presented with unsatisfactory, they remain free not to enter into an agreement with the fund. Because hedge fund investors are qualified and sophisticated, negotiating contractually the nature of disclosure seems acceptable. Jean Pierre Jouyet, President of the French Autorité des Marchés Financiers speaking about this topic in a conference on hedge funds denounced the opacity with which they carry out their activities. He argued that this opacity has a cost that is too high if one looks at the risks inferred by this lack of transparence[121].

This concern has led to the idea of setting an ongoing public disclosure requirement. As Lo pointed out, “without more comprehensive data on hedge-fund characteristics such as assets under management, leverage, counterparty relationships, and portfolio holdings, it is virtually impossible to draw conclusive inferences about the systemic risks posed by hedge funds”[122].

Although it is difficult to disagree with this statement, public disclosure is not the right answer. Indeed, “aside from diminishing the overall value of hedge funds, would completely fail to address systemic risk”, as Professor Hal Scott notes[123], since disclosure regime is primarily meant for investor protection and not for the reduction of systemic risk.

Parts II and III develop in greater details the idea that information is needed to assess systemic risk but that this information should be used by regulators only and remain confidential and anonymous.

2.3 Investor protection

Less convincing is the investor protection rationale. Hedge funds are no longer unheard of.

Unlike the rationale for bank regulation, which makes sense because it protects all individuals, the rationale for protecting hedge fund investors is unsatisfactory.

Indeed, only sophisticated investors can enter a partnership agreement and because they are sophisticated, they are deemed to be able to fend for themselves. Thus, they cannot claim that they are unaware of the risk all the more since hedge funds must put a written notice specifying that they are not registered with the SEC on their documents. Investors should understand that these types of investments are risky and that it is a price to pay for the potential greater returns they will get. They need to understand, as Keynes would say, that “the market can stay irrational longer than you can stay solvent”. One should therefore be careful not to infantilize them by granting too much protection.

In Europe, similar restrictions both quantitative and qualitative exist which limits the access to this type of investments and protect retail investors.

There is therefore as Demirakou writes it no reason to believe that hedge fund investment losses however painful they are, have a social cost[124]. As Ben Bernanke noted “experienced investors know, or should know, that in any given year some hedge funds lose money for their investors and some funds go out of business. Those occurrences are only normal and to be expected in a competitive market economy”[125]. Congressman Kanjorski also questioned the investor protection rationale by saying that he “could care less about high-wealth individuals who want to contribute their money to a group of investors. If they want to take the shot of losing it, it does not really affect the rest of society”[126].

Shabab also demonstrated that “a general lesson from the law and economics of hedge funds is that when a legal regime permits financial intermediaries to be flexible in their investment strategies and aligns the incentives of investors and innovators through performance fees and co-investment by managers, financial innovation is likely to complement investor protection without wide- ranging regulation”[127]

Moreover, it has been argued that the level of due diligence performed by hedge fund investors, who because they are sophisticated know what they are doing might be significantly more rigorous than any registration regime would ever require[128].

SEC Commissioner Troy Paredes goes further by underlining that the risk of loss incentivizes investors to do the kind of diligence that will protect their own interests best and that additional SEC oversight based on an investor protection rationale is not justified. “That wellheeled, sophisticated investors choose to invest in a hedge fund that provides its investors with little information should not trigger more SEC oversight. Neither the complexity of hedge fund strategies nor the fact that hedge fund investors may lose money because of a hedge fund fraud or risky hedge fund trade is grounds for more hedge fund regulation”[129].

Similar arguments were made by the European Central Bank which questioned the need to regulate in the European Union and called for investigating more closely before considering regulation from an investor protection point of view[130]. Two small reservations to the above needs to be mentioned. The first one is the German legal framework which does not provide any minimum requirement to invest in a hedge fund and which could potentially raise some investor protection issue.

The second one is the fact that, as some people have observed[131], a growing number of investors could potentially qualify as accredited investors[132]or its equivalent in other jurisdictions. This phenomenon, which according to Lieder is due to inflation is referred to as “retailization”[133]. Some argue that hedge funds should be made available to retail investor through a fund of hedge fund[134]which is the approach followed by the FSA. Indeed on February 25, 2010, the FSA released a statement introducing a retail Fund of Alternative Investment Funds[135].

I personally do not disagree with such initiatives although I believe that one should be extremely careful to guarantee the appropriate level of investor protection through stricter regulation whenever retail investors are involved[136].

For hedge funds themselves however, this paper argues that sophistication is a key factor because it justifies the light regulatory environment they benefit from. Should more and more unsophisticated investors have access to hedge funds, investor protection could become an issue and therefore justify more regulation. An alternative issue would be to raise the standards of the definition of an “accredited investor” in the 1933 Act and its equivalent in other legal systems in order to limit the range of investors who could have access to hedge fund interests issued through a private offering exemption (Rule 506), in the case of the United States.

A similar idea can be found in the PFIARA. It requires the SEC to reconsider within one year of enactment the thresholds in dollar amount to adjust the “qualified client” standard to inflation and to repeat this process every five years. The Dodd bill has a similar provision but focuses on the “accredited investor” standard. I am a bit doubtful as to using a quantitative measure of sophistication which do not guarantee that investors are indeed qualified and able to fend for themselves. Some qualitative restrictions should also be introduced to complete the existing framework. Broker dealers could for instance be in charge of assessing the client’s knowledge through detailed questionnaires following the examples of the questionnaire requirement created by the Mifid Directive[137]in the European Union and of the “offeringquestionnaire” hedge funds often use to assess the level of sophistication in the United States.

The call for more disclosure is also said to be for investors’ sake. The SEC staff report made the comment that hedge funds “generally are not required to meet prescribed disclosure requirements”. However, a hedge fund is compelled to make a comprehensive disclosure to potential investors, both to satisfy fiduciary obligations under the Advisers Act and state laws and to comply with antifraud provisions of the securities laws[138]and the requirements of the private offering exemption”[139].

Moreover, as sophisticated investors more and more aware of how hedge funds work, they tend to require extensive disclosure from managers. Unlike the purchase of publicly traded securities, ownership in a hedge fund comes from a contractual agreement, which may potentially be negotiated. This has a direct impact on the amount of information hedge funds disclose in their offering and private placement memoranda (PPM). The PPM is not mandatory under Rule 506 but results from market practice and from the need hedge fund managers have to protect themselves from liability under antifraud provisions.

Moreover, practice has shown that hedge funds have to disclose more and more information to more and more exigent investors and this, without the need for formal disclosure requirements.

Therefore, in my view the investor protection argument is questionable and does not justify additional regulation.

Systemic risk, however, seems to be a legitimate source of concerns although several doubts can be raised as to the capacity of regulation to address it in a fully satisfactory manner. Part II provides an analytical and critical overview of the U.S. Congress’ and of the European Commission’s proposals.

PART II : THE FUTURE OF HEDGE FUND REGULATION : ASSESSING THE

IMPACT OF THE PRIVATE FUND INVESTMENT ADVISERS REGISTRATION

ACT OF 2009 AND OF THE ALTERNATIVE INVESTMENT FUND MANAGERS

DIRECTIVE

As we discuss current proposals in the U.S. (1) and in the European Union (2), to reform the legal regimes applicable to hedge funds, one must bear in mind that current regimes are very different from one another. Since, the U.S. and the EU agree on the need to regulate hedge funds, it would seem like the perfect time to try to harmonize the various legal regimes and to set up global rules. This section examines both the European and American proposals and determines whether or not efforts in that direction are being made.

1. The Private Fund Investment Advisers Registration Act of 2009

1.1 Provisions of the Act

The Private Fund Investment Advisers Registration of 2009 aims at regulating hedge fund advisers, not hedge funds themselves. It provides first and foremost a definition of “private fund” as investment fund that rely on an ICA exemption, either 3(c)(1) or 3(c)(7). The Act gets rid of the private adviser exemption relying on Rule §203(b)(3) of the IAA and requires most hedge fund advisers above a $30 million threshold of assets under management to register with the SEC as investment advisers[140].

In other words, hedge funds will no longer be able to rely on the 15 clients exemption under the IAA and will have to be registered. The Act also empowers the SEC as a risk assessment authority which could potentially establish new requirements if it deems it necessary, including regulating funds themselves based on their size, governance and investment strategies.

Among the requirements that will be established by the SEC in consultation with the Federal Reserve, will be the records and files keeping one. Hedge fund advisers would be required to keep information regarding the assets they manage, their use of leverage, and their counterparty credit risk and these records could be subject to examination at any moment.

Indeed the PFIARA imposes stricter reporting and disclosure requirements that will affect the entire industry, including advisers already registered with the SEC. The PFIARA provides that disclosing non-public sensitive information would not be required and that all other information would be kept confidential. However, if one reads between the lines, one quickly realizes that hedge funds could in fact be asked to reveal their trading practices and positions as well as any other information that would be deemed necessary by the SEC and the Fed in order to protect investors and assess systemic risk. These informations would be shared with the Fed and any other entity whose aim is to control systemic risk, in particular with the newly established Financial Stability Oversight Council.

This forced disclosure if made publicly available may be extremely problematic as I shall explain further in Part III, mainly because hedge funds distinguish themselves from one another by their setting their own strategies. They create value using their unique models and one can imagine that having to publicly disclose this type of information would harm both hedge funds and their clients. It will be very interesting to see how the Senate will approach the disclosure requirements and whether it will require public disclosure or keep the confidential reporting adopted by the House.

The Dodd Bill seems to follow the PFIARA’s path and provides that “proprietary information” such as trading data or strategies should not be made publicly available. However both versions allow these informations to be shared with courts, agencies or federal departments which still raise questions in terms of confidentiality and protection of business strategies.

In this regard, this paper supports the recommendation made by the Committee on Capital Markets Regulation[141] (CCMR) to create a confidential reporting requirement, provided that the information collected remain confidential and is not accessible by other hedge funds.

Rather, the data should only be used by the regulator to assess potential threats to the financial stability and take action if needed to prevent failures and chain reactions. This information should also be made anonymous in order to avoid information leakage. The CCMR Report suggests that information about the fund’s liquidity needs, use of leverage, risk concentrations and connectedness should be disclosed among others. It further adds, and I completely share this analysis, that “the regulator would bear the burden of demonstrating its need for the required information as well as its ability to use that information effectively”.

The PFIARA has been well received by the industry, as most of them have already registered voluntarily with the SEC. The Alternative Investment Management Association (“AIMA”) whose Chairman Todd Groome declared that the association supported the registration of managers and Richard Baker of the Managed Funds Association (“MFA”) acknowledged that the mandatory registration of investment advisers was “the right approach” although not a “panacea”142[142], in particular because of the costs registration will entail.

Indeed, in an article published in December 2004, shortly after the adoption of the Hedge Fund Rule by the SEC, Chris Kentouris wrote that “the SEC's initial estimate of $50,000 a year”, in compliance costs, “was quickly debunked. There is just too much to do and too few who know how to do it, with some citing a figure of at least double that amount[143].

This approach chosen by the SEC would resemble the U.K’s which also require that advisers be registered with the FSA. This aspect can be seen as a significant and encouraging step toward greater harmonization of the legal regimes of the two main platforms for hedge fund managers[144], the United States and the United Kingdom.

1.2 Assessing the PFIARA

To assess the utility and the potential effectiveness of this proposal, two questions come to mind. (i) Does the PFIARA provide a real improvement and is likely to generate substantial changes in the hedge funds’ course of business? (ii) Does it address effectively the issue of systemic risk?

Registration

First of all, was the PFIARA really necessary? The main provision is the mandatory registration of all investment advisers who manage more than $30million of assets[145]. Many within the industry have expressed doubts as to what registration would really accomplish for investors, for hedge fund managers and for the markets. I tend to believe that registration is a good thing because it provides the SEC with the opportunity to exercise is oversight on the activityof hedge funds themselves through the oversight on hedge fund advisers.

However, I wonder why Congress would want to make this registration mandatory.

Indeed, there is a natural incentive from a hedge fund manager’s point of view to register as it gives them a competitive edge. It is particularly true in this economy that when an investor is faced with a choice between a registered fund and an unregistered one, she will naturally favor the one which is regulated.

Some even declared that registration for registration’s sake seems like a waste of time, as a growing number of hedge funds, 70% according to the Managed Funds Association, with majority of assets has already voluntarily registered, provide a list of holdings on a quarterly basis. The MFA further argues that having hedge funds register was in no way a guarantee that no incident would ever occur[146].

After all, the current crisis was caused by investment banks which are regulated and one of the biggest fraud of the century was committed by Madoff, a SEC registered broker-dealer.

Raising this particular issue, Juraj questioned in quite a humoristic way the effectiveness of regulation when he quoted one sentence from George Soros “I am having a good crisis”[147]and then the word “Guilty”[148] pronounced by Bernard Madoff at his trial and then explained that the main difference between these two gentlemen was that Madoff was subject to the SEC’s oversight whereas Soros was not[149].

Finally, Groome expressed concerns however, as to the implications of the bill for non-US managers who could face dual registration and he therefore called for a full exemption for non U.S. managers who are already registered in an OECD country or others where domestic regulator cooperates and shares information with the SEC[150].

This concern, although legitimate, is addressed in the PFIARA which would, if not modified by the Senate, include a foreign private advisers exemption. Provided that (1) the adviser does not have her place of business in the United States (2) has had 15 or fewer clients in the preceding year, (3) has less than $25 million of assets under management[151]and (4) doesn’t hold herself out to the public or advises a registered investment company, she wouldn’t need to register with the SEC. The exemption seems a bit artificial because of the $25 million threshold which is low. As a result this exemption will be limited to a few investment advisers only whose involvement with U.S investors is low.

Transparency

Another concern is transparency. A previously discussed, hedge funds are often criticized for their opacity. However, stricter disclosure requirements to investors may not be needed.

Managers, whether registered or not, have fiduciary duties, are subject to antifraud provisions and must fulfill the requirements of private offerings under Section 4(2) of the Securities Act.

They must make true, accurate and comprehensive disclosure in their Private Placement Memoranda (PPMs), their Partnership Agreements, their Subscription Agreements which typically contain the kind of information that would be required in a registration statement[152].

Moreover, as previously mentioned, as investors become more and more comfortable with hedge funds and their practices, their disclosure expectations grow which leads managers to disclose more information on the risks they take, on their compensation arrangements or on the type of strategies used.

It is however difficult, in practice to grasp the risks that are taken as most of the time, PPMs list of types of potential risks to shield the manager and the fund from liability without being too specific, therefore failing to give an accurate picture of the risks at stake.

As far as the investor protection rationale is concerned, some argue that because pension and mutual funds invest in hedge funds additional protections should be created. Such protections already exist however. Mutual funds are subject to diversification requirements under the Investment Company Act and both pension funds and mutual funds’ interests in a hedge fund cannot exceed 30%.

The second concern is the disclosure to counterparties. I don’t believe that regulations need to be passed in order for broker-dealers or banks to assess risks. These counterparties have the expertise and the tools to carry their own due diligence and remain free not to enter into agreement if they reckon that the level of disclosure is not satisfactory enough. Therefore the opacity between hedge funds and counterparties can be solved by contractual agreements between parties, and need not regulatory intervention.

Leverage

Regulation T[153]already indirectly limits the amount of leverage hedge fund can undertake.

Indeed, Reg T regulates the extension of credit provided by broker-dealers and imposes a control of margin requirements of 50% for securities bought on margin. This means that hedge funds may be required at any time to satisfy margin calls and to deposit additional money or stocks to meet these requirements. This indirectly limits hedge funds’ use of leverage as margin calls may occur at any time, especially when markets depreciate.

Jonna[154]however points out that broker-dealers typically arrange financing through foreign affiliates which are not registered with the SEC.

Leverage can be a real issue in terms of systemic risk. However, it seems that the industry spontaneously limits its leverage use. The chairman of the FSA recently said that the average leverage of hedge funds was two or three to one and, which Congressman Edward Royce called a “staggeringly low amount of leverage if you consider that our most heavily regulated institutions like the government sponsored

enterprises Fannie Mae and Freddie Mac, were leveraged here in the United States by 100 to 1”[155]. The exhibit below, provided by the Charles River Associates Report on the impact of the AIFM Directive illustrates this relatively low use of leverage on a global level. The report points out the fact that the amount of leverage depends on the strategies carried out by hedge funds and varies accordingly, arbitrage funds being for instance more leveraged than distressed securities-based investments[156].

The Fed also acknowledged that overall the industry showed a lack of leverage which explained why the losses hedge funds suffered didn’t threaten the stability of financial system.

Richard Baker, CEO of the Managed Funds Association reported that a recent study found that 26,9% of hedge funds used zero leverage[157].

The main reason explaining this relative lack of leverage is the fear to disappear. Leveraged funds run the risk of being wiped out.

Indeed, hedge funds often invest in products that are already intrinsically leveraged and prone to illiquidity such as junk bonds. Moreover, because of redemption rights, investors may take their money away at any time, creating a potential danger for the fund, should it be too leveraged. Thus, there is a strong natural incentive for hedge fund managers to be spontaneously cautious about leverage. This incentive may be more effective at preventing irresponsible behaviors prone to pose a systemic risk problem than formal rules. The market acts as the best arbitrator between well and bad managed funds and operates a natural selection. Well managed, low leveraged funds are less likely to disappear, creating the best incentive for hedge fund managers to follow this “best practice”.

Risk

Although one should not generalize too much, risks managers take may not be as dangerous as they appear, especially if one takes into account the fact that most hedge funds have socalled “high water mark” provisions which means that the manager only receives her performance fees when the assets’ value is greater than its previous greatest value. Studies have shown that funds with high water marks perform better than those without, which according to Shadab demonstrates that managers react positively to this incentive[158].

Role of the SEC

One may question the relevance of the PFIARA. I believe one should be extremely careful when trying to constrain these vehicles not to be too aggressive but rather to favor flexibility.

This doesn’t mean that hedge funds should be allowed to engage into any type of fraud or any other activity that would pose a real threat to the financial system. This means that the current legal framework needs not be changed. Preventing reckless behaviors and enforcing current rules may be achieved by reinforcing the powers of the SEC. In this regard, the recent trends and evolutions within the SEC must be applauded. Indeed, the SEC recently established five new units within its enforcement division, including one for hedge funds and private equity firms, regarded as one of the priority areas[159].

The newly appointed SEC’s N.Y Chief George Canellos also confirmed that hedge funds were a big area of emphasis and that the SEC had conducted a number of significant sweeps of investment advisers in the last year or two. He further explained that they had moved towards cause and risk-based exams rather than more routine checks[160].

Finally, there seems to be a trend consisting in including more industry participants within the SEC’s staff which is an interesting and encouraging evolution that could lead to a better understanding and therefore a better control of hedge fund activities.

Based on the above-mentioned, I am doubtful of what the additional regulation could bring that market discipline and better-tailored SEC oversight couldn’t achieve on its own.

Although registration is a good thing as it allows the regulator to have some control over hedge funds’ activities, since there is a natural trend for hedge fund advisers to register voluntarily.

If the sole purpose of the PFIARA was to make registration mandatory, the impact will be very marginal compared to the time and costs this reform will have generated. It seems to methat the PFIARA fails to provide a sufficient benefit in terms of systemic risk reduction compared to the costs it entails.

The Obama/Volcker’s proposal

The PFIARA is not the only proposal that would have an impact on the hedge fund world.

More problematic and potential harmful is the so-called Obama Proposal[161]introduced on January 21, 2010 which would bar bank holding companies from owning or investing in hedge funds and private equity funds. The rationale behind this proposal is to reduce systemic risk by limiting the interconnectedness of financial institutions. Yet, it is not clear that the rule would really have the effect it predicts. As Professor Hal Scott, Director of the Committee onCapital Markets Regulation expressed in his testimony before the U.S Senate Committee onBanking, Housing and Urban Affairs last February, “the Volcker Rules are over-inclusive because not all banks, and not even all large banks, pose chain-reaction risks to the financialsystem” and in the meantime, they “are also potentially under-inclusive, because manyinterconnected financial institutions which do pose systemic risks are not deposit-takingbanks”[162].

Besides potentially failing to address the systemic risk issue, it would harm the hedge fund industry. Andrew Baker, CEO of the Alternative Investment Management Associationexpressed concerns about the “possibility of liquidity in markets being reduced and the primebroker relationship being adversely affected”163[163]. This situation is all the more preoccupyingsince the U.K has explicitly ruled out such a proposal and since the European Union is notlikely to adopt such provisions. One can easily imagine what the lack of coordination mightdo to the U.S. hedge fund industry, should this proposal be adopted.

2. The Alternative Investment Fund Managers Directive

2.1 Provisions of the Directive

In April 2009, the European Commission released a draft of the Alternative Investment Funds Managers Directive (“AIFM”) aiming at regulating the non-UCITS fund managers who have more than € 100million of assets under management. They are two exemptions from this Provision.

First, fund managers who have less that € 500 million of assets under management, whose portfolios are unleveraged whose funds offer no redemption rights during 5 years may be out of the scope of this Directive. So would be an alternative fund manager who wouldn’t manage a EU domiciled hedge fund and who wouldn’t market in the European Union.

The AIFM Directive would require all alternative investment fund managers to be authorized in the member state in which its registered office is located and subject to harmonized regulatory standards on an ongoing basis. By alternative investment fund (AIF) the Commission means “any collective investment undertaking, including investment compartments thereof whose object is the collective investment in assets and which does not require authorization under the UCITS Directive”[164]. This definition, extremely broad and general includes hedge funds. Once authorized, fund managers would be allowed to market anywhere in the European Union, thus benefiting from the European passport[165], which would significantly reduce their costs.

Articles 19 to 21 impose transparency requirements such as the need to provide an audited annual report and to disclose information to investors and to regulators about the fund’s investment strategy, the identity of depositary, the valuation procedure, and how liquidity risk is managed. According to CRA’s impact report, the rationale behind this requirement is that, “disclosure to investors is expected to reduce asymmetric information and increase investor confidence about investing in the fund” and “disclosure to competent authorities is expected to bring about improved regulatory oversight of AIF including with respect to systemic risk”[166].

Third countries funds could also be granted access to the European market provided that they meet EU regulatory and supervisory requirements and this, after a transitional period of three to five years. In other words, third countries funds would be allowed to be marketed in the EU if their legislations are equivalent to the provisions of the Directive, if there were reciprocal market access, and if they complied with the OECD Model Tax Convention standards.

Needless to mention that this particular provision, Article 35, has raised many critics that will be discussed below, all the more since only 5,8% of global hedge funds are domiciled in the EU, mainly in Ireland and in Luxembourg[167].

Finally, the AIFM Directive would impose minimum capital requirements[168], as well as conflicts, risk and liquidity management requirements[169], independent valuation of assets[170], threshold disclosure[171]and would limit the fund’s use of leverage.

Assessing the AIFM Directive

On February 1st, the Spanish government, which currently holds the rotating presidency of the Union, published a new draft of the AIFM, the third one[172]which is heavily criticized, in particularly in the UK by the Bank of England, the Financial Services Authority and the House of Lords which warned that the rules could have disastrous consequences for the European economy and sap its competitiveness. On March 16, Spain announced that the vote of the Union’s finance ministers on the AIFM Directive would be postponed to the beginning of the summer[173] which provoked strong reactions among members of the European Union Parliament and from some member states such as Germany.

Several provisions of the AIFM draft are problematic. The best illustration of the controversial nature of the European Commission language are the number of amendment suggestions[174]that have been made : more than 1000 so far, 80 were made by the AIMA[175] and the arguments it raised among member states and even within European institutions.

Leverage

The same reasoning as the one developed in the above PFIARA’s assessment applies to the leverage requirements that the Directive would develop and impose on hedge funds. It seems like there is a natural incentive to limit leverage in order to avoid potential failures. Moreover, as the CRA impact study demonstrate, “it unclear that the AIFMD will be effective in preventing the transmission of systemic risk associated with leverage and leverage limits could add to pro-cyclicality at a time of crisis by forcing hedge funds to sell to stay within the prescribed regulatory limit. In addition, investors would no longer have access to particular strategies with high leverage, further reducing choice and returns”[176].

Finally, it should be mentioned that specific rules on leverage would be adopted through implementing measures after the Directive comes into force which creates uncertainty and make leverage limitations provisions difficult to assess at that stage of the legislative process.

Third country

The main critic targets the provision applicable to foreign funds. Under the current draft, foreign funds would not be allowed to market in the EU unless they meet EU standards that are stricter than most of their home jurisdictions’, and only if co-operation arrangements are in place between the regulator of the manager’s jurisdiction and that of the EU member state in which investors are located. This proposal would bar funds whose home jurisdictions’ rules aren’t as strict which represent 40% of the world’s hedge funds according to Dan Waters, head of the FSA’s asset management division[177].

In addition, this provision creates a blurry framework and is source of legal uncertainty. CRA’s report points out that the current draft of the Directive “indicates that the EC will determine whether or not third countries are considered to have equivalent regulation to that in the Directive. This decision will occur after the adoption of the Directive and therefore at present no non-EU country can be assumed to have met the equivalence test”.

Under such circumstances, the U.K’s House of Lords has urged the British government to veto the proposed rules unless it is made “compatible with equivalent legislation with regulatory regimes in third countries and in particular in the United States”[178]. The HFSB also issued a statement expressing its concerns. “The draft directive has not been discussed with  the key interested parties nor is it consistent with the analysis and recommendations of the Commission’s own experts as outlined in the well received De Larosière Report. The Directive also ignores the efforts already underway to develop global proposals such as those taking place under the G20 process. We are particularly concerned that the draft Directive opts for prescriptive norms, in contrast with the principles-based approach under which the industry developed in the UK. It would empower the Commission to issue detailed regulations, in effect sidelining national regulators. It would also force non-EU countries to approve equivalent regulation if they want to maintain access to the European market”[179].

Jacques de Larosière himself acknowledged in a conference in June 2009 that the directive went “much further” than his report recommended[180].

Finally, the United States Secretary of Treasury has expressed his worries in a letter addressed on March 1, 2010 to EU Commissioner for Internal Market and Services Michel Barnier.

Geithner asserts that “U.S-EU relationship is absolutely vital for achieving effective regulation of financial markets and that both markets should fulfill the G20 commitment to avoid discrimination and maintain a level playing field”. He further explained that the United States is worried about “various proposals that would discriminate against U.S firms and deny them the access to the EU market”[181].

It is not clear at the moment whether the United States would fail the equivalence test since the criteria are not defined yet although the differences in tax regimes for instance could very well become an issue. Indeed the concerns expressed by third countries such as the United States come mainly from the lack of certainty regarding the criteria that would be used to determine whether a country’s regulatory framework is equivalent and from the fact that these criteria are believed to be used as a way to bar non EU hedge funds from the European market.

The draft has also raised many critics within the hedge fund industry, particularly afraid that the Directive would put the hedge funds out of business in the EU. Hedge fund lawyers also expressed concerns about the potential outcome of such draconian measures and warned that should the Directive come into force, one would witness a hedge fund exodus and that soon no hedge fund would operate from within the European Union, since hedge funds are much more mobile than banks and would have no trouble relocating in more friendly jurisdictions[182].

Potential impact on investors

In the end, EU-based investors may also suffer as well. European institutional investors are currently free to seek out the best managers globally, but it seems that this freedom will soon cease to exist. Indeed, the quantity and variety of funds available would diminish a great deal as a result of this Directive coming into force because investors will not have access to funds managed by a non-registered manager.

Article 3(d) of the Directive defines marketing as “any general offering or placement of units or shares in an AIF to or with investors domiciled in the Community[183], regardless of at whose initiative the offer or placement takes place”.

Marketing would be prohibited for funds that do not comply with the Directive’s provisions.

This is a different approach to that taken in the UCITS Directive, which allows investors to purchase securities that are not marketed in the EU. Since many funds will not be able to comply with the Directive requirements and will not be allowed to market in the European Union, investors will loose investment opportunities evaluated as a reduction in the annual returns to EU investors of around €1.4 billion[184]. This will also have a significant impact of such funds, as Andrew Baker from the AIMA explains. “Any restrictions imposed on European investors would also hit asset managers in financial centers such as the United States, Canada, Switzerland, Hong Kong, Singapore, Japan, Australia and South Africa”[185].

This paper supports the position taken by the UK and by the industry itself. The project of Directive doesn’t bring any benefit to European member states’ legal environments and may harm the industry. Its vagueness on disclosure issues and capital requirements for instance would make it either dangerous or ineffective. Moreover, the third country provision would be a disaster for hedge funds and for investors. Although some argue that the EU doesn’t want to discriminate against EU managers and that “it is a matter of level playing field”[186], one could answer to these people that the markets should not be regarded at the European level only but rather that one should seek to avoid discrimination on a larger scale, that is globally.

Therefore this paper concludes that the AIFM draft is inadequate at best because it fails to improve the current system and remains vague, if not dangerous and protectionist.

PART III: HOW TO REGULATE HEDGE FUNDS : SEVERAL ELEMENTS THAT SHOULD BE TAKEN INTO ACCOUNT BEFORE CONSIDERING IMPOSING MORE REGULATION ON HEDGE FUNDS.

The debate of whether or not to regulate one player of the financial system is a crucial one that takes us back to a law and economics analysis of financial regulation.

Therefore, I would like to offer some general remarks on financial regulation and to apply those comments to the hedge fund situation (1). Following a cost/benefit approach, I conclude that current regulatory trends may be mis-oriented and fail to propose a better alternative to present legal regimes. Finally, Part III advocates for the creation of a global database of financial information that will allow regulators to monitor systemic risk without impairing hedge funds’ activities and performances and discusses the challenge of developing global standards (2).

1. General remarks on hedge fund regulation : What needs to be taken into account before considering more regulation

1.1 Questions to be asked and remarks to be made before considering modifying legal frameworks applicable to hedge funds Know what you want to regulate

When trying to regulate hedge funds one faces a major challenge that has to do with the subject of regulation itself.

Indeed, regulating hedge funds as a homogeneous entity may turn out to be a “fruitless exercise” because hedge funds are heterogeneous to the point of “being the entire investment world less the small subset of traditional investment strategies” from arbitrage to event driven or macro strategies. “With so broad a classification, seeking a uniform approach would be like developing a single set of traffic rules to apply for all modes of transportation, from pedestrians to commercial jets”[187]. Juraj makes a similar point when he writes that there is no single regulatory framework which can be imposed on all hedge funds because the variety of fund structure, strategies and their social positions require a varied approach[188].

Although I agree with the above, I would like to make a distinction between regulation as it is often regarded that is a between a rules-based approach and a principles-based approach of regulation. Trying to regulate such a heterogeneous group with stringent rules may be challenging, impossible and even dangerous. A principles-based regulation like the British Financial Services Authority’s or the Dubai Financial Services Authority’s (DFSA)[189] provides a general framework that the industry must follow and adapt to its own business. This approach is more flexible, thus making regulation better suited to the industry’s needs and more likely to be properly enforced by hedge funds. This statement is illustrated by the forewords of the DFSA in its Hedge Fund Code of Practice: “Instead of rules, we have adopted a principles-based approach for developing best practice standards. We believe that those best practice standards will promote certainty while allowing industry participants a degree of flexibility to adapt these standards to suit their particular businesses in light of changing market conditions and emerging issues”[190].

The heterogeneity argument can also be applied to the size of these investment vehicles. It is quite intuitive to say that smaller funds are less likely to pose a systemic risk problem and thus need less supervision[191].

In the United States for instance 213 hedge funds are in the so-called “billion dollar club” and hold more than $1 billion of assets under management and 34 only manage more than $10billion[192]. This is a modest number compared to the 9 400 hedge funds that exist worldwide. This also means that most majority are probably too small to raise concerns of systemic risk.

It should be noted and appreciated that both the PFIARA and the AIFM address this concern by exempting small funds from registration and therefore by providing them a way out of complying and supporting the costs that registration and on-going disclosure would entail. Under the PFIARA, funds with less than $30 million of assets under management would be exempted from registration. The AIFM Directive also sets a threshold of € 100 million of managed portfolio below which hedge funds registration will not be required. Should the Directive be adopted, 90% of assets of EU domiciled hedge funds would fall under the scope of the Directive and would have to register[193]. The draft also sets a higher exemption threshold of € 500 million for funds which do not use leverage and have a five years lock-in period for they are then deemed not to present a systemic risk.

Introducing more regulation can have several drawbacks that must be careful looked at prior to considering imposing new rules on one part of the financial industry. This analysis can be done by asking a set of questions as described below.

Are the potential benefits really worth the costs?

One cannot prevent what one cannot predict. In this regard, regulation may be justified if more transparency is needed, which as we have seen is not really the case, or when a financial entity pose a systemic risk, which is more problematic in the case of hedge funds.

Because the term “regulation” encompasses the regulation of structure, of reporting, of activities, one must be extremely careful not to draw a conclusion that would be too general.

Indeed, although some types of regulation seem needed and relevant, some are not necessary.

Regulation consisting in the collection of data for instance allows to anticipate risks in order to mitigate them and avoid potential chain reactions. Allowing regulators to exercise a deeper oversight over the sector and to have access, under certain conditions already mentioned to hedge fund data bring a certain benefit to the financial system. Yet is this benefit really worth the costs and the energy governments are devoting to it at the moment?

One should never forget that introducing more regulation is costly, for governments, for regulators and for the industry itself. It is for instance estimated that the AIFM Directive would cost € 3,2 billion[194]to the hedge fund/private equity industry due to rules on delegation and changes to legal structures which may require the reorganization of the business models, and around € 27 million in ongoing compliance costs[195]. Studies have also shown that the SEC’s estimates are understated[196].

The term “costs” goes beyond the simple issue of compliance. Here costs refer to a broad category. It encompasses the time that will be devoted to discuss, evaluate, vote for, enforce on the part of the Legislator, to process the new registration, audit, investigate on the part of the regulator, to fill out forms, answer the regulator’s demands, set out new compliance procedure, and provide extensive disclosure on the part of the investment managers. It also refers to the above-mentioned compliance costs for hedge funds and to a lesser extent to regulators as well as to reduced investment opportunities[197]for investors.

Costs in terms of personnel needs especially the ones borne by regulators are often forgotten.

They would need to find competent economists and analysts to process the information provided by hedge funds if they want to properly assess systemic risk and anticipate potential crisis. This is particularly true for the SEC which is essentially composed of lawyers and would need to hire economists and experts in statistics to exercise an effective oversight on hedge funds.

One needs to be extremely careful not to impose an excessive financial burden of hedge funds which could potentially harm them. This last remark is particularly addressed to the “third country” provision of the AIFM Directive which would probably have, should it come into force a disastrous financial impact on those funds and deter them and their managers from doing business from and with the European Union. The argument is less relevant however in the PFIARA case, which does not impose excessive requirements prone to financially destabilize hedge funds.

Finally, introducing new regulations can ultimately carry negative costs for the home country as it may impair its competitiveness. London, the EU’s main hub for investment management could for instance lose a huge part of its business, should the Directive be enacted as it is drafted today. More generally one should think twice before passing regulations that could put a 1,7 trillion industry employing 150 000 people worldwide out of business[198].

What effect could direct regulation have on hedge funds, and on financial markets?

Introducing more regulation may also impair performances of hedge funds and harm the financial markets. Indeed, empirical studies[199]have shown that there is causal link between the amount of regulation and hedge fund performances and that the current legal regime in the United States is a source of Alpha[200]. According to Cumming “the data indicate that regulatory requirements in the form of restrictions on the location of key service providers and marketing channels that permit wrappers tend to be associated with lower MPPMs[201], lower alphas, lower average returns, higher fixed fees and lower performance fees.

The standard deviation of returns is lower among jurisdictions, with restrictions on the location of key service providers and higher minimum capitalization requirements”[202].

The current regime also has advantages on the market itself since hedge fund must constantly innovate to maintain their competitive edge, which the current legal framework allows thanks to its absence of constraints. Although some may argue that innovation tends to develop more complex products that carry more risks, innovation is first and foremost a key component of financial dynamism. Stifling financial innovation may result in stifling growth.

Alan Greenspan expressed further worries that over-regulating hedge funds may reduce liquidity which would have a large negative effect on the markets[203].

Is the proposed regulation flexible enough to meet hedge funds’ characteristics?

Hedge funds are flexible investment vehicles tailored to meet the requirements of various exemption regimes. One need to keep in mind when dealing with this investment management funds that imposing strict regulations on them and/or on their advisers might not only drive them away but may also be counterproductive and encourage them to find loopholes.

By developing new techniques and products that would escape the regulatory scope they could potentially be even more dangerous for the market stability. Lo’s comment on what regulation should be is, in this respect interesting when he writes that “new regulations should be adaptive and focused on financial functions rather than institutions, making them more flexible and dynamic”[204].

Christian de Boissieu, comparing the tension between financial innovation and regulation to a « hide and seek game », concluded that a direct control of hedge funds would fail because the controlled instrument would reappear elsewhere under a new name and a new form.

According to him, it would better to rely on an indirect regulation of those funds, consisting in reinforcing controls on counterparties[205]. This is also the opinion of CESR Chairman Eddy Wymeersch who suggested that systemic risk-related information be gathered from prime brokers[206]and of Hellgardt who reckons that “since it is not warranted to destroy the hedge fund industry through heavy regulatory measures but rather to cultivate its beneficial impact on the financial markets, while monitoring the dangers for systemic stability, it is preferable to employ indirect regulatory techniques instead of reforming direct hedge fund regulation”[207] and to employ banks as gatekeepers for minimal interference with hedge funds operations.

These recommendations underline the need to regulate enough to prevent hedge funds from becoming a threat to financial stability, but not too much in order to avoid the counterproductive effects mentioned above.

The challenge lies in finding the right balance and appropriate measures that will provide benefits without creating a burden on hedge funds’ competitiveness and operations. This comes down to asking the question of whether regulation is always the best alternative to reach the objectives sought and if similar goals could be reached otherwise.

The hedge fund industry gives a lot of importance to self-regulation, also known as market discipline which is organized by so-called SROs (self regulated organizations). The Hedge Fund Working Group in the UK, the Alternative Investment Management Association (AIMA), the Managed Funds Association (MFA), the Asset Managers’ Committee to the President’s Working Group on Financial Markets in the US are the main organizations providing guidelines to the industry and working hand in hand with regulators.

These SROs are well established authorities. In Europe for instance, the Hedge Fund Standards Board (HFSB) was set in 2008 and its board aim at codifying best practices.

Managers representing 60% of the European hedge fund industry and $350 billion in as assets follow the voluntary code of conduct of the Hedge Fund Standards Board[208].

Ben Bernanke in 2006 argued that “direct regulation may be justified when market discipline is ineffective at constraining excessive leverage and risk taking but, in the case of hedge funds, the reasonable presumption is that market discipline can work”. He further underlined the costs in terms of moral hazard and the loss of private market discipline that direct regulation would imply and well as the possible limits on funds’ ability to provide market liquidity[209]. SROs tend to establish rules that are better tailored to the realities and needs of the market and of the relevant activity. One of the main critic that was addressed to the SEC was that its staff was mainly composed of lawyers who may be disconnected from the realities of the industry they aim at regulating. Self regulation, through code of best practices enjoys a higher degree of acceptance by the rules addressees which as Fischer noted, leads to a greater degree of compliance by leveraging the industry’s expertise by shifting at least part of the regulatory burden from the public authority to the industry[210].

Critics of self regulation include the suspicion of conflicts of interests, as the industry creates rules that will apply to themselves, and concerns as to how these codes of conduct could be enforced[211].

The HFSB for instance specified in its response to a IOSCO consultation that “it is important to highlight that, while HFSB monitors the Standards, it does not serve as a regulator and does not enforce them”[212].

Therefore I do not believe in a control solely exercised by the industry but rather in a coordinated approach and in a stronger cooperation between regulators and SROs to create rules that are flexible enough to adapt to this fast-paced changing financial environment. By associating SROs to the rule-making process one may also achieve greater compliance and limit by-pass behaviors. One way of combining appropriately SROs and regulators would be to require mandatory membership in industry associations as Jiri Krol, Minister of Finance of the Czech Republic advocates for[213].

Juraj goes farther by suggesting that legislators should set basic goals and require regulators to ensure that each categories of funds adequately pursue these goals and that the assessment of adequacy should be a matter of negotiation and in case of controversy, of judicial determination[214]. This could however raise a lot of issues in

terms of legal certainty and even more critical in terms of how the SEC would treat funds that carry several strategies and do not fall into one specific category.

Also interesting is the initiative of the Asset Managers’ Committee to the President’s Working Group on Financial Markets, which released its “Best practices” report together with a separate “Investors’ Report”, in order to increase accountability for hedge fund managers[215].

The PWG reckons that a large part of the responsibility of investment assessment should be on investors themselves[216]. This regulation by the market that would sanction managers that do not comply with best practices principles while educating investors at the same time can also help making sure that rules are effectively enforced without additional costs on regulators and on managers.

At that point a general recommendation can be made. When contemplating more regulation, legislator should keep in mind that the more they will make their interests and the industry’s interests coincide, the more effective and the better enforced their rules will be. Regulation is often seen as a punishment on such or such activities or market players. This can and should be remedied by at least trying to reach an alignment of all parties’ interests.

1.2 Proposal for the creation of a global database of systemic risk

The dangers of mandatory public disclosure

Legislators and regulators need to understand hedge funds and the impact such regulation would have in order to achieve a reasonable legal framework that will not jeopardize their activities and their very existence. In that respect, initiatives such as the studies of the AIFM Directive that were made, must be encouraged and developed[217].

To illustrate how regulators’ goals can directly conflict with hedge funds activities, one can mention the provisions of both the PFIARA and the AIFM Directive requiring disclosure of positions and strategies. One can understand that there is a legitimate rationale in trying to assess the risks posed by each hedge funds to limit systemic risk. However it is not clear that these information will remain confidential or if they will be made public. If the purpose of these provisions is to disclose these information to the public, they could have dreadful consequences on the industry and be counterproductive in many respects.

First of all, it raises an intellectual property issue. Hedge funds distinguish themselves from other funds by their investment strategies. As Lo expresses it, hedge funds are “among the most secretive of financial institutions because their franchise value is almost entirely based on the performance of their investment strategies, and this type of intellectual property is perhaps the most difficult to patent”[218]. If forced to disclose such strategies, they may not be able to maintain their competitive edge, thus affecting their competitiveness and diminishing their contributions to markets liquidity. Lo warns about the disastrous effects forced disclosure would entail.

According to him the most intellectually innovative funds would cease to exist or move to less intrusive regulatory jurisdictions generating a major loss to the American capital markets. This argument is easily transposable to the EU. This provision could have a procyclic effect and increase systemic risk. Indeed if rules have a negative impact on hedge funds and lead them to fail, this will certainly not be an improvement for systemic risk prevention.

Second, full disclosure could entail moral hazard issues as the Issing Committee preparing the London G20 meeting highlighted in its report. According to the Committee, full disclosure could lead hedge fund advisers to feel “wrongfully safe”[219]and therefore less cautious.

Third, making positions and strategies available to other funds could lead to herding behaviors which, as we have previously discussed is source of systemic risk.

Finally, there is a practical concern which relates to the ongoing collection of hedge fund information. The Issing Committee called it “unrealistic, because of the fast changes in fund exposures and the enormous data collection and analytical requirements involved”[220].

The day to day monitoring of hedge funds was also rejected by Ben Bernanke, who stated that “a system in which hedge funds and other highly leveraged market participants submit position information to an authority that aggregates that information and reveals it to the market would probably not be able to address the concern about liquidity risk. Protection of proprietary information would require so much aggregation that the value of the information to market participants would be substantially reduced”[221].

Preliminary remarks

Therefore, as previously mentioned, this paper advocates for a cautious approach to data collection. It supports the idea that all the information gathered be kept anonymous and confidential, accessible for the sole purpose of assessing risks and for the use of regulators only. To do so will guarantee that hedge funds will be able to carry their strategies while allowing regulators to properly exercise their control. This paper also supports the idea that burden of proving that the information are necessary to assess systemic risk should be placed upon regulators[222]in order to avoid excessive requests. It also argues that the day to day collection of data is irrelevant, excessive and costly and that information should be collected on a monthly basis, or at a smaller interval when the markets are too volatile and only if regulators prove it to be necessary.

Finally, this monitoring will only be effective if information are shared on a global scale, through an alert system for instance. When a regulator would detect a significant risk, it would send an alert to regulators of jurisdictions in which the fund is a potential threat. There is no national systemic risk anymore due to the interconnectedness of economies. Only by achieving effective global cooperation can risks be properly mitigated. I believe that cooperation among regulators is a key.

For a global database of financial information

Taking into account all the arguments developed above, this paper recommends the creationof a global database of financial information[223].

By financial information, I mean all useful and relevant information necessary to carry out a proper assessment of systemic risk, such as information on leverage, value-at risk (VaR)[224], collateral, liquidity needs, use of financial instruments, especially of complex financial  instruments such as over-the-counter derivatives, and of course information about theinterconnectedness to other large financial institutions.

Hedge funds would disclose such data but any other financial entity that is potentially

systemically significant would be required to as well[225]. To do so will allow regulators to understand the structures and dynamics of interconnections between financial institutions and to develop an ex-ante approach to regulation of systemic risk which is probably the most effective way to deal with such complex financial networks. The information gathered on hedge funds would remain confidential and anonymous in order to avoid the intellectual property issues we already discussed.

On February 25, 2010, the International Organization of Securities Commissions (IOSCO), whose members amount 95% of the world’s securities markets released a template for theglobal collection of hedge fund information to be disclosed every six months that “will assistin assessing possible systemic risks arising from the sector”[226].  Although, the organization has

First of all, this provision is insuffi cient as it targets hedge funds only and fails to make this global database a true systemic risk monitoring tool that would encompass other financial institutions and would allow a complete assessment that would take into account mutual exposures.

Secondly, it is not clear that these informations will be confidential and will not be disclosed to the public which I regard as problematic. The third concern that may be expressed has to do with enforcement, as the IOSCO doesn’t have any direct authority on hedge funds.

2. The challenge of developing a global approach to hedge fund regulation

2.1 The difficulties of developing global standards

Another quite intuitive remark must be made. In today’s world, markets are interconnectedand finance ignores borders when the law is confined within a defined territory, creating a disjunction between territorial regulation and global activities.

This remark is a general one but applies to hedge funds and might be one of the greatest challenge financial law is faced with.

Indeed, with operations and investors in different jurisdictions come besides the potential conflicting regulations issues as well as high costs of compliance. It also carries the risk of forum shopping since the absence of coordinated approach at the international level allows hedge funds to run away to less stringent jurisdictions out of the reach of regulatory oversight which is hardly good news for the efforts to mitigate systemic risk.

This aspect was highlighted by the Florence Lombard, Executive Director of the Alternative Investment Management Association (AIMA) who called for a system of mutual recognition of international standards even from offshore jurisdictions[227]. It seems that a coordinated approach to regulation would be much more effective and less costly.

Achieving a global harmonized legal framework for hedge funds appears to be very utopian, at least for now. As Part I demonstrated there is no common regulatory approach in the United States and even within the European Union. As Part II then tried to convey, the current reform proposals didn’t seize the opportunity to promote a coordinated approach.

There still is no consensus on what form regulation should take, on what should be regulated.

Even within the European Union, member states fight among themselves to impose their own visions of financial regulation and do not seem to be willing to compromise and move toward greater harmonization.

This paper doesn’t support the idea that international financial regulation can never be achieved, it just acknowledges the fact that there are some structural and cultural elements that must be taken into account by anyone who is willing to overcome those difficulties and promote an international framework.

There are some deep philosophical and cultural differences that have shaped different conceptions of regulation itself and of regulation of investment vehicles in particular. There seems to be on one side the U.K and the U.S and to a lesser extent Italy which favor a flexible approach to hedge fund regulation, and France and Germany on the other side which keep pushing for more regulation. Understanding these divergences is the first step to overcome them and to develop an international legal framework.

These differences may, first of all, be rooted in the very conception of the role of the state, as France and Germany have a strong state intervention tradition while the US has a more liberal. This may also come from the role of the law itself in each country. France for instance has always been a highly regulated country and has a frantic legislative activity while the United States regulates more lightly and only if necessary.

The way each of the countries discussed in this paper regard hedge funds is also influenced by the importance of the industry in these countries. For instance, France and Germany may not be so concerned about the impact of hedge fund regulation on their economies because this impact would not be so significant whereas the U.K and the U.S have a strong incentive to preserve their competitiveness as the two main financial centers for hedge funds.

Finally, and despite the efforts of the G20, there seems to be a competition between the jurisdictions mentioned in this paper to impose their own vision of regulation in a very chauvinistic way which is prejudicial in my view[228].

In today’s financial world, one can no longer afford this nationalism of another age. I particularly find regrettable certain statements made by regulators or politicians that jeopardize the efforts to built an effective international cooperation. For instance, the answer given by the President of the French AMF when asked what should be done at the European level to deal with hedge funds which consisted in the following answer: “setting the example and not be subject to a regulation that would be strictly American”[229]or EU Commissioner Michel Barnier who declared that he would not be “bullied by Paris, by London and certainly not by Washington”, the FSA officials publicly saying that the UK would not make any compromise on the current draft of the AIFM Directive, or Angela Merkel who verbally attacked Gordon Brown over his refusal to move forward with the Directive[230].

Beyond philosophical and cultural differences, there is a competitiveness issue that makes the internationalization of financial regulation quite slow. Indeed, although achieving a levelplaying field seems compelling in many respects, many countries fight to keep their competitive edge in sometimes a very protectionist way. This is what Joseph Stiglitz develops in a recent article when he states that “each country looks at each proposal and assesses how it affects the competitiveness of its financial system. The objective too often is to find a regulatory regime that crimps competitors more than one's own companies. As the saying all politics is local, and, at least in the US and many other jurisdictions, finance is a big political player”[231].

2.2 Overcoming divergences and differences to effectively mitigate systemic risk on a global scale

If I do agree with Stiglitz’ above statement which identifies a real issue, I do not agree with the remedy he advocates for. Indeed, he claims that since achieving global coordination seems difficult, there is no time to lose in trying to do so. According to him still, since each country is responsible for “ensuring the safety and stability of its financial system and economy, it is far better to have strong action now and then harmonize the regulatory structures later. It may be "second best" but far better than the third-best alternative of delayed and ineffective regulation”.

Given the nature of systemic risk and the interconnectedness of the financial markets, delaying efforts to develop a coherent global framework for entities with global operations is hardly conceivable and certainly not in my opinion the best alternative. Since the PFIARA and the AIFM are simultaneously discussed, one can deplore that the opportunity to promote a global approach to hedge fund regulation was not seized despite the recommendations of the G20, of many committees, think-tanks and academics publications.

Failure to achieve global standards in current reform proposals doesn’t mean that efforts in that sense do not exist. Examples of these efforts to develop global cooperation may for instance be illustrated by the existence of bilateral agreements between regulators such as the “memorandum of understanding on consultation, cooperation and information exchange related to the supervision of financial services firms and market oversight” between the FSA in the U.K and the SEC in the United States. The “strategic dialogue” between the two regulators was initiated in 2006 and met for the fifth time on February 2nd to discuss among other things the regulation of hedge funds and investment advisers[232].

Efforts are also made for instance within the G20, IOSCO, the CESR and various fora and committees to develop international standards, which should be encouraged.

Yet, if such initiatives exist, they are often more formal and rarely lead to legal harmonization, often confronted with legislators who are not willing to go down that path. The most advanced example of global cooperation to this date remains at the SROs’ level.

They indeed easily generate consensus within the industry. The guidelines they provide the industry with are flexible and easily transposable on a global level. Andrew J. Donohue, Director of the Division on Investment Management at the SEC referred to such rules as “serving as an excellent model for the way in which industry can work together with regulators around the globe to develop smart and sensible solutions to hedge fund regulatory issues and to strengthen and enhance confidence in all of our markets”[233].

In other words, it seems that the hedge fund industry is ready for an international legal framework but that unfortunately governments and regulators still struggle to overcome their national particularisms.

This leads to a deadlock. Harmonization of legal frameworks appears to be illusory since regulators continue to contemplate national-based reforms when an effective prevention of systemic risk calls for international cooperation.

The proposal presented in this paper takes this structural difficulty into account. It acknowledges the natural tendency jurisdictions have to handle regulation on a national-basis.

The creation of a global database of systemic risk doesn’t negate national prerogatives to regulate as each country sees fit but promote a framework for global cooperation via an information sharing system superimposed on national regulations.

Conclusion

This paper has reviewed existing legal frameworks applicable to hedge funds in the United States, the United Kingdom, France, Germany and Italy. It has come to the conclusion that additional regulation is not necessary, and in certain cases would potentially be counterproductive or even dangerous if it failed to be properly tailored to this industry’s needs and characteristics.

The paper deplores the lack of global coordination and convergence in current efforts to reform the hedge fund legal framework. It therefore recommends that hedge funds remain lightly regulated and that increased harmonization be reached through private initiatives that have demonstrated their success in developing international best practice standards, which are now widely accepted by the industry and implemented.

Nonetheless this paper acknowledges that hedge funds raise legitimate concerns about systemic risk, and that action should be taken in order to try to mitigate potential threats to financial stability.

Systemic risk is neither national nor limited to one player. It must be treated using a coordinated and global approach. As a report of the British Academy very well noted “risk calculations were most often confined to slices of financial activity, using some of the best mathematical minds in our country and abroad. But they frequently lost sight of the bigger picture”[234]. In order to reach this “bigger picture” this paper recommends the creation of an international database that would be in charge of collecting of all the financial positions and the counterparts of all the big financial institutions and to monitor systemic risk on a global scale through increased cooperation efforts.

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