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Direct or Indirect Regulation of Hedge Funds: A European Dilemma

Published online by Cambridge University Press:  20 January 2017

Giorgio Tosetti Dardanelli
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Abstract

This paper deals with the debate on the methods to regulate hedge funds, with a particular focus on direct or indirect regulation. After having briefly examined the pros and the cons of directly regulating these investment schemes, it comes to the conclusion (largely shared by most scholars) that hedge funds should not be directly regulated, while regulation should concern their management companies and, most of all, their counterparts (lenders in the first place) with a view to managing systemic risk. In addition, regulation should also set precise thresholds for access which should aim at protecting unsophisticated investors from hazardous moves, without, however, falling into the trap of regulating hedge fund themselves.

The attention is then turned to the European Union and to its Alternative Investment Fund Managers Directive (AIFMD). An analysis is conducted on some of the most significant approaches to hedge fund regulation which have fuelled (and are partly still fuelling) the debate within EU institutions in its struggle to provide Member States with a valid response to the financial crisis, and on some key provisions of the first level AIFMD. In this light the author concludes that, despite the declared intent to regulated fund managers, the directive often seems to regulate hedge fund themselves. This does not seem to be in line with the thoughts of most scholars and market operators on hedge fund regulation and also looks at odds with other pieces of EU legislation (in particular with the so-called “Newcits”).

Type
Research Article
Information
European Journal of Risk Regulation , Volume 2 , Issue 4 , December 2011 , pp. 463 - 480
Copyright
Copyright © Cambridge University Press 2011

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References

1 Directive n. 2011/61/EU.

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3 This also explains why the European Commission has carefully avoided any possible definition of “hedge fund” in its Proposal for a Directive on Alternative Investment Fund Mangers of April 2009 at its subsequent amendments, trying to circumvent the obstacle by referring to “alternative investments” in general.

4 As opposed to beta. In finance, the beta (β) of a portfolio is a number describing the relation of its returns with that of the financial market as a whole. Alpha (α) is the portion of a portfolio's return that cannot be attributed to general market returns, and is thus independent from them.

5 Phoebus Athanassiou points out that “Hedge Fund” is a misleading term of convenience, not least because hedging is not the purpose of most hedge funds and because, outside Europe, hedge funds are not “funds” from a legal technical point of view, but, instead, limited partnerships or limited liability companies, with the fund investors as limited partners or limited liability company members. Athanassiou, P., Hedge Fund Regulation in the European Union – Current Trend and Future Prospects (Berlin: Wolters Kluwer, 2009), at p. 12 Google Scholar.

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11 The President's Working Group included the Federal Reserve, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), as well as the US Treasury.

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13 Ibid.

14 Available on the Internet at <http://ec.europa.eu/internal_market/investment/docs/alternative_investments/fund_managers_proposal_en.pdf> (last accessed on 27 October 2011).

15 Like shareholder activism, market transparency, etc., Davies and Green, Global Financial Regulation supra note 2, at pp. 231 et sqq.; McVea, Harry, “Hedge fund regulation, market discipline and the Hedge Fund Working Group”,4(1) Capital Markets Law Journal (2008), pp. 709 et sqq., at pp. 65 et sqq CrossRefGoogle Scholar.

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19 P. Athanassiou, Hedge Fund Regulation in the European Union, supra note 5, at p. 227.

20 The term “retail investor” should not be read here in accordance with its technical MiFID meaning, but rather as a generic synonym of household investor, or “consumer” of financial services, with little investment experience and relatively limited financial resources.

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22 Harry McVea has stressed that this argument “is predicated on the assumption that since both parties – investors and fund operators/advisers – are of roughly equal bargaining power, they are capable of entering into mutually beneficial arrangements”, while even in relation to wealthy investors “significant information asymmetries continue to exist, often preventing investors from making fully informed decisions.” McVea, Harry “Hedge funds and the new regulatory agenda”, 27(4) Legal Studies (2007), pp. 709 et sqq., at p. 725CrossRefGoogle Scholar. In addition, hedge fund prospectuses “are deliberately drafted in a very broad manner so that they do not restrict the manager's flexibility to seize new investment opportunities”, as the FSA pointed out. FSA, Hedge Funds: A discussion of Risk and Regulatory Engagement (Discussion Paper 05/04), at p. 33, available on the Internet at <http://www.fsa.gov.uk/pubs/discussion/dp05_04.pdf> (last accessed on 27 October 2011).

23 Deutsche Bank, Equity Prime Services Alternative Investment Survey Results Part 2: Inside the Mind of the Hedge Fund Investor 22 (Mar. 2003)

24 Davies and Green, Global Financial Regulation, supra note 2, at p. 236

25 Danielsson, Taylor and Zigrand, “Highwaymen or heroes: Should hedge funds be regulated? A survey”, supra note 21, at p. 528

26 Ibid., at p. 528

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29 The Australian Commonwealth Corporations Act 2001 contains a single financial services licensing regime for advice and dealings in relation to financial products, which include units in managed investment schemes, life products and derivatives as well as securities such as shares and debentures issued by companies. Just like other types of managed funds, hedge funds fall under the scope of the Corporations Act, which also contains rules governing the disclosure and marketing of financial products and, although with some exceptions, can apply to hedge funds structured as trusts (and not as companies). Susan Hilliard, Cf. and Boynton, James, “Regulation of Hedge Funds in Australia”, 20(1) Journal of Taxation and Regulation of Financial Institutions (2006), pp. 17–22, at pp. 18–19Google Scholar.

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31 A “Ponzi Scheme” is a fraudulent investment scheme in which returns are paid to investors by the money invested by subsequent participants in the scheme investors, rather than from any actual profit earned. It is named after Charles Ponzi, the Italian financial swindler who pioneered this kind of fraud in the 1920s in the USA.

32 The Independent, Tuesday 16 December 2008, Madoff's kiss of death for hedge funds, available on the Internet at <http://www.independent.co.uk/news/business/analysis-and-features/madoffs-kiss-of-death-for-hedge-funds-1135376.html> (last accessed on 27 October 2011).

33 Available on the Internet at <http://europa.eu/rapid/pressReleasesAction.do?reference=SPEECH/09/544&type=HTML> (last accessed on 27 October 2011).

34 Stephen J. Brown, The Role of Hedge Funds in Financial Crisis, Roubini Global Economics (2008), available on the Internet at <http://www.roubini.com/financemarkets-monitor/254088/the_role_of_hedge_funds_in_financial_crisis> (last accessed on 27 October 2011).

35 Financial Stability Forum, Report on Highly Leveraged Institution (2000), at para. 117.

36 The largest hedge fund collapse in history is the insolvency of Amaranth LLC, an American investment adviser managing multistrategy hedge funds that collapsed in September 2006 after losing approximately $6 billion on natural gas futures, one of the largest known trading losses.

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38 Trennert, Jason, New Markets, New Strategies (New York: McGraw Hill, 2005), at p. 38 et sqq Google Scholar. However, Phoebus Athanassiou points out that other authors have oppositely “asserted that because fund managers have no interest in earning performance fees on the back of outsized but short-lived profits, performance fees act as disincentives against risky investment decisions” (R. Jeager) or that “a manager's incentive to assume unreasonable risks is neutralized by his or her personal stake in their funds and by the “negative utility in losing money” (A.M. Ineichen); P. Athanassiou, Hedge Fund Regulation in the European Union, supra note 5, at p. 61, fn. 28.

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44 Supra para. II.2. and notes 36 and 37.

45 Notably during the most relevant currency crises of the 1990s, Danielsson, Taylor and Zigrand, “Highwaymen or heroes: Should hedge funds be regulated? A survey”, supra note 21, at p. 528

46 Gupta, Anurag and Liang, Bing, “Do Hedge Funds have enough capital? A value-at-Risk approach”, 77(1) Journal of Financial Economics, pp. 219–253 CrossRefGoogle Scholar, available on the Internet at <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=424370&rec=1&srcabs=850304> (last accessed on 27 October 2011).

47 Danielsson, Taylor and Zigrand, “Highwaymen or heroes: Should hedge funds be regulated? A survey”, supra note 15, at pp. 529 et sqq.

48 Supra para. II and note 4.

49 Cf. supra note 45.

50 Harry McVea, “Hedge funds and the new regulatory agenda”, supra note 22, at p. 721.

51 Ben Shalom Bernanke, Hedge Funds and Systemic Risk, Federal Reserve Bank of Atlanta's 2006 Financial Markets Conference (Georgia, 16 May 2006), available on the Internet at <http://www.federalreserve.gov/Boarddocs/speeches/2006/200605162/default.htm> (last accessed on 27 October 2011), at p. 1.

52 King, Michael R. and Maier, Philipp, “Hedge funds and financial stability: Regulating prime brokers will mitigate systemic risks”, 5 Journal of Financial Stability (2009), pp. 283–297, at p. 289CrossRefGoogle Scholar.

53 Ibid., at p. 289.

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55 European Parliament Resolution of 23 September 2008 with recommendations to the Commission on hedge funds and private equity (2007/2238(INI)), available on the Internet at <http://www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//TEXT+TA+P6-TA-2008-0425+0+DOC+XML+V0//EN> (last accessed on 27 October 2011). This followed a report on hedge funds and private equity funds presented by Poul Nyrup Rasmussen, the leader of the Party of European Socialists.

56 The summary of the responses and the feedback statement are available on the Internet at <http://ec.europa.eu/internal_market/consultations/docs/hedgefunds/feedback_statement_en.pdf> (last accessed on 27 October 2011).

57 The summary of the conference is available on the Internet at <http://ec.europa.eu/internal_market/investment/docs/conference/summary_en.pdf> (last accessed on 27 October 2011).

58 High-Level Group of Financial Supervision in the EU chaired by Jacques de la Rosière, Report (Brussels: 2009), available on the Internet at <http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf> (last accessed on 27 October 2011), at p. 24.

59 Supra note 14.

60 Commission Staff Working Document of 30 April 2009 – Impact Assessment, SEC (2009) 576, available on the Internet at <http://ec.europa.eu/internal_market/investment/docs/alternative_investments/fund_managers_impact_assessment.pdf> (last accessed on 27 October 2011).

61 Before adopting its compromise amendments on May 17th, 2010, ECON published approximately 1,700 proposed amendments submitted by MEPs.

62 Despite some new exceptions now included in the Council and ECON versions, the breadth of the purported scope of the proposed directive causes concerns. Chamberlain, Margaret, “Regulating alternative investment funds: casting the net too wide?”, 25(2) Butterworths Journal of International Banking and Financial Law (2010), pp. 72–77, at p. 75Google Scholar.

63 Although with some exceptions, Art. 2, para. 2 AIFMD.

64 Under the Australian Commonwealth Corporations Act 2001, supra note 30.

65 As they are named in the version approved by the Parliament. In the previous drafts, they were categorized as “conduct of business rules”.

66 Under the so-called “most favoured nation” clauses.

67 FSA, “Hedge fund: A discussion of risk and regulatory engagement”, Feedback Statement 06/02, available on the Internet at <http://www.fsa.gov.uk/pubs/discussion/fs06_02.pdf> (last accessed on 27 October 2011).

68 See also Art. 4, para. 41 of Directive 2006/48/EC.

69 Art. 24, para. 4, AIFMD.

70 Art. 25, para. 3, AIFMD.

71 On the contrary, in private equity structures debt is often incurred by special purpose vehicles (“newcos”).

72 Directives 2006/48/EC and 2006/49/EC.

73 AIMA (supra note 18) has shown to be supportive of the regulatory goals of the AIFMD, in particular increased transparency and improved systemic risk assessment in the interests of financial stability, but has repeatedly expressed its strong concern that many of the proposals are impractical and unworkable. The relevant press releases, guidance notes and statements are available on the “Directive Centre” section of the AIMA website <http://www.aima.org/en/directive-centre/index.cfm> (last accessed on 27 October 2011).

74 Directive 2001/108/EC of the European Parliament and the Council (level 1), available on the Internet at <http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2002:041:0035:0035:EN:PDF> (last accessed on 27 October 2011).

75 Supra notes 56 and 57.

76 CESR's Advice to the European Commission on Clarification of Definitions concerning Eligible Assets for Investments of UCITS (CESR/06-2005), available on the Internet at <http://www.cesr-eu.org/index.php?page=document_details&from_title=Documents&id=3694 (last accessed on 27 October 2011).

77 Commission Directive 2007/16/EC, available on the Internet at <http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2007:079:0011:0019:EN:PDF#> (last accessed on 27 October 2011).

78 The so called “NEWCITS”, Level 3 guidelines on the classification of hedge fund indices as financial indices (CESR/07-434), available on the Internet at <http://www.cesr-eu.org/index.php?page=document_details&from_title=Documents&id=4688> (last accessed on 27 October 2011).