Canada: Proposed Regulation Of Asset Managers And Best Practices For Hedge Funds Released - Canadian And U.S. Implications

Hedge Fund Transparency Act 2009

On January 29th, Senators Chuck Grassley and Carl Levin introduced the Hedge Fund Transparency Act of 2009 (HFTA) to give the Securities and Exchange Commission (SEC) authority to require all hedge funds, private equity funds and other similar entities, including Canadian funds with US investors, to register with the SEC. The new legislation, like a version of the legislation introduced two years ago by Senator Grassley, would require such funds to file annual disclosure forms, maintain books and records in accordance with SEC standards and to cooperate with requests for information from the SEC. In addition, Senator Levin drafted new provisions that would require funds to establish an anti-money laundering program and report suspicious transactions.

Unlike the bill's predecessor which amended the Investment Advisers Act, the HFTA amends the Investment Company Act (ICA). The bill would impose the requirements summarized above on hedge funds, private equity funds, venture capital funds, real estate funds and other investment funds that have or manage at least $50 million in assets and typically rely on an exemption from the ICA registration requirement by limiting the number of US investors to not more than 100 or by issuing securities only to "qualified purchasers". Currently, Canadian (and other non-US) private equity funds and hedge funds rely on such exemptions when offering securities in the US. Under HFTA, such non-US investment funds will be subject to the same requirements, described above, as US funds. For Canadian hedge funds, the HFTA will mandate compliance similar to that required of advisors under Canadian provincial regulation. For private equity and other funds that are not currently regulated in Canada or the US, the effect of the bill will be more dramatic.

The senators said their legislation is needed because of the 2006 decision of the D.C. Circuit Court of Appeals, which provided that the SEC went beyond its statutory authority when it passed rules requiring mandatory registration of hedge funds. In support of the HFTA, Senator Levin stated "if the events of the last year have taught us anything, it's that we need to regulate firms that are big enough to destabilize our economy if they fail. It's time to subject financial heavyweights like hedge funds to federal regulation and oversight to protect our investors, markets, and financial system."

It is our understanding that the HFTA has the support of treasury secretary Timothy Geithner and Mary Schapiro, the new head of the SEC. The bill will be referred to the Senate Committee on Banking, Housing and Urban Affairs.

Hedge Fund Managers and Investors' Best Practices

Two private sector committees, comprised of disparate representatives of hedge funds and their investors and appointed by the President's Working Group on Financial Markets (PWG), recently released their final reports outlining principles and best practices related to managing and investing in hedge funds. The PWG was established by executive order in response to the October 1987 stock market crash to give recommendations for legislative and private sector solutions for enhancing the integrity, efficiency and competitiveness of the US financial markets and maintaining investor confidence.

Early in 2007, the PWG published a set of Principles and Guidelines Regarding Private Pools of Capital and later appointed an asset managers' committee to develop best practices for hedge fund managers (Managers' Report) and an investors' committee to establish best practices for investors in hedge funds (Investors' Report). The reports intend to set a new standard of best practices for hedge fund managers and for investors to foster investor protection, enhance market discipline and integrity, reduce systemic risk, and augment regulatory safeguards regarding investor protection.

The reports expressly acknowledge that a one size fits all approach to managing or making investment decisions regarding hedge funds is not appropriate. The Managers' Report encourages managers to assess their current practices, to adopt the best practices applicable to their business and to be able to explain why certain of the recommendations are not appropriate for them. Similarly, the Investors' Report acknowledges that no single set of best practices applies uniformly to every hedge fund investment. Rather, the Investors' Report offers a guide to present and prospective investors to assess whether an investment in hedge funds is appropriate for them and to manage such investments effectively.

The Managers' Report focuses on key areas where best practices will most effectively accomplish the goals of the committee, including better initial and ongoing communication with investors, robust valuation procedures, comprehensive risk management, effective supervision and control of business operations and requiring and promoting a culture of professionalism and regulatory compliance.

The reports do not place all responsibility for complying with best practices on hedge fund managers. The Investors' Report makes recommendations for best practices for those individuals and institutions (fiduciaries) that determine the suitability of investing in hedge funds and provides detailed guidance for those charged with implementing and monitoring the investment decision (investors).

A prudent evaluation must be undertaken by fiduciaries to determine if an investment in hedge funds is appropriate in light of the various factors identified in the Investors' Report. The Investors' Report contains a comprehensive framework for the due diligence process to be undertaken by both fiduciaries and investors prior to any investment and on an on-going basis. This process includes gaining knowledge of the fund's investment strategy, risks, constraints, tax implications, accounting methods, valuation process, liquidity, and reporting commitments. Once an investment decision is made, continued monitoring must be undertaken to understand new risks and their impact on the portfolio. The Investors' Report provides extensive best practice requirements in respect of each of these areas that will promote the report's objectives.

These reports have been released at the height of perhaps the most troubling economic environment that any of us has experienced. The likes of Bernard Madoff are being arrested for allegedly engaging in fraudulent ponzi schemes that will cost investors billions of dollars and hedge funds are gating, freezing redemptions and shutting down operations in unprecedented numbers. Still, hedge funds will continue to play an important role in the global economy by providing investors with alternative means of returns, by increasing liquidity in certain markets, and as substantial participants in the financial system. The reports' recommendations set a new standard for managing and investing in hedge funds and voluntary compliance will contribute to the growth, stability and integrity of the industry and financial markets. In order to stay competitive, fund managers and investors in Canada and the United States should take this time to review internal procedures and strive to achieve the standards established under the reports. These, and similar reports, are likely to be adopted by various non-governmental organizations in Canada and elsewhere and it is clear that law-makers will not be satisfied until further regulatory compliance and oversight are imposed on hedge funds and the markets in which they operate.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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