Originally pubished in Legal Week, March 2006.
February 1, 2006 was the deadline date for hedge funds to register with the U.S. Securities and Exchange Commission (SEC) in compliance with SEC Rule 203 (b)(3)-2 ("New Rule 203"). With 80% of the world’s more than 8,000 hedge funds domiciled in the Cayman Islands, the impact of the new regulations has certainly been felt in this jurisdiction, primarily in the areas of structuring lock-ups for new funds clients and creating independent boards of directors for hedge funds.
The volume of hedge funds in Cayman likewise makes the jurisdiction a global bellwether for how the new rules will play out on a global basis.
One of the key criteria under New Rule 203 is that any fund with 14 or more U.S. investors is required to register with the SEC, even if the fund is not domiciled in the U.S. Unlike the rules that apply to U.S. managers, there is no minimum amount of assets under management that an offshore fund manager needs to have before registration is required.
One work-around is to take advantage of the exemption from registration that applies to funds with a 25-month lock-up on capital contributions made on or after February 1, 2006. Some funds are making this lock-up across the board while others are employing "side letters," or special arrangements for select investors, that reduce the lock-up for a small number of investors. The SEC has stressed that any liquidity side letter arrangements must be disclosed to all investors.
We have seen lock-ups being used by 20-30% of the new funds with which we are working. While some experts say that making the funds illiquid is not desirable for investors, there are some indications that, as the surplus in capital as well as more stable markets mean generally lower returns, some hedge funds are getting into longer-term investments.
Other trends that our firm expects to see as funds tackle the compliance burden include a limit in the number of U.S. investors and possibly a consolidation of smaller fund managers to help spread out the financial costs and risks.
The cost of regulation is estimated to be between USD 25,000-40,000 annually, not including the cost of hiring a compliance officer, so for funds with less capital, sharing this cost with other managers is an attractive option for some.
Walkers has seen an increase in the number of senior funds attorneys leaving private practice for positions as general counsel or compliance officers for investment managers. This migration reflects such added responsibilities as:
- Ongoing compliance requirements including preparation and filing of Form ADV once a funds manager is registered
- A prohibition against charging performance fees to investors who do not qualify as "qualified clients"
- The adoption of a written code of ethics
- Certain disclosure requirements upon payment of case referral fees to third-party placement agents
- Enhanced record-keeping requirements
- Additional reporting and audit requirements if the advisor has custody of client assets
- Periodic SEC inspections
Since many of the smaller funds have proportionally small staffs, the burden of all of the new compliance measures will be cumbersome at best. Some experts predict that a fund may need USD 100-150 million in assets to be profitable while fulfilling the latest SEC obligations.
Another result of the SEC regulations that is being seen in Cayman is a move for more and more companies to appoint independent directors to their corporate board. In light of both the New Rule 203 and Sarbanes-Oxley, fund managers want to reduce their liability by establishing more distance between management of the investment company and management of fund assets.
The Fund Services group at Walkers SPV Limited has seen a marked rise in their work as a result of these additional requirements. Many multi-billion dollar hedge fund complexes approached the firm just before the first of the year, asking for help in moving to an independent board. Walkers SPV has also provided independent directors to the leading Cayman-based institutional hedge funds.
It should be noted that special purpose vehicles (SPVs) are not required to register as an investment adviser if the affiliated adviser is already registered. However, its investment advisory activities would still be subject to the Advisers Act and its rules, and the SPV would be subject to examination by the SEC.
Most experts agree it is probable that, over a period of time, the SEC staff will review the effects of New Rule 203, especially in regards to non-U.S. advisors, and that they may make some changes. In fact, SEC Commissioner Cynthia A. Glassman even said in a presentation in London last month that she felt the registration requirement for hedge fund advisers adopted by the SEC was "not well thought out."
"Had [the SEC] approached the hedge fund issue more analytically at the outset – deciding what information [the SEC] really needed and how best to get it – I believe we would be in a much better position today to provide effective monitoring and to see red flags," Ms. Glassman said. "Further, we should have considered alternatives, such as raising the financial qualification criteria for eligible investors, especially if we were really concerned about retailization. Not surprisingly, the rule has had unintended but totally predictable consequences."
Overall, though, the spirit of the regulations – which is obviously all about lessening the incidence of hedge fund fraud – is applauded by the industry. The UK has been regulating hedge fund managers for several years. Germany, Hong Kong, and other jurisdictions also have robust regulatory requirements for advisers. In fact, with Cayman’s strict "know-your-client" and document retention obligations already in place, the jurisdiction is well positioned to help U.S. clients transition to the new regulations.
Gary Linford, Head of Investments and Security for the Cayman Island Monetary Authority (CIMA), has said that 75-80% of hedge fund fraud occurs in the U.S. where until now there has been no effective scrutiny by regulators. This issue was highlighted last year by problematic funds including Bayou Management and Wood River Capital Management. The SEC also just filed a fraud lawsuit last month against International Management Associates, LLC, alleging that they lost millions of dollars for their clients.
We certainly support any legislation that will protect investors and help the industry. As more private investors and pension funds begin to look to hedge funds as an investment vehicle, this legislation takes into account the long-term security of investors of all sizes. Since the Cayman Islands has a solid base of lawyers, accountants, and fund administrators, there is a model structure in place to help manage these new regulations.
Jonathan Tonge is a partner and co-lead of the Investment Funds team at Walkers.
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