Regulation of Hedge Funds (3/3)

In Mar 2006, IOSCO released a survey report which studied the global regulatory environment for hedge funds, covering a number of jurisdictions (including HK). There are 4 significant conclusions:

1. No member country had adopted a formal, legal definition of "hedge fund".
2. Hedge fund managers were regulated in most of the jurisdictions.
3. Few jurisdictions reported any significant "retailization" of hedge funds.
4. There had been some incidents of fraud relating to hedge funds.

According to a testimony of SEC, there are 3 principal areas of regulatory concern over hedge funds:

• Fiduciary obligations
• Market abuse
• Risks to broker-dealers

Fiduciary Obligations

SEC has handled many enforcement against hedge fund managers, which involve:

• misappropriation of fund assets
• "portfolio pumping" (i.e. bidding up the value of a fund's holdings right before the quarter-end)
• side letter agreements (i.e. hedge fund managers give certain investors more favorable privileges than others receive, e.g. liquidity preferences or more portfolio information)
• improper valuation of fund assets in order to hide losses or boost performance

Market Abuse

The market abuse activities include insider dealing, illegal short selling, market manipulation, late trading and fraudulent market timing. We still remember how hedge funds attacked the Asian financial markets during 1997-1998. Such manipulative activities were facilitated by investment banks and prime brokers.

Risks to Broker-Dealers

One core service prime brokers offer their hedge fund clients is margin financing. Under the competitive business environment, some prime brokers may be tempted to relax their risk management and credit policy, thus creating unduly large exposure to hedge fund risks. Derivative is a 2-side sword. Amarthan was killed by natural gas futures. A recent article of Forbes alerted investors to the potential disaster of hedge funds for trading in credit derivatives. Nevertheless, Donald Tsang still mentioned in his policy address that the government would study for the development of a commodity futures market in HK. Is it an idea to attract more hedge funds to HK, or provide one more gambling tool to retail investors?

Hedge fund is definitely a growing business but the global regulators are still sorting out the best regulatory model for such a mix of devil and angel. While we are concerned about systemic risk and investor protection, we can't deny that hedge funds contribute substantially to market efficiency, price discovery, liquidity and financial innovation.

Regulation of Hedge Funds (2/3)

SFC may feel proud of Hong Kong becoming a leading hub for hedge funds in the Asian region. The survey report indicated that HK has achieved a high growth of hedge funds, managers and AUM over the past 2 years.

Details of the survey are not reproduced here. I just want to highlight the following findings:

• 74% of responends reported that they had 10 or less staff. It could be envisaged that they may not have a full time compliance officer. Quite probably one staff is required to oversee risk management, compliance and operations.
• Most of the hedge funds are offered only to institutional investors. This is normal as most of retail investors and even salespersons could not understand hedge funds well. However, I also wonder whether institutional investors like pensions could master hedge funds.
• While the textbook tells us there are so many alternative strategies adopted by hedge funds, the strategies used by HK hedge fund managers are occupied by equities long/short (34%), multi-strategies (25%) and FoHFs (20%). Only a very small portion is playing more fantastic strategies like global marco, event driven, distressed debts, etc.
• A majority of hedge funds used no or little leverage. This is because they mainly invested in equity markets and did not trade heavily in derivatives.

In HK, direct regulaton of hedge funds is not practical because most of them are unauthorized private funds. SFC can only indirectly supervise the licensed hedge fund managers. It seems that the hedge funds managed by HK managers are still far from sophisticated as the overseas ones. Therefore the corresponding compliance concerns are still limited to those basic topics such as internal controls and conflicts of interest.

Next Monday I will touch on the international arena of hedge funds.

Regulation of Hedge Funds (1/3)

Hedge funds has become an important regulatory agenda in the past few years, especially after the LTCM incident. The recent collapse of Amaranth Advisors has made this topic hot again. Hedge fund is attractive in terms of the pursuit of "absolute return", flexible investment strategies and the low correlation to the overall market. But it is sometimes viewed as a mysterious monster which could disturb the markets from time to time.

In US and UK, hedge funds are only made available to private and institutional investors. Therefore the regulatory concern is not investor protection but the market impact. In the case of Amaranth, despite the size of loss (US$6 bn), the financial markets were not extensively affected. This may reflect the improved risk management measures taken by the market practitioners.

In HK, though a segment of hedge funds are made available to retail investors, most of the hedge fund managers licensed by SFC are managing private hedge funds. Obviously SFC's focuses are put on the internal control and risk management issues of both hedge fund managers and prime brokers.

Yesterday SFC banned Mr Charles Lee Schmitt from re-entering the industry for life for misappropriating client assets and being convicted of false accounting. This is the well-known case initiated by the report of directors of Charles Schmitt & Associates that Schmitt was suspected of misappropriating client assets from the CSA Absolute Return Fund. SFC found that Schmitt diverted the investors’ subscription proceeds for the Fund for his own use. He was charged with offences under the Theft Ordinance and now waiting for sentence.

SFC has just released a survey report on hedge funds managed by SFC licensed fund managers. I will comment on it tomorrow.

Supervisory System

Many firms have a misconception that once a perfectly written compliance manual is put in place then everything will be under control. They ignore the fact that a good supervisory system should at least include ALL of the following:

• Written compliance procedures which are properly communicated to all relevant staff
• Effective and consistent enforcement of compliance procedures by regular monitoring and disciplinary action for non-compliance
• Keeping of adequate records to demonstrate compliance

NASD recently fined CCO Investment Services Corp. US$850,000 for failing to establish, maintain and enforce a reasonably designed supervisory system and written procedures relating to a series of issues. Some violations are highlighted below:

• CCO failed to maintain business-related email and records of compensation given to its brokers by issuers of variable contracts or mutual funds.
• CCO's suitability reviews of variable annuity contract sales were not reasonably designed to prevent and detect sales practice violations. For example, although the firm utilized surveillance reports and its operations personnel reviewed variable annuity applications before the transactions were completed, it inconsistently provided for reasonable follow-up and review to ensure that noted exceptions were adequately addressed.
• Although the firm had some policies related to variable annuity sales to elderly clients, it failed to provide for reasonable follow-up and review to ensure that those policies were implemented for these clients. To the extent that the firm had customer suitability review procedures, such as mandating the use of customer financial profile forms, it did not consistently enforce those procedures. As a result, customer information that could have assisted registered persons and the firm in assessing suitability was not always available.
• CCO made telephone calls to prospective customers during "call nights". The firm required affiliated bank employees, who were not registered representatives, to use pre-approved scripts and not to discuss specific financial products with customers. But the firm had no supervisory system or written procedures for monitoring compliance with its supervisory procedures in this area. The firm had no reasonable way of even tracking the occurrence of call nights or otherwise monitoring compliance with its procedures.

Compared with dealing operations, sales operations is more difficult to monitor. The audit trails are usually maintained by human efforts (instead of automatic capture by computer systems), thus the probability of misuse and abuse is higher.

Ponzi Scheme

A "Ponzi scheme" is a fraudulent investment operation that involves paying abnormally high returns to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business. It was "invented" by the notorious Charles Ponzi in early 20th century.

Nowadays the Ponzi schemes are often more sophisticated but the underlying formula is quite similar. They continue to prevail because greed is a human nature.

Last week US SEC filed emergency securities fraud charges against a promoter (Pinnacle) to halt a Ponzi scheme that raised at least US$30m from around 2,000 investors in fraudulent "real estate development partnerships".

SEC alleged that from at least Oct 2006 to present Pinnacle has:

• sold interests in such scheme through a nationwide advertising campaign (including solicitation for investors in magazines & newspapers)
• promised investors a 25% return in 45 or 60 days, and a second 25% return and the return of capital after 90 days
• represented that the profits would be earned by purchasing foreclosed real estate, making minor repairs and reselling the property within 45 to 60 days.

Without disclosure to investors, Pinnacle in fact purchased property from third parties and sold it to investors at high mark-ups. The exorbitant returns promised to investors were generated by selling the property to other "fooled" investors.

Under the SFO, the above Ponzi scheme may be regarded as a collective investment scheme or regulated investment agreement. Marketing of it to the HK investing public without SFC authorization is illegal. But from time to time I've received those suspicious advertisements from different sources.

People could not eliminate greed, but at least they should learn to be smart investors. In their new book "Why We Want You To Be Rich", Donald Trump and Robert Kiyosaki even alleged that middle classes in developed countries would eventually become poor if they don't have financial education!

Manipulation of Futures Market

Last week SFC suspended the licence of a futures dealer (Tsoi Bun) for 15 months due to manipulation of the futures market. This is a rare case because usually people are caught by SFC for manipulation of the stock market.

In Jun 2000, HKFE introduced the pre-market opening period (30 minutes before the normal trading hours) as a price discovery mechanism. An indicative calculated opening price (COP) is calculated every time an order is placed, changed or cancelled. Orders are received, ranked and ultimately matched at the last indicative COP.

During the pre-market opening periods of 2 trading days in 2002, Tsoi artificially increased the COP of the HSI futures contracts by 160 points and 76 points respectively, and made a profit of $510,000 through his net short positions.

When Tsoi committed such market manipulation, the SFO was not yet implemented. But even Tsoi had appealed to SFAT, how could SFC take 4 years to conclude this case?

SOX Compliance

Following the accounting scandals in such companies as Enrol, Tyco and WorldCom, SOX has become a new challenge to the compliance field and also created many career opportunities for compliance officers.

SOX stands for the Sarbanes-Oxley Act of 2002, also known as the Public Company Accounting Reform and Investor Protection Act of 2002, is the US federal law for the listed companies. The more remarkable provisions of SOX include:

• Certification of financial reports by CEO and CFO
• Independence of auditor and audit committee
• Significantly longer maximum penalties for corporate executives who knowingly and wilfully misstate financial statements
• Employee protections for corporate fraud whistleblowing
• Establishment of internal controls over financial reporting

IT plays a key role in the financial reporting process and thus SOX compliance. Recently a software company Approva conducted a survey of more than 200 high-level finance and IT executives at listed companies. The purpose of this survey explored how executives at leading listed companies view their compliance-related investments.

Major findings of this survey are set out below:

• The vast majority of companies who currently use software to automate their controls think their investment will provide business value beyond SOX compliance.
• Despite the recognized value of automation, most companies have yet to automate the testing of their IT controls.
• ERP systems alone are not adequately equipped to support proper monitoring of controls to ensure regulatory compliance.
• Open, cross-application controls automation and monitoring solutions are critical in the audit process.
• Most companies who currently do not have a software solution for controls automation are planning to invest in one in the next year.
• Investment in audit preparation continues to rise.
• Most companies expect to realize measurable returns on their IT controls and compliance investents.
• Many companies believe SOX has been successful in helping to prevent corporate fraud and increase investor confidence.

In forseeable future, we can expect compliance monitoring to be more automated (therefore less labor-intensive), then the role of compliance officers would turn into being more analytical and advisory.