Strategies to Develop Korea s Hedge Fund Regulations

Transcription

1 Funds and Pensions Strategies to Develop Korea s Hedge Fund Regulations Heejin Noh, Senior Research Fellow* Recently, Korea s financial authorities introduced Korea-style hedge funds through the revision of the Enforcement Decree of the Financial Investment Services and Capital Market Act. They extended the range of qualified investors, eased restrictions on management, established an entry barrier for hedge fund management companies, and strengthened reporting duties. This article examines related regulations in other developed nations and recent changes in the hedge fund industry. Then, it is suggested how Korea can adjust its regulations appropriately considering its regulatory rationality, the level of regulations, investor protection, recent global trends, long-term development of private equity funds, and developing hedge fund infrastructure. 1. Overview In 2009, the revision of the Financial Investment Services and Capital Market Act (FSCMA) provided new regulations on privately offered collective investment funds for qualified investors. The laws were revised in order to introduce hedge funds in Korea. However, typical hedge funds could not be established in Korea because of some restrictions. For example, over 50% of the fund assets should be invested in companies subject to restructuring. The Korean market faces significant changes including: the growing demand for alternative vehicles that use different approaches from traditional investments, and * All opinions expressed in this paper represent the author s personal views and thus should not be interpreted as the Korea Capital Market Institute s official position. Tel: , hjnoh@kcmi.re.kr 23

2 Capital Market PERSPECTIVE the increased need to invest in new growth engines such as green growth. Against the backdrop, Korean financial regulators passed reforms Due to the growing to introduce hedge funds in Korea. The reforms eased need to introduce hedge funds, the government the restrictions on privately placed collective recently revised the Enforcement Decree of the FSCMA in order to launch Korea-style hedge funds. In this article, I first examine Korea s hedge fund investment vehicles for qualified investors. Hereinafter, in this article, I first examine Korea s hedge fund regulations as well as global regulations and recent trends. Then, I present the desirable future direction for Korea-style hedge funds. regulations as well as global regulations and recent trends. Then, I present desirable future II. Korea s Hedge Fund Regulations directions for Koreastyle hedge funds. The main contents of the revised Enforcement Decree of the FSCMA in 2011 introduce home-grown hedge funds and prime brokers to Korea s capital markets by giving wider discretion to asset management firms and strengthening regulations, such as reporting duties. 1) First, the bill expanded the range of qualified investors. In addition to the existing qualified investor, such as banks, insurance companies, financial investment companies, and pension funds, individual investors will be allowed to directly invest in hedge funds with the minimum investment requirement set at KRW 500 million. High net worth individuals will now have access to the alternative investment instruments. 2) Second, the regulations on hedge fund management were also eased to give more flexibility in asset management. The borrowing limits are raised to 400% of the 1) In 2011, FSC announced a new amendment to the capital market law, which laid the foundation for introducing home-grown hedge funds and prime brokers by establishing the requirement for investors and prime broker businesses. Following the amendment, FSC approved the revision of The Code of Financial Investment Services in November 2011, and KOFIA devised Best Practice of Hedge fund and Prime Brokerage Services in December ) Privately placed collective investment vehicles for qualified investors refer to a collective investment scheme which is privately placed. The investors of this scheme have to be composed of no more than 49 investors. In calculating the number of investors, professional investors such as institutional investors are not included in the number, and the number of retail investors with investments over KRW 500 million won should be less than Vol. 3, No. 4

3 Strategies to Develop Korea s Hedge Fund Regulations fund s assets from the previous 300%, while the value at risk from derivatives trade is increased to 400% from 100%. 3) In addition, the requirement that at least 50% of fund assets be put into companies under restructuring was removed. Third, the revised bill introduced a mixed asset fund as a unit for hedge fund management business, and allowed qualified asset management companies, securities firms, and investment advisory firms to operate the To sum up, the revised hedge fund business. The qualification includes the bill includes HNWIs in following: 1) at least 6 billion won in paid-in capital; 2) the qualified investor the track record to consider equity capital, AUM, fund class, and then modified a series of size, and performance; and 3) at least three employees regulations. It eases who have prior experience working with hedge funds. asset management restrictions by relaxing Under the revision, asset management companies the limit on borrowing with more than KRW 10 trillion of AUM 4) are allowed to and derivatives trading, operate a hedge fund management business. Securities while tightening reporting duties. In firms should have at least KRW 1 trillion of equity addition, the entry capital, and investment advisory firms must have more barrier for hedge fund than KRW 0.5 trillion of AUM. management firms is modified. Fourth, the new amendment gives more discretion to hedge funds while tightening mandatory reporting obligations on their operation strategies and derivatives deals. Under the new bill, the FSC specifies detailed reporting criteria necessary to enhance investor protection and prevent systemic risks: A fund manager has to report its main management strategy, the type of investment assets, the use of leverage, and the state of derivatives every quarter. In addition, a fund manager is restricted from advertising the name, investment performance, and strategies of the privately placed fund including hedge funds. 3) The methods of calculating the estimated maximum loss from derivatives trading is revised. For example, under the previous regulation, netting is allowed only for derivative products with the same underlying assets and maturities. However, the revised bill allows for the use of netting for derivative products with different maturities as long as their underlying assets are same and offset each other s risks. 4) The amount of total funds here is calculated based on the fund balance (sales balance) as of the day that a hedge fund registers for operation. 25

4 Capital Market PERSPECTIVE Table 1. Korea-style hedge funds Highlights The revised Enforcement Decree of the FSCMA Revision of The Code of Financial Investment Services Investors Regulations on fund management Entry barrier for fund managers Reporting duties Calculating the value at risk Conflict of interest Criteria for hedge fund management firms and professionals Expand the range of hedge fund investors by adding individuals with over KRW 500 million investments in the qualified investor category (Article 271-2) Ease the restriction of fund management --Abolish the mandatory investment limit (50%) for restructuring firms (Article 271-2) Ease the restriction on the leverage and derivatives investment. --1 Raise the borrowing limit from 300% to 400% of the fund s assets. --2 Raise the derivatives investments limit from 100% to 400% of the assets in a collective investment scheme (CIS, hereinafter) measured by exposure (maximum loss). Set the criteria for hedge fund management firms. --Establish a mixed asset fund under which asset management companies, securities companies, and investment advisories that meet requirements for capital, track record, and manpower can manage hedge funds. --An asset management company of hedge funds needs at least KRW 6 billion in paid-in-capital. Strengthen the reporting obligations of hedge fund managers (Article 271-2). --Specify detailed reporting criteria, such as the main management strategy, the type of investment assets, the use of leverage, the state of derivatives, etc. --Quarterly reporting is required. Improve the method of calculating the value at risk (Code 4-54) --Netting will be allowed for trading derivative products with different maturities and same underlying assets as long as they offset each other s risks. Strengthen the measures to prevent conflicts of interest arising from hedge funds operations (Code 4-64). --The personnel in charge of hedge fund management will be prohibited from managing other funds and discretionary investment assets, and sharing investment-related information of other funds. Requirements for hedge fund management firms --Asset management companies with AUM over KRW 10 trillion will be allowed to operate the hedge fund management business. --Revise the track record criteria for securities and investment advisories: (i) Securities firms with equity capital more than KRW 1 trillion; and (ii) Investment advisories with more than KRW 0.5 trillion of AUM. Qualifications for fund managers --Professionals with more than two years of experience in securities investment who complete training provided by the Korea Financial Investment Association (KOFIA) regarding hedge fund operations --Professionals with more than two years experience in operating overseas hedge fund. --At least 3 qualified fund managers are needed Vol. 3, No. 4

5 Strategies to Develop Korea s Hedge Fund Regulations Best Practice of Hedge fund and Prime Brokerage Services Source: FSC and KOFIA Hedge fund establishment, operation and distribution, and hedge fund managers internal control system and risk management system General provisions --Provide definitions of hedge funds, prime brokers and leverage. Establishment of a hedge fund --Internal controls: Appoint a chief compliance officer, place a risk management system, and limit floor trading. --Risk management standards: Establish a hedge fund risk management committee and a hedge fund risk management organization, and report the decisions of those organizations. --Measures to prevent conflicts of interest: Establish a conflict of interest management committee and devise measures to prevent conflicts of interest; and set up a Chinese wall. Fund management --Limit borrowing and investments in self-operated hedge funds. Disclosure --Establish a disclosure system to provide information such as a fund s track record as well as asset management and custody reports. Distribution --Describe the qualifications for hedge fund distributors and investors. Liquidation --Provide a guideline for termination and liquidation procedures according to the type of CIS. Risk management for privately placed CIS to invest in hedge fund. --Stipulate the purpose and target of the regulation, and describe rules, for example, prohibition of setting up the same type of fund, the portfolio diversification requirement, and targets for investment advisors, and limitation on investment targets. III. Global Trends on Hedge Fund Regulations 1. Regulations on hedge fund establishment In the US, Section 4(2) of the Securities Act of 1933 (1933 Act, hereinafter), known as the private placement or private offering exemption, exempts registration and prospectus delivery for transactions not involving a public offering. Rule 506 of Regulation D under the 1933 Act provides a safe harbor for private placements of securities specifically placed to qualify for the exemption. Hedge funds also fall under the definition of a private fund. A private fund can be an investment company that is exempt from registration pursuant to Section 3(c)(1) or 3(c)(7) of the Investment Company Act of

6 Capital Market PERSPECTIVE In the UK, in order for a fund to be regulated by the Financial Services Authority (FSA), it has to meet the conditions and requirements of the FSA Handbook. Generally, the FSA expects a regulated fund to be managed by an Authorized Person in the UK. The FSA s Collective Investment Schemes Rules (COLL) demand the registration for collective investments in transferable securities (UCITS) schemes, non-ucits retail funds and qualified investor schemes (QIS). The COLL Rules allow for the use of derivatives in authorized funds. Therefore funds can adopt some characteristics of hedge funds and these funds can be promoted to the general public. However, there is a general prohibition on the promotion of unregulated collective investment schemes, the most common form of hedge fund, to the general public. 5) In Hong Kong, hedge funds are generally regarded as non-traditional funds that possess different characteristics and utilize different investment strategies from traditional funds. A hedge fund that is authorized by the Securities and Futures Commission (SFC) is eligible to be offered to the general public, while an unregulated hedge fund can only be offered to people who are qualified as professional investors as defined in the Securities and Futures Ordinance (SFO). In order for a hedge fund to be authorized by the SFC, it should meet the conditions and requirements set out in the Code on Unit Trusts and Mutual Funds (UT Code) and submit an application to the SFC. In Singapore, a hedge fund must have its prospectus approved by the Monetary Authority of Singapore (MAS) before establishment if it wants to market to retail investors. The fund manager must possess a Capital Markets Services (CMS) license. Hedge funds offered to retail investors and constituted in Singapore are called authorized unit trusts. Authorized unit trust funds that are available to the retail investors, including hedge funds, are required to comply with the Code on Collective Investment Schemes under the SFA. 5) However, under the conduct of business rules for the promotion of unregulated CIS, the fund may be promoted to a potential investor where the firm making the promotion has sufficient understanding of an individual s wealth and risk appetite and the customer meets the criteria for being an elective professional client and has been accepted as such. Client categorization is dealt with in the FSA s Conduct of Business Sourcebook (COBS) Vol. 3, No. 4

7 Strategies to Develop Korea s Hedge Fund Regulations Table 2. International regulations on hedge fund establishment Country US UK Hong Kong Singapore Contents Section 4(2) of the Securities Act of 1933, and Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 allows a broad exemption from registration. UCITS schemes, Non-UCITS retail funds and QIS are required to register. It is not allowed to promote unregulated collective investment schemes to the general public. A hedge fund which is authorized by the SFC is eligible to be offered to the general public. A hedge fund marketed to retail investors has to have its prospectus approved by MAS. 2. Regulations on asset management In most countries, there is no restriction on types of investments, leverage ratio, strategies, or the manner in which hedge funds can invest. Non-registered investment companies, such as private funds that meet exemption requirements, may keep the investment guidelines as specified in the offering memorandum and subscription documents in the US. Moreover, there is no restriction in the UK for management of authorized hedge funds, and so there are no rules on investments and other constraints. An SFC-authorized single hedge fund, not a fund of hedge funds, is not limited in the investment direction and types of financial instruments. 3. Regulations on hedge fund managers/advisors It shall be unlawful for any investment adviser, unless registered under the Investment Advisers Act of 1940, to mail or use any means of interstate commerce in connection with business as an investment adviser in US. There were, however, some exceptions to the registration requirement: Investment advisers whose clients all reside in the same state as the adviser s business office and who do not provide advice on securities listed on national exchanges; any investment adviser whose only clients are insurance companies; investment advisers who have fewer than 15 clients 29

8 Capital Market PERSPECTIVE in any previous 12-month period; and any investment adviser that is a charitable organization. 6) After the economic crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) changed the regulatory regime governing investment advisers including private funds advisers. Among other effects, the Act requires many currently unregistered investment advisers to register with the SEC pursuant to the Investment Advisers Act of 1940, as amended by removing a commonly used exemption from registration under the Advisers Act. The Act also will impose increased recordkeeping and reporting obligations on investment advisers to certain private funds. 7) DFA eliminates (1) the private investment adviser exemption, which is available to investment advisers with fewer than 15 clients, among other criteria and (2) the intrastate registration exemption for investment advisers with any private fund client. Moreover, the SEC registration for minimum assets under management for regulated investment advisers will be $100 million in general, and regulatory authority for smaller funds (less than $100 million) is transfered to states. Therefore, states have proven to be strong regulators in this area and subjecting more entities to state supervision will allow the SEC to focus on large hedge funds. Despite the elimination of the private adviser exemption, the Act provides for several new exemptions to the registration requirements for private fund advisers, which are advisers to venture capital funds, small business investment company advisers, certain private fund advisers, 8) mid-sized private fund advisers, 9) family offices, and foreign 6) IAA section 203(b) 7) The Act requires advisers to private funds to maintain, but not necessarily to file with the SEC, certain records and reports pertaining to the following items: assets under management; use of leverage, including off-balance-sheet leverage; counterparty exposure; trading and investment positions; valuation policies and practices; types of assets held; side arrangements or side letters; and trading practices and other information deemed necessary by the SEC, in consultation with the Financial Stability Oversight Council. 8) The Act requires the SEC to provide an exemption from registration to any investment adviser that (1) acts solely as an adviser to private funds and (2) has assets under management in the US of less than $150 million. 9) The Act does not define the term mid-sized private funds. The Act requires the SEC, in prescribing regulations to carry out the registration requirements of Section 203 of the Investment Advisers Act with respect to investment advisers acting as such to mid-sized private funds, to take into account the size, governance and investment strategy of such funds to determine whether they pose systemic risk and to provide for registration and examination procedures with respect to such advisers that reflect the level of Vol. 3, No. 4

9 Strategies to Develop Korea s Hedge Fund Regulations private advisers, etc. The UK hedge fund managers and advisors are typically required to seek authorization under the Financial Services and Markets Act 2000 (FSMA2000) by the FSA prior to commencement of business because FSMA2000 sets out the instruments, activities, and services that require prior authorization. 10) The minimum regulatory capital requirements for hedge fund managers depend on its activities but for most the requirements will be based on the Capital Requirements Directive (CRD) as set out in the FSA GENPRU and BIPRU sourcebooks. Based on the kind of business activity, the required capital amount differs. Generally, its minimum regulatory capital requirement is the highest of three different calculations: (1) base requirement of EUR 50,000/EUR 125,000 depending on whether the firm is permitted to hold client money and/or assets, (2) sum of credit risk and market risk requirements, (3) fixed overhead requirement of 25% of relevant annual expenditure. In Hong Kong, generally, the typical business activities of a hedge fund manager/ advisor will likely fall into the scope of regulated activities as defined in Part 1 of Schedule 1 to the SFO. There are nine types of regulated activities as defined in Schedule 5 of the SFO: dealing in securities, dealing in futures contracts, leveraged foreign exchange trading, advising on securities, advising on futures contracts, advising on corporate finance, providing automated trading services, securities margin financing, and asset management. Therefore, the hedge fund manager/advisor should apply for the appropriate license from the SFC when carrying out regulated activities in Hong Kong and the minimum regulatory capital required for a hedge fund manager/advisor varies depending on the type of regulated activities it is approved to carry out and the licensing conditions attached to its license. The hedge fund manager/advisor should systemic risk posed by such funds. 10) The activities and services include, but are not limited to: dealing in investments as agent on behalf of clients; managing investments on behalf of clients; advising clients on investments; and establishing, managing, operating, or winding up a collective investment scheme. Investments include: shares, warrants, debt instruments, units, and various derivative products (including futures, options, and contracts for difference). 31

10 Capital Market PERSPECTIVE also provide documents to satisfy the SFC that it has the proper business structure, internal control systems, and qualified personnel. Section 8.7 of UT Code, established by the SFC, has specific requirements for a fund manager and its key personnel that manage SFC-authorized hedge funds. Especially, the SFC would generally expect at least $100 million for the total amount of AUM that follow hedge fund strategies. The management company must have the requisite competence, expertise, risk management, and internal controls systems. It must also be adequately and suitably staffed in order to properly manage the risks and operational issues in connection with its hedge funds business. There must be at least two key personnel in the management company each having at least five years of relevant experience. Most hedge fund managers operating in Singapore restrict their fund management activities to not more than 30 qualified investors and are therefore exempt from licensing. However, should the fund manager decide to market a fund to retail investors, the fund manager will have to obtain a CMS License from the MAS under the Securities and Futures Act (Chapter 289) (SFA). If the fund manager holds a CMS license under the SFA and manages retail hedge funds, a minimum base capital of SGD 1 million is required Vol. 3, No. 4

11 Strategies to Develop Korea s Hedge Fund Regulations Table 3. International regulations on hedge fund managers/advisors Country US UK Hong Kong Singapore Contents Beefed up regulations on hedge funds and private funds, and tightened the regulatory standards with the adoption of the Dodd-Frank Wall Street Reform. Increased the scope of investor adviser registration obligations. --Require hedge fund and private equity advisers to register as investment advisers with the SEC if their AUM is above the predetermined level. --Added new exemptions from registration with the SEC for i) investment advisers to venture capital funds, ii) investment advisers to small business investment companies, iii) investment advisers who manage certain private funds and have AUM of less than $150 million, and iv) foreign private advisers. --Increased the threshold for federal regulations on investment advisers to AUM of $100 million and transferred the authority to regulate small private funds to states. Tightened record keeping and reporting requirements. Typical fund managers/advisors are required to seek authorization under the FSMA2000 by the FSA prior to commencement of business including dealing in investments as agent on behalf of clients; managing investments on behalf of clients; advising clients on investments; and establishing, managing, operating, or winding up a collective investment scheme. The hedge fund manager/advisor should apply for the appropriate license from the SFC when carrying out regulated activities in Hong Kong. Chapter 8.7 of the UT Code set out the criteria of management company including the experience of the key investment personnel and the risk management profile and internal control systems, prime broker, minimum subscription, limited liability, valuation, etc., for hedge funds. Fund managers to market a hedge fund to retail investors have to obtain a CMS License from the MAS. 4. Regulations on investors Marketing is not permitted, or is strictly limited in some circumstances, for nonregistered investment companies in the US. Rule 506 of Regulation D under the 1933 Act provides a safe harbor for private placements of securities intending to qualify for the private placement exemption, which may be made to an unlimited number of accredited investors and up to 35 nonaccredited investors. Current requirements command an individual to have at least 33

12 Capital Market PERSPECTIVE $1 million in net worth, or an annual income of $200,000 (or joint income of $300,000 for married couples) per year for the past two years with a reasonable expectation that such income levels will be attained in the current year in order to qualify as an accredited investor. A private fund can be an investment company that is exempt from registration pursuant to Section 3(c)(1) or 3(c)(7) of the Investment Company Act of To qualify for exemption under section 3(c)(1) there must be no public offering, current or proposed, and no more than 100 owners of securities (with limited exceptions), other than shortterm paper. To qualify for redemption under Section 3(c)(7), there must be no public offering, current or proposed, and all securities owned by qualified purchasers (with limited exceptions). Qualified purchasers include any natural person who owns not less than $5 million in investments, any company that owns not less than $5 million in investments, any person who in the aggregate owns and invests on a discretionary basis, not less than $25 million in investments, and any qualified institutional buyer. There are no restrictions on the maximum or minimum number of investors. However, if the fund is UK-authorized, then it must be open to all investors notwithstanding any prospectus minimum subscription requirements. Moreover there is a general restriction on promoting unregulated schemes to the general public regardless of whether it is a hedge fund or not. Restrictions apply to the type of individuals to whom unregulated collective investment schemes (UCISs) can be promoted in Promotion of Collective Investment Schemes (Exemptions) Order 2001 (PCIS Order) and Conduct of Business Sourcebook (COBS) primarily. Under the COBS rule for the promotion of UCISs, the fund may be promoted to a potential investor where the firm making the promotion has sufficient understanding of an individual s wealth and risk appetite and the customer meets the criteria for being an elective professional client and has been accepted as such. 11) 11) Client categorization is addressed in the FSA s COBS, which deals with clients such as retail clients, professional clients, and eligible counterparties. COBS 3 defines a retail client as a client who is not a professional client or an eligible counterparty. A professional client is a client that is either a professional client (a credit institution; an investment firm; any other authorized or regulated financial institution; a pension fund or the management company of a pension, a local, etc.) or an elective professional client, which is the firm that undertakes an adequate assessment of the expertise, experience and knowledge of the client that gives reasonable assurance, in light of the nature of the transactions or services envisaged, that the Vol. 3, No. 4

13 Strategies to Develop Korea s Hedge Fund Regulations In 2010, the FSA has reviewed the sales of UCIS. The Promotion of Collective Investment Scheme Order (PCIS) introduces the concepts of investment professionals, certified high net worth individuals, and sophisticated investors. Under the PCIS Order, the types of investor to whom UCISs can be promoted to are as follows: an investment professional who is FSA authorized or someone who is involved with unregulated schemes by way of business; certified high net worth individuals who have certified in writing within the previous 12 months that they either have an income in excess of 100,000 per annum or net assets (excluding their primary residence, insurance benefits, and pension schemes) of 250,000 plus; certified sophisticated investors who is self-certified in writing that they sufficiently understand the risks associated with UCISs. There is no restriction on the minimum or maximum number of investors in a hedge fund in Hong Kong. However, there is a general prohibition on the marketing of non-sfc-authorized hedge funds in Hong Kong, regardless of its place of domicile, to the general public in Hong Kong, unless the marketing efforts are made to only professional investors as defined in Part 1 of Schedule 1 to the SFO. If the hedge fund is an SFC-authorized hedge fund, the fund s promotional material has to be authorized by the SFC before it is released to the general public. The management company must issue regular reports to holders on the scheme activities at least on a quarterly basis and the offering document must disclose all relevant matters relating to the investment operations and risk management aspects of the scheme and clearly explain the scheme s strategy and the risks involved. An SFC-authorized hedge fund is open to the general public to subscribe, notwithstanding the minimum level of initial subscription requirement stated in the UT Code. The minimum level of initial subscription by each investor of an SFC-authorized hedge fund should not be less than $50,000 equivalent, except for fund of hedge funds, where the minimum initial subscription should not be less than $10, ) client is capable of making his own investment decisions and understanding the risks involved. 12) No minimum subscription level will apply to a hedge fund which provides at least 100 percent capital guarantee. 35

14 Capital Market PERSPECTIVE In Singapore, onshore hedge funds marketed to retail investors are typically not subject to investment guidelines. However, hedge funds that are authorized schemes offered to retail investors must comply with the Hedge Fund Guidelines in the Code issued by the MAS. Moreover, it must comply with the minimum subscription amount for single hedge funds which is SGD 100,000 and that for hedge fund-of-funds of SGD 20, ) Table 4. International regulations on hedge fund investors Country US UK Hong Kong Singapore Contents Qualified purchaser --Any natural person or company that owns not less than $5,000,000 in investments and any person who in the aggregate owns and invests on a discretionary basis, not less than $ 25,000,000 in investments and any qualified institutional buyer. Accredited investors --An individual to have at least $1 million in net worth, or an annual income of $200,000 (or joint income of $300,000 for married couples) per year for the past two years Adjustment of Accredited Investor Standard by DFA --DFA provides that, apparently upon enactment and for four years following enactment, the net worth threshold is $1 million, excluding the value of the investor primary residence. Set the criteria for individual investors to whom UCISs can be promoted. --Certified high net worth individuals, certified sophisticated investors, etc. The minimum level of initial subscription by each investor in a scheme must not be less than $50,000, except for funds of hedge funds, where the minimum initial subscription must not be less than $10,000. Criteria of accredited investor --An individual (A) whose net personal assets exceed in value $2 million or (B) whose income in the preceding 12 months is not less than $300,000 --A corporation with net assets exceeding $10 million in value --The trustee of such trust as the authority may prescribe, when acting in that capacity The minimum subscription amount for retail investors --SGD 100,000 for single hedge funds, and SGD 20,000 for hedge fund--offunds 13) The same applies to recognized offshore hedge funds Vol. 3, No. 4

15 Strategies to Develop Korea s Hedge Fund Regulations Onshore hedge funds offered to accredited investors and other people 14) can only be offered to certain types of investors as defined under Section 305 of the SFA. These investors require a minimum total net asset size or annual income exceeding a certain amount or at a minimum of SGD 200,000 per transaction. The same applies to offshore restricted recognized schemes. For both onshore and offshore funds marketed to institutional investors, there are no minimum subscription requirements for all funds including hedge funds. 5. Implications First, there are few restrictions on hedge fund management including the use of leverage and derivatives before and after the financial crisis. Apparently, regulatory authorities have placed an emphasis on ensuring maximum discretion for privately placed funds management performance. Second, concerning the strengthened regulations on hedge fund managers, most regulators focus on large hedge fund managers and specify detailed criteria for reporting. In the US, the threshold for federal regulations on investment advisers increases to AUM of $100 million. Also, the US transferred the authority to regulate small private funds to states. Moreover, in the EU, the Directive on Alternative Investment Fund Managers (AIFM) allows the exemption of registration for AIFM managing assets of less than 100 million, or 500 million without leverage where redemptions in the AIF are prohibited for the first five years. This means that strict oversight is necessary for large hedge funds managers in order to prevent systemic risk, while it is necessary to lower regulatory costs for small- and medium-sized hedge funds to ensure that they support more easily innovative companies, new growth companies, and venture capital. Especially, there are specific exemptions from registration with the SEC for certain investment advisers with other requirements including the venture capital funds. This 14) They include a corporation the sole business of which is to hold investments and a trustee of a trust the sole purpose of which is to hold investments and each beneficiary of which is an individual who is an accredited investor. 37

16 Capital Market PERSPECTIVE implies that regulations are necessary for small- and medium-sized hedge funds man agers from the investor protection perspective, but the Global regulations level of those regulations does not have to be too strict on hedge funds tend to give hedge because an ex-ante measure, such as investor funds discretion on qualification criteria, exists. asset management. Registration and Third, the criteria for individual investors of hedge reporting obligations funds or unregulated CIS are adjusted. DFA provides on large hedge fund that the SEC is authorized to review the definition of the managers were tightened. Also notable term accredited investor, as applied to natural persons, is the discussions over and the net worth threshold for accredited investors as the qualifications for applied to natural persons is $1 million, excluding the retail investors. Most value of the investor s primary residence. 15) In case of nations govern hedge funds in the regulatory the UK, the type of individuals is expanded, and net framework for privately asset and income are used as the criteria of HNWI. placed funds, and the level of regulations Fourth, the US tightened the regulation on increase as a hedge hedge funds and hedge fund advisers, and the UK fund grows beyond a strengthened the regulation on hedge fund managers certain size. In Asia, where countries want comprehensively by increasing the level of macroprudential regulation. However, Singapore and Hong to foster the hedge fund industry, there has Kong maintain the existing regulatory framework been no movement to strengthen regulations related to hedge funds. Hedge fund regulations were since the global tightened in countries where the hedge fund industry financial crisis. represents a significant portion of the financial system and is linked with various and complex market participants which increases systemic risks. On the other hand, this move was not seen in Asian nations that want to foster their hedge fund industries. 15) The Act requires the SEC, four years after the date of enactment and every four years thereafter, to review the entirety of the definition of the term accredited investor, as applied to natural persons, and authorizes the SEC to modify the definition as appropriate for the protection of investors, in the public interest, and in light of the economy. Any net worth threshold must be an amount exceeding $1 million, excluding the value of the investor s primary residence Vol. 3, No. 4

17 Strategies to Develop Korea s Hedge Fund Regulations Fifth, most countries have the common regulatory system for privately offered funds or UCIS that also covers hedge funds. It is rare to set out a separate regulatory system only for hedge funds. In addition to regulations on private funds, hedge funds and managers are governed by the macro-prudential regulations to which other financial investment firms and CIS are subject. The level of regulations gets tightened if the funds are distributed to retail investors and thus investor protection is required. Moreover, while privately placed funds can be classified into hedge funds, PEF, and venture capital according to management strategies, they are basically subject to a single regulation. IV. Recommendations for Hedge Fund Development If hedge funds take root in the Korean market, they will be able to improve market intensity and efficiency as a financial venture industry. Also, this will help create the alternative investment market, and therefore promote the quantitative as well as qualitative growth of the asset management industry. Moreover, by preventing systemic risk and market disruption caused by excessive leverage, hedge funds could enhance liquidity in the financial market. Ultimately, hedge funds can vitalize the whole financial industry by helping nurture professional manpower in hedge fund related areas. In order to enjoy the economic benefits provided by hedge funds, we need to endeavor to find optimal regulatiory scheme in Korea. After a brief assessing Korea s current regulatory scheme from various perspectives, ways to develop hedge funds are suggested. 1. Regulatory structure Hedge funds are a kind of privately placed financial product. Thus, in general, it is reasonable that the level of regulations over hedge funds is lower in terms of investor protection and market efficiency, compared to publicly placed mutual funds. Hedge fund managers tend to be less strictly regulated than mutual fund managers. 39

18 Capital Market PERSPECTIVE In Korea, when establishing a hedge fund, there is no obligation to register in advance in accordance with the exemption set out in of the FSCMA, 16) so the regulatory level of hedge funds seems to be lower than that of mutual funds. However, it is questionable that the post-registration duty will be the only regulatory hurdle in practice. If hedge funds take root in Korea, it is desirable to impose only a postreporting duty to help hedge funds be established more easily and efficiently. Moreover, since hedge funds are only allowed for asset management companies, securities companies, and investment advisory companies with certain capital, track record, and manpower, hedge fund managers are often subject to stricter regulations than mutual fund managers. 17) The measure initially intended to raise the entry barrier and mitigate the negative effects of hedge funds. But this conflicts with the regulatory scheme for privately placed funds including hedge funds, and thus is viewed as unreasonable. It is recommended that the regulatory level of hedge funds, compared to that of mutual funds, be lowered. Market discipline works especially well for PEFs, which currently have no restrictions on managers. 2. Level of regulations Compared with overseas regulations on hedge fund establishment, management, and investors, Korea s laws appear to be fairly strong. The US places the exemption from registration for hedge funds with certain conditions, and reporting obligations about important information including the use of leverage. Investment advisers are exempt from registration depending on the number of investors in the pre-dfa era, and the size and nature of the fund in the post-dfa era. 16) An investment trust which is a privately placed fund for qualified investors or a collective investment business entity of an undisclosed investment association or an investment company which is a privately placed fund for qualified investors shall, when a privately placed fund for qualified investors is created or established or any other reason specified by Presidential Decree occurs, report the fact to the Financial Services Commission under the conditions prescribed by Presidential Decree within one month from the date on which such a reason occurs. 17) For example, an asset advisory firm that has already had a mutual fund license cannot manage a hedge fund if their AUM is less than KRW 10 trillion Vol. 3, No. 4

19 Strategies to Develop Korea s Hedge Fund Regulations In regards to the eligibility of individual investors, the investment requirement set at KRW 500 million is almost eight or nine times higher than the investment requirement for individual investors, which is $50,000 in Hong Kong. Considering regulatory arbitrage with other countries and regulatory efficiency, it is necessary to ease regulations on establishment, management, and investors. 3. Investor protection Privately placed funds can offer investors high returns and better risk management. However, because hedge funds use leverage and unregulated investment strategies, it is necessary to apply investor eligibility criteria when privately placed funds are offered to investors. Then, what are the appropriate criteria for investor protection? If the criteria for individual investors are set too high, then this will deprive investment opportunities for investors who can protect themselves, and ultimately will go against the initially intended investor protection. In the UK, eligible individual investors are certified sophisticated investors (those who have self-certified in writing that they sufficiently understand the risks associated with UCISs) are eligible individual investors. Moreover, it is necessary to adjust the criteria for individual qualified investors. In other countries, various criteria including net asset, annual income, and minimum subscription are applied to individual investors. In the US, a privately placed fund for a small number of investors should be owned by less than 100 investors (no more than 35 purchasers who are not accredited investors), while the number of investors is not limited in Hong Kong. Thus, Korea should review the criteria for individual investors, and then adjust the number accordingly. 4. Trends on global regulations After the financial crisis, the US and other G20 countries have been leading discussions about potential systemic risks related to hedge funds, and then discussed the adoption of tighter regulations on hedge fund managers through DFA and EU 41

20 Capital Market PERSPECTIVE AIFM Directives for systemic risk prevention. However, the countries that plan to develop their hedge fund industries, like Hong Kong and Singapore, have not shown such initiative. Korea hopes to foster the hedge fund industry as a new financial growth engine, and thus needs to develop the financial environment where the industry can use creative investment strategies and where financing is easier. Of course, Korea needs financial supervision to prevent systemic risks and enhance investor protection. Also, prime brokers will play an important role to accomplish the goal. 5. Long-term directions for privately placed CIS The FSCMA first prescribes regulations on publicly placed funds, and then adds additional regulations for privately placed funds, such as General Private Funds, Private Funds for Qualified Investors (hedge funds), and Private Equity Funds (including PEF for corporate restructuring). Korea-style hedge funds are defined independently, and subject to separate requirements in terms of their manager, system to prevent conflicts of interest, and custody under the regulatory framework of Private Funds for Qualified Investors. Considering the long-term development of privately placed funds and their compatibility with global standards, it is necessary to integrate the three types of privately placed funds in the FSCMA, and then create a unified category which includes future hedge funds in Korea. 6. Infrastructure for development of the hedge fund industry In order to foster the hedge fund industry as an alternative investment industry, other industries related to hedge funds should play vital roles. Particularly important is establishing the necessary infrastructure: Investors should change their perception about benchmarks; hedge funds should differentiate themselves from other types of Vol. 3, No. 4

21 Strategies to Develop Korea s Hedge Fund Regulations funds; and basic infrastructure, such as research capabilities, should be built. Only then will innovative fund managers get higher performance-based fees and investors be able to enjoy more benefits, thereby creating a win-win structure. Thus, self-regulatory organizations like Korea Financial Investment Association (KOFIA) need to build up an information infrastructure, based on track records, and provide a relevant index and management data until the hedge fund industry grows to a certain size. In the US and other developed countries, private firms have built a commercial DB for hedge funds. It will take time for the market to voluntarily build the infrastructure. Also, there is a risk that asymmetric information will dominate the market before the market has the In order to fully capitalize on the proper structures. Thus, one possible solution is for economic benefits that self-regulatory organizations to serve as information hedge funds provide, infrastructure providers or for an agency to manage Korea should adjust its the hedge fund industry information. The organization regulatory level and system considering can use the data reported to regulatory authorities to diverse factors such as calculate a specific index or performance data of each the regulatory regime, hedge fund adviser. the level of regulations, investor protection, Moreover, Korea needs to strengthen the role of recent global regulatory prime brokers to vitalize funding to hedge funds. 18) trends, long-term In development of particular, the main role of prime brokers is securities privately placed funds, lending for short selling and leverage. Therefore, it is and infrastructure. necessary to continuously adjust relevant services and regulations to keep pace with hedge fund trends. Korea should impose a minimum level of eligibility criteria for prime brokers, and thus encourage as many financial investment companies as possible to participate in the prime broker business. Also, it is necessary to spur competition in the market. 18) The Enforcement Decree of the FSCMA and The Code of Financial Investment Services define the prime brokerage services, and allow only the securities companies with sufficient capital and risk management capacity to perform the prime broker business. Moreover, they ease the restriction on prime brokers credit provision, and modify the existing regulation related to fund asset custody and Chinese wall. 43

22 Capital Market PERSPECTIVE References Ahn, N.K. et al., 2010, Recent Trends on Hedge Funds Regulations in Developed Nations and Their Impact, Korea Center for International Finance, Issue Analysis. Binh, K.B.,, 2009, Understanding Privately Placed Funds and Korea s Laws and Regulations, Korea Capital Market Institute, Capital Market Weekly Davis Polk & Wardwell LLP, 2010, Side-by-Side Comparison Chart-Key Senate and House Bill Issues. Davis Polk, 2010, Summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Passed by the House of Representatives on June 30, Enhance Support Solution Limited, 2010, Regulatory Update(August 2010). Financial Services Commission, The Revised FSCMA Approved by the State Council, Press Release, 2011 (November 22). Financial Services Commission, The Revised Enforcement Decree of FSCMA Approved by the State Council, Press Release, 2011 (September 27). Financial Services Commission, Advance Notice of the Revision on FSCMA, Press Release, 2011 (July 26). Financial Services Commission, Advance Notice of the Revision on the Enforcement Decree of FSCMA, Press Release, 2011 (June 16). Financial Services Commission, Financial Supervisory Service, Korea Financial Investment Association, 2011, Briefing for Revised Financial Investment Services Regulations and Best Practices for Hedge Fund (Draft). FSA, 2010, FSA factsheet for Financial Advisers, SFDFS058 07/11. FSA, 2010, Unregulated collective Investment scheme: Good and poor practice report. Kim, I.K. et al., 2010, US Financial Reform Highlights and Outlook, Bank of Korea, Bank of Korea Research, Kim, J.C. et al., 2009, Desirable Directions to Integrate Fund Regulations, Korea Capital Market Institute, Research Paper, Vol. 3, No. 4