Hedge Fund Regulation by Banking Supervision

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1 Wulf Alexander Kaal Hedge Fund Regulation by Banking Supervision A Comparative Institutional Analysis PETER LANG Europaischer Verlag der Wissenschaften

2 Table of Contents A. THE PROBLEM OF REGULATION 19 B. THE APPROACH OF THE DISSERTATION 21 C. HEDGE FUNDS AND HLIS 23 I. DEFINITION OF HEDGE FUNDS The Jones Hedge Fund Model The Evolution of Hedge Funds 28 II. KEY CHARACTERISTICS OF HIGHLY LEVERAGED INSTITUTIONS Significant Leverage Limited direct prudential regulation Limited disclosure requirements 33 D. SPECIFIC PROBLEMS OF HEDGE FUNDS AND INVESTOR PROTECTION 33 E. THEORY OF REGULATION 37 I. THE THEORY OF INCOMPLETE CONTRACTS 37 II. THEORY OF REGULATION- NEW INSTITUTIONAL ECONOMICS Basics of New Institutional Economics 38 a) Institutions 39 b) Bounded rationality 39 c) The economic paradigm 40 d) Methodological Individualism 40 e) Maximizing profit 41 0 Transaction costs Differences between NIE and neo-classic Theory Differences between Relational Contract and Classical Contract 43 HI. INCOMPLETE CONTRACT THEORY AND MODERN INSTITUTIONALISM ; Principal Agent Model 44 a) Moral Hazard 45 b) Adverse Selection Property Rights 46 13

3 IV. PRUDENTIAL BANK REGULATION 47 F. MODEL APPROACHES TO HEDGE FUND REGULATION 48 I. CO-COORDINATED INTERNATIONAL CO-OPERATION 48 II. NATIONAL DIRECT REGULATION 49 III. INDIRECT REGULATION 49 IV. PRUDENTIAL HEDGE FUND REGULATION 50 V. HYPOTHESIS 51 G. REGULATORY APPROACHES 52 I. LONG TERM CAPITAL MANAGEMENT, L.P 52 II. MEASURES IN RESPONSE TO LTCM Regulatory Measures 58 a) U.S. Securities Exchange Commission 60 b) U.K. Financial Services Authority 61 c) Conclusion Legislative Measures 63 a) Hedge Fund Disclosure Act b) Derivatives Market Reform Act c) Conclusion 64 d) International Accounting Standards Committee 66 e) U.S. - Financial Accounting Standard Board 68 0 U.K. - Accounting Standards Board, FSA 70 g) France 71 h) Conclusion 72 HI. RULES AND REGULATION IN MAJOR HEDGE FUND JURISDICTIONS Regulatory Provisions in the United States 74 a) Securities Laws 75 b) The Securities Act of (1) Private Placement Exemption -Accredited Investors 77 (2) Private Placement Exemption 78 (3) Disclosure Requirements 79 (4) Resale Restrictions 79 14

4 (5) Private Placement and Offshore Public Offerings 80 (6) State Legislation - Blue Sky Requirements 80 c) Securities Exchange Act of (1) Brokers-Dealers and the Issuer Exemption 81 (2) The Agent Exemption 81 (3) The Finder Exemption 82 (4) Registration 83 (5) SoftDollaring 83 d) Investment Company Act (1) Section 3(c) (1) Exemption 84 (2) Section 3(c) (7) Exemption 86 (3) Registration 88 e) Investment Advisers Act of (1) The Adviser Exemption 88 (2) Registration 89 (3) State Law 91 0 The Commodity Exchange Act of (1) Exemptions 92 (2) Limited Relief 93 (3) Registration 95 g) Hot Issue Securities 96 h) Conclusion Regulation in the United Kingdom 98 a) Rules and Regulations of the FSMA and FSA 100 (1) Supervision by risk assessment 100 (2) Regulated and Prohibited Activities 101 (3) Authorization to Carry On Regulated Activities 102 (a) Authorization Requirement - The Business Test 102 (b) Gaining Permission to Cany on Regulated Activities 104 (c) Exemptions 105 (4) Financial Promotion in the UK 107 (a) Real Time and Non-Real Time Financial Promotions 108 (b) Direct OfTer Financial Promotions

5 (c) Approval of Financial Promotions by a Firm 110 (d) Collective Investment Schemes and Financial Promotion 110 (e) Exemptions 111 (5) Investment Advice 112 (a) Market Abuse 113 (i) The Regular User Rule 114 (ii) Behavior 115 (Hi) Misuse of Information 115 (iv) False or Misleading Impressions 117 (v) Distortion 118 (vi) Penalties for Market Abuse 119 (b) Money Laundering 120 (c) Official Listing 121 (d) Collective Investment Schemes 121 (6) Investment Businesses 123 (a) Investment Management Firms 125 (b) Rules on Large Exposures relating to ISD firms 127 (i) Record Keeping 128 (ii) Consolidated Supervision 128 (7) Enforcement 129 b) Conclusion Germany 132 IV. REGULATORY PROPOSALS The Board of Governors of the U.S. Federal Reserve System Hong Kong Regulatory Framework International Organization of Securities Commissions Basle Committee Basle Committee and IOSCO joint consultative paper Credit Risk Management Policy Group Multidisciplinary Working Group on Enhanced Disclosure Committee on the Global Financial System International Swaps and Derivatives Association U.S. President's Working Group on Financial Markets

6 11. Hedge Fund Industry Group The Report of the Financial Stability Forum 166 a) The Working Group Recommendations 168 b) Implementation Progress Summary : Conclusion 171 H. DIRECT HEDGE FUND REGULATION 174 I. HEDGE FUND REGULATION IN THE US SEC Requires Registration of Hedge Fund Advisers 180 a) The SEC's Rationale for Regulation 181 b) Rule 203 (b) (3) c) Supplemental Rule Changes and SEC Reasoning Cost-Benefit Analysis Revisited 186 a) Regulation to Prevent Investor losses from Hedge Fund Fraud 186 b). Improved Information and Compliance Controls? 189 c) Cost of Regulatory Arbitrage A Strongly Worded Dissent Another Avenue of Regulation? 193 II. HEDGE FUND REGULATION IN THE EU EU Directives Hedge Fund Regulation in the United Kingdom 199 a) Minimizing Systemic Risk 200 b) Regulation of Hedge Fund Managers 201 c) Retailization of Hedge Funds in the UK? 201 d) The Impact of the SEC Rule on UK Hedge Fund Regulation Hedge Fund Regulation in Germany 203 a) Overlapping Regulatory Regimes or Pre-emption? 204 (1) The Old but still Valid Regime 204 (a) The Investment Companies Act (KAGG) 205 (b) The Foreign Investment Act (AusllnvestG) 207 (c) Strategies to Overcome Regulatory Inflexibility 208 (2) The Impact of the New Regime: Investment Modernization Act

7 (a) The Primary Objective of the Act 209 (b) Modernizing Hedge Fund Regulation in Germany 209 (3) The new Investment Ordinance 212 b) Deficits of German Hedge Fund Regulation 213 c) Conclusion 214 I. NORMATIVE ANALYSIS I. ANALYSIS OF MODEL APPROACHES TO HEDGE FUND REGULATION Co-coordinated International Co-operation National direct Regulation Indirect Regulation Prudential Hedge Fund Regulation 217 II. HEDGE FUND REGULATION BY BANKING SUPERVISION The Core Principles for Effective Banking Supervision The New Capital Adequacy Framework 219 a) - Key aspects of Basle II 221 (1) Pillar 1 - minimum capital requirements 221 (2) Pillar 2 - supervisory review process 221 (3) Pillar 3 - market discipline 222 b) Implementation 223 HI. CONCLUSION 223 J. BIBLIOGRAPHY

Appendix B International developments

Appendix B International developments a) IOSCO In the wake of the 2008 global financial crisis, IOSCO established a task force to work to eliminate gaps in various regulatory approaches to naked short