Hedge funds have long been a source of worry for regulators, and their concerns have spurred efforts to bring the industry under greater oversight. Yet much remains to be done.

Traditionally, hedge funds have been in the purview of so-called “sophisticated investors.” The assumption is that these investors are smart enough and have enough resources to take care of themselves. However, hedge funds increasingly have been finding their way into the hands of ordinary retail inves-tors, largely packaged as principal-protected notes, giving rise to more acute regulatory fears.

Hedge funds have been blamed for a multitude of sins, including the U.S. mutual fund market-timing scandal. They have also been accused of creating systemic threats. While the most notorious hedge fund failures have occurred in the U.S., Canada has seen its share of stumbles, most recently the bankruptcies of Portus Alternative Asset Management Inc. and Norshield Asset Management (Canada) Ltd.

Regulators’ worries about the evolution of the Canadian hedge fund sector were laid out in a May 2005 report from the Investment Dealers Association of Canada, which highlighted concerns such as the marketing practices of hedge fund manufacturers and dealers, conflicts of interest, size and transparency of fees, the funds’ lack of disclosure and the use of PPNs — which are largely exempt from securities laws — to market hedge funds to ordinary investors. In response, the report recommended a variety of reforms.

Two and a half years on, the IDA has largely adopted the measures recommended in the report, whereas the proposals that fall to the provincial securities commissions to implement remain works in progress.

The report made five recommendations to the IDA and the IDA has essentially fulfilled them, says Paul Bourque, senior vice president of member regulation at the IDA in Toronto. The regulator has reviewed the activities and controls of its members that manage hedge funds, and its routine compliance examinations now also cover conflicts of interest at firms with hedge fund businesses.

More important than brokerage firms running their own hedge funds is how they get the funds into their clients’ hands. The report called on the IDA to prevent members that have limited market dealer affiliates from directing business to their LMDs that would otherwise go through the highly regulated IDA firm. The lightly regulated LMDs fall under the supervision of the securities commissions rather than the self-regulatory organizations. Bourque reports that firms with LMD affiliates have been identified and no new LMD affiliates have been allowed.

The IDA also has dealt with other distribution-related concerns. Earlier this year, it published due-diligence guidelines for dealers selling PPNs. It also issued a notice in July that addressed further issues raised by the report, outlining appropriate referral arrangements and reiterating the prohibition against off-book transactions.

While the IDA has tried to address the role its members are playing in the increasing retail penetration of hedge funds, a number of issues raised in its report are beyond its authority. Perhaps most important is the packaging of funds in PPNs, which are considered banking products, not securities, and, therefore, are exempt from most regulatory requirements.

DUE-DILIGENCE GUIDELINES

The IDA report called for a review of provincial laws and regulations to bring funds being sold to retail investors within the regulatory system. The report suggested that could include reconsidering the PPN exemption, examining distribution to retail investors, ensuring appropriate referral arrangements, addressing conflicts of interest and imposing registration requirements on hedge fund managers.

The Canadian Securities Administrators is tackling these issues. It has conducted its own review of the hedge fund arena, which echoed many of the concerns of the IDA report — including use of PPNs, referral arrangements, disclosure, distribution practices and registration. The CSA also has indicated it believes these issues can be dealt with under the current regulatory regime without the need for major new initiatives.

Perhaps most critical on the PPN issue is that the CSA is not seeking to do away with the exemption that keeps these vehicles out of the securities regulatory regime. Instead, it is deferring to the federal Department of Finance on the issue. In the spring budget, Ottawa announced plans to introduce new principles-based requirements for PPNs, most of which are issued by federally regulated banks.

@page_break@These requirements are meant to address quality of disclosure for PPNs (including fees, risks and investor rights) and mandate ongoing performance disclosure. The CSA indicates that, based on discussions with Finance officials, these new requirements will probably resolve most of its concerns about PPNs.

However, these proposals have yet to be released, although a Finance official says they will be published before the end of the year. But the new federal rules won’t apply to Quebec’s caisses populaires, which also issue a significant number of PPNs. But, the CSA indicates, once the new rules are adopted, Quebec’s Autorité des marchés financiers will consider whether those rules should apply to the caisses.

Preserving PPNs’ status as banking products limits the ability of the CSA and the SROs to oversee these products and their distribution. According to the CSA, the vast majority — 70%-80% — of PPNs are sold by IDA members; firms belonging to the Mutual Fund Dealers Association of Canada sell another 10% of these products. The rest are sold outside the SRO system.

The IDA has confirmed that suitability, know your client and other obligations apply when member firms deal in these products, as has the MFDA. The risk is that as long as PPNs remain banking products, they can be sold by those other than securities and mutual fund dealers — and thus away from SRO scrutiny.

Dual-licensed advisors who have insurance licences, for example, can put sales of PPNs through the insurance side of their businesses, away from the prying eyes of securities industry SROs. This creates a risk of regulatory arbitrage. So, while 80%-90% of PPNs may be sold within SRO-supervised dealers today, that could shift away from SRO-regulated firms in the future.

Issues relating to hedge fund managers are to be dealt with in the CSA’s proposed registration reform project that was launched earlier this year. That proposal calls for a complete overhaul of the registration system, including introducing a requirement that all investment managers, including hedge fund managers, be registered. It also creates a new exempt market registration category that would cover a variety of players in that part of the market, including firms registered as LMDs.

MORE OVERSIGHT

Registration requirements will mean that firms face more oversight, including capital requirements, proficiency standards and compliance obligations. Among the new compliance responsibilities, the proposal deals with a number of the issues raised by the IDA report regarding hedge funds, such as mandating disclosure and outlining how firms must deal with conflicts of interest. The proposal also addresses the question of referral arrangements.

These measures should go a long way toward resolving a number of the concerns outlined in the original IDA report. The question is whether the new regime will take effect — and when.

When the regime was first proposed in February, the CSA had indicated it hoped to have the new registration system in place by the end of this year. It knew such a fundamental overhaul would probably attract a slew of responses from the industry, so it issued the proposal for a 120-day comment period instead of the usual 90 days. The CSA also held several events to explain the new system. Sure enough, the comments flooded in.

Now, not surprising, the CSA plans to put the proposed rule out for another round of comments. That means the proposal has undergone some significant changes. The CSA expects to publish a revised version later this year, this time for a 90-day comment period. And it plans to have the new rules implemented by mid-2008.

It remains to be seen what has changed in the proposed rules, and if the CSA can meet the new deadline. Past experience with major regulatory reforms suggests the process may drag out longer than expected. That said, the CSA has been working on these reforms for some time and it seems unlikely that it would just give up. But, until any rule is formally adopted, there is no guarantee that it will become law.

Another possible source of regulatory pressure on the hedge fund industry is the standing Senate committee on banking, trade and commerce. Earlier this year, it undertook hearings on the subject of hedge funds and their regulation. It didn’t issue a report or any recommendations following the hearings, which took place during the last session of Parliament. The committee has yet to be reconstituted since Parliament was recalled. Until a new Senate banking committee is formed, notes the committee’s clerk, it’s impossible to say what its priorities will be and whether it will again pick up the hedge fund issue.

Whether the Senate banking committee decides to wade back into the fray or not, regulators appear to have plenty on their plates as they come to grips with their concerns about hedge funds. These efforts remain largely a work in progress. IE