In response to the significant financial distress experienced since late 2007, in connection with the global financial crisis, lawmakers and regulators (particularly in the US and Europe) are in the midst of efforts to effect comprehensive reforms to their respective financial regulatory systems. While the principal focus of these efforts is domestic financial service institutions and financial markets, a number of proposals that are likely to be enacted would have an impact on hedge fund managers and fund service providers operating in Asia that provide products and/or services to US or European investors, even if the manager does not, otherwise, have a place of business in the US or Europe.
Although these financial reform efforts are not yet complete, based on sentiments reported by politicians and regulators involved in this process, the likely outcome of these efforts is starting to take shape. This article briefly summarises the most important proposals being debated in the US and Europe and their likely impact on the fundraising efforts by Asia-based hedge fund managers if adopted substantially as currently proposed.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the 'Act') is intended to be a comprehensive response to the global financial crisis and will bring about significant changes for Hong Kong hedge fund managers and service providers. In particular, the Act will require registration with the US Securities and Exchange Commission (SEC) on the part of many Hong Kong-based advisers of hedge funds that engage in fundraising efforts in the US on more than a sporadic or opportunistic basis as well as a comprehensive review of the adviser's policies and procedures to ensure compliance with best practice standards and the applicable provisions of the US Investment Advisers Act of 1940 (Advisers Act) prior to registration.
Changes to US Investment-Adviser Registration Requirements
Currently, many investment advisers, including many advisers to private funds such as hedge funds, may avoid registration with the SEC in reliance on the so-called 'private adviser exemption', which exempts from US registration requirements an investment adviser that (among other conditions) has fewer than 15 clients. For the purposes of this exemption, a private fund generally will count as a single 'client' and investment advisers located outside of the US must only count their US clients.
The Act will effectively rescind the private adviser exemption and replace it with an exemption from registration for any investment adviser that is a 'foreign private adviser,' which is defined as an investment adviser that, among other things, has:
- no place of business in the US;
- less than $25 million in aggregate assets under management that are attributable to clients in the US and investors in the US in private funds advised by the investment adviser;
- and fewer than 15 clients and private fund investors in the US.
Accordingly, any Hong Kong hedge fund adviser with more than 14 US clients and US investors in private funds or that manages $25 million or more of assets attributable to US clients and US investors, generally, would be required to register with the SEC. However, if the adviser does not have any US clients (as distinguished from investors in its funds) and sources less than $150 million of assets from US investors, it may be excused from registration, although it would still be subject to recordkeeping and reporting requirements. While the Act does not specifically address this point, US-registered investment advisers domiciled in Hong Kong presumably will still be able to rely on the 'regulation-lite' regime, under which the substantive provisions of the Advisers Act do not apply with respect to such advisers' management of non-US client accounts.
The revised registration provisions would become effective one year after the date of enactment of the Act, with the expectation that investment advisers will comply with the provisions of the Act prior to the expiration of the one-year transition period.
Recordkeeping and Reporting Obligations
Under the Act, the SEC would be able to require a registered adviser to a private fund to maintain and file with the SEC certain information relating to each private fund it advises that is relevant to the protection of investors and assessment of systemic risk. Any 'proprietary information' (as defined) would not be considered public information and accordingly, would be shielded from public disclosure, although the SEC would be required to make available to US regulators copies of all documents and information filed, and report annually to the US Congress on how the SEC has used the data it has collected.
Exemptions for Venture Capital Fund Advisers and Family Offices
The Act would provide exemptions from the registration requirements of the Advisers Act for investment advisers that provide investment advice solely to venture capital funds. The SEC would be required to define the term 'venture capital fund' and issue final rules regarding records to be maintained by advisers to such funds, as well as reports required by the SEC. The Act also would add a 'family office' exemption to the definition of 'investment adviser' under the Advisers Act, thus exempting family offices from the registration requirements thereunder, with the SEC to define the term 'family office' in a manner consistent with regulatory guidance provided in the past.
Revised US Investor Standards
Effective immediately upon approval of the Act, US 'accredited investor' standards will be boosted to require that individuals and couples must have a net worth in excess of $1 million excluding the value of their primary residence before investing in a private placement. The current standard includes the value of the primary residence. Accordingly, funds and administrators should promptly revise their offering materials and subscription monitoring procedures to screen for this revised standard.
Since the first draft of the Alternative Investment Fund Manager (AIFM) Directive was issued by the European Commission early last year and through each subsequent redraft since then, one key point of contention has remained – the right of 'third countries' (for example, non-EU members) to access EU-based investors. This is reflected in the draft directive by proposed restrictions on the marketing of non-EU funds by EU fund managers and on the marketing of EU funds by non-EU fund managers, unless they are authorised by the relevant EU country or otherwise meet requirements of equivalence to EU standards. These requirements pose significant practical hurdles to non-EU funds as well as many non-EU service providers and are of particular concern to Asia-based managers, many of whom have traditionally sourced investors from Europe.
Within the EU itself, opposing views on these proposed marketing restrictions have seen the European Parliament and the European Council each formally adopt different proposals in May this year, with the European Parliament advocating stricter restrictions on the passporting of funds, national private placement regimes and national government discretion.
Many factors have worked together to encourage the movement of asset managers to Asia (primarily Hong Kong and Singapore), thus compounding the issue faced by these non-EU managers under the directive, among them the trend towards general increased regulatory oversight in the US and Europe, income and profits tax initiatives, as well as funds seeking increased exposure to emerging markets and China, and investors raising allocations to Asia ex-Japan.
In terms of equivalence, Hong Kong is arguably in a better position than Singapore to satisfy EU standards with its own requirements for the registration of hedge fund managers, robust short-selling restrictions, independence of custodians and administration and proposals for increased reporting requirements. The Securities Futures Commission in Hong Kong has also recently introduced additional requirements to be observed by intermediaries in the investment product distribution process.
Singapore has recently done away with part of its previously much-touted exempt manager regime (which exempted fund managers servicing no more than 30 investors from the need to comply with full local licensing requirements), replacing it instead with the licensing of only larger-sized asset managers with AuM of S$250 million (approximately $183 million) and imposing a minimum capital requirement of S$250,000 (approximately $183,000) on smaller managers.
This development, which levels the playing field somewhat between the Hong Kong and Singapore licensing regimes, while still less onerous than the proposals potentially emanating out of the EU, is being closely monitored by the industry as a possible harbinger of additional future changes to the regulatory landscape in Asia.
Angelyn Lim is a partner in Dechert's financial services group in Hong Kong. She advises on the establishment of private equity, hedge and mutual funds and their registration in Hong Kong, as well as on Hong Kong securities-regulatory issues.
Keith Robinson leads Dechert's Asian financial services practice. His primary areas of concentration include unregistered investment vehicles and products, offshore funds and distribution issues, investment adviser and broker-dealer regulation, and representation of registered investment companies and their board members.
This article first appeared in HFMWeek (Pg 27, Hong Kong 2010 special report). For more details, please visit www.hfmweek.com