| There is no statutory definition of the term | | | | advisor that it will not be liable under ERISA for |
| "Hedge Fund." The industry accepted definition is | | | | any misconduct on the part of the hedge fund |
| that they are privately offered investment | | | | adviser in managing plan assets. |
| vehicles in which the contributions of the high net | | | | The Commodity Futures Trading Commission |
| worth participants are pooled and invested in a | | | | (CFTC) provides hedge fund advisors exemptions |
| portfolio of securities, commodity futures | | | | from Commodity Pool Operator (CPO) and |
| contracts, or other assets. Investors are typically | | | | Commodity Trading Advisors (CTA) registration. |
| able to redeem their investments on a quarterly, | | | | Though they are required to keep the books of |
| semi-annual or annual basis. A high net worth | | | | record, but can avoid disclosure, periodic reporting |
| participant (or a qualified purchaser) as defined by | | | | or audit requirements that apply to a registered |
| Securities Exchange Commission (SEC) is an | | | | CPO/CTA. Regulations under the Commodity |
| individual with an asset base of $ 1 million dollars | | | | Exchange Act (CEA) provide an exemption from |
| and an institution or a fund or a trust with an | | | | registration to CPOs operating pools that engage |
| asset base of $ 5 million. Apart from this | | | | in limited commodity futures activities and sell |
| statutory limit, investment in hedge funds is | | | | interests solely to certain qualified individuals and |
| largely the preserve of sophisticated investors | | | | that sell interests to highly sophisticated pool |
| who possess the required knowledge to assess | | | | participants. Investment advisors to Hedge funds |
| the risks associated with investing in this asset | | | | that operate in reliance upon Section 3(c)(7) of |
| class. | | | | the Investment Act may be able to rely upon |
| Though the original purpose of hedge funds was | | | | one of these CFTC exemptions. Like the Advisors |
| to invest in equity securities and use leverage and | | | | Act's de minimis exemption CEA also provides a |
| short selling to "hedge" the portfolio's exposure to | | | | similar de minimis exemption from CTA |
| movements of the equity market, this remit has | | | | registration. |
| altered. Today, hedge fund advisers use | | | | Sections 352 of the USA Patriot Act require |
| labyrinthine investment strategies and techniques | | | | every "financial institution" to establish an |
| to increase investor returns and many are very | | | | anti-money laundering program that meets certain |
| active in the trading of securities, representing | | | | minimum requirements, especially related to anti |
| between nearly 20% of equity trading volume in | | | | money laundering procedures. In addition to |
| the US securities market. | | | | adopting an anti money laundering program, these |
| Regulating the Hedge Funds | | | | entities would be required to provide a written |
| The most clamorous reasons cited by the | | | | notice to the Treasury within 90 days of |
| votaries of regulating the Hedge Fund industry is | | | | becoming subject to the rule. |
| the incredible growth of hedge funds and the | | | | Regulations in India: |
| increased influence and power that hedge funds | | | | With the notification of SEBI (Mutual Fund) |
| are having on the financial markets. The industry | | | | Regulation 1993, the asset management business |
| is attacked for being secretive, engaged in risky | | | | under private sector took its root in India. In the |
| behavior and capable of unduly influencing global | | | | same year SEBI also notified Regulations and rules |
| economies and corporate activities. An increase in | | | | governing portfolio managers who pursuant to a |
| fraud cases involving hedge fund advisers, | | | | contract or arrangement with clients, advice |
| juxtaposing with an increase in exposure of | | | | clients or undertake the management of portfolio |
| unsophisticated small investors to the risks of | | | | of securities or funds of the client. There are no |
| hedge fund investing has enticed the policymakers | | | | hedge funds domiciled in India and they are not |
| and regulators to bring the hedge fund industry | | | | allowed to raise funds from the domestic market. |
| under greater scrutiny. Hedge Funds were largely | | | | Further, on account of limited convertibility, |
| held responsible for the South East Asian | | | | offshore hedge funds have yet to offer their |
| Economic crises in the late 1990s, the failure of | | | | products to Indian investors within India. The RBI |
| the Long Term Capital Management Fund in the | | | | through liberalized remittance scheme has allowed |
| US in 1990s and its subsequent $ 3.5 billion bailout | | | | resident individuals to remit up to US $ 25,000 per |
| by the Federal Reserve Bank to prevent the | | | | year for any account or for capital account |
| cascading collapse of global financial markets; and | | | | transaction. This liberalized scheme will allow |
| the current surge of the Bombay Stock | | | | individual investors to explore the possibility of |
| Exchange SENSEX, which even surprised the | | | | investing in offshore financial products. |
| Indian Finance Minister as to comprehend the | | | | The current fiscal year has seen a spectacular |
| reasons for such a surge, creates an argument | | | | growth in FII investment activities and they |
| that some form of regulation should be | | | | account for nearly 30% of FII inflows into the |
| encouraged for hedge Funds. | | | | Indian market. Robust economic fundamentals, |
| There have been studies into the possibility of | | | | strong corporate earnings and improvement in |
| direct regulation undertaken over the past number | | | | market micro structure are driving the FII interest |
| of years by such bodies as the Basel committee | | | | in India. With such fundamentals, hedge funds |
| on banking supervision, the International | | | | have evinced keen interests and would like to |
| Organization of Securities Commissioners and | | | | directly invest in Indian markets as a registered |
| probably most significantly, the US president's | | | | entity under the SEBI (Foreign Institutional |
| working group on financial markets. However, no | | | | Investors) Regulations, 1995 (FII Regulations). |
| major regulatory body has advocated direct | | | | Hedge funds typically invested in the offshore |
| hedge fund regulation. | | | | derivatives instruments (Participatory Notes (PNs)) |
| Self Regulations: | | | | issued by FII against the underlying Indian |
| Even though there is no statutory obligation to | | | | securities. Through this route the hedge funds |
| make a public disclosure, hedge funds provide | | | | could derive economic benefits of investing in |
| their potential investor with a private placement | | | | Indian securities without directly entering the |
| memorandum that discloses information about the | | | | Indian market as FIIs or their sub-accounts. As of |
| overview and investment strategies of the hedge | | | | October '07 there were more than 1,100 |
| fund. The memorandum also provides the adviser | | | | registered foreign investors and 3,447 registered |
| with the maximum flexibility in selecting, shifting | | | | sub-accounts. |
| and modifying its strategies and arms him with | | | | Through recent amendments to the FII |
| broad discretion in valuing hedge fund's assets. | | | | Regulations (Regulation 15A and 20 A), the |
| Hedge Fund investors generally receive some | | | | Regulatory regime has been further strengthened |
| ongoing performance information, risk analysis and | | | | and periodic disclosures regime has been |
| portfolio profiles from their hedge fund advisors. | | | | introduced. The provision 15 (3)(a) of the FII |
| Most hedge funds retain an auditor to conduct an | | | | Regulations relates to the prohibition on short |
| independent audit which if certified is prepared | | | | selling of securities by FIIs. It allows that FIIs may |
| using generally accepted accounting principles | | | | transact business only on the basis of taking and |
| (GAAP). Market competition has also led to a | | | | giving deliveries of securities bought and sold, and |
| growing demand by the investors for | | | | cannot engage in short-selling securities. Further |
| business-unit level SAS 70 assessment | | | | regulation 6(1)(b) of FII Regulations, provides that |
| (Statement on Auditing Standards No.70 Service | | | | the hedge fund have to be registered with the |
| Organizations,) by reputed firms. | | | | statutory regulatory authority in their place of |
| The hedge fund industry's main trade group in the | | | | incorporation. Most Hedge funds would fail to |
| US, Managed Funds Association, has laid down | | | | meet this criterion because they are not |
| certain professional the guidelines in a publication | | | | registered with any regulatory authority, nor are |
| called "Sound Practices for Hedge Fund Managers". | | | | the managers registered with regulatory |
| It contains guidance about anti-money laundering | | | | authorities. |
| policies, determining net asset value, risk | | | | In October '07 SEBI has mandated that in the |
| monitoring and also a model "due diligence" | | | | spot market, FII will not be allowed to issue |
| questionnaire to enable the investors to question | | | | P-notes that were more than 40 per cent of their |
| hedge fund managers. | | | | assets under custody and those FII over the |
| Also though the much talked about performance | | | | threshold will have to freeze their holdings. FIIs |
| fee figure is generally 20%, yet the common | | | | that have issued P-notes below the limit may |
| practice is that there is a "high water mark" that | | | | increase issuances at an incremental rate of 5 per |
| is often applied to its calculation. This means that | | | | cent of their assets under custody, he said. Also |
| the manager does not receive performance fees | | | | the reference date for calculating such assets will |
| unless the value of the fund exceeds the highest | | | | be September 30, which is the latest date for |
| net asset value it has previously achieved. This | | | | which data is available. |
| measure is intended to link the manager's | | | | The FII Regulations allow sub accounts sponsored |
| interests more closely to those of investors and | | | | by registered FIIs to invest in India. Regulations 2 |
| to reduce the incentive for managers to seek | | | | (k) defines "sub-account" which "includes foreign |
| volatile trades. It is pertinent to keep in mind that | | | | corporate or foreign individuals and those |
| these are more of market competitive regulations | | | | institutions, established or incorporated outside |
| than statutory regulations. | | | | India and those funds or portfolios, established |
| Statutory Regulations in the US: | | | | outside India, whether incorporated or not on |
| Most Hedge funds have substantial investments in | | | | whose behalf investments are proposed to be |
| securities that would cause them to fall within the | | | | made in India by a foreign institutional investor". |
| definition of Investment Company under the | | | | Further provisions of regulation 13 lay down the |
| Investment Company Act 1940 (Investment | | | | conditions and the procedure for granting |
| Act). However, Hedge Funds generally rely on one | | | | registration to a sub-account of an FII. But the |
| of two statutory exclusions from the definition of | | | | October '07 SEBI mandated new guidelines, under |
| "Investment Company" which enables them to | | | | which FII currently registered in India will not be |
| avoid the regulatory provisions of the Investment | | | | allowed to issue new derivatives from |
| Act. | | | | sub-accounts based in tax havens such as |
| Section 3(c)(1) of the Investment Act, excludes | | | | Mauritius. |
| from the definition of investment company any | | | | However in practice if an applicant indicates in the |
| issuer whose outstanding securities(other than | | | | application that it is a Hedge Fund, the |
| short term paper) are beneficially owned by not | | | | consideration of the application is generally |
| more than 100 investors and which is not making | | | | withheld. Since granting of registration to FII |
| and does not presently propose to make a public | | | | sub-accounts is based on the disclosure of the |
| offering of its securities. | | | | details and on the undertaking given by the |
| Section 3(c)(7) of the Investment Act excludes | | | | applicant in the application form; it could be |
| from the definition of the investment company | | | | possible that the few entities who described their |
| any issuer whose outstanding securities are | | | | activities in the application form in terms other |
| owned exclusively by persons who at the time of | | | | than Hedge Funds could have already got |
| acquisition of such securities are "qualified | | | | registration as sub-accounts. However it is |
| purchasers" (high net worth individual) and which is | | | | mandatory that the sub accounts have to be |
| not making and does not at the time propose to | | | | sponsored by registered FIIs who are required to |
| make public offering of its securities. Though a | | | | be regulated entities by relevant regulators in their |
| hedge fund relying on this provision may accept | | | | home countries. |
| an unlimited number of qualified purchasers for | | | | Chapter II of the SEBI (Foreign Institutional |
| investment in the fund, but in practice, however, | | | | Investors) Regulations, 1995 interalia lists out the |
| most funds refrain from signing up more than | | | | instruments in which an FII/sub-account can |
| 499 investors in order to avoid the registration | | | | invest. The regulation does not include currency or |
| and reporting requirements of the Securities | | | | commodities as eligible instruments for investment |
| Exchange Act,1934 (Exchange Act). | | | | for the FII. Therefore, currency trading or |
| The Exchange Act contains the registration and | | | | investment in commodity related financial products |
| reporting provisions that may apply to Hedge | | | | will not be an option for any hedge fund under |
| funds. Section 12 of the Exchange Act and the | | | | the present FII Regulations. |
| rules promulgated there under govern the | | | | The FII Regulations also lays down scrip-wise and |
| registration of classes of equity securities traded | | | | fund wise maximum limits a fund can invest. |
| on an exchange or meeting the holder of record | | | | Further, through circular dated February 12, 2002 |
| and assets tests of section 12 (g) and related | | | | and March 9, 2004 issued in the Secondary |
| rules. Section 12(g) and rules 12 (g)(1) there under | | | | Market Department, position limits for investment |
| require that an issuer having 500 holders of | | | | by FII in derivatives have been advised. These |
| record of a class of equity security (other than an | | | | limits will help diversify the foreign hedge fund |
| exempted security) and assets in excess of $10 | | | | investments and further help in jettisoning |
| million at the end of its most recently ended fiscal | | | | concentration in any specific scrip. The |
| year register the equity under the Exchange Act. | | | | government wants to keep the hedge funds out |
| Registration of a class of equity security subjects | | | | of short selling at least in the cash segment and |
| domestic restraints to the periodic reporting | | | | thus provisions of chapter III (Regulation 15 (3) |
| requirements of section 13, proxy requirements | | | | (a)) disallows short selling by FII and stipulates that |
| of section 14 and insider reporting and short swing | | | | all trades by FII be delivery based. |
| profit provisions of section 16 of the exchange | | | | The Money Laundering Act, 2003, is an |
| Act. To avoid registration most hedge funds have | | | | endorsement of various international conventions |
| not more than 499 investors affiliated to a | | | | to which India is signatory. It adequately |
| particular fund. | | | | empowers the state authorities to declare |
| The Beneficial ownership reporting rules under | | | | laundering of monies a criminal offence. Working |
| sections 13(d) and 13(g) of the Exchange Act | | | | out modalities of disclosure by financial institutions |
| generally require that any person who beneficially | | | | regarding reportable transactions, confiscation of |
| owns greater than 5% of the class of equity | | | | the proceeds of crime, declaring money laundering |
| securities, file a beneficial ownership statements | | | | as an extraditable offence and promoting |
| (schedule 13D or 13G). Hedge fund advisors also | | | | international cooperation in investigation of money |
| may be subject to the quarterly reporting | | | | laundering is the main aim of the act. It also |
| obligations of section 13(f) of the Exchange Act, | | | | provides for reciprocal arrangement for assistance |
| which apply to any "institutional investment | | | | in certain matters and procedure for attachment |
| manager" exercising investment discretion with | | | | and confiscation of property to facilitate transfer |
| respect to accounts having an aggregate fair | | | | of funds involved in money laundering kept |
| market value of at least $100 million in equity | | | | outside the country and extradition of the |
| securities. An institutional investment manager | | | | accused person from abroad. |
| includes any person(other than natural person) | | | | CONCLUSION: |
| investing in or buying and selling securities for its | | | | Hedge Funds as a whole are becoming a |
| own account, and any person exercising | | | | prominent segment of the asset management |
| investment discretion with respect to the account | | | | industry and gaining popularity from investors |
| of any other person. | | | | particularly from high net worth investors, |
| Section 16 applies to every person who is the | | | | universities, charitable funds, endowments, pension |
| beneficial owner of more than 10% of any class | | | | funds, insurance and other institutional investors. |
| of equity security registered under section 12 of | | | | Most hedge fund managers are embracing the |
| the Exchange Act and each officer and director | | | | new sources of capital from institutional investors, |
| of the issuer of the security (collectively, | | | | who are, by their very nature, highly regulated |
| "reporting persons"). Upon becoming a reporting | | | | and their investments scrutinized. They encourage |
| person, a person is required by section 16(a) to | | | | the hedge funds to improve their internal controls |
| file an initial report with the SEC disclosing the | | | | to meet the Alpha requirements. |
| amount of his or her beneficial ownership of all | | | | The assets under management of the hedge |
| equity securities of the issuer and also any | | | | funds are growing on a double digit rate and it is |
| subsequent changes thereafter. Hedge funds are | | | | estimated that worldwide the Hedge Fund |
| also subject to the short swing profit provisions | | | | industry is nearly $3 trillion dollars. This has created |
| of section 16 (b) of the exchange act. | | | | a lot of disquietude for financial regulators as |
| The Investment Advisors Act, 1940s (Advisors | | | | Hedge funds are able to influence markets in a |
| Act) regulates the actions of investment advisers. | | | | more radical manner than they would do so when |
| Many hedge fund advisors, however, avoid | | | | they first started. |
| registering with the SEC by relying on the | | | | In India the issues are intended to widen the FII |
| Advisors Act de minimisexemption under section | | | | inflow and to allow these alternatives investment |
| 203(b) by having fewer than 15 clients during the | | | | pools to our securities market in a transparent |
| preceding 12 months, For the purposes of section | | | | and orderly manner. In addition, the suggestions |
| 203(b), current SEC rules provide that investment | | | | also provide for adequate safety measures to |
| advisors may count a "legal organization" such as | | | | address legitimate concerns associated with these |
| a hedge fund as a single client. | | | | funds. |
| Investment advisors that are exempt from | | | | Most industry people are of the view that |
| registration nevertheless are subject to the | | | | regulation is welcome and good but only if it does |
| antifraud provisions of the Advisors Act. But it is | | | | not impinge on innovation, competitiveness and |
| pertinent to know that many hedge fund | | | | the industry's ability to evolve. It's all about |
| managers due to market competition do register | | | | educating the investors and ensuring they know |
| with the commission voluntarily because the | | | | what they are getting into. |
| investors demand it. The SEC's attempt in | | | | Hedge Funds bring liquidity to capital markets, and |
| December 2004 to require hedge fund managers | | | | also make capital markets more efficient because |
| to register under the Advisers Act failed when it | | | | they scour the financial landscape for inefficiencies, |
| was challenged in court and the SEC was asked | | | | and then use expertise to structure the optimal |
| to review the requirement (Philip Goldstein v SEC | | | | investment to take advantage of the opportunity. |
| (2006)). | | | | They have been instrumental in transforming the |
| The Employee Retirement Income Security Act | | | | investment landscape, making it much broader |
| (ERISA) plans are very alluring from the point of | | | | than equities, bonds and property. Hedge funds |
| investment and some hedge fund advisors accept | | | | have acted as a beachhead in new investment |
| regulations under the ERISA in order to have an | | | | strategies, including middle market lending, |
| access to ERISA pension funds. An investment | | | | asset-backed lending, credit derivatives, |
| advisor to a hedge fund is an Employee | | | | reinsurance, and carbon credits.The greater |
| Retirement Income Security Act (ERISA) plan | | | | challenge for the regulators is as to how to |
| fiduciary if it exercises discretionary authority | | | | increase compliance and protect investors without |
| over the management of "plan assets". The | | | | making hedge fund managers relocate to |
| assets of a hedge fund are deemed to be "plan | | | | unregulated jurisdictions. |
| assets" if an ERISA plan's investment is deemed | | | | The governments, central banks and the |
| to be significant (25%), a benchmark that many | | | | regulating agencies have to make a choice |
| hedge funds want to keep under. Generally, hedge | | | | between the efficaciousness of a regulation and |
| fund adviser can shield ERISA plan fiduciaries from | | | | the price involved in complying with it. As for the |
| liability for its misconduct by registering as an | | | | Hedge funds, an investment sector wary of |
| investment adviser under the Advisers Act, and | | | | watchdogs after years of being unregulated, |
| by qualifying as an "investment manager" under | | | | regulators will need to persuade fund managers |
| ERISA. Before investing plan assets in hedge fund, | | | | that the free flow of information and open |
| however, the non-advisor ERISA plan fiduciary | | | | dialogue are essential, and that intervention will |
| typically will require assurances from hedge fund | | | | only come where market stability is at stake. |