Following a summer of crisis in the financial markets, the last thing hedge fund managers want now is a regulatory clampdown, but they are facing one nonetheless. European and American regulators have raised concerns about the threat to economic stability amid high-profile blow ups of funds caught out by the credit crunch.

The industry has tried to head off a regulatory clampdown by governments increasingly concerned with their influence by coming up with a voluntary code of practice. In London, Sir Andrew Large, a former deputy-governor of the Bank of England, is leading a hedge fund working group, which has published a draft industry-backed governance code. The group is hoping that a ‘comply or explain’ approach to the code will be enough to fend off any calls for tougher regulation.

The code calls on hedge funds to voluntarily disclose interests in companies held through indirect investments, to bolster strategies to weather big market swings, and to detail procedures followed in putting valuations on illiquid assets such as sub-prime debt, among other provisions. “We certainly hope that this might reduce somewhat the appetite of governments to regulate,” said Mr Large.

Complacent attitude
UK regulator the Financial Services Authority doesn’t seem convinced. It recently slammed the ‘complacent attitude’ of hedge funds towards setting up internal controls to prevent market abuse, for example. Those comments stemmed from a series of inspection visits, which were part of a wider regulatory inquiry into whether hedge funds have been abusing the market.

“Some hedge fund managers had a high level of awareness and appropriate controls in place, while others were less aware, had fewer controls and demonstrated a complacent attitude to the risks. We are disappointed by some of what we saw,” the FSA said. “We will be following up with the firms visited and are launching a programme of visits to a wider cross section of managers over the coming months to assess formally their market abuse systems and controls.”

And legislation is certainly on the agenda in Germany, where hedge funds have made themselves unpopular, and many politicians and business figures disparage them as ‘locusts.’ When a London-based fund blocked Deutsche Börse’s bid for the London Stock Exchange two years ago, causing the departure of its chief executive, Werner Seifert, the government decided something had to be done. In September this year it finally tabled draft laws that would crack down on the behaviour of such investors. But corporate governance activists are outraged, saying the legislation would hamper their efforts to raise boardroom standards and encourage responsible share ownership.

Wider definition
The important part of the proposed Risk Reduction Act is a new and wider definition of what it means for one investor to be ‘acting in concert’ with another. German law already requires investors who own more than 30 percent of a company to launch a bid for the rest if they are working together, and to make disclosures about their plans. But last year an important court ruling significantly narrowed the situations where this applied, effectively limiting its scope to co-ordinated voting at annual shareholder meetings. Now the government is tabling new laws to undo that court ruling and cast the net wider.

The new law deems investors to be acting in concert if they co-operate to ‘permanently or extensively’ influence a company’s corporate policy and it extends to co-ordination outside of public shareholder meetings. The investors’ reasons for working together “would not necessarily be relevant,” according to a briefing note from lawyers Clearly Gottlieb. Whether they are working together to improve corporate governance or to launch a hostile takeover bid, the law treats them the same, it would seem.

The lack of clarity on this point has worried corporate governance bodies. The International Corporate Governance Network (ICGN), a global member body that represents investors with assets of $15trn, has raised its fears with the German government. “The ICGN is concerned that the proposed law will introduce uncertainty as to whether shareholders discussing corporate governance matters might be captured within the concert party rules,” wrote its executive director, Anne Simpson. That uncertainty would discourage shareholders from talking to each other, she said, or would limit their discussions to governance issues that had already been aired in the media. “Neither of these approaches is conducive to a system of good governance.”

Shareholders must be able to discuss their concerns privately so that they can clarify issues and agree the corrective action that they want a company to take, said Ms Simpson. “This means that companies get a clear and unambiguous message from their shareholders and often some constructive suggestions for improving practice.”

Other corporate governance groups share these concerns. Hermes, one of Europe’s most influential fund managers, has written to the government saying the acting in concert rules would lead to a ‘significant weakening’ of the corporate governance system because of the effect it would have on constructive private dialogue. It would also be ‘counter productive’ to the government’s attempt to make sure that short-term investors do not have disproportionate influence.

“The new definition of acting in concert would create a lot of legal uncertainty and may expose investors to legal risks, simply for talking ahead of annual general meetings or even talking to companies during the year about common concerns they share,” says Hans-Christophe Hirt, associate director of Hermes Equity Ownership Service, part of the fund management group. “That would hinder the useful dialogue we are currently having with companies in Germany and is likely to lead to a more public and confrontational style of activism.”

Effective
Mr Hirt says that other investors have contacted Hermes to support its stance. There is talk of a campaign. “We are considering different options and trying to figure out the most effective way forward, given the timetable for consultation,” he says. The government plans to have the law effective by January 1, 2008.

The ‘concert party’ issue is not limited to Germany. “There is a great deal of uncertainty across all major markets – except for the UK – about what shareholders can do ahead of an annual meeting and when they are in concert party territory,” says Mr Hirt. “What is clear is that the German definition is the widest that we have come across so far.”

While the measures in the Risk Reduction Act have come in for criticism, Carsten Grau, head of regulatory matters in the Hamburg office of lawyers DLA Piper, says they are better than some of the alternatives the government considered. These included measures aimed directly at investors, such as screening them to weed out the undesirable locusts. These would have increased the compliance burden, for both regulators and investors, and “would have had a tremendously disadvantageous effect,” says Mr Grau. More recently, politicians have come to realise that Germany needs foreign investors, says Mr Grau, and, “If we protect our economy too much, these investors will shy away.”

By comparison, the Risk Reduction Act “is a soft solution, which is much better,” he says. But does that mean it is a good idea? “This is a very political question,” he says. Under German law, a move by shareholders to act in concert is considered dangerous to companies, he says, and it is difficult to thwart the plans of ‘undesirable’ short-term investors without catching others in the same net. “Of course there are black sheep in the markets,” he says. “But how can you define them? There are no criteria available. It’s a problem that you cannot solve by means of legislation.” Legislation, however, is the government’s chosen weapon. In swatting the locusts it might also damage the work of some more desirable investors.

Spearhead
Germany’s enthusiasm for legislation has importance beyond its domestic markets because the country’s finance ministry is spearheading an inquiry into the sub-prime crisis by the G7 group of industrialised nations. “It’s the duty of the G7 to look at where there could be black holes in financial markets and black holes are always the source of future crises,” said Thomas Mirow, Germany’s deputy finance minister. As G7 president, Germany has been lobbying for greater hedge-fund disclosure and transparency.

Mario Draghi, Chairman of the Financial Stability Forum, the G7 body that is conducting the review, said recently that the hedge fund sector “has not been the primary source of the recent market turmoil.” But he added that “the severity of market problems has highlighted the importance of ensuring sound counterparty risk management at regulated institutions and fostering the exchange of relevant information between hedge funds and their counterparties.”

Mr Draghi said progress had been made in this area, citing the code produced in London and a similar initiative in the US. His group issued a special report on “Highly Leveraged Institutions” in May, before the crunch started to bite – work on its recommendations is underway, he said.

That report made four recommendations for regulatory action: strengthen the counterparty risk management practices at core intermediaries, work with them to improve their “robustness to the potential erosion of market liquidity,” explore the extent to which developing more systematic and consistent data on core intermediaries’ consolidated counterparty exposures to hedge funds would be an effective complement to existing supervisory efforts, strengthen the effectiveness of market discipline, including obtaining accurate and timely portfolio valuations and risk information. The fifth recommendation called on the global hedge fund industry to “review and enhance existing sound practice benchmarks for hedge fund managers in the light of expectations for improved practices set out by the official and private sectors.” Which is official speak for buck your ideas up.

Careful consideration
More widely, Mr Draghi said that “the events in financial markets of recent months, and their underlying causes, have raised issues that require careful consideration by market participants and financial policymakers. Many of the weaknesses in the underpinnings of the structured finance markets and in risk management practices will be addressed through adjustments in the private sector.  The authorities will need to monitor and reinforce these changes and take action where additional discipline is required to make markets more resilient.”

The FSF has created a working group to move this forward. It includes national authorities, the chairs of the relevant international supervisory, regulatory and central banking bodies and other international organisations. “The working group will investigate the causes of these events, identify the weakness that merit attention and recommend actions needed to enhance market discipline and institutional resilience,” he said. Areas it will address include liquidity and credit risk management practices at regulated financial institutions; valuation, risk disclosure and accounting practices related to structured credit instruments; the role of credit rating agencies in the structured finance market; and principles and practices of prudential oversight.  The group will also review the way that regulators and other authorities responded to events. Its report should be with G7 ministers by April 2008.

Is all that official pondering likely to lead to a tougher regulatory climate for hedge funds? It will be a miracle if it doesn’t.