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Legal Framework For Hedge Fund Regulation
There is no statutory definition of the term "Hedge Fund." The industry accepted definition is that they are privately offered investment vehicles in which the contributions of the high net worth participants are pooled and invested in a portfolio of securities, commodity futures contracts, or other assets. Investors are typically able to redeem their investments on a quarterly, semi-annual or annual basis. A high net worth participant (or a qualified purchaser) as defined by Securities Exchange Commission (SEC) is an individual with an asset base of $ 1 million dollars and an institution or a fund or a trust with an asset base of $ 5 million. Apart from this statutory limit, investment in hedge funds is largely the preserve of sophisticated investors who possess the required knowledge to assess the risks associated with investing in this asset class.
Though the original purpose of hedge funds was to invest in equity securities and use leverage and short selling to "hedge" the portfolio's exposure to movements of the equity market, this remit has altered. Today, hedge fund advisers use labyrinthine investment strategies and techniques to increase investor returns and many are very active in the trading of securities, representing between nearly 20% of equity trading volume in the securities market.
Regulating The Hedge Funds
The most clamorous reasons cited by the votaries of regulating the Hedge Fund industry is the incredible growth of hedge funds and the increased influence and power that hedge funds are having on the financial markets. The industry is attacked for being secretive, engaged in risky behavior and capable of unduly influencing global economies and corporate activities. An increase in fraud cases involving hedge fund advisers, juxtaposing with an increase in exposure of unsophisticated small investors to the risks of hedge fund investing has enticed the policymakers and regulators to bring the hedge fund industry under greater scrutiny. Hedge Funds were largely held responsible for the South East Asian Economic crises in the late 1990s, the failure of the Long Term Capital Management Fund in the in 1990s and its subsequent $ 3.5 billion bailouts by the Federal Reserve Bank to prevent the cascading collapse of global financial markets; and the current surge of the Bombay Stock Exchange SENSEX, which even surprised the Indian Finance Minister as to comprehend the reasons for such a surge, creates an argument that some form of regulation should be encouraged for Hedge Funds.
There have been studies into the possibility of direct regulation undertaken over the past number of years by such bodies as the Basel committee on banking supervision, the International Organization of Securities Commissioners and probably most significantly, the president's working group on financial markets. However, no major regulatory body has advocated direct hedge fund regulation.
Even though there is no statutory obligation to make a public disclosure, hedge funds provide their potential investor with a private placement memorandum that discloses information about the overview and investment strategies of the hedge fund. The memorandum also provides the adviser with the maximum flexibility in selecting, shifting and modifying its strategies and arms him with broad discretion in valuing hedge fund's assets. Hedge Fund investors generally receive some ongoing performance information, risk analysis and portfolio profiles from their hedge fund advisors. Most hedge funds retain an auditor to conduct an independent audit which if certified is prepared using generally accepted accounting principles (GAAP). Market competition has also led to a growing demand by the investors for business-unit level SAS 70 assessment (Statement on Auditing Standards No.70 Service Organizations,) by reputed firms.
The hedge fund industry's main trade group in the Managed Funds Association, has laid down certain professional the guidelines in a publication called "Sound Practices for Hedge Fund Managers". It contains guidance about anti-money laundering policies, determining net asset value, risk monitoring and also a model "due diligence" questionnaire to enable the investors to question hedge fund managers.
Also though the much talked about performance fee figure is generally 20%, yet the common practice is that there is a "high water mark" that is often applied to its calculation. This means that the manager does not receive performance fees unless the value of the fund exceeds the highest net asset value it has previously achieved. This measure is intended to link the manager's interests more closely to those of investors and to reduce the incentive for managers to seek volatile trades. It is pertinent to keep in mind that these are more market competitive regulations than statutory regulations.
Most Hedge funds have substantial investments in securities that would cause them to fall within the definition of Investment Company under the Investment Company Act 1940 (Investment Act). However, Hedge Funds generally rely on one of two statutory exclusions from the definition of "Investment Company" which enables them to avoid the regulatory provisions of the Investment Act.
Section 3(c)(1) of the Investment Act, excludes from the definition of investment company any issuer whose outstanding securities(other than short-term paper) are beneficially owned by not more than 100 investors and which is not making and does not presently propose to make a public offering of its securities.
Section 3(c)(7) of the Investment Act excludes from the definition of the investment company any issuer whose outstanding securities are owned exclusively by persons who at the time of acquisition of such securities are "qualified purchasers" (high net worth individual) and which is not making and does not at the time propose to make public offering of its securities. Though a hedge fund relying on this provision may accept an unlimited number of qualified purchasers for investment in the fund, in practice, however, most funds refrain from signing up more than 499 investors in order to avoid the registration and reporting requirements of the Securities Exchange Act,1934 (Exchange Act).
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