Focus: Further consultation on new disclosure rules for retail hedge funds
16 March 2012
In brief: As anticipated, the Australian Securities and Investments Commission has released a further consultation paper in response to submissions on the new disclosure rules for retail hedge funds and funds of hedge funds, and has released a draft regulatory guide. Partner Susan Burns , Senior Associate Marc Kemp and Lawyer Dora Chan look at the proposed benchmarks and disclosure requirements, and the difficulties that some of them may pose.
- Who do the disclosure requirements apply to?
- Interaction with the shorter PDS regime
- Disclosure requirements
- Are the disclosure requirements appropriate?
- Timing and next steps
How does it affect you?
- ASIC Consultation Paper 174 (CP 174) contains proposals (including a draft regulatory guide) that, if implemented, will require detailed disclosures to be made by any registered managed investment scheme that can be described as, or promotes itself as, a 'hedge fund' or a 'fund of hedge funds'.
- The issuer of hedge fund products would be required to include detailed disclosures in its Product Disclosure Statement (PDS) on a prescribed list of matters that the Australian Securities and Investments Commission (ASIC) considers necessary for retail investors to make a fully informed investment decision. The list includes the fund's investment strategy and holdings, information on the use and source of fund-level leverage, and details of the use of derivative and short-selling strategies.
- Hedge funds are excluded from the shorter PDS regime until further notice.
- Submissions on CP 174 are requested by 19 April 2012. ASIC expects to release a regulatory guide by mid-2012.
The proposed disclosure rules will apply to any registered managed investment scheme that 'is, or has been promoted as, or is generally regarded as (a) a hedge fund; or (b) a fund of hedge funds'. ASIC has listed broad 'indicative factors' to assist issuers of hedge fund products to determine whether or not the disclosure requirements will apply. These include whether a fund:
- pursues 'complex strategies' that aim to generate absolute returns;
- uses leverage to increase investment returns, derivatives to create complex investment strategies or for gearing purposes, or engages in short selling techniques; and
- has exposure to 'diverse risks and complex underlying products'.
ASIC considers that a fund that satisfies only one indicative factor may be caught by the definition. If the issuer is uncertain about whether a fund is caught, it is expected to follow the disclosure requirements to the relevant extent, or seek clarification from ASIC.
Where a hedge fund invests 25 per cent or more of its assets in an underlying hedge fund or structured product, the disclosure requirements are taken to apply to the underlying fund or structured product. Disclosure is expected for each underlying fund, or each structured product and the product's reference assets. These disclosures are additional to disclosures for the hedge fund itself. If a hedge fund invests in a number of underlying hedge funds or managed accounts with common or related managers, each of those investments should be aggregated for the purposes of determining whether the 25 per cent threshold is satisfied, and, if it is, disclosure for each such underlying fund or managed account is required.
The enhanced disclosure requirements do not apply to issuers that are not registered managed investment schemes (eg investment companies and unregistered wholesale funds). However, ASIC has made it clear that it thinks the enhanced disclosure requirements would be equally useful to institutional investors, and that there may be merit in 'encouraging' wholesale funds to comply with the disclosure requirements.
The good news for hedge funds is that the Federal Government indicated in December 2011 that hedge funds are to be excluded from the shorter PDS regime until further notice. The consultation paper affirms this approach, although the final legislative or regulatory step to give effect to the exclusion remains to be taken.
The proposed disclosure requirements are in the form of two benchmarks, and a detailed and prescriptive list of disclosure principles. First, the issuer of a hedge fund product is required to address the following two benchmarks on an 'if not, why not' basis. In other words, if the issuer does not meet a benchmark, it must explain why not, and how it addresses the factor or issue underlying the benchmark in its PDS.
- Valuation and custody of assets: the issuer is expected to implement a policy that requires: (a) the valuations of assets that are not exchange traded to be provided by independent third-party administrators; and (b) all custodians (including of any underlying funds) to be unrelated to the issuer or investment manager of the hedge fund.
- Periodic reporting: the issuer is expected to provide certain information on an annual basis (including current funds under management, actual allocation to asset type, liquidity profile of assets at the end of the period, investment returns over a five-year period and key service providers) and other information on a monthly basis. The information is expected to be available on the hedge fund's website.
Further, each hedge fund's PDS would need to include disclosures addressing the following disclosure principles:
- a fund's investment strategy (including detailed information on asset classes targeted, any assumptions underpinning the strategy, diversification limits, the key risks inherent in implementing the strategy, the fund's risk management strategy, the role of leverage, derivatives and short-selling);
- the terms of the management arrangements applying to a fund (including the identity and experience of senior investment personnel, and the proportion of their time each manager will devote to executing the fund's investment strategy, unusual or onerous terms in management agreements, and circumstances in which the manager's appointment can be terminated);
- a fund's downstream investment structure (including details of holding structures, identity of jurisdictions involved, details of due diligence undertaken on investments, the identity of service providers and intermediaries, the existence of any related relationships in the structure, and the fees and costs paid at each level of a tiered fund structure);
- a fund's investment holdings (including details of valuation policies and custody arrangements, the types of assets and the allocation range of each asset type, and geographic location of material assets);
- a fund's liquidity (including a description of illiquid classes of assets of more than a 10 per cent threshold and key aspects of the fund's liquidity management policy);
- detailed information on leverage at both a fund and investment level (including the sources, amount and providers of leverage, details of assets used as collateral, anticipated levels of leverage (including leverage embedded in fund assets) and a worked example of the impact of leverage on investment returns);
- information on the use of derivatives, structured products and short-selling (including the rationale for using derivatives, structured products or short-selling, the types of products used and the criteria for engaging, and identity of, counterparties); and
- details of the terms on which investors can withdraw from the fund (including full disclosure of the limitations applying to withdrawals such as gating restrictions).
Failure to include the disclosure required under the proposed rules may result in ASIC issuing a 'stop order' on the PDS in question.
Although we agree with the rationale behind the proposals, we are concerned about their practical implications. In particular, we are concerned about what is, in our view, a lack of certainty in the definition of 'hedge fund', the disclosure of potentially sensitive or unhelpful information, and a lack of flexibility.
While we appreciate the difficulty that ASIC faces in defining the nature of a hedge fund, in our view the definition of hedge fund remains unsatisfactory. The current definition means that a fund that is, objectively, not a hedge fund must comply with the disclosure requirements because it is 'generally regarded' (by whom is not clear) as a hedge fund. In our view, an undue emphasis on what the fund is called or how it is regarded may result in a lack of certainty. However, ASIC is proposing to retain this definition. We are also concerned that the indicative factors are not easy to apply. For example, it is not clear to us what 'complex strategies' or 'diverse risks and complex underlying products' may be.
While we agree with the principle of improving disclosure of complex products to retail investors, we are concerned that the more detailed and prescriptive disclosure requirements may unnecessarily burden or restrict issuers, and in some cases may ultimately prove to be confusing or irrelevant for retail investors. Our concerns include the following:
- The requirement that funds of hedge funds disclose against the benchmarks and principles for each underlying fund in which the fund of hedge funds has invested 25 per cent or more of its assets is onerous; would entail obtaining and preparing information that may not be readily available; imposes disclosure risk on the fund of hedge funds, which will have to rely on information provided by a third party; and may make it more difficult for a fund of hedge funds to move assets from one underlying hedge fund to another, reducing the flexibility that is a hallmark of the sector.
- Some categories of required information may ultimately be of little assistance to investors. One example is risk management strategies, which may not be helpful, given the degree of complexity that these policies may entail. It may be sufficient for investors to know that risk management plans are currently covered in the compliance plan and audited by the compliance plan auditor. Another example is the requirement that the PDS disclose the proportion of the time of key investment personnel devoted to a fund's investment strategy. In a large fund manager with more than one fund, this information may be difficult to determine, and may be of little value to investors.
- Aspects of the principles against which issuers are required to disclose are unclear, or may impose a significant compliance cost on issuers without an apparent benefit to investors. For example, issuers are required to disclose 'leverage embedded in the assets of the fund'. 'Embedded leverage' presumably refers to the leverage of the underlying investment (eg the debt to equity ratio of a company whose securities the fund holds). If that is correct, this information may be very difficult to obtain, verify and meaningfully consider as part of the leverage of the fund. This information may also change without the fund being aware of the change. Although the benchmark reporting requirement excludes leverage 'embedded' in listed equities and bonds, the relevant disclosure principle does not.
ASIC is currently seeking feedback on its further consultation and the draft regulatory guide, and comments must be made by 19 April 2012. ASIC expects to release a regulatory guide by mid-2012.
- Penny NikoloudisPartner,
Ph: +61 2 9230 4805
- Mark CerchéConsultant,
Ph: +61 3 9613 8872
- John BeckinsalePartner,
Ph: +61 7 3334 3520