FSA CEO Examines Hedge Fund Valuations and Transparency

While noting that hedge funds were not the catalyst of the market crisis, UK Financial Services CEO Hector Sants said that reform of hedge fund valuations and transparency will be needed to restore investor confidence. In remarks at the 2008 Hedge Fund Conference, he urged hedge funds to comply with the principles adopted by the Hedge Fund Standards Board. The official said that the FSA will take compliance with these standards into account when making judgments on ensuring compliance by hedge fund managers with FSA regulations. The principles are on a comply or explain basis and include valuation, disclosure, and risk management guidelines.

He emphasized that transparent valuations are vital to FSA regulation. The FSA, which supports the IOSCO valuation principles, considers it a best practice for hedge fund managers to compare their policies, sources, and methodology for obtaining values against these and other industry standards. Valuation policies must be regularly reviewed to take account of changes in circumstances. Changes to methodologies arising from current turmoil, for instance in the use of side pockets, need to be disclosed to investors. When portfolios are misvalued, and where performance has been poor, the pressure on hedge fund managers to provide overstated valuations is greatest. In his view, weak systems, inadequate valuation policies and inadequate independent challenge of price verification all increase the susceptibility of firms to the risk of mismarked frauds.

The official urged hedge fund managers to look for guidance in this area to a recent Dear Chief Executive Letter to the CEOs of banks and investment firms with large and/or complex principal trading operations. This letter spoke of valuation processes that were flawed and the need for adequate valuation controls; and sets out prudent valuation principles.
On the transparency front, his remarks focused on the disclosure of contracts for difference and other derivatives. A contract for difference is a share in a derivative product giving the holder an economic exposure to the change in price of a specific share over the life of the contract. Hedge funds are the typical holders of contracts of difference, which allow them to take an economic exposure to a movement in the referenced share at a small fraction of the cost of securing a similar exposure by acquiring the shares themselves

While contracts for difference can provide valuable liquidity to the market, said the CEO, the problems caused by their use on an undisclosed basis must be addressed. In July, the FSA, in an effort to prevent hedge funds and other market participants from using contracts for difference to influence corporate governance and build up undisclosed stakes in companies, proposed requiring disclosure of interests in a company’s shares held through derivatives, such as contracts of difference. The new disclosure regime would make it harder for derivatives holders to build up significant stakes in companies without disclosure. The new regime would also mean greater transparency for issuers and for the market at least in terms of who holds economic interest in them and therefore who their potential shareholders are. The disclosure threshold will be set at 3 percent, in line with the existing disclosure rules.

After consideration, noted the official, the FSA has concluded that this approach remains the best way of addressing the market failures caused by access to voting rights and influence on corporate governance on an undisclosed basis. As expected, the issue has drawn strong and conflicting views from across the spectrum of market participants, including issuers, institutional investors, and hedge funds. The FSA intends to implement the regime, emphasized the CEO, because enhancing disclosure is the right thing to do. The prospective regime will be explained in more detail in a forthcoming feedback statement, as the FSA works with the industry to ensure that the rules are framed in the most effective way.