UK Hedge Fund Standards Board Relies on Investor Due Diligence and FSA Involvement

The UK Hedge Fund Standards Board has promulgated standards on a comply or explain basis and relies on investor due diligence and the active involvement of the Financial Services Authority. In testimony before a Treasury Select Committee, HFSB Chair Antonio Borges said that the comply or explain principle is admired by many investors who think this is exactly the way to go. This is not a toothless approach, he said, because the whole point is that investors are in charge. The Board views its role as giving more power to investors to control what is happening in the hedge fund industry. That is the whole purpose of the standards.

These standards are far more effective and powerful than other forms of regulation which are very prescriptive but do not operate. In his view, the current crisis shows that the regulation of the banking sector, however prescriptive it may be, has failed and it is appropriate to consider whether comply or explain and investor due diligence is a more powerful mechanism to achieve results.

He emphasized that the Madoff scandal is probably the best example of why these standards are needed. If the standards existed in the US, he said, the Madoff fraud could not have happened, or it would have been extremely difficult to carry out. Madoff operated with complete integration of the whole activity from custody to brokerage to management to evaluation and administration. It was all under the control of one person and that made possible the kind of fabrication of statements and misinformation that went on and prevented due diligence from discovering any kinds of results. With the standards, noted the Board leader, this would not have been possible.

Mr. Borges insisted that the standards are not self-regulation, but build on FSA principles. The Board has received a great deal of support from the FSA, which believes that the standards are an extremely helpful way to deal with the problems of the industry precisely because they are rooted in FSA principles. The Board extends FSA regulation in a way that makes verification by investors easier.

For its part, the FSA has indicated that for fund managers that adopt the standards they will verify the extent to which the standards are being followed. It will be an important part of the FSA’s supervisory process. Thus, the standards give the FSA an additional instrument to verify at what level they operate. Mr. Borges noted that the FSA has indicated that it will take compliance with these standards into account when making supervisory judgments

Currently, the Board is in intense discussions with the FSA on what is the best regime for redemptions. The Board and FSA do not want a run on hedge funds; but at the same time want to protect every investor in hedge funds. Also, the regulators do not want investors who redeem early to be privileged. Therefore, they are trying to put in place standards that will deal with this threat.

In addition, the Board is looking into behavioral standards. It is examining every type of behavior that will lead to the goal of reassuring investors. The Board does not want to react after crises happen but take preventive action if possible.

Finally, the HFSB’s chief addressed the fact that only 34 hedge funds out of over 1000 have agreed to comply with the standards. He said that only a very small number of fund managers have said they are not interested; and he assumes many will join shortly. He also urged people not to underestimate the time and effort required to join because the standards are quite onerous and complying with them is a serious responsibility.