IDA weighs in on hedge funds, referrals

(May 27, 2005) Investment dealers and their firms are responsible for the suitability of their clients’ investments, even if the product in question is exempt from regulatory oversight, according to an IDA report entitled Regulatory Analysis of Hedge Funds.

“The complexities of many hedge fund products make assessment of their suitability difficult,” the report says. “Where a registered representative on his or her own decides to recommend a hedge fund product to a client, even in an exempt transaction, the firm has a responsibility to ensure that the recommendation is suitable. It cannot do so without sufficient knowledge of the product.”

The IDA report points out that it is the firm’s responsibility to conduct its own due diligence on “any product recommended to a client where its characteristics, risk profile and merits may not be readily apparent,” including referrals to a third party.

“The original notices on off-book transactions, Compliance Interpretation Bulletins C-93 and C-106, were issued in 1996 and dealt only with off-book mutual fund transactions, although the principles apply to all off-book transactions,” the report says. But just to be clear on the matter, the report recommends these regulations be re-written to explicitly include hedge funds.

The IDA report calls for a full review of provincial securities laws, regulations with an eye toward bringing retail focused hedge fund products completely under the purview of the regulatory environment.

Hedge funds are traditionally available only to accredited and qualified investors, due to their employment of sophisticated investment strategies. The IDA commissioned the study in January — well before problems emerged at both Portus and Norshield — over concerns of the proliferation of hedge funds into the retail market.

Registration and accreditation

Hedge funds, with the exception of commodity pools, which include managed futures funds, are offered without a prospectus. That frees them of the investment restrictions placed on mutual funds.

There are three routes to offering a hedge fund without a prospectus. The old “sophisticated investor” criteria allows investors to put up a minimum of $97,000 to $150,000, depending on the province.

There is the accredited investor exemption, which also varies by province, but requires a $200,000 income or $1 million in financial assets. For example, an investor could have a “fully managed account” with a registered investment counselor that could invest in a hedge fund — except in Ontario, where no investment in an investment fund is allowed. Finally, there is the offering memorandum exemption. In that instance, there is no minimum investment required.

These inconsistencies come to the fore with Portus, the report says. Clients opened fully managed accounts and Portus purchased exempt products through those accounts for much less than the sophisticated investor minimum of $150,000.

“It is not clear how or whether Portus relied on the ‘fully managed account’ category of accredited investor in Ontario, as the Portus product issued as trust units qualified as an investment fund,” the report states, adding, “It is not known whether Portus relied on the exemption for registration … granted to PPNs, as the Portus product was issued by a non-financial institution as trust units.”

The trust units owned PPNs, not the investors. Outside of Ontario, direct ownership of an investment fund would have been permissible.

Referrals

There is also a fog about referral arrangements.

“Portus may claim that it was not obligated to ensure the suitability of hedge fund investments for the referred clients because the referring dealers, probably holding other assets for the clients and having a broader picture of their needs, would only send those clients for whom such investments are suitable.”

Yet, “dealers likewise may claim that they were acting solely as referring dealers and were not involved in specific trades, and as Portus’ IC/PM arm is registered, it was required to ensure the suitability of any hedge fund investments by the clients.”

The payment of referral fees further clouds the issue and the IDA report suggests that obliges the dealer to ensure the suitability. The report points out that the IDA attempted to implement a by-law covering referral arrangements in 2002, but the move was scuttled by the Canadian Securities Administrators (CSA) in a dispute over commission splits.

Explosion in assets

The IDA study notes that the Canadian hedge fund industry has reached $14 billion in assets, half of which is concentrated in principal-protected notes (PPNs). But while assets have “exploded,” the IDA notes that there are “heightened” concerns about the use of the exempt marketplace, marketing practices in general, fee transparency and transparency of funds’ business operations.

“The high levels and lack of transparency of fees have not prevented hedge fund offerings from finding investors, suggesting a relative lack of sophistication of many investors, accredited or not,” the report says. “It is, therefore, unlikely that such investors are any more deterred by the lack of transparency of intended investment strategies, risks and actual investments held.”

The report highlights a number of regulatory gaps. According to the Securities Act, dealers are not required to register to trade in “bonds, debentures, and other evidences of indebtedness” — including PPNs — provided they are guaranteed by a Schedule I or Schedule II bank, the latter being the Canadian subsidiary of a foreign bank. The report also notes that PPNs are not subject to the accredited investor rules, so that investors need not report incomes of $200,000 or financial net worth of $1 million to purchase a note.

“While PPNs may fit within the current definition of exempt securities,” the report notes, “they include significant risks to investors that directly contradict the apparent rationale for making them exempt in the first place — that such products are simple and low risk because of the financial stability of the issuer or guarantor.”

The IDA says that 10-year lockup — the term to maturity for most notes — with the prospect of zero return “is no small risk to a retail investor.” It also urges the Canadian Securities Administrators to revisit the definition of PPNs to see how they fit into the category of “debt-like derivatives,” a category that was the subject of an Ontario Securities Commission task force in 1999.

“As securities, [PPNs] fall within the ambit of IDA regulations as to suitability, but not all Members have that obligation in all situations,” the report says. “Furthermore, even in pursuing due diligence on hedge fund products, dealers will have to contend with the risks resulting from conflicts of interest, complex fees structures, lack of disclosure requirements, lack of controls on pricing and valuation and all the other problems introduced by the lack of direct regulation of highly complex products.”

The report also recommends that IDA members be restricted from distributing exempt products through affiliates with limited market dealer registration, if these activities could be carried out through the member firm. Such moves are seen as evading investor protection as afforded by the IDA by using the less regulated firm to make the sale, while the client believes the dealer is wearing their IDA hat.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(05/27/05)

Steven Lamb and Scot Blythe