CSA seeks hedge fund transparency

(January 2007) As the Canadian hedge fund industry continues to grow, regulation is on a lot of people’s minds. The Canadian Securities Administrators has addressed investor concerns with the release of a six-page report that says the securities framework that’s in place for hedge funds is “appropriate.” However, a few issues related to fees, marketing and principal protected notes, among other things, still remain.

“We did the review because we’ve seen an increased interest in hedge funds as an asset class globally and in Canada,” says Leslie Byberg, manager of the Ontario Securities Commission’s investment funds branch. “Some hedge fund failures that have occurred prompted the review as well.

“The framework is there to regulate advisors and regulate disclosure . . . but we did identify some areas that can use additional thoughts.”

One issue needing attention is hedge fund fees. In the report, which examined 37 hedge funds with a total asset value of $1.25 billion, the CSA writes that it has “concerns with the clarity of the disclosure, the fact that the disclosure of various fees often appeared in many unrelated places in the documents . . . and with the transparency of the overall levels of fees.”

“That’s a question that has plagued the financial industry forever,” says Phil Schmitt, chairman of AIMA Canada, who agrees with all of the report’s findings. “All the [CSA] is saying here is, let’s make sure the advisors are using product appropriately as opposed to moving to a higher fee product.”

When it comes to marketing products, the CSA has questions about the presentation of performance returns and managers making “inadequate or inaccurate” disclosure.

Under the heading “referral arrangements” — another area that could be improved — the report points out an instance where one Ontario registrant delegated its responsibilities to supervise trades to a non-registrant. The agreement made by the registrant and the non-registrant failed to properly define the roles and responsibilities between the two parties. In British Columbia, there were issues of disclosure that resulted in a conflict of interest. “These instances were not representative of the population,” says the report.

“What we want is industry participants to look at this and what they’re doing and address these concerns,” says Byberg.

Schmitt adds that mainstream investors are now looking to hedge funds as a place to put their cash. The CSA, he says, is “trying to get a handle around it, but it’s the investing public who they’re trying to protect. They want to make sure they’re gaining access appropriately with enough clarity to make good investment decisions.”

While the CSA is satisfied with the framework that is in place, one of its larger concerns is with PPNs.

“They give retail investors access to alternative asset classes that are not usually available to retail investors without a prospectus and that carry different risks,” writes the CSA in its report.

There are also concerns surrounding the disclosure of PPNs, their investment risk when they’re linked to more complex investments, and that registrants selling PPNs “may not be meeting their KYC and suitability obligations.”

Schmitt says that the problems with PPNs aren’t exclusive to hedge funds but that investors have a right to clarity.

Although the report outlines areas where hedge fund managers can improve, following these specific recommendations isn’t yet mandatory. However, Byberg says there are a few ways to keep the industry in check. “With any registrant, we have the ability to go out and see how they’re doing so we can note deficiencies to them. There are things around their registration we can do . . . [such as imposing] terms and conditions around registration. There are ways to follow up.”

Neither Byberg nor Schmitt expect any problems though. At the end of February, the CSA plans to release another report specifically discussing referral arrangements, and the organization is currently discussing ways to address the issues surrounding PPNs, so any further questions the industry might have should be addressed in the coming months.

Regardless, Schmitt says it’s just better business to follow the CSA’s suggestions. “I don’t think there’s anything here that’s a compliance burden,” he says. “Most of these are statements of best practices, and everyone’s moving towards that.”

Filed by Bryan Borzykowski, Advisor.ca, Bryan.Borzykowski@advisor.rogers.com

(01/17/07)