Why a code of conduct for hedge funds is good news
6 May 2008
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Six weeks ago, shortly after shares in HBOS plunged by 17 per cent in one day, the Financial Services Authority took the unprecedented step of attacking publicly the "completely unfounded rumours" spread by a number of unscrupulous investors.
There was no explicit mention of hedge funds, but inevitably the finger of blame fell on the self-styled 'masters of the universe' who run these funds, posting vast profits on the back of market volatility.
Weeks later an Icelandic bank accused hedge fund investors of trying to drive it to bankruptcy for their own gain. Then came the news that one of the US's best-known banks Bear Stearns had been brought to its knees when hedge fund managers withdrew their assets.
Hedge funds, and the financial dark arts they employ, are in the spotlight as never before and there is a growing sense in the industry that something has to change.
The response from 14 of the City's largest funds has been to set up the world's first voluntary code of conduct for the industry.
The new rules, calling for more transparency and clearer risk management, are set to come into force at the end of the year.
"The big boys are saying we want to hold ourselves out as behaving in these laudable ways," says Allen & Overy (A&O) funds partner Matt Huggett. "That's a good thing."
It is certainly a good thing for City lawyers, who have already begun the scramble to advise top hedge fund clients on compliance.
So which firms are leading the way in this brave new world of voluntary regulation? Lining up alongside the usual suspects is, surprisingly, Herbert Smith.
The firm advised the Hedge Funds Working Group (HFWG) on drawing up the standards last year, despite being a relatively minor player on the scene.
A significant number of the 14 funds on the HFWG rely on the big three - Dechert, Simmons & Simmons and US firm Schulte Roth & Zabel - for legal advice.
Herbert Smith's role on drafting the code certainly ruffled feathers among the hedge fund specialists. So much so that when the first draft was sent out for consultation the big three were falling over themselves to have a say on the final version.
Dechert European head of finance Peter Astleford was one of those who helped finalise the code. He says the draft needed work, adding: "The guidelines and the consultation process were much improved by the input of those law firms who represent most of the hedge funds."
Other key advisers included funds partner Iain Cullen at Simmons, while Schulte advised on US issues.
One ;of ;the ;changes ;they demanded was a recognition that most hedge funds are offshore entities, ;with ;investment managers answerable to a board of directors in the Cayman Islands or the British Virgin Islands.
Was Herbert Smith chosen as the main legal adviser because it was unburdened by excessive client interest? Perhaps. The firm operates mainly in the closed-ended arena, acting for the listed vehicles of large funds - a relatively small slice of the hedge funds pie. But the firm, along with A&O, is Brevan Howard (Nagi Kawkabani)Brummer & Partners (Klaus Jantti)Centaurus Capital(Bernard Oppetit)Cheyne Capital(Stuart Fiertz)CQS (Michael Hintze)Gartmore (Jeffrey Meyer)GLG Partners (Manny Roman)Lansdowne Partners(Paul Ruddock)LDFM (Rob Standing)Man Group (Stanley Fink)Marshall Wace (Paul Marshall)Och-Ziff (Michael Cohen)RAB Capital (Michael Alen-Buckley)Sloane Robinson(George Robinson) trying to make up ground on the big three.
Herbert Smith set out its stall in the sector last month by launching a 'healthcheck' scheme for hedge funds. The fixed-fee service will see lawyers visit funds and check their internal systems to prevent market abuses, such as the 'trash and cash' short-selling that nearly brought down HBOS.
Herbert Smith asset management partner Mark Geday admits: "We're not a firm one would readily come to if you were launching a straight-up hedge fund.
"We concentrate on situations where funds have matured into businesses and their needs have developed - particularly in relation to listed vehicles."
For all the firms with large hedge funds on their books, there is much to do before the HFWG standards come into force in December.
The code itself, like a similar system proposed for the private equity industry, is a voluntary set of standards. Designed to remove some of the secrecy surrounding the activities of funds, members will have to comply with its rules or explain why they have not.
This ;'comply ;or ;explain' approach is designed to regulate the industry without being overly restrictive.
"It isn't intended to be a straitjacket," says Herbert Smith financial services regulatory partner Patrick Buckingham. "You can choose to comply to a particular principle or you can say, 'this doesn't fit my business', and explain why."
Despite being a voluntary code, there are plenty of legal issues on which investment managers might be forced to call the lawyers.
The new rules set out better standards for disclosing information about complex holdings to investors, and for the methods used to value them. A&O's Huggett says: "We're acting for quite a few hedge fund managers who are keen to join the standards board and want to spend time and money looking through all the documentation and procedures."
There are also potentially thorny litigation issues. Signatories to the code will carry a kitemark promising to abide by its rules. But if a fund loses a substantial amount of investors' money, it might leave itself open to accusations it had failed to live up to its own rules.
"If there's any litigation investors might say there was a breach of conduct," says Astleford. "It's a stretch, but they'd try it."
Huggett adds: "You need to be careful in case something goes wrong. That is where the lawyers are getting involved."
Meanwhile, hedge funds will continue to make headlines as one of the most important influences on the global markets - albeit in a far more difficult economic climate.
Buckingham believes there will be more high-profile fund collapses this year following the implosion of Peloton Partners, EuroHedge and Carlyle Capital in recent months.
Hedge funds, with their high-risk strategies and highly focused investments, ;are ;inherently more vulnerable than most to the ravages of the credit crunch.
As Buckingham says: "If you're a hedge fund, and all your eggs are in one particular basket, and that basket gets turned upside down, you're that much more exposed.
"I don't think I can ever recall such an intense sense of jitteriness. There's a feeling that something might come out of the woodwork in the near future."
#Fund managers signed up to the Hedge Funds Working Group: