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Donohue Addresses Developments in Hedge Fund Regulation

In remarks at a London conference on private investment funds, Andrew Donohue, the director of the SEC's Division of Investment Management, said he believes that the U.S. and the U.K. regulate markets through a combination of rules and principles. The U.S. has been criticized for having a rigid regulatory regime, but Donohue maintained that regulators have the flexibility to craft principles-based solutions for the investment management industry. Donohue's remarks are posted on the SEC's Web site.

Neither the U.S. nor the U.K. regimes are entirely rules-based or principles-based, according to Donohue. Each country regulates its markets through a combination of the two strategies, in his view. Donohue said he sees a lot of similarity in both countries' approaches to regulating investment advisers, including those that advise hedge funds.

Supporters of principles-based regulation believe it permits a more nuanced approach, Donohue explained, but it comes with certain drawbacks. He pointed to concerns raised by retail firms in England about how the Financial Services Authority would interpret breaches of principles. The firms expressed concern about the potential for retrospective enforcement actions as a result of the principles-based overhaul of the anti-money laundering handbook.

Rules-based regulation also has certain benefits and drawbacks, according to Donohue. Rules satisfy the demand for specificity with respect to legal duties and compliance responsibilities. However, they can also increase compliance costs. The more limited flexibility requires more formal exemptive relief or additional rulemaking and can result in boilerplate disclosure documents.

Donohue described the SEC's recent principles-based rulemaking initiative to require investment advisers to write plain English brochures about their business practices, including the services they provide, their fees and risk information. If the SEC adopts the proposal, the brochures would be required to be delivered to clients and prospective clients. The brochures would also be available to the public through the investment adviser Web site.

Donohue also talked about the regulation and oversight of private equity funds and their advisers. The Division has focused on the best way to discharge its responsibilities with respect to hedge funds and their advisers since a district court vacated its rule to require hedge fund managers to register as investment advisers. The Division is seeking a balanced and effective regime that will allow the industry to evolve while providing appropriate investor protections, he explained.

Donohue added that he is aware of the global nature of the hedge fund industry. He has held a number of meetings with his foreign counterparts to learn from their experience and approaches. Donohue said he has paid particular attention to the FSA's approach to industry developments and believes the U.K. regulatory regime is relevant to the U.S

Meanwhile, Donohue said the Commission is active in its pursuit of enforcement actions against both registered and unregistered advisers and their personnel. Recent cases have involved insider trading, fraud, illegal short selling, late trading and deceptive market timing, undisclosed conflicts of interest and misappropriation of assets, he reported.

The SEC's examination program identifies areas that may be deficient and recommends enforcement action where appropriate, Donohue advised. The staff has identified deficiencies in a number of major areas, including insider trading policies and compliance policies and procedures. The staff looks at whether a hedge fund adviser's insider trading policies are tailored to fit its specific facts and circumstances, he explained. The staff will consider the types of investment strategies a hedge fund employs such as distressed debt and bank loan participations, or the use of long/short equities.

Donohue said that forensic tests may be an effective compliance program component for detecting any unusual patterns related to investment decisions. Funds must adapt their processes to keep up with areas of concern such as the valuation of increasingly complex products.

Hedge fund investors such as endowments and pension funds may be more cautious and risk averse, Donohue said, so they may demand more transparency and better valuation techniques. Their demands are leading to best practices among hedge funds that serve these investors, he advised.

Donohue noted that a hedge fund working group issued a final report on voluntary best practices in the U.K. earlier this year. The FSA has also issued principles of good business conduct. Donohue reported on a similar initiative that is underway in the U.S. The President's Working Group provided principles-based guidance last year, he said, but it also established two private sector committees to develop best practices based on the guidance. These committees should issue reports in the near future. They may differ from the U.K. hedge fund working group's final report, he said, but both will cover a lot of common ground.

Donohue also noted that the Hedge Fund Standards Board will cooperate and share information with the President's Working Group. Regulators will work together to develop sensible solutions to hedge fund regulatory issues, in Donohue's view, which will enhance confidence in all of their markets.