Singapore's Failed Attempt at Hedge Fund Regulation

Recently Singapore announced a major change in its approach to hedge fund regulation - and the hedge fund community celebrated. Previously in Singapore hedge funds were not required to be licensed as long as they were classified as exempt fund managers. As long as they only marketed themselves to so-called qualified investors and met some other basic criteria, there wasn't much oversight or regulation of their activities. All hedge fund managers had to do was provide notification to the Monetary Authority of Singapore ("MAS") of their choice as to whether to be licensed or not - and most chose the latter. This fast and loose approach to hedge fund regulation was originally utilized as a marketing tool to lure fund managers to Singapore, and as a 2010 Bloomberg article stated, "put the city back on the map" as an Asian hedge fund destination. For the past two years, the MAS has been studying ways to increase regulation of hedge funds. After two years of study, and seemingly taking cues from the U.S.'s Dodd-Frank legislation and recent SEC registration requirements, the MAS decided to effectively require all hedge fund managers above S$250 million to register. Specifically, under the Securities and Futures (Licensing and Conduct of Business) (Amendment No 2) Regulations (2012), hedge funds will now be classified into two different categories: Fund Management Companies ("FMC") and Registered Fund Management Companies ("RFMC") . RFMC replaces the old Exempt Fund Manager ("EFM") classification. RFMCs can serve up to 30 qualified investors and manage up to $250 million in Singapore dollars, (commonly written as S$). RFMCs do not need a license but FMC's will need a license. According to the MAS press release regarding these new regulations, FMCs will subject to "enhanced business conduct and capital requirements. These include rules requiring independent custody and valuation of investor assets, as well as requirements for FMCs to undergo independent annual audits by external auditors and having an adequate risk management framework commensurate with the type and size of investments managed by the FMCs." Let us analyze each of these items individually: Requirements for independent custody – Does anyone remember Bernard Madoff? The potential for manipulation in self-custody relationships is too great. While it is commendable that the Singapore financial regulators now require independent custody for FCMs- investors should avoid self-custodied managers, such relationships are generally not worth the potential risk to investors. Additionally, it could be asked, why does the MSA only require independent custody it for larger managers? Perhaps a custody related fraud below S$250 million does not outweigh the burden and costs of hiring a third-party custodian placed on smaller fund managers in the mind of the MSA, however such considerations would likely hold little recompense for the investors who could lose capital in such a situation.

Requirements for independent valuation of investor assets "Independent" is a vague term at best. Does this mean that a hedge fund that trades highly liquid positions such as equities, and is able to price such positions from a third-party source such as Bloomberg, has satisfied this requirement? Or instead is the work of a third-party firm engaged by the hedge fund manager, such as a fund administrator, required? Does this mean that it is now a violation of the Singapore regulations for FCM's to self-administer? What about situations where positions are thinly traded or initially manager marked? Would the hedge fund manager hiring a third-party administrator, who may not have the competency to independently price such thinly traded positions, still satisfy this requirement? An overarching concern relating to the use of such third-party administrators is that administrators themselves are hired by the fund managers. While they work for the fund, there are legitimate questions about the true independence of such relationships. Requirement for FCMs to undergo independent annual audit by external advisors Would this requirement be satisfied by a hedge fund manager’s regular annual financial statement audit. Does this "new" requirement mean that it was previously fine for a manager not to be audited? Once again, it seems the MSA is finally catching up to what is common sense to investors. While investors should in no way outsource their operational due diligence responsibilities to a third-party auditor, the work of an auditor and the subsequent financial statements are extremely valuable to investors during due diligence. If a hedge fund manager is not audited - investors should move on. If on the other hand the "independent annual audit" language does not imply that a financial statement audit will not encompass the "independent annual audit" language of the MSA, will FCM hedge funds now be required to have a separate audit performed in addition to the financial statement audit? Requirement to have an adequate risk management framework commensurate with the type and size of investments managed by the FMCs Once again, this is perhaps so vague as to be useless. Many logical well-intentioned hedge funds may take different approaches, some less conservative than others, in regards to the definition of the word “adequate”. Certainly, it would be considered adequate to have an independent dedicated risk manager, but other fund managers may feel that non-dedicated oversight is sufficient. How will the MSA regulate this? Conclusion: On the surface investors’ initial reactions to such enhanced regulatory reforms may be that more regulation is better for investors. However, it is important that investors take measures to not only understand the technical requirements of new regulatory requirements but also whether these additional requirements will be effective.

Singapore has grown as an Asian hedge fund center in the past few years and is increasingly nipping at the heels of Hong Kong for hedge fund business. Additionally, despite recent efforts to create a more hospitable environment for hedge funds in other Asian countries, scandals such as the AIJ fraud in Japan and continued concerns related to fraud in mainland China, continue to push Singapore to the forefront ahead of other Asian jurisdictions. In the case of recent MSA measures to further regulate the domestic Singapore hedge fund industry, the MSA has unfortunately stopped short in its attempts to implement real oversight and reform. By setting artificially low limits for hedge fund transparency and independence, the MSA has demonstrated that it is still partially a captured regulator in the shadow of the hedge fund industry it seeks to regulate. One of the more concerning themes of the recent MSA reforms is the shifting of the onus towards hedge funds themselves. It is up to hedge funds to ensure adequate risk management procedures are in place and that assets are independently valued. Yet, the MSA stops short of saying how it will police these items. Effectively, the MSA is hoping the largest hedge funds play by the rules and will likely utilize these new regulations as a fee generation tool to issue technical fines. Unfortunately, pomp and circumstance seem to have won the day, and little actual ongoing oversight will be performed. With this new regulation the MSA has asked investors to shoulder the burden of hedge fund oversight and due diligence. While the recent MSA reforms are a step in the right direction, it is unfortunate that meaningful hedge fund regulation has yet to come to Asia. Hopefully, it will not take an Asian Madoff to sound the alarm and cause regulators to take meaningful action.
Originally posted in the August 2012 edition of Corgentum Consulting's Operational Due Diligence Insights. For More Information

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About Corgentum Consulting:

Corgentum Consulting is a specialist consulting firm which performs operational due diligence reviews of fund managers. The firm works with investors including fund of funds, pensions, endowments, banks ultra-high networth individuals, and family offices to conduct the industry's most comprehensive operational due diligence reviews. Corgentum's work covers all fund strategies globally including hedge funds, private equity, real estate funds, and traditional funds. The firm's sole focus on operational due diligence, veteran experience, innovative original research and fundamental bottom up approach to due diligence allows Corgentum to ensure that the firm's clients avoid unnecessary operational risks.

©2012 Corgentum Consulting, LLC

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