Let go of the last era, and get with the new one

As waves of regulatory reform continue to sweep across the world, those who are most prepared to react and flex their business models will emerge ahead of the competition.

The rapidly evolving world of regulation continues to present challenges for the asset management industry. The result is an on-going, perhaps revolutionary, transformation in the scope and structure of the global and domestic capital markets, that’s unlikely ever to be reversed. And while it’s generally accepted by the industry that hedge funds did not cause the crisis, this is not the view of regulators, governments and politicians. Particularly in the US and Europe, hedge funds and their activities have become a key focus over the last two years.

Asset managers everywhere are grappling with understanding and responding wisely to the new regulatory framework and a multitude of new rules governing how they do business. Stakeholder expectations have never been higher, with demands for greater transparency and more assurance that asset managers have strong compliance and internal controls.Their expectations are heightened by recent fraud and compliance failures. The bottom line for many asset management firms is that their existing legacy compliance programs may not be up to the job. In a fast changing political, economic and regulatory landscape it’s more important than ever to effectively navigate and plan responses to regulatory change and ever-growing compliance requirements.

In the US, Dodd Frank will change the regulatory framework considerably, aiming to enhance consumer protections and limit the risk taking activities of individual organisations. With Dodd Frank and the subsequent rules, the SEC is delivering the most significant legal developments for investment advisers in decades and they impact far beyond the US. The rules also create a new category of investment adviser, an Exempt Reporting Adviser (“ERA”).

Advisors might think they’re exempt from full registration, but they also need to accurately assess whether they’re subject to reporting obligations as ERAs. If you manage solely private funds and have less than $150 million in private assets under management in the United States, you’re classed as an ERA, and you’ll have to register and meet some reporting requirements too.
Currently there’s a huge and very dangerous misconception amongst some in the industry that the ERA registration  is just a form filling process. This is absolutely not the case and ERA’s must realise that they will have reporting obligations and be subject to certain SEC rules and the SEC’s examination authority.

What this means, is that many businesses locally may need to enhance or amend existing policies and procedures to meet SEC expectations, and may not even realise it yet. The SEC expects compliance programs to address critical compliance risk areas, and to detect, correct and prevent any violations of the SECs anti-fraud principles, which ERA's are subject to. And the biggest lesson our staff learnt whilst working in PwC US on clients preparing for registration, is that the SEC is purely focused on protecting investors and any explanations of practical difficulties will fall on deaf ears.  

As you’d guess, therefore, the cost of non compliance is very high. The SEC has created a special unit within the Enforcement Division to investigate and bring cases against asset management firms.  While it has stated that it won't conduct regular ERA compliance examinations, any indications of wrongdoing (e.g. tips/complaints/referrals) will trigger cause examinations. This could lead to monetary penalties, imprisonment, disclosure of SEC actions on all marketing material for up to 10 years, restrictions or prohibitions from US markets or on US investors/clients.

To facilitate this process the SEC are offering whistle blowers between 10 to 30% of any penalties raised. The SEC recently has an increased focus on how non-US advisers approach US investors and what exemptions within the US securities laws are used. If you need further convincing, the SEC’s Dodd Frank - Whistleblower Annual Report 2011 shows that for just 2 months of activity there was a significant volume of whistleblowing. Moreover it includes  lots of activity from Europe/UK together with claims of inappropriately accessing the US markets and investors.

It’s also critical ERA’s collect and disseminate accurate and complete information as it will be publically available. It’s the SEC’s window in to your organisation and you do not want to inadvertently trigger some red flags leading to investigation of your business. Consequently, we’re encouraging clients to make sure they’re ready for examination around the key anti-fraud principles and at the same time limiting the likelihood that they are chosen for examination.

And of course we’ve also got the Alternative Investment Fund Managers Directive (“AIFMD”)  reshaping the alternatives space in Europe. In April 2009 the EU Commission adopted a proposal for the AIFMD which became the subject of over 18 months of highly politically charged negotiation before its finalisation.

When new regulation is under development, judging the right time to start preparing for it and how much effort to devote to anticipating the eventual detail that will follow, can be difficult.  Our local industry has been kept well informed of how things were unfolding and shaping up with AIFMD. I was involved first hand in the final negotiations of the Directive during a 1 year secondment to FSA where I worked alongside ESMA in drafting and negotiating the level 2. My practical understanding of the Directive and appreciation of how complex and challenging its interpretation, is gained from experiencing hours of discussions at both UK and European level. We know this complexity presents a challenge to businesses, but whilst a ‘watch and wait’ approach has been right up until now, we think the right time for action has come:

Service providers and administrators will be the first port of call for many asset managers seeking solutions and so should have started planning their responses already. While waiting for the final adoption of the advice may be an option for smaller managers with less complex business models and product ranges, larger managers should already be in the process of completing impact and gap analysis.  Regardless by Q2 2012 all managers should be starting preparation for implementation.  

A key focus of AIFMD for many managers will be the internal framework for risk management and liquidity management. Whilst this could be a culture shock – especially for those private equity and real estate funds that have not had comparable experience under UCITS – the Directive will impose a structure of discipline and rigor which the far-sighted firms should welcome.

However, AIFMD is wide reaching and, as it stands, is likely to also have significant unintended consequences.  Other groups at risk include those providing custodian services for assets. With the potential for unlimited liability, firms will likely either raise the fee that they charge or stop providing custody services altogether, causing a reduction of choice and another system-endangering concentration of assets on the balance sheet of several institutions.

With limited resources, multiple regulators and strong winds of regulatory change blowing from all sides, it’s hard to assess what actions to prioritise for your business. The old adage, ‘fail to plan, plan to fail’, will too often prove true, particularly for organisations operating in multiple jurisdictions who face additional challenges.  

Biggest trees weather the storm if their branches are flexible to the wind:  Ensuring clear leadership and accountability, facilitating proper strategy and planning, mobilising and maximising available resources, put firms in the best position to withstand the winds of change effectively. The first step to being flexible is to review your existing compliance and operating systems against those required under the new regulatory framework.  And the time for such gap analysis is definitely now; we have been working closely with our clients to ensure they are on track. One of the biggest challenges is balancing the need to remain compliant with these regulations with ever increasing resource pressures. But you can be sure those who take up the challenge and are most prepared will emerge ahead of the competition.