1. Despite the fact that there is no widely accepted definition of a hedge fund, in essence they are unregulated private collective investment vehicles, targeted in the main at sophisticated investors. Such funds have almost unlimited discretion over the investment strategies they adopt and the range of investments to which those strategies are applied. Accordingly the term ‘hedge fund’ is misleading, since the fund does not have to ‘hedge’. In many ways, hedge funds are perhaps best regarded ‘as an approach to investment rather [than] a distinct asset class’: Moloney, N. ‘The Ec and the hedge fund challenge: a test case for Ec securities policy after the Financial Services Action Plan’ (2006) 6 Journal of Corporate Law Studies 1 CrossRefGoogle Scholar at 5.

2. Hedge funds are, as yet, subject to few disclosure requirements.

3. Greupner, Ej Hedge funds are headed down-market: a call for increased regulation?’ (2003) 40 San Diego Law Review 1555 Google Scholar at 1561. For slightly different estimates, see FSA Hedge Funds and the FSA (Discussion Paper 16, 2002) pp 9–10 and sources cited therein (FSA DP 16, 2002).

4. ‘Onwards and upwards for hedge fund assets’ FT.com Alphaville, available at http://ftalphaville.ft.com/blog/2007/04/19/3965/onwards-and-upwards-for-hedge-fund-assets/. Although $1500 billion is small in comparison to the $30,000 billion–$40,000 billion that is invested in retail investment vehicles, hedge funds are much more active players in the world’s financial markets: K Burgess and J Drummond ‘Common elements involve complex strategies’ Financial Times 24 June 2005.

5. J Drummond, G Tett and P Thal Larsen ‘FSA looks at boosting hedge fund supervision’ Financial Times 24 June 2005. In Europe alone, it is believed that at the beginning of 2005 $250 billion worth of assets were under management in hedge funds, an increase of almost $100 billion from the previous year: FSA Hedge Funds: A Discussion of Risk and Regulatory Engagement (Discussion Paper 05/04) (FSA DP 05/04) at 11 and sources cited therein.

6. See, Greupner, above n 3, at 1564. See also, Staff Report to the US Securities and Exchange Commission (SEC) Implications of the Growth of Hedge Funds (September 2003) (SEC Staff Report) at vii; and Parry, H. Hedge funds, hot markets and the high net worth investor: a case for greater protection?’ (2001) 21 Northwestern Journal of International Law and Business 703.Google Scholar

7. ‘In 2001, the average US hedge fund… returned 5.6%, while the [Standard & Poors Index 500] fell 11.9% and the average equity mutual fund fell 12.6%’: B Goodman ‘Hedge funds for the not-so-rich’ TheStreet.com (13 May 2002), available at http://www.thestreet.com/funds/mutualfundmodayby/10021885.html, quoted in Greupner, above n 3, at fn 53.

8. For one of the first serious attempts to assess the hedge fund industry, see President’s Working Group Hedge Funds, Leverage and the Lessons of Long-Term Capital Management – Report of the President’s Working Group on Financial Markets (1999), available at http://www.treas.gov/press/releases/reports/hedgfund.pdf. See also Review of Issues Relating to Highly Leveraged Institutions (HLIs) – Basel Committee on Banking Supervision and the International Organisation of Securities Commissions (March 2001), available at http://www.bis.org/publ/bcbs79.pdf. For one of the most recent discussions of the hedge fund industry, see Banque de France Financial Stability Review – Issues on Hedge Funds No 10 (April 2007), available at http://www.banque-france.fr/gb/publications/telnomot/rsf/2007/rsf_0407.pdf.

9. In the UK, see FSA DP 05/04, above n 5. In the US, see SEC Staff Report, above n 6. Regulators in other jurisdictions have also expressed interest in the regulation of hedge funds: see FSA DP 05/04, above n 5, pp 14–15 and sources cited therein.

10. Governed by EU law in the form of the Undertakings for Collective Investments in Transferable Securities Directive (UCITS Directive 85/611/EEC), such funds were designed to be relatively low risk and relatively low performing investment vehicles and, hence, traditionally have been tightly regulated as to their legal and management structures and the range of products in which they may invest. In addition, such funds have typically been subject to extensive controls regarding disclosure and reporting requirements as well as leverage. However, recent reforms have substantially liberalised the rules for UCITS schemes. See, in particular, Directive 85/611/EEC, as amended, inter alia, by Directive 2001/107/EC (the Management Company Directive) and Directive 2001/108/EC (the Product Directive). The latter two Directives are generally known as UCITS III. For a discussion of these and other developments, see, generally, FSA Wider-Range Retail Investment Products (Discussion Paper 05/03, June 2005).

11. The term ‘hedge fund’ has its origins in the idea of ‘hedging one’s bets’ – in the world of finance, this meant hedging against both market risk and volatility. Today, however, hedge funds focus ‘almost exclusively on the speculative role of investment management, that is, the attempt to outperform the market average by superior security valuation and successful trading strategies’: G Connor and M Woo An Introduction to Hedge Funds available at http://www.lse.ac.uk/collections/accountingAndFinance/pdf/ConnorIntroToHedgeFundVv3.pdf at 26. ‘Funds of funds’ hedge funds invest in other hedge funds. The main benefit of this strategy is portfolio diversification.

12. Many offshore funds require a minimum investment of $100,000, or higher.

13. Although see n 62 and accompanying text.

14. Edwards, Fr The regulation of hedge funds: financial stability and investor protection’ in Baums, T. and Cahn, A. (eds) Hedge Funds: Risks and Regulation (De Gruyter Recht, 2004) p 30 Google Scholar. The most popular strategy continues to be the ‘long-short equity’ strategy: C McCarthy Hedge Funds: What Should be the Regulatory Response? Speech on behalf of the FSA (7 December 2006), available at http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2006/1207cm.shtml, p 2. However, also note the recent amendments, known as UCITS III, to the UCITS Directive 85/611/EEC, above n 10.

15. That is to say, the trading is backed by extensive borrowings. ‘Although leverage historically was obtained primarily by purchasing securities with borrowed money, today futures, options and other derivatives contracts may be a major source of leverage’: SEC Staff Report above n 6, pt 37. See also FSA DP 05/04, above n 5, pp 30–31.

16. ‘Creditors may require the fund to provide more collateral to secure their loans, which may in turn require the fund to sell some of its capital to meet its margin calls’: Gibson, We, ‘Is hedge fund regulation necessary?’ (2000) 73 Temple Law Review 681 Google Scholar at 686. Although some funds have leverage of more than ten times their capital base – the now infamous Long Term Capital Management fund is said to have had leverage of 30 times – many funds operate a more conservative leverage ratios. See

17. By contrast, institutional fund managers are typically benchmarked against market indices, such as the FTSE 100. Thus, in a declining market the manager may claim success for the fund over which he has control even if the fund has lost money, provided it has outperformed the chosen benchmark (and vice versa). By emphasising absolute returns, hedge fund managers seek to create profits irrespective of the movement in market indices. A typical performance fee is in the region of 20% of the absolute return secured by the fund: L Tiernan, D Eustace and D Thompson ‘Irish domiciled hedge funds and the role of the prime broker’ in Cullen and Parry, above n 16, p 159, para 9.03. To some extent this emphasis on absolute returns is changing with the introduction of hedge fund indices.

18. G Duncan ‘Hedge funds – weapons of financial destruction’ The Times 25 October 2004. Complex computer models are routinely used to manage risk and exploit inefficiencies.

19. The Cayman Islands, the Virgin Islands, Bermuda, the Bahamas and Panama are all favoured locations.

20. The number of centres providing such advisory services is, however, continuing to grow: France, Germany, Italy and Hong Kong are notable examples; see I Cullen ‘Hedge funds: structure and documentation’ in Cullen and Parry, above n 16, para 1.01.

21. ‘Prime brokers provide clearing, custody, margin financing, reporting and stock lending services to hedge funds in a single package’: Tiernan et al, above n 17, para 9.02, and generally paras 9.03–9.09. See also SEC Staff Report, above n 6, pp 53–54.

22. SEC Staff Report, ibid. and sources cited therein. Most administrators of UK managed hedge funds are in fact regulated by the Irish Financial Services Regulator. See D Waters Regulation and the Hedge Fund Industry: An Ongoing Dialogue Speech delivered on behalf of the FSA (8 February 2005), available at http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2005/0208_dw.shtml, p 2.

23. According to research conducted by the FSA, the ‘optimal location and form of each entity within the structure is frequently determined according to factors such as tax efficiency, proximity to major markets and appropriate regulatory regime’: DP 05/04, above n 5, pp 11–12. See generally Cullen, above n 20, para 1.00.

24. FSA DP 16, 2002, above n 3, p 12.

25. Spangler, T. Hedge funds: the building blocks’ (2007) Jan/Feb, Practical Law Company 31 Google Scholar at 33–34.

26. Ibid, at 34. ‘Units or shares [in] close-ended funds are not eligible for interim liquidity and, as result, must either be held until the fund’s liquidation, or traded from investor to investor in secondary transactions’; ibid.

27. SEC Staff Report, above n 6, pp 44–45.

28. M Vassatou Hedge Funds and Their Prospects (22 June 2006), available at http://www.bankofgreece.gr/en/announcements/text_speech.asp?speechid=91.

29. Above n 16, para 2.08.

30. See below n 93 and accompanying text.

31. T Geithner, C McCarthy and A Nazareth ‘A safer strategy for the credit products explosion’ Financial Times 28 September 2006.

32. Sir Gieve, J. Hedge funds and financial stability’ (2006) Q4 Bank of England Quarterly 447 Google Scholar at 449.

33. SEC Staff Report, above n 6, pp 4–5.

34. Danielsson, J., Taylor, A. and Zigrand, J-P Highwaymen or heroes: should hedge funds be regulated? a survey’ (2005) 1 Journal of Financial Stability 522 CrossRefGoogle Scholar at 523.

35. Ibid, although the writers accept that the matter is by no means settled (at 535). However, according to Gieve, in the autumn of 2003 and the spring of 2005, hedge funds helped to provide liquidity in times of market stress, enabling large banks and other investors to adjust their positions: above n 32, at 449.

36. President’s Working Group, above n 8, p 2.

37. Gibson, above n 16, at 688.

38. Though there also exists ‘the potential pitfall for style drift, whereby a hedge fund manager drifts into strategies which are neither his forte, nor provide the expected diversification benefits to investors’: Danielsson et al, above n 34, at 534.

39. SEC Staff Report, above n 6, p viii.

40. Danielsson et al, above n 34, at 533 (footnotes omitted).

41. Ibid (footnotes omitted). See also, ‘Hedge funds: what’s in a name?’, above n 4 (‘Most hedge funds try to identify the mis-pricing – whether in equity, credit, debt or FX and commodity markets. By arbitraging out the structural or short-term mis-pricings they help all market participants operate in a more efficient market’).

42. See below n 67 and accompanying text.

43. Financial Services and Markets Act 2000 (Regulated Activities) Order 2001, SI 2001/544 (RAO), art 53.

44. FSMA, s 22 and the RAO.

45. Aside from general law constraints – such as fraud and misrepresentation – those who ‘service’ hedge funds will also be subject to the Criminal Justice Act 1993 (Part V) and to the market abuse regime (FSMA, Part VIII).

46. FSMA, s 19 and s 40. The most common form of authorisation in this respect will be via FSMA, Part IV (the so-called ‘Part IV Permission’).

47. FSA DP 05/04, above n 5, p 16.

48. RAO, art 25.

49. See arts 37 and 53 of the RAO, respectively. Firms providing such services will be required to meet the threshold conditions under Sch VI. Failure to maintain the threshold conditions enables the FSA to vary or cancel the permission: FSMA, s 45. An authorised person will also be required to meet the FSA’s requirements on ‘Senior Management Arrangements, Systems and Controls’ (ie ‘take reasonable care to establish and maintain such systems and controls as are appropriate to its business’(SYSC 3.1.1R)). And, in relation to private and intermediate customers, to abide by the FSA’s dealing and managing Conduct of Business rules such as best execution and fair and timely trade allocation. In addition, any individuals performing ‘controlled functions’ in accordance with s 59 will require approval by the FSA. Though similar, a more extensive regime will apply in the wake of the implementation of the Markets in Financial Instruments Directive 2004 (MIFID). Unlike under the Investment Services Directive (ISD), MIFID makes both investment advice and dealing in commodity derivatives a core activity for which a passport will be available.

50. See FSMA, s 21 and the FSA’s Conduct of Business rules, ch 3.

51. Note that typically the fund, rather than the fund manager, enters into the trades and consequently the manager’s capital is not normally available to guarantee the fund’s performance. See Frase, above n 16, para 2.20. By the end of 2006, UK-based hedge fund managers managed £361 billion, representing 79% of all assets for all hedge fund managers based in Europe and as much as a quarter of all hedge fund assets worldwide: D Waters FSA Regulation of Alternative Investments Speech on behalf of the FSA (29 March 2007), available at http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2007/0313_dw.shtml, p 1.

52. FSA DP 05/04, above n 5, p 15.

53. See discussion at n 23 above and accompanying text.

54. See FSMA, s 235 (which defines a ‘collective investment scheme’ (CIS)). UK-based regulated collective investment schemes may be marketed to the general public in compliance with the FSA’s CIS Sourcebook (COLL). Despite recent liberalisations as a result of UCITS III, CISs remain relatively heavily regulated ‘low risk-low return’ investment vehicles directed at, and considered suitable for, retail investors. In 2004, the European Parliament adopted a resolution proposing a ‘light touch’ regulatory regime for sophisticated alternative investment vehicles including hedge funds, the purpose of which was ‘to bring funds onshore that are presently offshore and to provide them with the benefits of a European Passport’: European Central Bank ‘Hedge funds: developments and policy implications’, Monthly Bulletin (January 2006) 63 at 72. This was followed in July 2005 by the European Commission’s Green Paper on Enhancement of the EU Framework for Investment Funds (COM (2005) 314), which found that there was no compelling case for EU legislation on hedge funds. More recently, a report commissioned by the European Commission has called for less regulation of the European hedge fund industry: Report of the Alternative Investment Expert Group: Managing, Servicing and Marketing Hedge Funds in Europe (July 2006), available at http://ec.europa.eu/internal_market/securities/docs/ucits/reports/hedgefunds_en.pdf. Nevertheless, as Moloney warns, the EC’s shift from market construction to market regulation raises ‘the risk of a dangerous momentum and overreaction if hedge funds become an instrument of institutional power dynamics’: above n 1, at 7.

55. See, in particular, ch 3 on financial promotions.

56. The Financial Services and Markets Act 2000 (Promotions of Collective Investment Schemes) (Exemptions) Order 2001, SI 2001/1060 (as amended).

57. See FSA Handbook, Glossary.

58. Ibid.

59. See COB 3.11 and COB 3, Annex 5. When a private customer is ‘opted-up’ the firm must take reasonable care to ensure that the customer is of sufficient experience and understanding to be classified as an intermediate customer. In addition, the customer must receive a written warning outlining the consequences of such a re-categorisation. The firm must then receive the customer’s written (or informed) consent to the change of status: COB 4.1.9R. According to FSMA, s 241, authorised persons who communicate (in breach of FSMA, s 238) or approve (in breach of FSMA, s 240) an invitation or inducement to participate in an unregulated investment scheme are liable for damages under s 150 at the suit of a private investor who has suffered loss. See Seymour v Ockwell [2005] EWHC 1137 (QB), [2005] PNLR 39 (concerning the promotion of an unregulated scheme in breach of similar provisions in the Financial Services Act 1986) .

60. There are, however, signs that this is changing, see Report of the Alternative Investment Expert Group, above n 54 (’retail investor access to appropriately marketed hedge fund-based investments should no longer be taboo’) (p 6). See also n 61 and accompanying text.

61. According to the Hennessee Group, in 2003 fund of fund hedge funds represented approximately 27% of hedge fund assets compared to 20% in 2002. Quoted in SEC Staff Report, above n 6, fn 154.

62. Above n 3, fn 107. The FSA has now recognised the need to embrace the retailisation of fund of funds hedge funds to ‘bring the UK in line with other jurisdictions (notably France, Germany, Spain, Italy and Ireland), which have already introduced retail funds of hedge funds’: FSA Funds of Alternative Investment Funds (FAIFs) (Consultation Paper 07/6, March 2007).

63. However, hedge funds may encounter difficulties in complying with these modifications since they must, inter alia, have an adequate spread of risks, remain passive investors and ensure that any external investment manager is independent of the board of directors. Somewhat controversially, secondary listing for overseas investment companies has been possible under the less strict chapter 14 of the listing rules since October 2006. Investment companies listing under chapter 14 are not required to disclose portfolio information or board independence. Brevan Howard’s BH Global Macro hedge fund was the first such fund to list in the UK: ‘Freshfields and Simmons list the first closed-end fund on LSE’ The Lawyer 13 February 2006. Going forward, the FSA has indicated that a single regime will be in operation by the first quarter of 2008: FSA Update on the Investment Entities Listing Review (4 April 2007).

64. The FSA claims that this situation has come about through ‘market evolution rather than policy design’: DP 16, 2002, above n 3, p 16. A possible justification, to which the FSA alludes, is that ‘fund of funds’ are more diversified than individual funds and therefore more suitable for sale to the retail market’: ibid.

65. Consequently, a person who has, for example, acquired securities in a fund or a fund of hedge funds, as result of defective listing particulars, may (provided they can show loss in respect of the securities) bring an action under FSMA, s 90, claiming compensation for that loss.

66. See, eg, H Davies Why Regulate? Henry Thornton Lecture, City University Business School (4 November 1998), available at http://www.fsa.gov.uk/Pages/Library/Communication/Speeches/1998/SP19.shtml, p 2.

67. See FSA Reasonable Expectations: Regulation in a Non-Zero Failure World (September 2003) para 4.7.

68. Danielsson et al, above n 34, at 538–539.

69. See Organisation for Economic Cooperation and Development Systemic Risks in Securities Markets (OECD, 1991) p 15.Google Scholar

70. See Dale, Rs Risk and Regulation in Global Securities Markets (John Wiley, 1996) p 8.Google Scholar

71. Wood, G. Competition, regulation and financial stability’ in Booth, P. and Currie, D. (eds) The Regulation of Financial Markets (Institute of Economic Affairs, 2003) p 63 Google Scholar at pp 66–68.

72. Reports indicate that the balance sheet leverage ratio was in excess of 25:1. At one stage it was believed to be as high as 50:1: FSA DP 05/04, above n 5, p 20. One study claims that in addition to its very high gearing it had ‘gross futures, forwards and options contracts outstanding equal to about 300 times its capital’: The Impact of Hedge Funds on Financial Markets Paper submitted by the Reserve Bank of Australia to the House of Representatives Standing Committee on Economic, Financial and Public Administration’s Inquiry in to the International Financial Market Effects on Government Policy (June 1999), available at http://www.rba.gov.au/PublicationsAndResearch/SubmissionsToParliamentaryCommittees/impact_of_hedge_funds.pdf, para 17 (Reserve Bank of Australia Paper).

73. BS Bernanke Hedge Funds and Systemic Risk Federal Reserve Bank of Atlanta’s 2006 Financial Markets Conference (Georgia, 16 May 2006), available at http://www.federalreserve.gov/Boarddocs/speeches/2006/200605162/default.htm, p 1.

74. L Chong ‘Collapsed fund’s founder returns to the fray’ The Times 12 July 2006.

75. Hearings of the US House Banking and Financial Services Committee on Hedge Funds, 105th Congress (1 October 1998), Statement of William McDonough, President, Federal Reserve Bank of New York.

76. Above n 71.

77. Ibid.

78. Ibid.

79. H Davies ‘Managing financial crises’ in Booth and Currie, above n 71, p 26 at p 27.

80. Dale, Rs International Banking Deregulation: The Great Banking Experiment (Blackwell, 1992) p 18.Google Scholar

81. See generally Dale, above n 70, ch 1.

82. ‘At its 7th meeting in March 2002, the FSF [Financial Stability Forum] discussed how far previous concerns about HLIs [Highly Leveraged Institutions] had been allayed by the implementation of its previous recommendations. The FSF noted that several developments – including improved counterparty risk management strengthened regulatory oversight and enhanced information flows – have helped to reduce the threat that hedge funds pose to the international system. But the FSF urged continued improvements in public disclosures by hedge funds to improve market discipline and reduce systemic risk’: FSA DP 16 2002, above n 3, p 32.

83. FSA DP 05/04, above n 6, p 19. The clustering of some funds in less liquid markets (accounting for up to and sometimes over 50% in some asset classes) raises concerns about how easily some of these positions could be unwound should the need arise.

84. Ibid, p 28. Furthermore, according to the FSA: ‘[s]maller hedge fund managers appear to communicate frequently with each other and sometimes share trade ideas’: ibid, p 29. The FSA also highlights events in the hedge fund industry in the wake of the credit downgrading of General Motors and Ford: ‘[I]t is interesting to observe the commonalities in losses by hedge funds pursuing similar strategies (together with losses in counterparties to these funds) and losses in individual funds or clusters of funds leading to investor redemptions and enforced liquidation of assets’: ibid, p 20.

85. Ibid, p 30: ‘[t]his liquidity may… turn out to be an illusion, disappearing in a falling market, if it is concentrated among hedge fund managers with similar strategies/risk management models who might choose to exit the positions/market at the same time’. Furthermore, ‘[o]ver-reliance on a single prime broker could leave the fund particularly exposed to the risk of leverage being withdrawn or its cost rising. This risk would be particularly acute where the source of leverage had similar market exposures to that of the hedge fund and so might be obliged to by its own funding/capital requirements to withdraw liquidity/increase its cost at the very time the fund needed it most’: ibid, p 31. See also Sir John Gieve, Deputy Governor, Bank England, Financial System Risk in the UK – Issues and Challenges Speech delivered at the Centre for the Study of Financial Innovation Roundtable (25 July 2006) (the capacity and willingness of hedge funds ‘to provide liquidity in the event of a large shock to the market remains uncertain’: p 7).

86. FSA DP 05/04, above n 6, p 22.

87. The FSA recognises that the collapse of some funds could provide commercial opportunities for other hedge funds. See ibid, p 28. Moreover, the US hedge fund, Amaranth, collapsed without significant disruption to the market, incurring losses estimated at £3.47 billion (although the capacity to absorb such losses may have had more to do with ‘benign’ market conditions at the time); see ‘ECB calls for hedge fund register to fend off financial crisis’ The Times 12 December 2006.

88. According to the Wall Street veteran, H Kaufman, ‘[w]e know less about the financial system today than we did 20 or 30 years ago. So much occurs beyond the balance sheet… [t]he build-up of derivatives is extraordinary’: ‘Investment banks getting more like hedge funds, says Dr Doom’ The Times 19 May 2006.

89. See Dale, above n 80, p 47 (expressing similar concerns about the merging of securities activities and commercial banking). See also L Chong ‘FSA warns institutions on risk of asset price correction’ The Times 28 July 2006 (institutions may not have taken sufficient account of the present scale of the risks that they are taking); and Bank of England Financial Stability Report (July 2006), available at http://www.bankofengland.co.uk/publications/fsr/2006/fsrfull0606.pdf (warning that competitive pressures have encouraged firms to extend their risk taking and, as a result, pushed the financial system as a whole further up the risk spectrum). According to the SEC Staff Report, above n 6: ‘Larger and more seasoned hedge funds often establish an internal risk management structure using their own resources and personnel. [Others] out source the risk management function to their prime brokers or to other service providers. Some of the less well established hedge funds advisers have little or no risk management controls’: p 67.

90. For indications that returns are falling, see P Hosking ‘Asset class suffers withering two months’ The Times 5 July 2006; and L Armistead (ed) ‘Hedge funds feel the pain’ The Times 20 August 2006.

91. FSA DP 05/04, above n 5, p 36. Note also that there are concerns that investment banks are increasingly adopting hedge fund strategies.

92. Ibid, p 16. See also Moloney, above n 1, at 5.

93. ‘We remain concerned that… investors, even those meeting accredited investor standard, may not possess the understanding or market power to engage a hedge fund adviser to provide the information necessary to make an informed investment decision’: SEC Staff Report, above n 6, p 81. See also Financial Economists Roundtable Stanford Graduate Business School Statement of the Financial Economists Roundtable on Hedge Funds (3 November 2005), available at http://www.luc.edu/orgs/finroundtable/HedgeFundStatement.htm, pp 1–2.

94. FSA DP 05/04, above n 5, p 33. Moreover, according to a survey by Deutsche Bank, 60% of institutional investors take between 2 and 6 months to complete due diligence on a hedge fund: quoted in SEC Staff Report, above n 6, fn 206.

95. SEC Staff Report, ibid, p 47 and sources cited therein. Even where investors have sufficient leverage to act as a moderating influence on hedge fund behaviour this fact does ‘not …increase transparency to regulators and will not therefore facilitate market supervision unless a regime is created that allows us to gather information in a systemic fashion and then subject it to ongoing analysis’: FSA DP 05/04, above n 5, pp 33–34.

96. See, Schroder Music Publishing Co Ltd v Macaulay [1974] 3 All ER 616 per Lord Diplock.

97. For growing retailisation of the market see above n 62.

98. As the FSA notes: ‘[i]n the last 12 months, a number of structured products based on hedge funds (listed on EU exchanges) have been launched with lower minimum investment thresholds (around £5,000 or £10,000…)… The UK listed fund of funds market is also showing signs of life with a number of new launches recently’: FSA DP 05/04, above n 5, para 2.12. Reports indicate that currently around about 4% of the funds controlled by pensions funds are invested in hedge funds: ibid, para 2.10.

99. Above n 61 and accompanying text.

100. FSA DP 05/04, above n 5, p 48. See also SEC Staff Report, above n 6, p xi.

101. FSA DP 05/04, above n 5, p 48.

102. Ibid, p 48.

103. Though to the extent that auditors only check valuation procedures annually errors can remain unchallenged for considerable periods of time: FSA Hedge Funds: A Discussion of Risk and Regulatory Engagement (Feedback on DP05/4) (March 2006) (FSA Feedback Statement 06/2) p 25.

104. Where the ‘industry quote is obtained from the actual counterparty to the trade then they might have an incentive to mis-price the deal for their own internal purposes’: FSA DP 05/04, above n 5, p 48. It is estimated by the Alternative Investment Management Association (AIMA) that in 2004 20% of hedge fund strategies were in hard to value securities (eg distressed debt, emerging markets, fixed income arbitrage): D Waters FSA Regulation and Hedge Funds: An Effective Proportionate Approach for a Dynamic, International Marketplace Speech delivered on behalf of the FSA (19 October 2006), available at http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2006/1019_dw.shtml, p 4.

105. FSA DP 05/04, above n 5, p 49; and FSA Feedback Statement 06/2, above n 103, p 5 (citing the case of regulatory action against Mr Jae Wook Oh, a former hedge fund investment manager at Regents Park Capital Management LLP). To the extent that the fund manager deliberately issues false valuations criminal sanctions could follow. In the USA, other fraud charges brought by the SEC relate to ‘misappropriation of assets; misrepresentation of portfolio performance; falsification of experience, credentials and past performance; misleading disclosure regarding claimed trading strategies’: SEC Staff Report, above n 6, p 74. In the context of the USA, see M Herman ‘Hedge fund chief accused of overstating assets by 2,500%’ The Times 8 February 2007. Moreover, ‘[t]he growth of the number of hedge fund fraud cases [in the USA] is likely [to be] attributable to a number of factors, including: the popularity of hedge fund investments and the large number of money they involve (and thus their attractiveness to perpetrators of fraud); the entrance to the industry of inexperienced, untested and, in some cases, unqualified individuals; and lack of adequate controls on the operation of some hedge fund advisers’: SEC Staff Report, ibid, p 73.

106. ‘The absence of any form of independent oversight over hedge fund pricing raises significant questions about the quality and fairness of the prices at which investors buy or redeem interests in some hedge funds’: ibid, pp 79–80.

107. FSA DP 05/04, above n 5, p 48.

108. Spangler, above n 25, at 38.

109. Ibid.

110. FSA DP 05/04, above n 5, p 48.

111. SEC Staff Report, above n 6, p 84.

112. Ibid.

113. Ibid.

114. R Fletcher ‘City regulator cracks down on hedge fund insider trading’ The Times 19 June 2005.

115. FSA DP 05/04, above n 5, p 53.

116. Ibid. Similar fears have been raised by Australian regulators: ‘It should be of concern to policy makers that, as well as positioning themselves to take advantage of expected market developments (which is a perfectly legitimate activity), these funds at times also try to influence the course of those developments. Their ability to do this reflects not only the size of their position-taking relative to some of the markets in which they operate, but their influence on the behaviour of other market participants because of the reputation they enjoy’: Reserve Bank of Australia Paper, above n 72, para 7.

117. Ibid, para 3.

118. Ibid, para 2.

119. FSA DP 05/04, above n 5, p 54. Already both here in the UK and in the USA high profile scandals regarding hedge funds and market abuse have emerged. In the UK, on 1 August 2006, the FSA fined hedge fund manager GLG Partners LLP and Mr Philippe Jabre, a former managing director of the firm, £750,000 each for market abuse and for breaching FSA principles. This was the largest fine the FSA had issued against an individual. In the USA, see Testimony of Gary J Aguirre, Before the United States Senate Committee on the Judiciary (28 June 2006).

120. H Sants The FSA’s Wholesale Agenda Speech on behalf of the FSA (7 July 2005, available at http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2005/0707_hs.shtml.

121. FSA Feedback Statement 06/2, above n 103, p 3.

122. Ibid, p 8.

123. ‘[C]urrent policy thinking is not to proceed with any specific changes to the rules applied to hedge fund managers [because of] concerns about the impact of regulation on the attractiveness of the UK as a location for hedge fund managers’: ibid, p 5.

124. See, eg, Technical Committee of the IOSCO, Consultative Report: the Regulatory Environment for Hedge funds – A Survey and Comparison (March 2006).

125. The Joint Forum was set up in 1996 under the aegis of the Basel Committee on Banking Supervision (BCBS), the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS). The aim of the body is to ‘deal with issues common to the banking, securities and insurance sectors, including the regulation of financial conglomerates’; see the website available at http://www.bis.org/bcbs/jointforum.htm.

126. The Financial Stability Forum (FSF) was convened in April 1999. Its declared aim is ‘to promote international financial stability through information exchange and international co-operation in financial supervision and surveillance’.

127. See above n 19 and accompanying text.

128. See above n 20 and accompanying text.

129. FSA Feedback Statement 06/2, above n 103, p 13.

130. Waters, above n 104, p 2.

131. Waters, above n 51, p 3.

132. ‘In aggregate the survey covers around 45% of global hedge fund assets under management’: ibid.

133. Waters, above n 104, p 2.

134. This stands for Advanced Risk Response Operating frameWork. Basically the FSA considers both the impact that a firm poses to its regulatory objectives in the event that something goes wrong, combined with the probability of that event occurring. The more significant the impact and the greater the probability of this impact occurring, the more FSA resources that are devoted to it. Following recent improvements to the ARROW process, it is now known as ARROW II.

135. Above n 34, at 537.

136. J Sanio Should Hedge Funds Be Regulated?, available at http://www2.goldmansachs.com/our_firm/our_culture/corporate_citizenship/gmi/images/GMI_Panels/Sanio_paper.pdf, p 1.

137. See Parkinson, Je Corporate Power and Responsibility (Oxford University Press, 1993) p 132 Google Scholar. See also TF Geithner Hedge Funds and Derivatives and the Implications for the Financial System (Speech 15 September 2006), available at http://www.ny.frb.org/newsevents/speeches/2006/gei060914.html (‘the effectiveness of market discipline in constraining the risk-taking behaviour of firms may, however, be compromised by the presence of market failures’: p 4).

138. [S]ystemic risk … is by definition an externality that internal procedures do not encompass and is not accounted for in the marketplace’: Alexander, K., Dhumale, R and Eatwell, J. Global Governance of Financial Systems: The International Regulation of Systemic Risk (Oxford University Press, 2006) p 260 Google Scholar. The fact that ‘the market’ cannot always identify in time – and subsequently – neutralise a liquidity crisis is illustrated by the LTCM crisis. Here, the risk of default was not accurately priced. Hence the need for a costly ‘bailout’. Similarly, although the backlog of unconfirmed trades in the credit derivatives market has been largely resolved, the fact that problems arose in the first place implies that the market exchanges of participating parties mis-priced the full costs of their ‘private’ transactions. In other contexts, the Enron, WorldCom and Parmalat scandals bear testimony to the fact that private interests and the public good can easily become misaligned in seriously damaging ways.

139. See Geithner, above n 137, pp 4–5

140. Ibid.

141. Ibid.

142. P Robotti Hedge Funds and Financial Stability: Explaining the Debate at the Financial Stability Forum (May 2006), available at http://fmg.lse.ac.uk/pdfs/dp560.pdf, pp 2–3. Moreover, ‘[d]ue to the multifarious interests banks hold in the hedge fund industry, they might not have [the] incentives to perform due diligence and properly assess risk as regulators expect them to’; ibid.

143. See, eg, B White and J Grant ‘Regulators see dangers in hedge fund collateral’ Financial Times 30 January 2007.

144. D Wighton and D Brewster ‘Morgan Stanley eyes up hedge funds’ Financial Times 13 October 2006.

145. The costs of regulatory intervention include, but are not limited to, moral hazard problems, enforcement problems, over-regulation and scope for regulatory capture.

146. See, generally, Parkinson, above n 137. Furthermore, as Sanio claims, reliance on the monitoring skills of prime brokers in this way amounts to a privatised form of supervision that, in his view, is an abdication of supervisory responsibility: ‘[w]e cannot hand over supervision to private parties that are far from being neutral, but are pursuing their own interests’: Sanio, above n 136, p 1.

147. Above n 14, p 31.

148. Ibid, p 32.

149. Ibid.

150. Ibid.

151. Edwards seems too ready to dismiss the fact that wholly inadequate levels of disclosure – and market discipline – were present preceding the collapse of the LTCM fund. Although levels of disclosure have improved, and leverage is today more constrained, significant market failures can and do occur.

152. ‘Although hedge funds still manage a small part of the total managed capital in international terms, approximately 5 per cent, they account for an increasingly large part of the liquidity in the market’: Riskbank Financial Stability Report 2006:1, available at http://www.riksbank.com/pagefolders/26147/2006_1_eng.pdf, p 99.

153. There is also the possibility of liability under the ‘general law’: eg fraudulent misrepresentation (resulting contract voidable and/or claim for damages) or breach of Misrepresentation Act 1967, s 2(1) (resulting contract voidable and/or claim for damages).

154. For the scope of the approval regime, see FSMA, ss 59–71.

155. FSA Feedback Statement 06/2, above n 103, p 6. So called thematic or project work is ‘supervisory work not focused on individual firms, but rather on a group of them’: Waters, above n 22, p 2.

156. FSA Feedback Statement 06/2, above n 103, p 26. The working party report was published in March 2007 (see the website available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD240.pdf) and was endorsed thereafter by the FSA.

157. H Sants Hedge Funds – How Far is it Necessary to Regulate? Speech on behalf of the FSA to the Thirty-First Annual Conference of The International Organization of Securities Commissions (IOSCO) (Hong, Kong, 8 June 2006), available at http://www.iosco.org/library/annual_conferences/pdf/ac20-15.pdf, p 8.

158. Waters, above n 104, p 4

159. Waters, above n 51, p 3.

160. FSA Feedback Statement 06/2, above n 103, p 6.

161. Ibid, p 23. From the point of view of evolving market practice, since side letters have become an burdensome feature of hedge funds, ‘increasing efforts are being made to include the most frequently requested side letter provisions in the fund’s constitutional documents instead’: Spangler, above n 25, p 39.

162. The FSA recommends that ‘investors ask firms if the fund boards follow principles set out in the Alternative Investment Managers Association’s (AIMA’s) Offshore Alternative Fund Directors’ Guide (May 2005) which includes general advice and guidance on matters which should be taken into account when considering requests to enter into side letters’: FSA Feedback Statement 06/2, above n 103.

163. Waters, above n 104, p 3. Examples of material terms are privileged portfolio information and special redemption rates, but not fee rebates.

164. Sants, above n 157, p 9.

165. FSA Feedback Statement 06/2, above n 103, p 17. Greater emphasis is also to be placed on the use of impact metrics. Here, the FSA proposes that ‘work on impact scoring specifically for hedge fund managers will be driven by funds under management, adjusted by existing data reporting on transaction volumes and various instruments obtained from our existing transaction reporting system, the Surveillance and Business Reporting Engine (SABRE). Revisions to SABRE are in progress’: ibid, pp 6–7.

166. FSMA, Part XI.

167. For example, ibid, ss 380(1), (2), (3) and 382. The FSA has expressed a similar policy approach in relation to market abuse. See Waters, above n 104, p 3.

168. Above 138 and accompanying text.

169. Geithner, above n 137, p 6.

170. Ibid, p 5.

171. Ibid, p 6. See also Alexander et al, above n 138, p 269.

172. As Geithner recognises, ‘[u]nderstanding and evaluating “tail events” – low probability, high severity instances of stress – is a principal, and extraordinarily difficult, aspect of risk management’: above n 137, p 6.

173. On recognition of the fact that international financial market problems require an international regulatory response, see generally Alexander et al, above n 138.