Hedge fund law will damage City
RICHARD MARTIN & SEAN DONOVAN-SMITH
SPEECHLY BIRCHAM
The EU parliament is today expected to vote through amendments to the Capital Requirements Directive concerning bankers’ remuneration.
Under the new rules, which will take effect in January 2011, only 30% of any bonus (20% for “larger bonuses”) may be payable immediately and in cash with the remainder to be deferred for 3 to 5 years. At least half of the total bonus will have to be paid in shares or other securities linked to the institution’s performance. The rules will apply to senior management, risk takers and those with equivalent remuneration. As well as being the toughest restrictions on City pay yet, the big news to come out of these rules is that hedge funds will be treated in the same way as banks. This is the first time that hedge fund manager pay will be regulated. The EU parliament’s rationale is that “when investors’ money is put at risk, the investing firm’s incentives should be aligned with theirs”..
Hedge funds will be treated in the same way as banks. This is the first time that hedge
fund manager pay will be regulated. The EU parliament’s rationale is that “when investors’ money is put at risk, the investing firm’s incentives should be aligned with theirs”. Arlene McCarthy, Euro MP and vice chair of the Economic and Monetary Affairs Committee, last week remarked: “these tough new rules on bonuses will transform the bonus culture and end incentives for excessive risk-taking… it would be obscene to allow the discredited bank bonus culture to continue”.
This is all very well but the reasons why curbs were introduced on banking bonuses do
not apply to hedge funds in the same way. Given the concern about the long-term
stability of banks themselves and the risk to the financial system if they were to fail, one
could see the justification for discouraging short-termism and tying rewards more closely
to the organisation’s future stability. However, hedge fund managers are paid bonuses
based on performance fees which are already aligned with the interests of the funds they
manage. Additionally, the risks to the financial system or significant numbers of shareholders associated with a hedge fund failing are much less.
These new measures seem to be more about attacking high levels of pay than about safeguarding the financial system. That may be a legitimate aim in itself, but the justification ought to be made clear rather than slipped through under the guise of something else. Given the capital they control, hedge fund trading activity can have significant effects on the market and so there may be a belief that extending the rules to hedge funds will have an effect on trading activity and market volatility – but this is a different issue entirely.
In reality, imposing bonus restrictions is more likely to result in significant sums being legitimately left offshore instead of being brought into the UK. Funds may choose to either simply accrue performance fee entitlement for longer periods or reinvest bonus proceeds into the funds being managed – an option that is already increasing in popularity.
A key issue is how much flexibility is left with the national regulator. As directives are not “directly applicable” but only instructions to the member states to bring their national legislation into line with EC requirements, there may be some leeway for national authorities when implementing the rules. For example, it has already been agreed that national regulators should decide what amounts to a “larger bonus”. The EU’s system of financial oversight is due to be overhauled in January 2011 and the new EU institutions may take a more interventionist approach, limiting the discretion of national regulators such as the FSA, or its successors.
Most hedge fund managers’ contracts will provide for when and how bonuses are to be paid. How these employment contracts will be varied to accommodate the regulatory changes may cause issues and be subject to legal challenge. It may, for example, require existing arrangements to run their course for the current financial year with anyone not agreeing to the new regime for the next year being dismissed and offered a new contract.
Given the sheer number of regulatory changes that have recently been proposed, there is a severe risk that further change will result in hedge funds simply upping sticks and carrying on exactly as they are, but outside the reaches of the EU. Eighty per cent of European hedge funds are based in London, so this could have disastrous effects on London. Coupled with the 50 per cent tax rate and the incoming AIFM directive, the pressure to leave may become irresistible.