Six Regulatory/Governance Themes for 2013

By Deborah Prutzman, The Regulatory Fundamentals Group LLC

January is always a good time to look ahead and prepare for what the New Year might have in store. With that in mind, we offer six trends that are likely to impact how you spend your time in 2013.


1. Need for Trust

The past few years have been less than stellar from the point of view of the individual investor. The global meltdown of 2008 was bad enough, but seemingly every week in 2012 brought another story about impropriety on the part of financial services firms and their traders. In a list too long to dwell on, a few low-water marks involved collusion on important bench mark rates (LIBOR), management failures by leading figures and firms (MF Global), and the ongoing press on insider trading. Key this year is whether advisers “get” the trust issue. Those who do will embrace the stronger regulatory environment and actively seek to deploy practices that are in the best interest of their investors. A proactive approach will differentiate these managers from the pack.

2. Focus on Governance

Related to the trust issue will be increased focus on how funds and advisory firms handle internal governance. As never before, governing bodies will be asked to explain how they establish the proverbial “tone at the top” which values fair dealing, integrity and professionalism, as well as how they identify and handle “risks.” Those with easily understood answers will garner investor allocations and positive reviews from the regulators. In short, they will be demonstrating that they understand the trust issue described above. The 2012 poster child for the developing governance approach appeared in an April press release announcing the DOJ would not bring a Foreign Corrupt Practices Act proceeding against Morgan Stanley because the firm had a comprehensive system of controls. The regulators will continue to send this message strongly in the months to come.

3. Pensions Search for Yield

Good news often plants the seeds of a future crisis, and the move by pension plans into alternatives may be no exception. It’s no secret that public pension funds have increased their allocations to alternative funds as a way to provide government employees with the money needed to fund retirements. By way of example, several New York City retirement systems recently announced an allocation of about $3.5 billion to hedge funds. For those alternative managers raking in the allocations, this is currently good news. Two outgrowths are likely. Since 2008, institutional investors have increasingly focused on operational due diligence. This is likely to continue in 2013 and grow into a demand for a true enterprise risk governance approach, reinforcing the trends noted above. At the same time, over the long-term increased pension allocations may result in increased regulation. If a lack of transparency, fairness or integrity leads, or is perceived to lead, to the failure to realize hoped for returns, greater regulation may be only a legislative session away. In this case, the Dodd-Frank layer of regulation may look mild in comparison.

4. Central Counterparty Risks

In 2013, advisers to funds that enter into swaps will face a new risk management challenge as mandatory swap clearing is implemented. In a cleared swap, a clearinghouse serves as the counterparty to both parties to the swap, and both parties are required to post initial and variation margin. If either side fails to meet its obligations, the clearinghouse assumes the position. Clearing does not, however, eliminate the risk that payment obligations will not be met. Rather, it shifts risk from swap counterparties to a clearinghouse and its clearing members. Advisers to funds that enter into swaps will thus face the complicated task of adjusting their risk management programs to address the risks associated with specific clearinghouses. Also, we shall learn if the clearinghouse approach is right or serves only to further concentrate risk. In any event, expect to hear a lot about systemic risk and the clearing system in 2013.

5. An Arms Race Between Regulators

Expect 2013 to shape up as “the year of enforcement,” with competing regulators looking for the proverbial headline. Fueled by tips from whistleblowers, there should be more than enough ammunition to keep enforcement personnel active. This will create an increased need for alternative firms to get on top of all regulatory regimes that apply. Expect increased activity beyond the SEC and CFTC to include the Federal Energy Regulatory Commission, bribery in all its forms, sanctions violations and anti-trust issues. Also watch for the Financial Stability Oversight Council to take an expanded role as it grapples with money market fund issues and increased regulation of systemically important institutions. Foreign regulators will join in the arms race, expanding the extraterritorial reach of their laws. For example, the EU recently implemented new short selling regulations that apply even when short sales take place away from EU trading venues. In addition, the EU is currently working on a new data protection regime that will impose potentially stiff new penalties (as high as 2% of a firm’s total worldwide revenues) and will reach across borders when data breaches impact EU-based customers and employees.

6. Marketing Becomes Accountable

Every adviser wants to land that new investor willing to make a substantial allocation. However, before someone from the marketing team gets on a plane, it is important that the firm fully understands the price it will pay for the allocation. This past year shows the price can be high. In 2012 the Carlyle Group was mired in an expensive dispute with former investors in Kuwait who alleged that their contract to make additional investments was void because Carlyle did not have a local license. In addition, Canada and Germany are making their laws about solicitation of residents more restrictive. More generally, advisers seeking European investors will need to conform to the new Alternative Investment Fund Managers Directive. Just as private equity managers tell portfolio companies to get things right first in order to drive future success, advisers will need to do the same—especially in the marketing area. Unless planned in advance, a rush to market in a new jurisdiction can trigger (i) registration requirements for the fund or the adviser (with on-going compliance and reporting burdens), (ii) licensing requirements for marketing staff, (iii) the need to change or modify product structures and offering materials, and (iv) penalties and other negative consequences, including rendering allocations unenforceable and a need to comply with local privacy laws. Aim before you fire in this area. If anything, the trend in 2013 will be for more regulation outside the U.S. and the price paid for any deficiencies will rise substantially.