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INVESTMENTS IN CANADA: Ideas for regulating hedge funds abound
By David Clarke
January 22, 2007

OTTAWA — Just when Canadian regulators thought they had a handle on hedge fund regulation, a new scandal has erupted.
The U.S. Securities and Exchange Commission on Jan. 4 said that it had filed anti-fraud charges against Joseph Spiegel, who worked at Spinner Asset Management LLC, a $200 million New York-based hedge fund.

According to the SEC, he agreed to invest in three private investment in public equity (PIPE) transactions and then shorted the securities through a broker-dealer in Canada.

The SEC alleged that after agreeing to invest in the PIPE financing, the hedge fund short sold the companies’ shares through “naked” short selling in Canada. The term refers to situations in which the investors haven’t arranged to borrow the shares and can’t guarantee that they will obtain them.

“To close out the Canadian short positions, Mr. Spiegel engaged in deceptive, prearranged trades with his Canadian broker-dealer,” the SEC alleged.

It was the third recent investigation by the SEC of U.S. hedge funds using such a scheme.

“There’s a whole lot of speculation as to why [the three hedge funds involved] did some of their trading through Canada,” said Alex Popovic, vice president of enforcement for the Investment Dealers Association of Canada, a Toronto-based self- regulatory organization.

Indeed, the high-profile collapse in 2005 of two hedge funds, Montreal-based Norshield Asset Management (Canada) Ltd. and Toronto-based Portus Alternative Asset Management Inc., prompted Canadian regulators to conduct a review of regulations governing hedge funds.

On Jan. 12, the Montreal-based Canadian Securities Administrators, an interprovincial group that serves as the de facto national regulator, said that it had completed its review of the industry.

“Regulators in Canada recognize the increased popularity of hedge funds among retail investors,” said the group’s chairman, Jean St-Gelais. “While we feel the necessary regulatory framework is in place, it is important to continually examine the framework against new products in our evolving markets.”

The review identified areas for improvement, including issues with principal-protected notes, referral arrangements, distribution, disclosure and registration of fund managers.

But is that all the regulation necessary?

“Transparency is key, and this could be achieved by some form of ongoing independent oversight,” said Alex Chapman, director of operations at Mintz Fund Services Inc. in Toronto. “One element of independent oversight would be a requirement for independent valuation of hedge funds.”

Currently, there is no such regulation in Canada. But many smaller firms do delegate their valuations to third-party administrators, and almost all the larger hedge fund managers perform this role internally, Mr. Chapman said.

“The only required protection for hedge fund investors in Canada is the fund’s annual audit,” he added.

“In most cases, this would allow up to 15 months between a misstatement or act of fraud and its uncovering,” Mr. Chapman said. “Although 15 days is too long, 15 months is enough time to not only sail halfway around the world but also to design and build the sailboat.”

Apart from the individual investors, do hedge funds pose a systemic risk?

“Hedge funds have had a largely positive impact on the efficiency of financial markets in Canada,” David Longworth, deputy governor of the Bank of Canada, the Ottawa-based central bank, said in a recent speech. “Given our role in promoting financial stability, it would be fair to say that any concerns we might have about the impact of hedge funds would stem largely from our concern about systemic risk.”

The central bank should be worried, according to Eric Sprott, chief executive of Toronto-based Sprott Asset Management Inc., which runs assets of about $3.3 billion, of which about $1.3 billion is in hedge funds.

“I’m the only person in the world, I think, who worries about the banking system,” he said in a recent speech. “And I worry every day about the banking system” and the “tremendous leverage taking place within the hedge funds and the banking system.”

Mr. Sprott doesn’t favor regulation that would control leverage offered to hedge funds by already-regulated banks, saying that there are already rules in place for regulated entities.

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