By Janaya P. Moscony, President, SEC Compliance Consultants -- Are Hedge Funds Ready for SEC Registration? In most cases, they are more ready than they believe.
October 16, 2009 - We at the SEC are committed to pulling back the curtain on hedge fund operations and taking a close look at their activity. We are developing a variety of initiatives to do that involving greater specialization and expertise, improved technological tools to track and analyze trading, better coordination among regulators and law enforcement, new legislative initiatives, and other means to address these areas.
It would be wise for investment advisers and corporate executives to closely look at [the Raj Rajaratnam] case, their own internal operations, and the increasing focus and scrutiny on hedge fund trading activity by the SEC and others, and consider what lessons can be learned and applied to their own operations.
Director, SEC Division of Enforcement
U.S. Securities and Exchange Commission
Based on the above quote, who can blame a hedge fund manger for being a little skittish about pending SEC registration.
Despite the hype, the SEC is not out to get hedge funds. They are focused on improving their batting average with finding fraud and hedge funds provide good headlines. Even though the number of hedge funds willfully engaging in misconduct is minute, hedge fund managers should expect to be examined by the SEC. Although the implications and cost of on-going registration may appear burdensome, many firms may be better prepared than they think. By formalizing existing procedures as part of a complete compliance program with policies and procedures mapped to a thorough firm-wide risk-assessment, any SEC visit should be routine.
Nonetheless, many managers to hedge funds continue to be concerned. This is to be expected with the recent passage of the Private Fund Investment Advisers Registration Act of 2010. The registration act is part of the larger Dodd-Frank Wall Street Reform and Consumer Protection Act. The 27 pages of the registration act could easily be missed in the 2,307 pages of the larger reform bill. However, the impact of those few pages will be dramatic on hedge funds with assets greater than $150 million.
Hedge fund managers will need to quickly become familiar with Rule 206(4)-7 of the Investment Advisers Act of 1940 known as the Compliance Rule. Enacted in 2004, following scandals almost a decade ago, Rule 206(4)-7 requires registered advisers to adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act by the adviser or any of its supervised persons. The rule requires advisers to consider their fiduciary and regulatory obligations under the Advisers Act and to formalize policies and procedures to address them.
Rule 206(4)-7 does not specifically list the elements that advisers must include in their policies and procedures. The SEC acknowledges that advisers are too varied in their operations for the rules to impose a single set of universally applicable required elements. Each adviser is required to adopt policies and procedures that take into consideration the nature of their specific operations. Advisers must therefore have customized policies and procedures designed to prevent violations from occurring, detect violations that have occurred, and correct promptly any violations that have occurred.
It is our experience that many unregistered hedge fund advisers already have procedures and controls in place in certain areas of their business that are pretty close to satisfying the SEC's expectations. In some cases, prime brokers and third party administrators and trading platforms provide certain checks and verification procedures which can be incorporated into a compliance program.
Below are some of the compliance areas hedge fund advisers may have procedures close to satisfying SEC requirements.
Portfolio Management Processes. This includes allocation of investment opportunities among clients, managing portfolios consistently with stated mandates, and abiding by applicable regulatory restrictions. Given that certain private fund advisers may manage more than one fund, matters regarding allocation and adherence to the different mandates and objectives of each fund, are already in place.
Trading Practices. This includes procedures by which the adviser satisfies its obligation to seek best execution and using client brokerage to obtain research and other services. Managers realize one of their strongest currencies on the street is their commission dollars and are aggressive in seeking the best combination of commission rates and services from their brokers. Hence, most advisers have practices in places to assess best execution.
Accuracy of Disclosures. All advisers, whether registered or not are subject to the anti-fraud provisions of the Advisers Act and ensuring adequate disclosure is always the first level of defense. As such, hedge fund lawyers are very good at ensuring all necessary disclosures are including in offering documents and a large part of the required disclosure is already exists. Once registered, advisers will be required to complete Form ADV, the main disclosure document for SEC-registered advisers. Also known as the firm’s brochure, Form ADV Part II is where advisers discuss their business, conflicts of interest and other material facts. All new investors must be presented with a copy and all existing investors must be offered at least annually an updated brochure. Even if something is not specifically addressed in the ADV, the SEC expects disclosure if an item would be deemed material to an investor making a decision to invest or remain invested with a manager. When we draft a hedge fund client’s ADV, we are able to obtain a great deal of the information from existing offering documents. The new ADV requirements will require all disclosure to be publically available on the SEC’s website.
Safeguarding of Client Assets. This includes safeguarding fund assets from conversion or inappropriate use by advisory personnel. Private fund managers may already have more sophisticated expertise in this area than other investment managers given the greater variety, and relatively atypical nature, of instruments held in some private fund portfolios compared to those of other advisers who typically hold only publicly-traded securities. Experience in securing possession of, and holding, non-traditional investments makes safeguarding an area where private fund advisers may already have established systems and controls, especially with the help of their prime brokers and other service providers.
Books and Records. This involves maintenance of records in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction. The SEC has precise requirements regarding types of records to be maintained and how long they must be maintained. Again, prime brokers and other service providers often perform services and maintain certain records with the necessary redundancy.
Asset Valuation. Valuation has been an issue of major importance to all hedge fund constituents including regulators as it is a critical factor in determining compensation to the fund adviser. Potential institutional investors often inquire about valuation methodologies used especially with respect to alternative, illiquid or otherwise closely-held investments. Private fund advisers should have fairly strong procedures in place for valuing investments. Like institutional investors, the SEC staff will also have similar interest.
Business Continuity Plans. Many private fund advisers may consist of just a few employees, having outsourced many functions to other service providers. Therefore, while they may not have formal business continuity plans, certain service providers may be providing the necessary level of redundancy in certain areas. As stated above, policies and procedures are to "take into consideration the nature of their specific operations." An adviser's business continuity plans should take into account the number of staff members and support provided by service providers in order to continue business operations during the period of disruption.
In many cases, hedge funds have established practices. It may be an issue of formalizing them into written policies and procedures.
SEC Compliance Consultants’ Guide to SEC Registration for Private Fund Investment Advisers provides a complete guide to the SEC registration process and the on-going compliance requirements.
Janaya Moscony, CFA, is the President and Founder of SEC Compliance Consultants, Inc. As a former Securities and Exchange Commission regulator, Moscony has extensive experience in the examination, implementation and enforcement of securities regulations of investment advisers. As a consultant, she advises financial institutions how best to effectively manage the regulatory environment with a focus on balancing business needs with regulatory requirements. Prior to incorporating SEC3, Moscony served as Vice President of Bank of Hawaii’s Asset Management Group where she advised and implemented the bank’s regulatory compliance program. Prior to Bank of Hawaii, Moscony was employed as a regulatory consultant by a nationally recognized consulting firm where she managed numerous engagements with banks, mutual funds, investment advisers and broker-dealers. Moscony began her career as an examiner with the Philadelphia District Office of the SEC where she worked on routine and for- cause examinations as well as enforcement cases on behalf of a broad-range of financial entities.