Top Five Steps For Building A Culture Of Compliance At Hedge Funds

Nov 12 2013 | 12:20pm ET

By Anthony Sperling
Executive Vice President, Advent Software

To say the climate for hedge funds has changed in recent years is an understatement. The financial crisis of 2008-2009 is still reverberating in the industry in the form of more stringent regulation. In the US, Dodd-Frank empowered the SEC to require hedge funds to register as investment advisors and file Form PF. The Foreign Account Tax Compliance Act (FATCA) requires offshore funds to report on their US investors to the IRS. And the Alternative Investment Fund Managers Directive (AIFMD) requires anyone managing or marketing funds in Europe to comply with new reporting requirements.

Meanwhile, hedge funds have moved from the fringe to the mainstream of investment activity. Institutions want the returns funds have historically produced, but they also demand to know how managers are managing risks. The rise in regulation, therefore, has coincided with investor demands for more transparency.

Many hedge funds remain in the early to middle stages in developing compliance programs, and some are finding the task difficult. Yet where some see added burdens, others will see an opportunity – in the contest for investors and capital, funds can gain an edge by building a strong culture of compliance.

More Than Attitude

A culture of compliance is more than a firm-wide attitude. The SEC uses the term to assess how effectively a firm adheres to policies and procedures that protect investors. Firms deemed to have a weak culture, or high risk, are likely to get more attention from the SEC and more frequent examinations.

As complicated as compliance requirements often seem, they all stem from a single, simple principle: Do what is right for the investor over and above what you would do for yourself. While it is important to follow the letter of the law, the spirit of responsibility to investors is equally important.

Marketplace Pressure: The Ultimate Compliance Driver

Institutional investors will always require greater transparency and accountability. Public funds, pension funds, foundations and endowments are ultimately accountable to a retail constituency. Funds of funds, a major source of assets, hold their underlying hedge funds to the same standards with which they must comply. Marketplace pressure may well drive hedge fund compliance to a greater degree than regulatory pressure. Unlike regulators, investors vote with their money—steering their investments toward firms that can demonstrate a culture of compliance, and shunning those that cannot.

Institutional investors perform due diligence both before and after placing their assets with a money manager. And they look at the same compliance hallmarks in a hedge fund firm as in any asset management firm: written policies and procedures, a code of ethics, trading and performance history, individual managers and, of course, litigation history. A hedge fund firm that can measure up to thorough, standard professional scrutiny stands a better chance of attracting investors.

The Top Five Steps for Building a Culture of Compliance

1. Establish written policies, procedures, and practices.

The cornerstone of compliance is a policies and procedures manual designed to prevent legal or ethical infractions. In the event of a regulatory action or investor complaint, the first question will likely be, “What are your firm’s policies or procedures regarding the behavior in question?” 

It is important that the policies and procedures manual does not become a token “desk manual” that meets the letter of the law but is ignored by employees. It should be written in plain English, easy to understand and follow, and reflective of the firm’s actual business practices. Above all, it must be a living document, reviewed and refreshed at regular intervals.

2. Institute a code of ethics.

SEC-registered advisors are required to have written codes of ethics. The point of a code of ethics is not just to instruct on the law, but also to make sure employees understand their responsibility to investors and foster a culture of above-board conduct. A code of ethics reaffirms that hedge fund managers recognize their fiduciary responsibility, and that it always outweighs the desire to make profit. Correlated to a code of ethics is a zero tolerance policy for employee misconduct.

3. Keep accurate and complete records, and be prepared to deliver them when requested.

According to the SEC, most portfolio management violations involve an advisor’s inability to maintain complete records. Hedge fund firms should have a strong system of record maintenance and retrieval. Along with traditional business records, firms should keep records of:

 • Every buy or sell transaction in every fund
 • Gain and loss allocations among partners
 • All correspondence—whether written or electronic—with investors, partners, and counterparties such as prime brokers and other custodians
 • All marketing materials and presentations (technically, any advertising, circular or article sent to “ten or more people”)

Electronic correspondence and documentation have become the norm. From a regulatory perspective, electronic communication – whether in email or through social media – is as definitive as anything on paper. It should be retained for at least five years and be readily retrievable. Employees should know that workplace communication is never “private,” and they should put nothing in an email or a “tweet” that they would not put in a hand-signed document.

Fund firms are also required to have a business continuity plan that provides for the recovery of data in the event of a disaster. 

4. Avoid conflicts of interest—always put clients first.

Putting clients first is more than a marketing slogan. It should be codified in policies and procedures designed explicitly to protect client interests. Policies should specifically address such issues as personal trading, access to non-public or inside information, and the handling of errors and complaints. A culture of compliance is built on the belief that protecting the investor’s interests is in the firm’s best interest.

5. Put your practices to the test.

Conduct periodic reviews that mirror what the SEC might do in an exam. Many firms engage auditors and consultants to examine their procedures and assess their compliance readiness. The review should identify and rank areas of risk, enabling management to deal with the highest-risk areas first. 

Supporting Compliance through Technology

Technology that mitigates operational risk has become indispensable. Investors place a premium on accurate, reliable information and effective controls that help reduce the risk of human error. Advanced technology that improves data integrity and delivers real-time answers has become a competitive essential. A sound technology infrastructure is also virtually imperative in SEC examinations. Technology allows firms to spend less time managing paper and people and more time actively managing risk, something the SEC likes to see.

Most hedge funds operate ethically and act in their investors’ interests. A practical reason for building a culture of compliance is to help reduce the risk of infractions that could lead to legal sanctions. The more compelling reason, however, is that it is simply good business. Think of the costs associated with compliance as an investment in your firm’s reputation, which will pay dividends in the form of client acquisition and retention. Losing clients or failing to attract them is far more costly in the long run.

Anthony Sperling is Advent Software’s EVP, Global Client Experience, and has worked with hedge funds and asset managers to implement technology solutions that help solve challenges in compliance and operations for more than two decades.


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