Monday, 24 October 2016
Last updated 2 days ago
Mar 17 2006 | 12:00am ET
By Sidney Wigfall, Esq., Guest Columnist
As seasoned Securities and Exchange Commission practitioners are well aware, SEC prospective guidance is rare, especially in areas considered virgin territory for the regulatory agency, like hedge funds. So undiscovered is the “hedge funds territory” from the regulatory side that the SEC is sending its inspection staffers to “hedge fund boot camp” via the CAIA designation program, which is offered by the Alternative Investment Management Association.
The program aims to give the staffers a practical, business side view of how hedge funds work and how managers ply their trade, which is why a speech given back in November by SEC Associate Director Gene Gohlke at the Fund-of-Funds Forum in New York was such a seminal event in the evolving regulatory landscape.
Whereas the SEC has at times displayed a reticence in offering regulatory guidance in the “unchartered gray areas” of the investment world, the speech may indicate a new day is dawning in the agency’s approach to regulatory oversight.
Gohlke’s speech, titled “SEC Expectations for Regulatory Compliance,” provides a useful and uncharacteristic preenforcement roadmap to building or enhancing a fund-of-funds’ compliance program to make it effective under SEC rules and the Investment Advisers Act of 1940. While I recommend that all senior managers at fund-of-funds read the entire speech* and its “good valuation practices” addendum, there are some key takeaways that merit highlighting from a proactive—rather than reactive—perspective.
While one may disagree substantively with some aspects of the SEC’s thoughts and industry assumptions in this area, it is refreshing to have some clear-cut guideposts as the funds-of-funds industry embarks on this regulatory journey involving many uncertainties and risks. The last time the SEC took such a comprehensive step was in its historical-looking 2000 Open Letter to SEC Investment Advisers; however, in this funds-of-funds roadmap speech, the SEC is taking a decidedly forward-looking approach in managing its regulatory oversight responsibilities in this new arena.
Based on my perspective as a former SEC counsel regulating investment advisers, the speech’s key highlights are as follows:
Highlight 1: Conflicts of Interest and the FoF Model Conflicts of interest — “they are everywhere” and are particularly prevalent in the investment advisory business because investment advisers have a fiduciary relationship with their clients. As fiduciaries, advisers must put clients’ interests first when making decisions and undertaking transactions affecting clients’ assets and other interests. Some of the areas in which conflicts of interest may exist in the business of fund-of-hedge fund managers include:
~ Fund manager’s relationships with managers of one or more of the underlying hedge funds. ~ Manager’s affiliate’s banking and investment banking relationships with issuers of securities held in underlying hedge funds.
~ Advisers to underlying hedge funds purchasing for those funds interests in instruments underwritten or distributed by a fund manager or its affiliates.
~ Side letter agreements with certain investors in a managed fund. ~ Valuations of interests in underlying funds held by a fund-of -hedge funds.
~ Calculation of fund-of-hedge funds’ performance numbers, especially when performance that is below a high water mark is the only factor preventing an adviser from getting an incentive allocation.
~ Allocations of investment opportunities among clients.
~ Proprietary trading by the fund manager or personal trading by its staff.
Highlight 2: An Effective Compliance Program for FoF’s After noting the customary Advisers Act (Rule 206(4)-7; “Compliance Program Rule”) areas of regulatory and risk compliance that must be addressed by compliance programs of all SEC-investment advisers, the speech touches on the 3 required steps under the Compliance Program Rule: (1) establishment of internal compliance policies/procedures reasonably designed to prevent, or to detect and correct promptly, Adviser Act violations; (2) an annual review of such compliance program coupled with implementation of any appropriate program changes/updates; and (3) designation of a CCO to administer such program.
The process of developing and managing a robust and customized compliance program may involve some or all of the following actions: risk assessments and gap analyses, creation of policies/procedures tied to such assessments/analyses, periodic program testing (transactional and forensic, as applicable), and implementation of policies/procedures using sound management and internal control principles.
Highlight 3: SEC Exams and “SEC-Exam Preparedness”
The speech describes the various types of SEC exams (on-site, written questions and “targeted sweeps”), and the typical outcomes (deficiency letter, “no further action” letter, and, less frequently, an enforcement referral). The speech also outlines the SEC’s new risk-based exam program methodology and the designation and implications of being a “high risk investment adviser” and “low risk investment adviser.”
As our firm has worked with and advised money managers and fund-of-funds, we continually emphasize being SEC-exam ready and consistently work with firm clients to build such exam-preparedness into their overall business practices and compliance/risk management program. There are the obvious regulatory/compliance benefits in adopting a proactive approach in managing SEC oversight; however, there are also business and client benefits to taking a proactive posture and staying ahead of the curve (see Barge Consulting—Clients & Friends Update (12/2005), SEC & Funds-of-Funds & Manager-of-Managers).
As the speech also notes, because conflicts of interest are so widespread and are often a subtle and natural part of a fund manager’s regular business, fund managers can easily overlook them until a harmful situation occurs. In addition, more institutional investors are negotiating enhanced “regulatory/compliance disclosure clauses” in their investment advisory agreements with funds-of-funds managers, and such agreements are covering the fund-of-funds manager as well as the underlying hedge fund managers. Such institutional clients are also implementing internal watchlist/probation programs or upgrading such programs in fully implementing their fiduciary and due diligence responsibilities in overseeing their fund-of-funds managers. Therefore, funds-of-hedge funds should devote appropriate and consistent attention to identifying, disclosing (in ADV-Part 1 and ADV-Part 2) and proactively managing their regulatory/compliance risks to maintain their business model for the long term. Such risk management includes regulatory/ compliance risks internal to the fund-of-funds manager as well as due diligence risks inherent in the fund-of-funds manager’s selection and oversight of the underlying hedge fund managers.
* For a full transcript of Gene Gohlke’s speech, see http://www.sec.gov/news/speech/spch111405gag.htm
Sidney Wigfall, Esq., is a Senior Adviser with Barge Consulting, a national boutique investment management and compliance consulting firm. Wigfall is a former SEC managing counsel with the SEC’s N.Y. Office and handled regulatory matters involving investment advisers, investment funds, hedge fund managers and broker-dealers. He has also served as chief legal-regulatory officer and chief compliance officer for multi-billion dollar money management firms and multi-manager investment funds, and also worked as a securities/corporate attorney for two large law firms. He may be reached at email@example.com.