Hedge funds prepare to strengthen compliance programs

May 02, 2013
<p>A recent all-day RCA symposium helped private fund managers gird up for a new era of expanded authority by the SEC.</p>

Hedge fund and private equity fund managers are considering tougher compliance practices now that their activities have come under the oversight authority of the Securities and Exchange Commission. Possible cases of inflated asset valuations, insider trading and aberrations in private funds’ investment returns are just a few of the areas the SEC will be looking to investigate as it takes a closer look at this vast investment universe. 

The latest educational symposium sponsored by the Regulatory Compliance Association on April 18 in New York was geared specifically to private investment funds to help them quickly get up to speed on practices public companies have been developing for many years.

In his keynote remarks, SEC Commissioner Luis Aguilar, a long-time champion of investor protections. and a former general counsel and compliance officer at investment firm Invesco, said a bigger budget will enable the SEC to hire 250 additional examiners, a large percentage of whom will be assigned to alternative fund advisors. The SEC is also improving internal coordination between various units. For example, the Division of Risk, Strategy, and Financial Innovation (RSFI) has increased its efforts to provide data analytics to other SEC units. These analytics are being used to evaluate performance data in order to help identify candidates for investigations, Aguilar said. That will help ‘better determine your risk structure and allow us to get in there more quickly’ to see if there has been any aberrational performance, he said.

The implications for private fund managers of changes at the SEC were discussed in greater detail during a later panel on investigation, enforcement and prosecution of hedge fund and private equity managers that featured a special agent for the FBI, two assistant U.S. attorneys for the Southern District of New York and a partner in Proskauer Rose’s Securities Litigation Group who spent a decade in the SEC’s Division of Enforcement. The panel focused on enforcement in the wake of the prosecution of SAC Capital Advisers, the hedge fund which agreed to pay the SEC $602 million in 2012 to settle insider trading claims regarding two pharmaceutical stocks.

Private funds are now coming under much closer scrutiny by the SEC’s Division of Enforcement thanks to newly established specialized units such as the Asset Management Unit, which will look at investor and systemic risks raised by these funds and their managers. Assisting these investigations will be a small army of former hedge fund managers, due diligence experts and other investment management professionals that the Division is adding to its staff.

In a recent interview with Hedge Fund Law Report in connection with the RCA event, Ronald Wood, the partner at Proskauer Rose, said that the Asset Management Unit plans to develop risk analytics to identify potential risk areas among the more than 1,500 private investment advisors who have registered with the SEC since July 2010 when President Obama signed into law theDodd-Frank Act, which eliminated the exemption for private fund advisors.

The panel shared advice on how to avoid the risk of insider trading charges. Insider trading has been a particular focal area for the SEC in recent years, and 16 percent of the insider trading cases the Commission pursued in fiscal year 2012 were against hedge funds and their advisors, including SAC Capital. Wood urged private fund managers to make sure they have a documented, legitimate source for any research they use to make asset decisions.

‘You want to discourage your people from talking to insiders or people with access to insiders’ he said, in order to avoid any possible taint of acting unlawfully on nonpublic information. Being aware that the SEC’s cases typically depend on confidential informants who may be wired when speaking to fund staff is another reason to keep clear of anything that could tarnish a fund’s reputation.

The panel also discussed hedge funds’ use of paid consultants and expert networks to supplement their investment research. Expert networks have been increasingly in enforcement agencies’ crosshairs since the SEC prosecuted Primary Global Research (PGR) in 2011 after four employees abused access to inside information at technology companies such as Apple and Dell by moonlighting as consultants and sharing non-public, confidential information with hedge fund managers in exchange for ‘consulting fees’ in the hundreds of thousands of dollars. As a result, expert networks have been forced to check their behavior and come back into conformity with proper conduct, Wood said.

In his interview with Hedge Fund Law Report, Wood urged hedge funds to conduct independent diligence and be clear about the specific information they are seeking to add to their knowledge.before participating in expert network calls. He suggests creating a diligence file that shows the fund is already studying a specific industry or company so that later the fund can show it had a legitimate reason to access the expert network.

The SEC’s probes into potential aberrations in fund returns come in the wake of the Madoff scheme and convictions. What constitutes aberrational performance will partly entail concluding whether something in a fund’s methodology or analysis is causing any performance inconsistent with other funds in the same sector, Wood said.      

Panel members additionally shared thoughts about the SEC’s new policy that awards cash bounties to whistleblowers in cases that lead to enforcement actions. These incentives should encourage firms to strengthen their compliance programs, they said. Firms also need to be careful of how they treat whistle-blowers in light of new anti-retaliatory protections that the SEC has put in place to discourage companies from taking any disciplinary action against employees they believe may be whistleblowers, Wood said. 

Compliance officers can compete with SEC incentives for whistleblowers only ‘if you have a culture that encourages compliance and if you are open and welcome it,’ Wood said. Where something a whistleblower reports involves a complicated issue, a compliance officer may want to reach out to an outside firm to investigate any suspicious activity.

‘That builds loyalty from the whistleblower and gets the company that has cooperated points from the SEC,’ he said.    

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