Alt Fund Managers: What Needs to Be Fixed Before the SEC Exam

Hedge fund and private equity fund managers top the list of firms having the most angst, when it comes to worrying about passing an exam  by the US Securities and Exchange Commission. They also are likely to have the the most work preparing for an exam.

A recent survey of C-level executives conducted by compliance consultancy Cipperman Compliance Services in Wayne, PA found that more than 40 percent of hedge fund and private equity fund managers believe their compliance programs are not up to snuff to pass SEC scrutiny. That compares to 32 percent of broker-dealers and only 25 percent of traditional asset managers. Of the 200 executives interviewed for the study, 115 represented alternative funds.

Alternative fund managers have good reason to be anxious. “Most alternative fund managers have not been reviewed by an SEC examiner and are waiting for them to show up,” says Jane Shahmanesh, managing director of Adherence LLC, a New York firm specializing in regulatory compliance. “They are doing the best they can with what they know but have no clue as to whether their effort meets SEC muster.”

The four main thrusts of the SEC’s focus, compliance experts tell FinOps Report, are fees and expenses, insider trading, cybersecurity, and compensation for capital raising. “The SEC isn’t concerned about whether the fund manager has made or lost money. All it cares about is whether the investor understands what it is paying for,” warns Shahmanesh.

Based on interviews with compliance experts, here are more information and suggestions on how to deal with each of these four areas of SEC focus.

1. Fees and Expenses

Although most of the SEC’s attention on fees and expenses has been focused on private equity fund managers, it is now starting to crack the whip on their hedge fund peers. Hedge fund managers don’t always allocate fees and expenses accurately for two key reasons, according to Louis Bruno, a principal in charge of global compliance and regulatory solutions at global consultancy EisnerAmper in New York. They could either have unclear or undefined policies or inadequate technology to perform the correct calculations.

“When making expense determinations, hedge fund managers must question whether a reasonable investor would expect a given expense to be charged to the fund based on a fair reading of its governing documents,” recommends Bruno. “There must also be a clear disclosure of all fees and expenses and consistency between fund agreements, governing documents, regulatory filings, investor due diligence, documents and questionnaires.”

What to charge investors isn’t necessarily a black and white decision. Case in point: a hedge fund manager may want to charge the cost of a corporate jet to investors on the grounds it needs that jet to reach clients more quickly. Hence, they benefit. “The hedge fund manager will likely have some heated discussions with the SEC over whether investors should pay for that expense,” warns Gregory Nowak, a partner with the law firm of Pepper Hamilton in Philadelphia. His recommendation: hedge fund managers might consider a tradeoff such as charging a higher management fee in exchange for reducing or not allocating some expenses to investors. Such a decision means that the hedge fund manager will need to keep its costs in check so it can keep as much of the management fee as possible as profit.

2. Insider Trading

Of course, the correct calculation and disclosure of expenses and fees can’t take place without a correct oversight program involving the finance, accounting, legal and compliance departments. The same could also be said when it comes to avoiding insider trading.

In its recent US$4.6 million settlement with hedge fund manager Deerfield Management Company, the SEC cited the manager’s violation of Section 204A of the Investment Adviser’s Act. That rule says that an investment adviser’s policies and procedures must take into consideration the nature of its business when trying to prevent the misuse of material non-public information.

Former analysts at Deerfield used information from a political intelligence consultant, who in turn, received the hot tips from from a government employee. Based on this information, the analysts then recommended the firm trade in the stocks of four health care companies.

According to the SEC, Deerfeld’s policies did not clearly explain how the firm’s employees should determine whether the research firms they used complied with applicable insider trading rules. The only procedure in place at Deerfield to prevent the receipt and misuse of material non-public information from research firms was that the research providers demonstrate they have policies and procedures. Deerfield was to verify those practices “from time to time.”

In a recent corporate blog, Lex Urban, a Washington, D.C. attorney in the white collar defense and investigations group at Cadwalder Wickershan & Taft, cautions that investment advisers should not rely on similarly worded vague language in their compliance procedures when it comes to insider trading. “Moreover, placing the burden of monitoring for insider trading on employees without specific guidance on how to implement those directions will be viewed as inadequate by the SEC,” he says.

3. Cybersecurity Gaps

Nowhere are clearcut rules required to be more stringently enforced than with cybersecurity. Although banks and wirehouses remain the prime target for hackers, alternative fund managers are also within their range. “The core assets of the fund are its customer data and trading strategies,” explains K.B. Venkataraman, chief information officer for Viteos Fund Services, a Sommerset, New Jersey-based hedge fund administrator. “Should the hacker manage to steal all of the fund’s files, its entire operations could come to a standstill.”

Data could be lost or altered in transit when payment instructions are being made. Having good policies such as multi-factor authentication and encryption is critical to preventing a data breach. Validating such practices on a frequent basis and responding to cybersecurity breaches quickly are also important to mitigate potential financial damage.

For hedge funds that rely on third-party service providers, such as an administrator, additional steps may be required to ensure that any weakness in the administrator’s cybersecurity policies won’t result in a drain of funds. Such was the alleged case with a fund manager suing SS&C Technologies for a fraudulent US$6 million redemption.

Venkararaman, whose firm specializes in shadow accounting, recommends that alternative fund managers carefully review their administrators cybersecurity procedures before engagements are made and conduct tests in social engineering to find out whether an employee error would ause the loss of confidential information or funds. Random calls or emails from a potential hacker could be sent to employees of the fund administrator to determine whether they will divulge any information, such as bank account numbers, or transfer of funds.

4. Compensation Language

Among the four hot-button topics for SEC examiners, compensation for capital raising could be the most worrisome for alternative fund managers, because the SEC’s intentions are unclear. The regulatory agency hasn’t explained what it plans to do with the information registered investment advisers must provide as part of a new Form ADV about the compensation agreements of investor relations, marketing and similar executives. In a question appearing on Form ADV for the first time, the SEC is asking managers whether their capital-raising employees are earning anything more than a base salary or discretionary bonus for bringing in new clients. Those new clients will likely be either new funds to manage, investors in side pockets of the hedge fund or separately managed accounts.

Even if the executive’s employment contract does not specify how such extra compensation could be earned, as long as any emails or other evidence exchanged between the employee and other executives of the manager suggest that compensation is tied to capital raising, the SEC could draw that conclusion. The SEC has historically ruled that paying commissions for the sale of securities requires an executive to be a registered representive of a licensed broker-dealer. Rules established by the Financial Industry Regulatory Authority (FINRA), the self-regulatory body for broker-dealers, prohibit fee splitting with unlicensed persons.

“A better idea for the alternative fund manager would be to replace any mention of compensation related to raising assets in the sales manager or marketing manager’s employment contract with language mandating that the bonus be discretionary,” says Nowak. Such a change could require legal counsel to draft new employment agreements for sales and marketing managers. Sales managers at some hedge fund management shops who spoke with FinOps say they aren’t keen to lose the guarantees of specific bonuses tied to their capital raising results. Therefore, they predict, hedge fund managers could ultimately have a harder time hiring and retaining the best sales talent.

5. Be Proactive

Regardless of how well the alternative fund manager tries to address fees and expenses, insider trading, cybersecurity and compensation, it could still fall short of what the SEC examiner expects. The SEC understands that 100 percent compliance may not be achievable, but it will expect firms to correct violations in a timely and reasonable way. “It is never a good idea to have an SEC examiner question why you didn’t take corrective action,” says Steven Fellin, a partner for Alternative Fund Consultancy, a New York firm specializing in the hedge fund industry.

“Never hide or ignore a violation you detect,” he warns. “Document how you detected the violation, the corrective action and most importantly what controls were incorporated to prevent future violations.” Such documentation can go a long way to proving good supervisory oversight. Likewise. it is advisable to look for any pattern of violation by the same person or business unit, adds Fellin. That is a sure indication of a weakness in controls or supervision.

The longer an alternative fund manager has an undetected violation, the more likely the SEC examiner will dig deeper into the firm’s records and processes. The same applies when the firm’s compliance manager tells the SEC the firm has never encountered any compliance issues. “It is a red flag for regulators that those responsible for compliance will not have the skill set, depth of knowledge or that the firm lacks necessary internal resources,” says Fellin. “The SEC will question whether the firm has an effective compliance program.”