A regulatory fine of US$50,000 might seem like a slap on the wrist for a large fund manager, but when an enforcement action from the US Securities and Exchange Commission makes its way into the agency’s press release and headlines from multiple media outlets it becomes a big concern for compliance and operations managers.
In a new settlement involving New York-based Water Island Capital, the SEC has just sent managers of so-called liquid alternative funds, or liquid alts for short, a clear message: we are watching your every step and won’t hesitate to not only fine you, but also embarrass you if you don’t follow the Investment Company Act of 1940 to a T.
“The SEC isn’t making a distinction between liquid alternative funds and mutual funds,” explains Jay Baris, head of the investment management practice for law firm Morrison Foerster in New York. “The agency expects every registered fund adviser to comply with the same legal requirements, which in the case of the 1940 act are quite detailed and rigorous to protect investors.”
While the liquid alt class comprises only an estimated one percent of the multi-trillion dollar US mutual fund market, service providers are bullish on its growth prospects. Hence, the SEC is also being aggressive in its examination process and repeatedly announced its intentions last year. Just what did Water Island Capital do wrong? The fund management firm, well-known for its merger-arbitrage investment strategies, didn’t safekeep cash collateral for swap deals with a custodian bank; didn’t follow the correct procedures for monitoring compensation to broker-dealers, and didn’t follow its own compliance policies in general.
The SEC didn’t accuse Water Island Capital of fraud or negligence and none of the firm’s employees were specifically cited for serous wrongdoing. Still, the reputational damage alone could be significant. “Regardless of the amount of a regulatory fine, the enforcement action sends a negative message to potential investors,” explains Gary Swiman, director of regulatory compliance for accounting firm Eisner Amper in New York. “Boards of directors of institutional investment firms will want to be reassured that a fund’s compliance and operating procedures are up to snuff.”
Just what does up to snuff mean when it comes to meeting the SEC’s compliance requirements? Plenty. “It is easy for even the most seasoned trading and portfolio management experts to make a mistake,” warns Swiman.
The personal credentials of senior-ranking executives of Water Island Capital listed on the firm’s website indicate substantial experience in corporate finance, equity trading, research and portfolio management. The firm also suggests that it knows the rules: “Mutual funds advised by Water Island Capital provide transparency, liquidity and low investment minimums,” Water Island Capital says on its website. Company officials did not respond to an email seeking comment and attorneys at external counsel Skadden, Arps in New York also didn’t respond to a call and emailed request to discuss the SEC settlement.
Making life hard for advisers to liquid alternative funds is the very nature of the asset class. It crosses two distinct worlds: the funds often managed by traders experienced in the hedge fund space rely on strategies common to alternative fund managers, but have to play by mutual fund rules. That means providing daily net asset values, daily liquidity, best execution, and protection of client assets to name just a few requirements.
So just what should compliance and operations executives at liquid alternatives be on the lookout for? From interviews with compliance and legal experts, FinOps Report came up with the following basics which extend beyond the case involving Waters Island Capital.
1. Review policies on safekeeping of client assets
The most serious of the SEC’s allegation against Waters Island Capital appears to be its decision to self-safekeep $247 million in cash collateral used in total return and portfolio return swap transactions with broker-dealer counterparties. Apparently, that decision violated the custody rule of the Investment Company Act of 1940 which the SEC says requires Water Island Capital to safekeep cash collateral with a custodian bank, the same way it would safekeep securities. “For [swap deals], a manager of a liquid alternative fund firm should establish a tripartite custodial agreement which would govern the safekeeping and right to the collateral between the counterparties and the custodian bank,” says Baris.
2. Review best execution and compensation policies
Registered investment fund advisers are required to ensure that their executing broker-dealers comply with “best execution.” They must keep a record of each transaction that includes the executing broker along with a detailed analysis of the explicit price and other costs regardless of the asset class, explains Swiman.
Yet another requirement with regards to broker-dealers: ensure they are paid correctly. The SEC claimed Water Island Capital did not implement its procedures or document that its payment of commissions to broker-dealers complied with regulatory rules. SEC rules do not explicitly prohibit mutual funds from executing trades through brokers who also sell fund shares, but they must establish procedures to ensure that the brokers are not being compensated for selling those shares through payment of trade execution commissions.
3. Review side-by-side trading policies
Although the SEC didn’t whammy Water Island Capital for giving any of its funds preferential treatment when it comes to its trading practices, it’s a serious mistake that can easily happen either unintentionally through a coding glitch or even intentionally because of higher performance fees for private funds.
“The SEC requires fund managers servicing multiple funds to execute the same order for the same price for each underlying fund,” says one compliance manager at an East Coast investment adviser. “You can’t allow one fund to pay a far lower price than another.” Yet another no-no: favoring hedge funds or private funds over mutual funds when it comes to how much of a particular trade was allocated to each fund. Such a scenario could result in a liquid alt fund underperforming relative to a related private fund.
4. Review valuation practices
If managers of alternative mutual funds must price their shares daily, they also need to be able to determine the value of each of their assets. Such valuations can be cumbersome when it comes to semi or illiquid securities because they are not-exchange traded. Without a commonly accepted market price, the ultimate decision on how to price the asset in question may be subjective.
Be ready to hand the SEC clearly documented pricing models, methodology and inputs for each asset class, recommends one operations specialist at a US liquid alternative fund management shop. “The documentation should also include an explanation of who at the firm makes the final call on the price, should the internal pricing experts and any external specialists differ subtantially,” he says. A red flag to regulators: relying on the trading desk or the portfolio manager to make a decision on its own. Another red flag: exceeding limit on the value of illiquid assets to over 15 percent of the value of the fund.
5. Review leverage
Liquid alts can easily exceed their allowed leverage if the risk management and operations executives are asleep at the wheel. “The amount of leverage reflects the types of investments made and swap transactions do count as part of leverage,” one operations specialist tells FinOps. Therefore, solid front, middle and back-office systems are necessary to ensure accurate and consistent position-keeping and accounting for all transactions at all times. The goals: minimized exposure to derivative contracts and more accurate calculations of total exposure across asset classes.
Given that the SEC discovered the few compliance anomalies at Water Island Capital during an exam, it stands to reason that it looked for others as well. Unfortunately for the fund management firm, the regulatory agency chose to publicize them in a rather harsh statement. It apparently wants to put all liquid alt managers on notice and used Water Island Capital to deliver the message.
Leave a Comment
You must be logged in to post a comment.