Proposed New Rules on Custody to Impact Hedge Funds
In what appears to be a direct response to the Madoff scandal, the SEC has issued a proposed amendment to the custody rule applicable to registered investment advisers.
Rule 206-4 currently offers certain protections to investment advisory clients. The proposed amendments, which seem certain to gain approval, go well beyond what is currently on the books. In summary, the proposals would require a registered investment adviser to:
1. Obtain a “surprise” audit by an independent auditor of custodied assets each year;
2. If an affiliate of the RIA is custodying assets, obtain a SAS70 (internal procedures review) regarding the safeguarding and custodying procedures;
3. Require custodians to send account statements directly to clients; and
4. Requires additional public reporting on custody issues.
It should be noted that the definition of “custody” is a technical one, and many hedge funds may not in fact under the rules as they stand actually “custody” assets. Overall however, the proposed amendments may prove to be very effective in reducing the incidence of fraud particularly because of the independent statement requirements (#3 above).
The proposals are in a public comment period during the next two months. A link to the proposed amendments is at: http://www.sec.gov/news/press/2009/2009-109.htm
Impact of New Regulations on Hedge Funds Expected to be Significant
According to a report by research firm TowerGroup cited in Saturday’s New York Times, 8 out of 10 hedge funds are ill-prepared for hedge fund registration. This is a significant statistic because it shows the infrastructure of the industry will need a serious upgrade… at a time when performance has had a serious downgrade and client redemptions have increased!
Regulations that are yet to come will likely address the areas of more disclosure, better asset valuation and closer supervision. The TowerGroup report indicates that additional hiring will need to be made in three main areas: IT (information technology) and operations, risk and compliance, and client/regulatory reporting.
Many hedge fund groups may need to able to withstand these additional costs, and in Darwinian fashion, we can expect to see many weaker groups close their doors. The TowerGroup press release regarding their report can be viewed at: http://www.towergroup.com/research/news/news.htm?newsId=5321
Hedge Fund Pay-to-Play Scandal Spotlights Placement Agents
The expanding pay-to-play probe of hedge fund “placement agents”, in combination with the central role that these intermediaries had in the Madoff scandal, is beginning to lead the hedge fund industry and its investors to focus as never before on their exact role and qualifications. 
Whereas in the past, funds may have left the business of raising money to such agents without much inquiry into their exact operations, Andrew Cuomo’s probe into Hank Morris and his alleged money-raising for hedge funds from NY pension funds has highlighted the need to determine whether the agent is appropriately registered as a securities broker with FINRA.
In addition, investors are drilling down on whether the placement agent they are contemplating using is actually doing the due diligence on the funds that they claim they are doing. In the post-Madoff world (in addition to the various other scandals that have come to light since then), investors need to know that the agents are performing more than a surface review of a fund’s operations.
It appears that as the hedge fund industry “grows up”, all of its players will join in that process, placement agents included.
Hedge Fund Compliance Poll
Loading ...JG Advisory is looking forward to your responses. We will report back results!
Priorities of SEC’s Office of Compliance Inspections Will Impact Hedge Funds
At a recent industry conference, the 2009 priorities of the SEC’s Office of Compliance Inspections (OCIE) were detailed by chief counsel John Walsh. Hedge funds need to pay particular attention to this list, as there are many items on it that directly relate to typical hedge fund activities.
Here are some highlights:
1. Custody and Control of Customer Assets -verification of customer assets and auditor
2. Controls over Valuations - existence of procedures; independent and qualified valuation agent
3. Supervision and Compliance - having and following established procedures; testing; staffing
4. Trading Issues - trading on rumors;compliance with short sale rules
5. Safeguarding Non-Public Information - compliance with firm policies and insider trading issues
6. Particular Hedge Fund Issues - preferential treatment of certain investors during a liquidation; undisclosed arrangements; insider trading
This is a helpful list that will allow compliance officers to focus on priorities side-by-side with the SEC.
PWG TechCheck: Online Best Practices Assessment for Hedge Funds
JG ADVISORY SERVICES ANNOUNCES THAT THE PWG TECHCHECK©; ONLINE BEST PRACTICES ASSESSMENT TOOL FOR HEDGE FUNDS BASED ON THE PRESIDENT’S WORKING GROUP REPORT NOW REFERENCES HFSB STANDARDS
JG Advisory Services LLC announced today that its online, self-assessment checklist based on the Report of the Asset Managers’ Committee to the President’s Working Group (PWG) on Financial Markets now incorporates the European Hedge Fund Standards Board (HFSB) guidelines. This upgrade allows hedge fund users to not only assess against the US best practice standards, but the European ones as well. The PWG TechCheck will facilitate users who wish to “sign on” to the HFSB standards, assisting them with completing the certification that is required by the HFSB.
Target users for the PWG TechCheck include:
-hedge fund groups’ compliance, legal and/or marketing divisions: as a self-assessment compliance tool, particularly those wishing to sign on to the HFSB standards certification, and as a tool to demonstrate compliance to investors;
-investors and fund-of-funds: to assess the degree of compliance in their hedge fund investments;
-industry consultants: as a tool for evaluating clients.
PWG TechCheck also includes a comparative data feature, to allow users to see how their manager’s responses compare to other similarly-situated managers.
JG Advisory Services is a leader in technology solutions for hedge fund compliance. Founded in 2005 by Judith Gross, an attorney with extensive experience on Wall Street and with hedge funds, the firm acts as consultant to a variety of hedge fund and industry service providers.
For additional information:
www.jgadvisory.com/PWG_TechCheck.php
Focus on Risk Management for Hedge Funds: Deutsche Bank Report
According to the annual Deutsche Bank survey of hedge funds, this is the year that “the hedge fund industry will grow up”. Barry Bausano, Deutsche Bank co-head, Global Prime Finance reported on CNBC today that more consolidation in the industry will occur, with further closings of funds ahead for 2009. While the hedge fund industry is resilient, continued outflows from the industry are expected as well for 2009, bottoming out at an estimated $1 trillion globally.
Not surprisingly, Mr. Bausano reported the Risk Management has moved up to the second most important factor that hedge fund investors consider prior to investing (as opposed to the old due diligence criteria of performance, pedigree and philosophy). Transparency and Liquidity also now rank high— another new trend.
You can view the CNBC interview of Mr. Bausano at:
http://www.cnbc.com/id/15840232?video=1070534569&play=1
State Regulation - The Oft “Missing Link” for Hedge Fund Compliance
It may not be front page news, but states are becoming more active in the regulation of hedge funds, stepping in where there is a perceived lack of action from the federal government. From blue sky laws to registration provisions, the states have always been “in the mix”, but now we are seeing an increase in interest from state regulators.
A case in point is Connecticut, the home base of a large portion of the US hedge fund industry. This state reportedly houses 17 of the world’s top 100 hedge funds, and roughly 1/3 of global hedge fund assets under management. At the current time, the Connecticut legislature has 3 pending bills that touch resident hedge funds in these areas:
-Regarding Disclosure: Hedge Funds with Connecticut-based pension fund investors would need to disclose to prospective pension investors, upon request, certain financial information, including detailed portfolio information. http://www.cga.ct.gov/2009/TOB/H/2009HB-06480-R00-HB.htm
-Regarding Investor Standards: Investors in Connecticut-based hedge funds would have to meet higher accreditation standards: individually or jointly with a spouse, would have to have not less than $2,500,000 in investment assets and institutional investors would have to have not less than $5,000,000 in assets. http://www.cga.ct.gov/2009/TOB/S/2009SB-00953-R00-SB.htm
-Regarding Licensing: All Connecticut- based hedge funds would need to be licensed by the state. http://www.cga.ct.gov/2009/TOB/H/2009HB-06477-R00-HB.htm
Whether or not these initiatives are passed by the legislature remains to be seen. Regardless of how the Connecticut propositions turn out, compliance officers need to aware of their state regulatory status as well as their federal status — and work to ensure compliance with both.
A “Minor” News Story Highlights Hedge Fund Compliance Issues
You may have noticed that we haven’t posted any blogs lately. That’s because we have been just overwhelmed with the sheer volume of information, particularly on the hedge fund scandal front — not to mention the regulatory front!
But for this post, we wanted to keep it simple and focus on a lesser-known recent news story that brings into focus a common compliance issue for hedge funds.
Several weeks ago it was reported that Merrill Lynch has paid a $1 million penalty to settle charges with the SEC for failure to disclose certain conflicts of interest to its pension consulting clients. While this case does not involve hedge funds specifically, it is significant to them in that is a reminder that hedge fund advisors, particularly those that sit within a larger organization, need to regularly (a) assess their conflicts of interest, and (b) disclose those conflicts to clients.
As Scott W. Friestad, the deputy director of the SEC’s enforcement division noted at the time of the announcement: “This case is an important reminder to firms and their investment-adviser representatives that, whenever they sit accross the table from their advisory clients, they need to make sure that all material conflicts of interest are disclosed.”
The SEC’s order in the case can be viewed at http://www.sec.gov/litigation/admin/2009/ia-2834.pdf.
�
Hedge Fund Compliance Riddle
Q: If hedge fund compliance professionals could roll back time and make one form of technology disappear, what would it be?
A: Clearly, without question, hands down: email (and its cousin, instant messages)
No matter how many warnings and explanations are given, the spate of wacky, stupid and worst of all, self-implicating, emails and IM’s by hedge fund employees just doesn’t lighten up.
Exhibit A this month is the newly-reopened Pequot inside trading probe. This SEC investigation relates to possible insider trading of Microsoft shares by Pequot Capital Management utilizing information gleaned from a Microsoft employee. The investigation appears to be centering on previously undisclosed personal account emails from a Pequot employee to a Microsoft contact in which the Pequot employees allegedly writes this completely unguarded message under the heading “missing earnings rumor“:
“Do you believe this? Should I sell my shares today or wait until after earnings come out?…”
If there is one take-away message here, it is that personal account emails can be subject to discovery or investigation by regulators, just as an employee’s work email account can be. Hedge fund employees need to understand that and compliance personnel should be ready to educate them specifically on this point.
