Oct. 25, 2018

Six Essential Articles for Private Fund Managers to Revisit Addressing Key Areas of Interest by OCIE Examiners

Fund managers need to remain vigilant to ensure that their advisory businesses are prepared to meet the rigors of an SEC examination. This is particularly true as the SEC has estimated that it will examine 15 percent of the adviser registrant pool in 2019, compared with merely 8 percent of the pool in 2008. In light of this, the Hedge Fund Law Report is highlighting six articles from its historical archives that provide guidance on key areas of focus during SEC examinations of private fund managers. Next week (the week starting October 29, 2018), the Hedge Fund Law Report will resume its normal weekly publication. To further explore this topic of exam preparedness, on Thursday, November 8, 2018, at 11:00 a.m. EST, the Hedge Fund Law Report will host a complimentary webinar discussing how examiners from the SEC’s Office of Compliance Inspections and Examinations (OCIE) are currently approaching examinations of private fund managers, as well as key areas of focus by OCIE during these exams. The webinar, entitled “Recent Trends in SEC Examinations of Private Fund Managers,” will be moderated by Kara Bingham, Senior Editor of the Hedge Fund Law Report, and will feature Andrew M. Calamari, partner at Finn Dixon & Herling and former Director of the SEC’s New York Regional Office; Patricia A. Poglinco, partner at Seward & Kissel; and Joel A. Wattenbarger, partner at Ropes & Gray. To register for the webinar, click here.

How Should Hedge Fund Managers Approach the Allocation of Expenses Among Their Firms and Their Funds?

The appropriate allocation of expenses between a fund manager and its clients continues to be a keen area of interest during SEC exams, evidenced by the fact that the SEC continues to bring enforcement actions against fund managers alleging failures to properly allocate expenses. See “SEC Settlement Reminds Fund Managers to Strictly Adhere to Disclosed Fee and Expense Calculation Methodologies and Fully Disclose Conflicts of Interest” (Nov. 16, 2017). The SEC’s Office of Compliance Inspections and Examinations recently provided some insight on this topic in a Risk Alert discussing the six most frequent fee- and expense-related issues identified in deficiency letters from more than 1,500 adviser examinations completed in the last two years. See “OCIE Risk Alert Warns of Six Most Frequent Fee and Expense Compliance Issues” (May 3, 2018). Thus, the SEC appears poised to continue to critically examine this issue. This two-part series discusses best practices for fund managers when approaching the allocation of expenses. The first article discusses the key issues and challenges inherent in allocation decisions, and outlines various regulatory and other concerns posed by allocation practices. The second article provides an overview of approaches used by hedge fund managers in allocating expenses; describes challenges associated with disclosure of expense allocation practices; highlights approaches for addressing the allocation of expenses when disclosures are silent with respect to specific expenses; and discusses key controls designed to ensure that expenses are being allocated in accordance with the manager’s policies and procedures. For more on fee and expense allocation practices, see our three-part series: “Practices Fund Managers Should Avoid” (Aug. 25, 2016); “Flawed Disclosures to Avoid” (Sep. 8, 2016); and “Preventing and Remedying Improper Allocations” (Sep. 15, 2016).

Best Practices for a Hedge Fund Manager General Counsel or Chief Compliance Officer That Suspects or Discovers Insider Trading by Manager Employees or Principals

A confluence of factors – including, most notably, the crackdown on insider trading by Preet Bharara when he served as the U.S. Attorney for the Southern District of New York – has led to enhanced scrutiny by regulators of actions at hedge fund managers that may constitute insider trading. In light of this ongoing regulatory scrutiny, fund managers must routinely review their policies, practices and procedures designed to prevent insider trading. See “Key Elements of a Hedge Fund Manager’s Insider Trading Policies and Procedures” (Oct. 29, 2009). Beyond having a best-of-breed insider trading policy, hedge fund managers must also think about how they would respond to suspicion or discovery of insider trading by an employee or principal of the manager. Within hedge fund management firms, the general counsel (GC) and chief compliance officer (CCO) are on the front lines of investigation, discovery and response. Accordingly, this article offers guidance and a review of best practices with respect to what a fund manager’s GC or CCO should do in the event of suspicion or discovery of insider trading. See our four-part series “How Can Hedge Fund Managers Structure, Implement and Enforce Information Barriers to Mitigate Insider Trading Risk Without Impairing Securities Trading?”: Part One (Jan. 16, 2014); Part Two (Jan. 23, 2014); Part Three (Jan. 30. 2014); and Part Four (Feb. 6, 2014).

Common Practices, Benefits and Drawbacks for Hedge Fund Managers of Using Target Returns

The use of target returns or performance targets by fund managers in offering documents and marketing materials will draw scrutiny during SEC examinations. Accordingly, fund managers must take care when using target returns and first consider the potential risks and consequences of doing so. This two-part series considers the advantages and disadvantages of managers’ usage of target returns in their marketing materials. The first article discusses common practices for the use of target returns by hedge funds; analyzes reasons for using target returns; and highlights some potential drawbacks of using target returns. The second article analyzes the legal risks associated with target returns and weighs the benefits of using target returns against those risks. See our three-part advertising compliance series: “Ten Best Practices for a Fund Manager to Streamline Its Compliance Review” (Sep. 14, 2017); “Five High-Risk Areas for a Fund Manager to Focus on When Reviewing Marketing Materials” (Sep. 21, 2017); and “Six Methods for a Fund Manager to Test Its Advertising Review Procedures” (Sep. 28, 2017).

How Does the SEC Approach Custody Issues in the Course of Examinations of Hedge Fund Managers?

The SEC intensified its scrutiny of custody issues following a number of high-profile scandals involving investment advisers. As a result, it is spending more time reviewing custody issues during examinations of registered investment advisers (RIAs), including hedge fund managers. In a 2012 Commission session entitled “Safety and Soundness of Client Assets/Custody” (Session), the SEC discussed the impact of Rule 206(4)‑2 under the Investment Advisers Act of 1940 (Custody Rule) on RIAs, such as hedge fund managers. The Session began with a discussion of the Custody Rule’s requirements, including a discussion of its 2009 amendments. See “How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures in Light of Amendments to the Custody Rule?” (Jan. 20, 2010). The Session also explained what an investment adviser should expect with respect to the review of custody issues during an SEC examination and how to prepare for custody reviews in the course of an examination. This article discusses the foregoing topics and the other key takeaways from the Session. See “SEC No‑Action Letter Eliminates Surprise Examination Requirement Under Custody Rule for Certain Sub-Advisers” (May 19, 2016); and “Repeat Custody Rule Offenders Face Severe SEC Sanctions” (Dec. 10, 2015).

Identifying and Addressing the Primary Conflicts of Interest in the Hedge Fund Management Business

Regulators and investors routinely scrutinize how fund managers address conflicts of interest. The SEC’s Office of Compliance Inspections and Examinations, for example, consistently evaluates fund managers’ handling of conflicts of interest pursuant to its yearly examination priorities. See “Retail Investors Top list of OCIE 2018 Exam Priorities” (Mar. 8, 2018). Regulators also initiate enforcement actions to address conflicts of interest that are not appropriately managed, handled and documented. See “SEC Charges Philip A. Falcone, Harbinger Capital Partners and Related Entities and Individuals With Misappropriation of Client Assets, Granting of Preferential Redemptions and Market Manipulation” (Jun. 28, 2012). Left unchecked, conflicts can ripen into legal violations. Accordingly, hedge fund managers must be vigilant in identifying and addressing conflicts. While the details of conflicts may differ from firm to firm, certain general conflicts pervade the industry. In a guest article, John Ackerley, then-director at and current CEO of Carne Global Financial Services in the Cayman Islands, provides a checklist of those pervasive conflicts and discusses specific measures that hedge fund managers can take to mitigate such conflicts. This article can be useful as a reference point in a mock examination, to prepare for marketing meetings and for other purposes. See “Absence of Harm No Defense Against Conflicts of Interest: SEC Issues Lifetime Bar From Compliance Work to CCO” (Sep. 13, 2018); and “SEC Enforcement Action Highlights Highly Specific Regulatory Focus on Conflicts of Interest” (Jan. 25, 2018).

Is the Use of an Independent Valuation Firm Superior to a Manager’s Internal Valuation Process?

As private equity (PE) valuations have increasingly become subject to review by investors and regulators, certain PE managers have turned to independent valuation firms to assist in their valuation processes. The practice, which can be expensive and time-consuming, can benefit managers with hard-to-value holdings. The use of an independent valuation firm in addition to a manager’s internal valuation process, however, remains above standard industry practice. In an interview with the Hedge Fund Law Report, Scott A. Arenare and Joseph P. Cunningham, partners in the asset management group at Willkie Farr & Gallagher, discussed the use of independent valuation firms by PE and hedge fund managers. This article presents their insights on, among other topics, the benefits of engaging independent valuation firms, trends in those engagements, the allocation of independent valuation expenses and best practices for managers conducting internal valuations. For more on valuation, see “Unreasonable Assumptions When Valuing Fund Assets May Lead to Charges of GAAP Non-Compliance, Fraud and Compliance Violations” (Aug. 24, 2017); “Three Approaches to Valuing Fund Assets and How Auditors Review Those Valuations” (May 11, 2017); and “Three Pillars of an Effective Hedge Fund Valuation Process” (Jun. 19, 2014).