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    Jan. 6, 2022

Five Things Hedge Fund Managers Should Do to Start 2022 Off Right

January can be a gloomy month and a letdown after the excitement and joy of the holiday season. Another perspective of the month, however, is that January provides a clean state and an opportunity to make plans for the upcoming year, such as rebooking a vacation that was cancelled due to the pandemic or scheduling a home remodeling project. The same is true in the hedge funds industry. At the beginning of a new year, there may be certain things that hedge fund managers are required to do – and certain things that they may want to do to set themselves up for success in the coming year. To that end, the Hedge Fund Law Report is highlighting five things that hedge fund managers should do to ensure that they begin 2022 on the right foot, along with five articles from its archives to help them complete those tasks, including conducting an annual compliance review; ensuring the compliance department is adequately resourced and supported; preparing the annual Form ADV amendment; ensuring that financial statements are audited and sent to investors as required by the custody rule; and preparing to comply with the new marketing rule. Next week (the week starting January 10, 2022), the HFLR will resume its normal weekly publication.​​​

Conduct an Annual Review of the Compliance Program

Registered investment advisers are required by Rule 206(4)‑7 under the Investment Advisers Act of 1940 to conduct annual reviews of the adequacy of their compliance policies and procedures, as well as the effectiveness of the compliance program’s implementation. The SEC has focused on the annual compliance program review requirement in its examinations and enforcement actions. Rule 206(4)‑7 does not specify when an investment adviser should conduct its annual compliance review. Throughout the industry, however, advisers often perform that review in conjunction with other year-end review processes. For instance, advisers with fiscal years that track the calendar year may choose to conduct the annual compliance review now while their annual financial audits are being done. This two-part series is designed to function as a checklist that investment advisers can use to streamline and organize their annual compliance reviews. The first article analyzes Rule 206(4)‑7 and sources of guidance on complying with the rule; spells out who should be involved in conducting an investment adviser’s annual compliance program review, what information should be gathered for review and what areas should be covered; and notes the questions that SEC examiners are likely to ask about an adviser’s annual review during an examination. The second article provides a non-exhaustive list of questions to be answered for each substantive area covered during an adviser’s annual compliance program review. See our two-part series “How Hedge Fund Managers Should Approach Preparing for, Conducting and Documenting the Annual Compliance Review”: Part One (Mar. 22, 2012); and Part Two (Mar. 29, 2012).

Ensure Compliance Department Is Adequately Resourced and Supported

The SEC has long held the position that CCOs play a vital role in preventing violations of the securities laws. To fulfill that role, however, CCOs and compliance departments in general need adequate support and resources from senior management – and unfortunately, they do not always get what they need when fund managers are setting their annual budgets. See “Developing a 2018 Compliance Budget: How Investment Advisers Can Make the Most of Limited Resources” (Dec. 21, 2017). As a result, in November 2020, the SEC’s Division of Examinations (Division) issued a risk alert on notable compliance issues its staff identified during examinations of private fund managers (Risk Alert). Among other issues, the Risk Alert details a lack of compliance resources and a dearth of autonomy and empowerment of CCOs. Division Director Peter Driscoll emphasized the severity of those issues in remarks given the same day (Speech). For more on the Risk Alert and Speech, see our two-part series: “Limited Staffing, Marginalized CCOs and an Overall Lack of Resources at Fund Managers” (Feb. 18, 2021); and “Inadequate Annual Reviews, Poorly Implemented Policies and Other Key Takeaways” (Feb. 25, 2021). In addition, related SEC enforcement actions illustrate what can happen when a CCO’s repeated calls for more resources and support go unheeded. In November 2018, Pennant Management, Inc. (Pennant), formerly a registered investment adviser, settled charges that it negligently failed to perform adequate due diligence and monitoring of certain investments contrary to its representations to clients, which ultimately contributed to substantial client losses. Separately, Pennant’s former CEO, Mark A. Elste, also settled charges that he contributed to Pennant’s violations by failing to address known resource deficiencies in its compliance program. This two‑part series explains why it is important for fund managers to provide adequate resources to support their CCOs and compliance programs. The first article details the compliance failures in the Pennant and Elste enforcement actions. The second article provides the key takeaways for fund managers and their CCOs from these actions.

Prepare Annual Form ADV Amendment

Since 1979, the SEC has required each registered investment adviser to deliver a written disclosure statement to clients pursuant to Rule 204‑3 under the Investment Advisers Act of 1940 (Advisers Act). Part 2A of Form ADV sets out minimum requirements for that disclosure statement, but in general, it requires advisers to disclose material facts; conflicts of interest; and risks to clients and investors. In addition to filing an initial Form ADV when advisers register, Rule 204‑1 under the Advisers Act requires them to amend their Forms ADV annually within 90 days of the end of their fiscal year. Therefore, an adviser whose fiscal year ended on December 31, 2021, is required to file the annual amendment to its Form ADV, Part 1 and Part 2A, no later than March 31, 2022. Over the years, Form ADV has been revised significantly, including through changes to the format of Part 2A and expansion of the scope of the information required in it. As a result, it is easy for private fund managers that are registered advisers to make mistakes on their Forms ADV, such as omitting required information or providing information that is inconsistent with other disclosures. Getting any part of Form ADV wrong can result in deficiency letters – and even enforcement actions. See “SEC Sanctions Adviser for Undisclosed Conflicts and Misleading Form ADV” (Jun. 3, 2021). A Washington, D.C., Compliance Round Table program addressed some common questions that arise when fund managers are completing their annual amendments to their Forms ADV, including some of the challenges posed by form amendments that took effect in 2017. Marina Baranovsky, principal owner of Scitus Consulting LLC, moderated the program, which featured Monique S. Botkin, associate general counsel of the Investment Adviser Association; and Dechert partner Michael L. Sherman and senior associate Christine Ayako Schleppegrell. This article highlights the panelists’ key takeaways for fund managers. For a tool to assist managers in completing Form ADV, Part 2A, see “A Checklist for Fund Managers to Ensure Form ADV, Part 2A Is Complete and Accurate” (May 6, 2021).

Ensure Financial Statements Are Audited and Sent to Investors As Required by the Custody Rule

The first quarter of the year marks the busy season for finance professionals at private funds. Once the investment manager (or its administrator) finalizes the prior year-end performance for its funds, the firm can officially commence auditing those funds’ financial statements, although preparations have likely been underway for several months. From a regulatory perspective, Rule 206(4)‑2 (the Custody Rule) of the Investment Advisers Act of 1940 is the driving force behind the flurry with which a hedge fund manager approaches the audit process. In addition, registered commodity pool operators must adhere to CFTC Regulation 4.22(c), which requires audited financial reports to be delivered to the pool’s investors and filed with the NFA within 90 days of the pool’s fiscal year-end. Of course, even without those regulatory requirements, most institutional investors – particularly those that owe a fiduciary duty to their end-investors – insist that funds to which they allocate undergo annual audits. This article considers the audit from the perspectives of the fund manager’s CCO and GC. Specifically, it analyzes the fund’s audit process and explores the extent to which legal and compliance personnel should be part of that process – or whether it is a purely financial function that is outside their purview. See “A Refresher on Custody and What to Expect on Surprise Custody Exams” (Feb. 18, 2021); and our discussion of the Custody Rule with Proskauer partner Robert Plaze: “History and Possible Amendments” (Dec. 19, 2019); and “Compliance Challenges, Common Issues and Tips” (Jan. 16, 2020). 

Prepare to Comply With the New Marketing Rule

One of the biggest regulatory developments of 2021 was the SEC’s issuance of a new marketing rule (Marketing Rule) – Rule 206(4)‑1 under the Investment Advisers Act of 1940 – which replaces the 1961 advertising rule and the 1979 cash solicitation rule. The Marketing Rule took effect on May 4, 2021, with an 18‑month transition period. Thus, compliance will become mandatory as of November 4, 2022. Many advisers have opted to wait until that deadline is closer to begin revising their marketing materials, policies and procedures. Now that it is January 2022, advisers that have not yet begun that process need to start soon given the extensive updates that may be required. An ACA Group program analyzed the key provisions of the Marketing Rule – along with its similarities to, and differences from, the existing regime – and offered practical insights on preparing marketing materials in accordance with the new rule. The program featured David W. Blass, partner at Simpson Thacher; Jeffrey Himstreet, vice president and corporate counsel at Prudential; and Julia Reyes and Kimberly Versace, respectively partner and director at ACA Group. This article outlines the key takeaways from the presentation. See our two-part series on the Marketing Rule: “Key Takeaways for Private Fund Managers” (Mar. 18, 2021); and “Next Steps for Legal and Compliance” (Mar. 25, 2021); as well as “The New Marketing Rule: Key Elements and Commissioner Concerns” (Mar. 4, 2021).

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