Sep. 1, 2022
Sep. 1, 2022
Back‑to‑School Basics: Five Primers on Key Topics for Fund Managers
This is the time of year when children, teenagers and young adults are headed back to school. Even adults who graduated years ago can grow nostalgic in September for classrooms, textbooks, new backpacks and learning in general. To capitalize on that feeling and in light of the upcoming Labor Day holiday in the U.S., the Hedge Fund Law Report is sending readers back to school – metaphorically, of course – by highlighting five articles and series that provide primers on key topics, including establishing a hedge fund manager; understanding, identifying, mitigating and monitoring conflicts of interest; tailoring a compliance program; establishing a cybersecurity program; and avoiding common custody pitfalls. Next week (the week starting September 5, 2022), the HFLR will resume its normal weekly publication.
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Fund Formation 101: Establishing a Hedge Fund Manager
Wall Street traders often consider leaving large investment houses to launch their own hedge funds. They have built solid track records; made money for their firms and clients; and figure it is time to be their own bosses and take the show on the road. What those emerging managers may not understand, however, is that running a hedge fund means overseeing a full-service business – not simply a trading strategy. Although the trading strategy is very important and generating returns is paramount, there is much more to consider when establishing and sustaining a successful hedge fund operation. This guest article by Marni Pankin, partner at Marcum, provides a checklist for emerging managers to follow when launching a hedge fund to meet various operational, accounting, compliance and regulatory requirements. See “Emerging Managers Need Appropriate Infrastructure – Not Only Solid Performance – To Attract Investors” (Jun. 20, 2019); and “Key Accounting and Legal Hurdles in Starting a Hedge Fund Management Business, and How to Surmount Them” (May 8, 2014).
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Conflicts of Interest 101: Understanding, Identifying, Mitigating and Monitoring Conflicts
In July 2019, the SEC’s Interpretation Regarding Standard of Conduct for Investment Advisers (Interpretation) took effect. The Interpretation confirms that an adviser owes its clients a fiduciary duty under Section 206 of the Investment Advisers Act of 1940 and that the duty is composed of a duty of care and a duty of loyalty. Elaborating upon that standard, the SEC stated that an “adviser must, at all times, serve the best interest of its client and not subordinate its client’s interest to its own. In other words, the investment adviser cannot place its own interests ahead of the interests of its client.” Thus, conflicts of interest are at the core of the Interpretation. This three-part series examines the practical implications of the Interpretation for private fund managers. The first article provides an overview of the Interpretation and explores six key takeaways for fund managers from it. The second and third articles explore how fund managers can adopt a more systematic approach to identify, mitigate and monitor their conflicts of interest in light of the SEC’s detailed discussion in the Interpretation regarding an adviser’s obligation to “make full and fair disclosure” of all conflicts of interest that might incline an investment adviser to render advice that is not disinterested. See “Using Technology and Outsourcing to Enhance Compliance Programs and Manage Conflicts of Interest” (Nov. 11, 2021); and “Proper Use of Advisory Committees by Private Fund Managers May Mitigate Conflicts of Interest” (Dec. 17, 2015).
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Compliance Programs 101: Tailoring Your Compliance Policies and Procedures
Fund managers are not only required to have compliance programs; they are required by the so-called “compliance rule” – Rule 206(4)‑7 under the Investment Advisers Act of 1940 (Advisers Act) – to have written policies and procedures that are “reasonably designed” to prevent violations of the Advisers Act and the SEC’s rules. The SEC has emphasized that, to fulfill that requirement, managers must tailor their compliance programs to their specific risks, processes and operations. Thus, relying on off-the-shelf compliance programs and manuals that do not reflect a manager’s individual business is not sufficient to satisfy the compliance rule. Tailoring a compliance program appropriately, however, can be a challenging task. This three-part series delves into the logistics of tailoring a fund manager’s compliance program. The first article outlines the expectations of the SEC, DOJ and investors as to the customization of compliance programs, as well as the consequences of failing to tailor those programs. The second article lays out what fund managers should consider when tailoring their programs, including the role of off-the-shelf programs. The third article identifies five triggers for a review – and possible update – of a manager’s compliance program. For examples of enforcement actions involving allegations that fund managers failed to tailor their compliance programs or manuals, see “SEC Enforcement Action Takes Aim at Adviser’s Wells Submission” (Dec. 19, 2019); “Hedge Fund Manager Deerfield Fined $4.7 Million for Failing to Adopt Insider Trading Compliance Policies Tailored to the Firm’s Specific Risks” (Sep. 21, 2017); and “SEC Charges Two Houston-Based Advisory Firms, Including a Hedge Fund Manager, with Principal Transaction, Custody Rule, Compliance Rule and Code of Ethics Violations” (Jan. 30, 2014).
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Cybersecurity 101: Structuring a Fund Manager’s Cybersecurity Program
Nation-states, organizations, groups and individuals continue to employ increasingly sophisticated methods to target information systems and computer networks. Governments and regulators – including the SEC – are also intensifying their scrutiny of organizations’ cybersecurity programs. In fact, information security and data protection controls are among the focuses identified in the SEC’s 2022 exam priorities. As a result, it is becoming more expensive to combat and contain cyber-related attacks. Given that cybersecurity is an enterprise-wide risk, fund managers must, at a minimum, ensure that they comply with industry best practices, including adopting one or more cybersecurity frameworks and creating a culture of cybersecurity compliance. This three-part series will help fund managers structure a cybersecurity program. The first article discusses the risks and costs associated with cybersecurity attacks; the global focus on cybersecurity; relevant findings observed during examinations of SEC registrants; and cybersecurity best practices. The second article analyzes the need for fund managers to hire a dedicated chief information security officer, review information security governance structures and explore the role of the CCO as a strategic partner. The third article evaluates methods for facilitating communication between cybersecurity stakeholders; outsourcing and co‑sourcing of cybersecurity functions; and best practices for employing and overseeing third-party cybersecurity vendors. See “A Checklist to Help Fund Managers Assess Their Cybersecurity Programs” (Jul. 14, 2022).
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Custody 101: Avoiding Common Pitfalls
Adopted in 1962, Rule 206(4)‑2 of the Investment Advisers Act of 1940 – commonly referred to as the “custody rule” – is intended to provide additional protection against the theft or misappropriation of client assets by investment advisers. Revised in 2009, the custody rule generally requires a private fund adviser to maintain client assets with a qualified custodian. If the adviser is deemed to have custody of client assets itself, it must either undergo an annual surprise exam or distribute an audited financial statement for the fund to all investors within 120 days of the end of the fund’s fiscal year. Although those requirements appear straightforward on their face, compliance with the custody rule continues to pose challenges for fund managers. For example, the SEC has included custody-related issues in its annual examination priorities for several years. In addition, the SEC has issued multiple risk alerts identifying examples of deficiencies in compliance with the custody rule observed by the exam staff. In this two-part series, the Hedge Fund Law Report identifies six common traps that can lead to a private fund adviser’s non-compliance with elements of the custody rule. The first article identifies options for private fund managers to comply with the rule; discusses the frequency with which custody is reviewed during SEC examinations; and identifies common weaknesses in the areas of inadvertent custody, preparing audited financial statements and meeting the delivery deadline for those statements. The second article discusses circumstances under which private fund advisers may fail to realize that they have custody, the auditor independence requirement and liquidation audits. See “A Refresher on Custody and What to Expect on Surprise Custody Exams” (Feb. 18, 2021); as well as our two-part 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).
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