Jan. 3, 2019

Six Essential Articles for Private Fund Managers to Revisit When Preparing for the New Year

As the calendar has changed to 2019, Hedge Fund Law Report is evaluating the challenges fund managers may encounter in the new year. Drawing from testimony SEC Chair Jay Clayton recently provided to Congress about the SEC’s top priorities for 2019, as well as other recent regulatory guidance issued by SEC staff and trends that we have observed in the private funds industry, Hedge Fund Law Report is highlighting six articles from its historical archives exploring issues that should be top-of-mind for fund managers in 2019, including the expected adoption of Form CRS; the transition away from LIBOR; steps fund managers should take in light of the recent risk alert issued by the SEC on adviser’s use of electronic communications; trends toward socially responsible investing; the use of mock exams to prepare for an actual SEC exam; and the use of big data by fund managers in their businesses. Next week (the week starting January 7, 2019), Hedge Fund Law Report will resume its normal weekly publication.

The SEC’s Proposed Form CRS: An Overview of the Key Requirements

In April 2018, the SEC proposed new rules under the Investment Advisers Act of 1940 and the Securities Exchange Act of 1934 that would require registered investment advisers and registered broker-dealers to provide a brief customer- or client-relationship summary in a new short-form disclosure document: Form CRS. According to the SEC, Form CRS is intended to provide retail investors with simple, easy-to-understand information about the nature of their relationships with each investment professional and would supplement other, more detailed disclosures. In his December 11, 2018, testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs, SEC Chair Jay Clayton stated that the staff of the Division of Trading and Markets and the Division of Investment Management are reviewing more than 6,000 comment letters received on the proposed Form CRS and the other rule proposals issued the same day – including proposed Regulation Best Interest for broker-dealers and the proposed interpretation of a standard of conduct for investment advisers – as part of their efforts to develop final rule recommendations on these topics. Thus, SEC-registered investment advisers and broker-dealers should begin to think about how they would comply with these new regulations once final rules are issued. This two-part series analyzes the proposed Form CRS requirements; discusses various issues the form raises; and provides insight from lawyers and compliance professionals on the proposal. The first article provides an overview of the proposed Form CRS and its key requirements. The second article discusses whether the form is likely to achieve the SEC’s stated goal and explores potential issues it raises for SEC-registered investment advisers. For more on Form CRS and the SEC’s proposed interpretation of a standard of conduct for investment advisers, see “SEC Investor Advisory Committee Seeks to Clarify Proposed ‘Best Interest’ Standard to Ensure a Uniform Fiduciary Standard for Advisers and Broker-Dealers” (Dec. 13, 2018); and “SEC Emphasizes Investment Adviser Fiduciary Duty and Proposes Enhanced Adviser Regulation” (May 10, 2018).

How Hedge Fund Managers Can Prepare for the Anticipated “End” of LIBOR

Andrew Bailey, Chief Executive of the U.K. Financial Conduct Authority, called into the question the future of the London Interbank Offered Rate (LIBOR) in a July 27, 2017, speech. While the current panel banks for LIBOR have agreed to sustain the benchmark in its present form until 2021, Bailey stated that thereafter the “survival of LIBOR on the current basis, as a dynamic benchmark based on daily submissions and updates, could not and would not be guaranteed.” In his December 11, 2018, testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs, SEC Chair Jay Clayton highlighted the transition away from LIBOR as an emerging market risk that is being closely monitored by the SEC. Given LIBOR’s pervasive use by hedge funds and other market participants, the consequences of its permanent discontinuation will be felt – for better or worse – throughout the financial markets, and a misstep could affect investors worldwide. In a guest article, Anne E. Beaumont, partner at Friedman Kaplan Seiler & Adelman, discusses the possible consequences for derivatives transactions that involve USD LIBOR and are governed by ISDAs, while also suggesting five steps that advisers can take today to prepare for this impending change. For additional commentary from Beaumont on derivatives documentation, see “The 1992 ISDA Master Agreement Says Notice Can Be Given Using an ‘Electronic Messaging System’; If You Think That Means ‘Email,’ Think Again” (May 23, 2014); and “Five Steps for Proactively Managing OTC Derivatives Documentation Risk” (Apr. 25, 2014).

Are Hedge Fund Managers Receiving the Message? SEC Takes Steps to Drill Down on Electronic Communications

The SEC’s Office of Compliance Inspections and Examinations reviewed a handful of investment advisers in 2017, focusing on the forms of electronic communications used by those advisers and their employees. At the time of those exams, many speculated that they were part of a sweep exam initiative focused on electronic messaging. On December 14, 2018, the SEC confirmed the accuracy of those speculations in a risk alert entitled, “Observations From Investment Adviser Examinations Relating to Electronic Messaging,” which discussed the results of those limited-scope exams. In light of the recent issuance of this risk alert, fund managers should revisit their policies and procedures concerning electronic communications. This three-part series is designed to assist compliance professionals with managing the ever-evolving electronic communication technologies that many adviser employees are already using, or desire to use, in their daily business practices. The first article provides background on sweep exams, with particular focus on this electronic messaging exam and the potential drivers of SEC focus in this area. The second article breaks down the various components of the types of requests made by SEC examiners and analyzes the implications and consequences of certain requests. The third article examines best practices for advisers when designing their electronic communications policies and discusses how advisers can proactively prepare for future scrutiny in this area. For more on electronic communications, see “ACA 2018 Compliance Survey Examines Electronic Communications, Personal Trading and Corruption Risk (Part Two of Two)” (Jun. 14, 2018).

The Past, Present and Future of ESG Investing in the Hedge Fund Industry

The integration of environmental, social and governance (ESG) factors into the investment process has become a primary objective of certain investors. According to the 2014 Trend Report on Sustainable and Responsible Investing Trends issued by the Forum for Sustainable and Responsible Investment, mutual funds, variable annuity funds, exchange-traded funds and closed-end funds that incorporate ESG factors into the investment management process more than tripled in terms of assets under management from 2012 to 2014, accounting for $1.94 trillion in ESG assets in 2014. Despite the significant amount of assets being directed into investment strategies that incorporate ESG factors, the general industry consensus is that the adoption of formal ESG policies by hedge fund managers remains fairly uncommon and that private equity managers continue to be comparatively better positioned to do so. The first article in this two-part series explores the development of ESG investing and its prevalence in the hedge fund space. The second article reviews advice from industry experts on considerations for managers wishing to develop an ESG investment policy, as well as the due diligence demands from investors seeking investment managers that incorporate ESG factors into the investment process. For more on ESG, see “Annual Walkers Fundamentals Seminar Explores Fund Launches, Asset Flows, Strategies, Durations, Fees, Governance and Hot Topics (Part One of Two)” (Dec. 20, 2018); and “ACA-IAA Investment Management Compliance Testing Survey Covers Fees and Expenses, Investment Mandates, Big Data and Custody (Part One of Two)” (Aug. 2, 2018).

Legal and Practical Considerations in Connection With Mock Examinations of Hedge Fund Managers

The SEC continues to take steps to increase its touch points with fund managers and estimates that it will examine 15 percent of the adviser registrant pool in 2019. Advisers that have successfully navigated the exam process have noted that preparation is paramount to surviving an examination, and mock exams provide an excellent opportunity to simulate the SEC exam experience. This article discusses the seven overlapping goals of mock examinations of fund managers; the types of entities that provide mock examinations; four areas of expertise that a hedge fund manager should look for in a mock-examination provider; what advisers should expect in terms of the cost of a mock exam; how mock exams are typically conducted; whether the results of the mock examination should be documented in writing; contractual and legal strategies for maintaining the confidentiality of mock examinations; and considerations with respect to the timing and level of disclosure to clients of the mock examination findings. See “Mock Audits Are Essential Preparatory Tools for Fund Principals in the Current Regulatory Environment” (Sep. 28, 2017).

A Fund Manager’s Roadmap to Big Data

The exponential growth of IT systems has given researchers, governments, corporations and fund managers the ability to identify correlations and patterns from a combination of previously unlinked data sets with incredible speed. “Big data” often refers to the use of predictive analytics, which extract value from these data sets. Raw data can be collected from a variety of sources, including user interactions on the internet, satellite images, consumer transactions and industry trends. Although only a small minority of fund managers comprehensively capture value from this data, spending on big data continues to increase with fundamental-driven investors seeking to enter the environment. Building an internal infrastructure to acquire and process raw data is a time-consuming and expensive undertaking. As a result, most fund managers look to third-party data vendors in an effort to not only generate alpha, but to respond to new regulatory requirements; reduce costs; and assist with other operational and managerial functions. The first article in this three-part series explores the big-data landscape and how fund managers can acquire and use big data. The second article analyzes issues and best practices surrounding the acquisition of material nonpublic information; web scraping; and the quality and testability of data. The third article discusses risks associated with data privacy, the acquisition of data from third parties and the use of drones, as well as ways fund managers can mitigate those risks. For more on big data, see “How the GDPR Will Affect Private Funds’ Use of Alternative Data” (Jun. 14, 2018); and “Tips and Warnings for Navigating the Big Data Minefield” (Jul. 13, 2017).