Oct. 6, 2022

Compliance Corner Q4‑2022: Regulatory Filings and Other Considerations That Hedge Fund Managers Should Note in the Coming Quarter

This twenty-second installment of the Hedge Fund Law Report’s quarterly compliance update, authored by ACA Group (ACA) consultants Joey Martinez, Valerie Speare and Dan Campbell, highlights upcoming filing deadlines and reporting requirements that fund managers should be aware of during the fourth quarter. This article also includes information on recent SEC enforcement actions against investment advisers focusing on compliance with the Custody Rule and the Pay to Play Rule under the Investment Advisers Act of 1940, as well as a recent risk alert concerning how the SEC’s Division of Examinations intends to focus on the new Marketing Rule. For more from ACA, see “Navigating Trade and Communications Surveillance Challenges” (Apr. 21, 2022).

AI Compliance Playbook: Seven Questions to Ask Before Regulators or Reporters Do

Regulators, news media and legislators are asking increasingly detailed questions about organizations’ artificial intelligence and machine learning (AI/ML) systems. Five financial regulatory agencies recently asked companies to answer a list of questions about their AI/ML use, and the European Commission asked for comments on 80 pages of proposed AI regulations. This second article in a series provides questions that companies can ask themselves to guide oversight of their AI use before outsiders demand answers. With each question, the article offers insights on steps to take and developments to watch. The first article covered compliance essentials for AI/ML tools, and the third article will examine how AI audits work and describe the Federal Reserve System’s recommended “three lines of defense” framework to manage algorithm risks. See “IOSCO Issues Final Guidance on AI and Machine Learning” (Oct. 7, 2021).

Advisers Must Adopt and Implement Appropriate Trade Allocation Policies and Monitor Employee Trading

Supervision of personnel is one of an adviser’s fundamental compliance duties. Advisers must adopt appropriately crafted policies and procedures to ensure effective supervision and must comply with those policies and any related disclosures. In a recently settled enforcement proceeding, the SEC claimed that an investment adviser failed on all counts. One of its investment adviser representatives, who is the subject of a parallel enforcement proceeding, allegedly ran a cherry picking scheme under the adviser’s nose for most of his eight-year tenure with the firm. The adviser allegedly failed to supervise the representative; failed to have appropriate policies and procedures governing trade allocations; and made materially misleading disclosures about its trade allocation policies, practices and monitoring. This article analyzes the alleged cherry picking scheme; the adviser’s compliance violations; and the terms of the settlement orders against both the adviser and its representative. See our three-part series on the duty to supervise: “Recent SEC Enforcement Actions Claim Violations by Broker-Dealers and Investment Advisers” (Sep. 6, 2018); “Conduct Proper Trade and Electronic Communications Surveillance” (Sep. 13, 2018); and “Respond to Red Flags; Implement Reasonable Policies and Procedures; and Conduct Adequate Training” (Sep. 20, 2018).

SEC and CFTC Impose More Than $5.6 Million in Disgorgement and Penalties on Recidivist Adviser

In 2019, the SEC and CFTC both issued settled administrative orders against a portfolio manager for an unnamed hedge fund adviser (Adviser), who allegedly used different valuation model inputs for similar assets to generate paper profits for the fund that he managed – and unwarranted bonuses for himself. Although both resolutions included a three-year industry bar, the portfolio manager allegedly continued to work as an adviser, raising money individually and through a separate entity, and diverting that money for his own use and to pay promised returns to other clients in a Ponzi-like scheme. In October 2021, the SEC and CFTC filed parallel enforcement actions against the portfolio manager; his spouse, who was named as a relief defendant; and the separate entity. All three defendants recently agreed to settle those actions and consented to the issuance of final judgments against them. This article details the alleged fraudulent misconduct; the SEC and CFTC enforcement actions; and the terms of the settlements. See “SEC, CFTC and DOJ Take Action Against Alleged $1‑Billion Valuation Fraud” (Mar. 17, 2022); and “SEC Sanctions and Bars Adviser’s Principal and Three Employees for Fraudulent Valuation Practices” (Dec. 2, 2021).

Robinhood Resolution a First for Cryptocurrency Enforcement in NY

Compliance officers looking for helpful “ripped-from-the-headlines” enforcement actions to support their requests for resources and direct access to the board need look no further than the recent $30‑million fine from the New York Department of Financial Services (NYDFS) on the cryptocurrency trading unit of online brokerage firm Robinhood Markets, Inc. The consent order for the NYDFS’ first crypto enforcement action describes deficiencies in the compliance culture; violations of a host of virtual currency, anti-money laundering, Bank Secrecy Act, financial services and cybersecurity regulations; and Robinhood’s hyper-fast growth and reliance on its parent company’s (also inadequate) compliance systems and resources as potential factors in its failures. This article discusses the alleged failures and provides commentary on the consent order’s implications from partners at Skadden and Greenberg Traurig. See “Navigating the Intersection of Digital Assets and AML” (Jul. 21, 2022).