Jan. 7, 2016

Managing the Machine: How Hedge Fund Managers Can Examine and Document Their Automated Trading Strategies (Part One of Two)

Financial regulators are urging firms to implement policies and controls to prevent their automated trading (AT) strategies from disrupting the markets. To wit: the CFTC recently proposed risk controls and other restrictions for certain market participants that use algorithmic trading systems. European firms will soon be subjected to similar restrictions for their algorithmic trading systems in all markets covered by MiFID II, including the equities markets. FINRA and several industry organizations have begun to fill in the gaps on the U.S. equities side by issuing detailed guidance covering everything from pre-trade controls to system documentation procedures. Consequently, all firms that use AT strategies must begin establishing policies and controls to mitigate risks associated with those strategies. In this two-part guest series, Douglas A. Rappaport, Patrick M. Mott and Elizabeth C. Rosen of Akin Gump outline five high-level first steps for legal and compliance professionals to jumpstart the process of designing and implementing a control framework tailored to a hedge fund manager’s particular AT program that will stand up to regulatory scrutiny. This article will cover the first two steps, including conducting a risk assessment of and documenting the AT system. The second article will explore the remaining steps, addressing protocols for monitoring and reviewing trading activity, code and disclosures. For additional insight from Rappaport, see “How Can Hedge Fund Managers Understand and Navigate the Perils of Insider Trading Regulation and Enforcement in Hong Kong and the People’s Republic of China?” (Mar. 28, 2013). For insight from other Akin Gump partners, see “Non-E.U. Hedge Fund Managers May Not Be Required to Comply With AIFMD’s Capital and Insurance Requirements” (Jul. 9, 2015); and “Structuring Private Funds to Profit From the Oil Price Decline: Due Diligence, Liquidity Management and Investment Options” (Mar. 19, 2015).

Navigating FCA and SEC Cybersecurity Expectations (Part One of Two)

Given the increased scrutiny of cybersecurity by governments around the globe, hedge fund managers operating in multiple jurisdictions must be aware of the relevant regulatory cybersecurity expectations. This two-part series examines the operations of the U.K. Financial Conduct Authority (FCA) and the SEC, both of which have increased their focus on cybersecurity, albeit with differing approaches. Part One discusses the FCA and SEC as regulators of financial services in their respective jurisdictions and outlines the guidance issued, and the methods adopted, by the two regulators. Part Two will explore how hedge fund managers can navigate the current regulatory environments, including existing guidance, in the U.S. and the U.K., and simultaneously satisfy the requirements of each regulator. See also our series on “How Hedge Fund Managers Can Meet the Cybersecurity Challenge”: Part One (Dec. 3, 2015); and Part Two (Dec. 10, 2015).

Preference for Investing in Proprietary Hedge Funds Must Be Fully Disclosed by Investment Banks to Avoid Conflicts

The SEC and CFTC recently announced the settlement of enforcement proceedings involving an investment bank and affiliated investment adviser that allegedly failed to disclose to clients various conflicts of interest arising out of their management of client funds. Although the respondents disclosed that client funds were invested in proprietary products, such as proprietary mutual funds and hedge funds, they allegedly failed to disclose that they preferred to invest in such products. In addition, the SEC and CFTC found that the bank and investment adviser failed to disclose certain other conflicts, including the bank’s preference to add to its private account platform hedge fund managers willing to pay placement fees, or “retrocessions,” to an affiliate, as well as the existence of lower-fee classes of certain proprietary funds available to investors. This article summarizes the business practices that gave rise to the enforcement proceedings, the specific violations alleged and the outcome of each proceeding. The SEC has made conflicts of interest a top enforcement priority in recent years, although until now the CFTC has been less vocal on that front. See “SEC’s Rozenblit Discusses Operations and Priorities of the Private Funds Unit” (Sep. 24, 2015); and “Conflicts Remain an Overarching Concern for the SEC’s Asset Management Unit” (Mar. 12, 2015).

Capital-Raising Issues Hedge Fund Managers Must Consider

One of the greatest concerns for hedge fund managers – particularly startup managers – is raising capital and increasing assets under management, especially in difficult fundraising environments. Managers must solicit investors and raise capital in order to successfully grow their businesses, but raising capital goes beyond simply demonstrating good fund performance. Hedge fund managers must successfully market themselves, understand their competition and know what investors are seeking and how their funds can meet those needs. Participants explored these and other matters at the annual Thompson Hine hedge fund seminar. This article highlights the key points discussed by panelists, including issues relating to raising capital, entering into seeding arrangements, offering founder share classes and understanding investor needs. For coverage of prior Thompson Hine hedge fund seminars, see “Seminar Offers Insights on Organizing Alternative Mutual Funds, AIFMD, FATCA and the JOBS Act” (Dec. 5, 2013); and “Seminar Focuses on Implications for Hedge Fund Managers of the JOBS Act, Form PF and Form CPO-PQR” (Nov. 9, 2012).

CFTC Resolves Its First Insider Trading Case

The CFTC recently settled its first enforcement proceeding involving alleged insider trading in commodities futures. Although there have been previous cases alleging insider trading of products traditionally thought of as futures or commodities, such as credit default swaps, these actions have been brought by the SEC. See, e.g., “After Bench Trial of First-Ever Credit Default Swap Insider Trading Action, U.S. District Court Rules That Swaps Referencing Bonds Are Securities-Based Swap Agreements Under Antifraud Provisions of Securities Exchange Act, but Holds That SEC Failed to Prove Insider Trading” (Jul. 8, 2010). A proprietary trader employed by a large public company surreptitiously, and in violation of company policy, matched company trades in oil and gas futures with trades in two accounts that he personally controlled. He also traded for his own account ahead of his trades for the company. The CFTC accused the trader of violating the antifraud and anti-manipulation provisions of the Commodity Exchange Act and its rules. Of particular note to any hedge fund manager engaging in transactions involving commodity interests (including futures, options on futures and related swaps), the CFTC has firmly asserted that its Regulation 180.1 – which closely tracks Rule 10b-5 under the Securities Exchange Act of 1934 – permits the CFTC to prosecute commodities industry participants for insider trading. This article summarizes the CFTC’s allegations; the relevant laws and regulations; and the outcome of the settlement. For more on CFTC enforcement priorities, see “Regulators From the SEC, CFTC and New York Attorney General’s Office Reveal Top Hedge Fund Enforcement Priorities (Part Two of Four)” (Dec. 18, 2014).

FCA Director Summarizes 2015 Regulatory Initiatives Applicable to Hedge Fund Managers and Financial Markets

In a recent speech delivered at the Investment Company Institute Global Trading and Market Structure Conference in London, David Lawton, Director of Markets Policy and International at the U.K. Financial Conduct Authority (FCA), reflected on what 2015 meant for the regulation of wholesale markets and the funds industry. Noting that change has come from several sectors (new technology, market players, innovation and regulation), Lawton highlighted some of the “more important” market policy developments and how they might contribute to the “core of timeless, immutable goals which policy and regulators are pursuing” – namely, the goal of “fair and effective markets.” This article summarizes Lawton’s speech, outlining his comments on the revised Markets in Financial Instruments Directive (MiFID II), dealing commissions, market abuse regulation, capital markets union and various U.K. market reviews. Lawton’s remarks are pertinent to hedge fund managers as they provide valuable insight into the FCA’s priorities and anticipated directions for the upcoming year, especially relating to MiFID II. For additional insight from Lawton, see “FCA Urges Hedge Fund Managers to Prepare for MiFID II” (Oct. 29, 2015).

Clifford Chance Boosts Investment Funds Practice in Luxembourg

Clifford Chance recently hired Arne Bolch as counsel in its Luxembourg investment funds practice. Bolch is a lawyer qualified both in Luxembourg and Germany with 10 years of experience advising on Luxembourg investment funds matters. See “Luxembourg Financial Regulator Issues Guidance on AIFMD Marketing and Reverse Solicitation” (Sep. 3, 2015); and “How Can Hedge Fund Managers Use Luxembourg Funds to Access Investors and Investments in Europe, Asia and Latin America?” (Jul. 12, 2012). His main areas of expertise are fund formation and providing ongoing regulatory advice to alternative investment funds and UCITS funds under Luxembourg law. For more on UCITS, see our two-part series addressing considerations for hedge fund managers launching UCITS funds: “Liquidity, Transparency and Performance” (Dec. 10, 2015); and “Distribution and Operational Due Diligence” (Dec. 17, 2015).

K&L Gates Further Expands Investment Management Practice in D.C.

On December 23, 2015, the Washington, D.C., office of K&L Gates welcomed Todd W. Betke as a partner in its investment management, hedge funds and alternative investments practices. Betke focuses his practice on commercial, legal and regulatory issues surrounding private equity, venture capital and hedge fund formation, as well as related acquisitions and dispositions of portfolio companies and assets. For insight from the firm, see “K&L Gates-IAA Panel Addresses Cyber Insurance Plans for Investment Advisers (Part Two of Two)” (Jul. 2, 2015); and “K&L Gates Partners Outline Six Compliance Requirements and Four Enforcement Themes for Private Fund Advisers (Part Three of Three)” (Jan. 8, 2015).