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    Dec. 1, 2016

Failure to Safeguard Customer Data, Preserve Records and Properly Supervise May Expose Broker-Dealers to FINRA Enforcement Action

FINRA recently entered into a Letter of Acceptance, Waiver and Consent with a general securities business that has in excess of 1,100 registered representatives in more than 500 branch locations. The action alleged that the firm failed to safeguard customer data, preserve customer records and implement an appropriate supervisory system to prevent these violations. The affected firm has agreed to a censure and to pay a substantial fine. Private fund managers with affiliated broker-dealers should pay particular attention to this ruling, although FINRA’s cybersecurity preparedness expectations outlined in the action should be of interest to all private fund managers. This article outlines the alleged misconduct, the terms of the settlement and the remedial measures the broker is implementing. For coverage of other FINRA enforcement proceedings, see “FINRA Fines Terra Nova $400,000 for Making Over $1 Million in Improper Soft Dollar Payments to Hedge Fund Managers” (Dec. 10, 2009); and “In FINRA’s First Action Involving Credit Default Swaps, FINRA Fines ICAP $2.8 Million to Settle Price Fixing Claims” (Jul. 16, 2009).

Ernst & Young’s 2016 Global Hedge Fund and Investor Survey Examines Industry Risks; Customized and Non-Traditional Products; Investor Allocation Preferences; Fees; and Hedge Fund Growth Priorities (Part One of Two)

Ernst & Young (EY) recently released the results of its tenth annual Global Hedge Fund and Investor Survey, which explored – among other things – industry risks, investor allocation preferences, management fee pressures, manager growth strategies, product customization and trends in non-traditional products. This first article in a two-part series summarizes the survey’s findings in these areas. The second article will detail the survey’s results with respect to marketing, operational efficiency, prime brokerage and talent management. For coverage of EY surveys from prior years, see “Hedge Fund Growth Priorities, Fee and Expense Climate, Prime Brokerage and Operational Matters” (Dec. 3, 2015); “Growth Areas for Hedge Fund Managers, Related Costs and Challenges, Operating Expenses and Cybersecurity” (Jan. 15, 2015); and “Trends in Asset Sourcing, Alternative Mutual Funds, Customized Solutions, Staffing, Administrator Shadowing, Expense Pass-Throughs and Outsourcing” (Dec. 5, 2013). 

How Investment Managers Can Advertise Sub-Adviser Performance Without Violating SEC Rules 

In a series of recent enforcement actions, the SEC has held investment advisers responsible for performance claims included in their marketing materials that they received from sub-advisers and that turned out to be false and misleading. Although the SEC acknowledged that the investment advisers may have been unaware that the performance information was false and misleading, the regulator concluded that they were nevertheless responsible for ensuring that the overall reported performance record from their sub-advisers was compliant with the Investment Advisers Act of 1940. To avoid running afoul of applicable law, investment advisers conveying third-party performance returns should obtain adequate documentation to verify their accuracy and establish policies and procedures that govern what due diligence they will conduct on the sub-advisers’ performance. In a guest article, Daniel G. Viola, partner at Sadis & Goldberg, and Antonella Puca, head of the investment performance attestation practice at RSM US, review the key aspects of the recent enforcement activity of the SEC on performance advertising and provide guidance on how to address some of the SEC’s concerns. For additional insight from Viola, see “Hedge Fund Managers Advised to Prepare for Imminent SEC Examination” (Jan. 28, 2016). For more on performance advertising, see “The SEC’s Recent Revisions to Form ADV and the Recordkeeping Rule: What Investment Advisers Need to Know About Retaining Performance Records (Part Two of Two)” (Nov. 17, 2016); and “Liquidity and Performance Representations Present Potential Pitfalls for Hedge Fund Managers” (Mar. 31, 2016).

How Fund Managers Can Mitigate Prime Broker Risk: Preliminary Considerations When Selecting Firms and Brokerage Arrangements (Part One of Three)

The actions and potential failure of prime brokers pose sizable threats to the well-being of fund managers. In 2008, insolvencies by prominent prime brokers such as Bear Stearns and Lehman Brothers imperiled a number of hedge funds. See “Hedge Funds Turning to Prime Brokerage Trust Affiliates for Added Protection Against Prime Broker Insolvencies” (Jun. 24, 2009). In addition, as recently as July 2016, Merrill Lynch agreed to pay a $415 million settlement to the SEC in connection with actions that threatened its hedge fund clients. See “Merrill Lynch Settlement Reminds Hedge Fund Managers to Be Aware of How Brokers Are Handling Their Assets” (Jul. 7, 2016). In an effort to help our subscribers mitigate the risks posed by their prime brokers, this three-part series outlines steps that fund managers can take when engaging a prime broker. This first article details preliminary considerations when engaging prime brokers, including regulatory protections, several types of arrangements based on fund risk profiles and due diligence efforts managers can undertake. The second article will examine structural considerations to mitigate prime broker risk, including the viability of multi-prime and split broker-custodian arrangements. The third article will describe legal protections that can be included in prime brokerage agreements to mitigate risk, including with respect to rehypothecation limits and asset transfer restrictions. For more on prime broker selection, see “Factors to Be Considered by a Hedge Fund Manager When Selecting a Prime Broker” (Dec. 4, 2014); “How Should Hedge Fund Managers Select Accountants, Prime Brokers, Independent Directors, Administrators, Legal Counsel, Compliance Consultants, Risk Consultants and Insurance Brokers for Their Funds?” (Jun. 13, 2013); and “Prime Brokerage Arrangements From the Hedge Fund Manager Perspective: Financing Structures; Trends in Services; Counterparty Risk; and Negotiating Agreements” (Jan. 10, 2013).

How Fund Managers Can Navigate and Avoid the Pitfalls of European Short Sale Reporting Obligations

On November 1, 2012, E.U. Regulation 236/2012 (Regulation) came into effect, imposing reporting obligations on short sellers and regulating certain aspects of the credit default swaps market. In the wake of the 2008 global financial crisis, the primary goal of the Regulation is to provide E.U. regulators with sufficient transparency to ensure that member states are in a position to reduce systemic risk and financial instability related to short selling. See “Regulatory Uncertainty and Market Instability Put Short Selling Under Fire” (Dec. 3, 2008). Compliance with the Regulation has been difficult for many short sellers, however, as the regulators have provided little guidance in this area. For example, short sellers with potential notification obligations often lack a definitive source of information to confidently calculate their net short positions. To help distill some of the issues surrounding the Regulation, the Hedge Fund Law Report recently interviewed Anna Lawry, counsel at Ropes & Gray, and Marye Cherry, E.U. regulatory counsel at Advise Technologies (Advise). In this article, Lawry and Cherry review certain mechanics of the reporting obligations and identify several gaps in the Regulation that are important for short sellers. On Wednesday, December 7, 2016, from 10:00 a.m. to 11:00 a.m. EST, Lawry and Cherry will expand on the topics discussed below and other challenges relating to the Regulation in a webinar presented by Advise, entitled “E.U. Short Sale Reporting,” which will be moderated by William V. de Cordova, Editor-in-Chief of the HFLR. To register for the webinar, click here. For additional insight from Advise, see our two-part series on how non-E.U. hedge fund managers can comply with E.U. private placement regimes: “Registration” (Dec. 3, 2015); and “Reporting” (Dec. 10, 2015). 

Annual Walkers Fundamentals Seminar Discusses How Managers Attract Investors in a Challenging Market by Tailoring Fund Structures and Governance Policies 

In a challenging funds market characterized by a high rate of redemptions and growing pressure on fees, fund managers are increasingly adopting strategies to curry favor with institutional investors. The popularity of these approaches is coupled with increased efforts by managers to monitor regulatory developments and ensure their compliance programs can withstand SEC scrutiny. See “How Hedge Fund Managers Can Accommodate Heightened Investor Demands for Bespoke Negative Consent, Liquidity, MFN and Other Provisions in Side Letters” (Oct. 13, 2016). These points came across in the annual Walkers Fundamentals Hedge Fund Seminar held in New York on November 1, 2016, which summarized the recent Walkers white paper that shared a title with the seminar. The speakers at the event included Walkers partners Tim Buckley, Ashley Gunning and Ingrid Pierce; Andrew Kandel, chief compliance officer, co-general counsel and senior managing director of Cerberus Capital Management; and Richard Swanson, managing director and general counsel of York Capital Management. This article highlights the key points presented during the seminar as well as Walkers’ insights contained in the white paper. For the HFLR’s coverage of the Walkers Fundamentals Hedge Fund Seminar from prior years, see: 2015 Seminar; 2014 Seminar; 2013 Seminar; 2012 Seminar; 2011 Seminar; and 2009 Seminar.

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