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    Mar. 3, 2016

Why All Investment Advisers – and Their Compliance Officers – Should Heed the SEC’s Risk Alert About Outsourced CCOs (Part One of Two)

As recent reports of the firing by JPMorgan Chase of the head of its government debt trading desk and another trader for compliance violations make clear, it is vital for hedge fund managers and other financial services firms to take compliance seriously. As part of its effort to ensure that regulated firms devote sufficient attention and resources to compliance, the SEC Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert in November describing its recent “Outsourced CCO Initiative.” In a two-part guest series, Andrew W. Reich, counsel at BakerHostetler, analyzes the Risk Alert and offers guidance on the issues addressed therein applicable to all investment advisers and investment companies as well as their CCOs (not just those employed at third parties), along with the application of those issues to their compliance programs. This first article explores the background that gave rise to the Risk Alert; allocation of resources to compliance; and CCO independence and empowerment. The second article will clarify written policies and procedures as well as outline steps to enhance firms’ culture of compliance. See “The Role of Outsourced Compliance Consultants in the Hedge Fund Compliance Ecosystem” (Jun. 27, 2014). For more on CCO responsibilities, see “SEC Chief of Staff Offers Nine Key Considerations for Investment Adviser and Broker-Dealer Compliance Officers” (Oct. 22, 2015); and “SEC Enforcement Action Shows Hedge Fund Managers May Be Liable for Failing to Adequately Support Their CCOs” (Jul. 23, 2015).

Hedge Fund Managers Are Advised to Build Robust Infrastructure

As investors conduct deeper due diligence into infrastructure – such as compliance policies and procedures, technology systems and cybersecurity protections – hedge fund managers must ensure that their programs and systems are robust and able to withstand scrutiny. See “Legal, Operational and Risk Considerations for Institutional Investors When Performing Due Diligence on Hedge Fund Service Providers” (Jul. 8, 2010). Managers may choose to supplement their in-house infrastructure by outsourcing and delegating to third-party service providers, while monitoring those providers to ensure quality. At a recent seminar hosted by Backstop Solutions Group and ACA Compliance Group, panelists discussed the integration of technology and compliance, outsourcing of business functions to third parties, due diligence of service providers and investor scrutiny of hedge fund managers. This article highlights the salient points raised during the program. For additional insight from Backstop, see “Essential Tools for Hedge Fund Managers to Combat Escalating Cyber Threats” (Feb. 4, 2016). For coverage of a recent program jointly offered by the HFLR and ACA, see “Recommended Actions for Hedge Fund Managers in Light of SEC Enforcement Trends” (Oct. 22, 2015).

Hedge Fund Managers May Be Liable for Performance Claims of Others

Performance advertising is a minefield for fund managers. Besides ensuring that their own performance is accurate, a recently settled SEC enforcement action makes clear that hedge fund managers and other investment advisers can be held liable for disseminating another adviser’s inaccurate claims. See also “Hedge Fund Managers Must Refrain From Combining Actual and Hypothetical Performance Results to Avoid Misleading Investors and Avert SEC Enforcement Action” (Feb. 11, 2016). When a registered investment adviser licensed proprietary trading strategies from another firm, it also began using performance information prepared by that firm. However, those performance claims were inaccurate because, rather than being based on actual track records as purported, they were hypothetical and backtested. See “SEC Settles Enforcement Action and Pursues Company Over Use of Backtested Performance Data” (Jan. 8, 2015). This article summarizes the SEC’s allegations against the relying investment adviser, as well as the terms of the settlement order. For more on backtesting, see “Under What Conditions Can a Hedge Fund Manager Present Hypothetical Backtested Performance Results?” (Feb. 1, 2013). For a discussion of performance advertising, see our two-part series on hedge fund managers’ use of target returns: “Common Practices, Benefits and Drawbacks” (Apr. 23, 2015); and “Legal Risks” (Apr. 30, 2015). For other performance advertising issues, see the HFLR’s articles on GIPS compliance claims; testimonials and social media; cherry picking and case studies; the use of gross performance results; and the use of other firms’ track records.

FCA Expects Hedge Fund Managers to Focus on Liquidity Risk

Investment managers must ensure that they appropriately manage liquidity risks in their funds and disclose those risks to investors, according to the U.K. Financial Conduct Authority (FCA). Working with the Bank of England to assess risks posed by open-ended investment funds investing in the fixed income sector, the FCA reviewed a number of large investment management firms to understand their liquidity management practices. The FCA has compiled its findings in an update recommending good practices for hedge fund and other investment managers to manage liquidity in their funds. The FCA expressly stated that, even though they originated in the open-ended fund context, its conclusions apply across the entire investment fund industry. This article outlines the FCA’s recommendations. For more on liquidity, see “Schulte Partner Stephanie Breslow Discusses Tools for Managing Hedge Fund Crises Caused by Liquidity Problems, Poor Performance or Regulatory Issues” (Jan. 9, 2014); and “Seward & Kissel New Hedge Fund Study Identifies Trends in Investment Strategies, Fees, Liquidity Terms, Fund Structures and Strategic Capital Arrangements” (Mar. 5, 2015). For additional recommendations from the FCA, see “FCA Urges Hedge Fund Managers to Prepare for MiFID II” (Oct. 29, 2015).

SEC Commissioner Calls for Increased Transparency and Accountability in Capital Markets

In her remarks at the recent “SEC Speaks” conference, Commissioner Kara M. Stein asserted that transparency and accountability are “critical to the efficient and effective operation of our capital markets” and central to SEC efforts in 2016. In addition, Stein discussed exchange-traded funds, along with areas of focus for the SEC in the coming year. Stein’s remarks calling for firms to increase disclosure to investors are particularly relevant to hedge fund managers, as they might be a harbinger of increased disclosure requirements for hedge funds and other entities currently subject to lower standards than those imposed by regulations such as those under the Investment Company Act of 1940. This article highlights the key points from Stein’s speech. For commentary from Stein’s colleagues, see “SEC Enforcement Director Assures CCOs They Need Not Fear SEC Action Absent Wrongdoing” (Nov. 19, 2015); “SEC Chair Emphasizes Enforcement Focus on Strong Remedies and Individual Liability” (Nov. 12, 2015); and “SEC Chair Highlights Two Types of Risks Hedge Fund Managers Must Consider” (Oct. 29, 2015).

U.K. National Audit Office Report Questions FCA Effectiveness

A recent report evaluates whether the U.K. Financial Conduct Authority (FCA) effectively protects consumers in the financial services industry, with potential implications for hedge fund managers and other financial firms. The U.K. National Audit Office (NAO) report provides insight into the FCA’s efforts to combat mis-selling and the effectiveness of those efforts. While commending those efforts, the report also calls for better data to determine whether the FCA’s efforts are providing “value for money.” Although the NAO report addresses consumer concerns, its recommendations could prompt the FCA to increase scrutiny of hedge fund managers and other financial services firms, which could result in stricter compensation and remuneration limitations on managers. This article examines the primary takeaways from the report. For a recent FCA report on hedge fund sales practices, see “FCA Report Enjoins Hedge Fund Managers to Improve Due Diligence“ (Feb. 25, 2016).

K&L Gates Further Bolsters Investment Management Practice in New York

K&L Gates has added Robert Sichel as a partner in the firm’s investment management practice. Sichel will oversee K&L Gates’ ERISA fiduciary group, advising investment managers and other financial institutions on the fiduciary responsibility and prohibited transaction rules of ERISA. See our series on “Structuring Private Funds to Avoid ERISA While Accommodating Benefit Plan Investors”: Part One (Feb. 5, 2015); and Part Two (Feb. 12, 2015); as well as our three-part series on ERISA considerations for European hedge fund managers: “Liability and Incentive Fee Considerations” (Sep. 24, 2015); “Prohibited Transaction, Reporting and Side Letter Considerations” (Oct. 1, 2015); and “Indicia of Ownership and Bond Documentation Considerations” (Oct. 8, 2015).

Tax Partner Joins Latham & Watkins in New York

Gregory Hannibal has joined Latham & Watkins as a partner in the tax department in its New York office. His practice focuses on tax issues arising from the formation and operation of private investment funds, and he advises on a variety of strategic transactions involving partnership, corporate and international tax matters. For more on U.S. and international tax issues relevant to hedge fund managers, see “How to Draft Key Hedge Fund Documents to Take New Partnership Rules Into Account” (Feb. 11, 2016); “Hedge Funds Organized As Delaware LLCs May Be Transparent for U.K. Tax Purposes” (Jul. 16, 2015); and “What Hedge Funds Need to Know About Tax Relief Under the New Australian Investment Manager Regime” (Jun. 11, 2015).

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