Life After Registration by Janaya Moscony

What is expected of advisers who are registered with the SEC? According to Rule 206(4)-7, advisers must:

1                      Adopt and implement written policies and procedures reasonably designed to prevent violations of the federal securities laws,

2                      Review those policies and procedures (at least annually) for their adequacy and the effectiveness of their implementation, and;

3                      Designate a chief compliance officer to be responsible for administering the policies and procedures.
 
Fast Forward One Year: Learn from the experience of others
 
For those advisers that have already been registered and hence, are not members of the pack currently scrambling to register by February 2006, Rule 206(4)-7 is old news.  That being said, the annual review requirement of the Rule is somewhat novel.  For advisers who have been complying since October 5, 2004, the deadline for completing this review is fast approaching.  Advisers must complete their initial annual review of the compliance policies and procedures no later than eighteen months after the adoption or approval of the compliance policies and procedures.
 
The review should consider the following:
 
1.      Any compliance matters that arose during the previous year,
2.      Any changes to the business activities of the adviser or its affiliates: and
3.      Any changes in the Advisers Act or applicable regulations that might suggest a need to revise the policies or procedures.
 
Addressing these three areas can be more complicated than meets the eye. With regard to compliance matters that may have surfaced over the past year, a good place to start is the routine compliance reviews performed daily, weekly, monthly and quarterly.    This is where an adviser should find the majority of the information that should be included in the review.  Some advisers are struggling because they are finding that they actually have very little documentation of what was reviewed over the past year.  This could potentially be a sign that there are a lack of controls in place and this would be a red flag to SEC examiners.  The best procedures may be in place, however, if not properly documented, the adviser will not only lack support for the annual review, but more importantly the adviser will not be able to demonstrate a sound and robust compliance program.    Changes in business activities, however slight, could affect an adviser’s compliance program. The SEC knows these subtleties exist and could very well go undetected. Hence, the annual review requirement.  Amending and updating policies and procedures to reflect any change in applicable regulations requires diligence.  This means that advisers must stay current on the rules by reading appropriate journals and compliance related news and/or working with a third-party to receive periodic regulatory guidance.

Although the rule dictates that reviews must occur annually, in reality, this is a misnomer because more frequent reviews are necessary in order to stay in compliance without lapse.  The fact that interim reviews are suggested and that only annual reviews are required does not provide Advisers with protection if any of the three items above have changed.  For example, if a new rule is adopted by the SEC during the year, the rule requires that the adviser adopt related written policies and procedure and the adviser waits until the annual review to address this, the adviser is in violation.  This could potentially have a wide-range of consequences.

We suggest in the year ahead that advisers create a routine system for documenting all  reviews on at least a quarterly basis.  Daily, weekly and monthly reviews must still be documented.  However, reviewing and summarizing the issues on a quarterly basis will  create the documentation required to demonstrate to the SEC that the adviser is taking the compliance function seriously.

Hedge fund advisers have unique risk that must be addressed.  Whether the adviser is still preparing to register with the SEC and hence, in the process of creating a compliance program or the adviser is evaluating its compliance program as a result of the annual review requirement, assessing risk is an integral step to complying with the regulations.  If the adviser’s resources are sufficient and employees have the appropriate skills and background, the adviser may prefer to address compliance issues internally.  However, if the adviser does not have the internal resources, it may be appropriate to consider engaging a third party. 

There are multiple areas where the adviser must have controls in place.  Let’s look at a few; the reconciliation process and marketing.

  
On a daily basis, trades executed should by reconciled against the prime broker’s records.  Weekly and monthly reconciliations should also be performed and documented.  Reviewing positions alone is not enough.  Valuation must also be reviewed and supported.  “Who is performing the reconciliation”?  If it is the trader executing the trade, the adviser may have a compliance issue. This would be a red-flag in the eyes of an SEC examiner.  This particular review should be done by a person other than the trader.  The reconciliation process should be documented so that the adviser can provide evidence that this function is consistently occurring.

 There should be a process for communicating all reconciliation issues to the appropriate manager and a process for resolving any discrepancies with the custodian and/or executing broker.  The adviser’s oversight should be well documented.

  Additionally, the brokers with whom the adviser executes trades should know who is approved to execute transactions within the adviser’s organization. 

 In an effort to establish a high level of internal controls, all of these details should be included in the adviser’s policies and procedures manual.
 
What is the concern with Marketing as it relates to Hedge Fund Advisers?
 
Hedge Fund Advisers have always had to exercise care and diligence with regard to soliciting investors to invest in a particular hedge fund.  This is not new information.
 
Private Funds are excluded from regulation under the Investment Company Act of 1940 by either Section 3(c)(1) or Section 3(c)(7).  Private Funds rely on the exemption from the registration requirements of the Securities Act of 1933 set forth in Regulation D for transactions by an issuer not involving a public offering.    Policies and procedures should be developed and include the process for documenting that a preexisting, substantive business or personal relationship exists. In addition, clear lines of responsibility should be drawn to designate who will be accountable internally for maintaining the documentation   SEC registered advisers may be asked to provide documentation related to the preexisting substantive relationship during a routine SEC examination. Policies and Procedures should also be developed to prohibit advertisements relating to a Private Fund and to limit the activities of related persons.  For example adviser representatives should be prohibited from engaging in cold calling and mass mailings.  While this may seem obvious, it should still be included in the adviser’s compliance manual and all employees should be trained.  Policies should include guidance on the types of seminars and/or meetings where information regarding a Private Fund can be discussed. If the attendees have been invited through any general solicitation or general advertising, all adviser personnel should realize that it is inappropriate to be discussing a Private Fund.
 
While hedge fund advisers have always had to comply with these exemptions, it is only now that the manager as a registered adviser will be subject to routine SEC audits.  SEC examiners will now be onsite at the adviser’s firm asking not only how the adviser complies with these exemptions, but how the adviser documents compliance.  Developing and adopting strict policies is an adviser’s best approach to creating a robust compliance program that meets SEC expectations.
 

There is the existing question as to whether or not the SEC initially will have adequate resources for conducting hedge fund adviser examinations. The SEC has taken several steps to streamline its examination program and is also preparing to conduct specific training focused on the hedge fund business and relevant risk.  The SEC faces the burden of ensuring their examiners understand the unique risks associated with hedge funds and their advisers.  While some SEC examiners may not be well versed in certain investment strategies, be assured they will be well-versed in assessing the adviser’s level of internal controls.