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News January 8, 2018 Issue

Hedge Fund Compliance: Insider Trading, Allocation, Alternative Data, and More

Advisers managing hedge funds, to a large extent, face many of the same issues that advisers managing other funds do. Requirements regarding fees and expenses, custody, books and records and more must be met. There are other compliance issues, however, where the SEC can be expected to pay particular attention to hedge funds – and managing advisers would be wise to make sure they are on top of them.

Of course, not all hedge funds can be painted with a single brush when it comes to compliance. "A lot depends on the strategy of the hedge fund, as well as its size," said Lowenstein Sandler partner Benjamin Kozinn. However, he said, "there is more political focus on the hedge fund industry since the 2008 financial crisis."

While advisers managing hedge funds need to be aware of the compliance topics that rank high on the SEC’s list and employ best practices to mitigate their risk, they should also check with internal and/or external counsel to make sure they understand what all those risks are and to ensure that their best practices are providing the necessary protection.

Following are just some of the compliance risks, as well as best practices, that hedge funds need to be aware of.

Insider trading

"If not the number one concern, very close to it," said Ropes & Gray partner Jason Brown. The SEC pays attention to the question of material nonpublic information here because "hedge funds tend to do more complex trading" than other funds. Recent insider trading cases, among them SAC Capital Advisors and Artis Capital Management (ACA Insight, 10/31/16), would seem to bear this out, as well as serve as an example of the media’s attention to this topic.

A particular risk involving insider trading when it comes to hedge funds, said Kozinn, is that "investors in hedge funds do not have tolerance for allegations of insider trading. Once the government starts alleging that there was insider trading related to a fund manager, investors become the judge and jury by withdrawing their capital."

Best practices to minimize the risk of insider trading include:

  • Create proper policies and procedures in terms of how information is brought into the fund;
  • Establish a culture of compliance "that starts with a zero tolerance for unlawful activity," said Kozinn;
  • Conduct training, including bringing in outside counsel to not only help employees understand what insider trading is, but to "scare people," said Brown;
  • Monitor trades. "If there is a trade followed by a stock pop-up, look into it," Brown said; and
  • Consider chaperoning telephone conversations with expert research providers. This is particularly important when expert networks are involved, said Brown. "You might chaperone the conversation between the firm’s analyst and the expert. The experts are used to such policies at this point."

Allocation

Hedge funds tend to invest more in illiquid securities than other funds do, which raises questions of how these investments should be divided, said Brown. "Investment priorities can overlap. What if one fund invests more in Asia, or if another has areas where it has chosen not to invest?" Kozinn noted that "fixed income funds may originate loans, so how do you allocate them?" Other funds are subject to ERISA and are limited in terms of how they invest.

"Disclosure is the key," said Kozinn. Beyond that, he said, there are different methods for allocation (ACA Insight, 7/31/17). Among the methods that advisers managing hedge funds might use include formulas for allocation or just simply allocate pro rata across a family of funds. A discussion with the fund’s allocation committee may be necessary. "There is no bright line test," he said, but added that whatever method is used, it must be documented.

Alternative data sources

"Information today is more prevalent, there is more of it, and it is traveling at faster and faster speeds than was the case years ago," said Kozinn. All that data has in turn created new kinds of data – what the industry calls alternative data – that was not available years ago. Examples include credit card panel data, which is data aggregated from individual credit card users to demonstrate, among other things, spending patterns; satellite imaging data, geolocation data, and data on the number of cargo ships in various sea lanes.

"All of this data can be used by investment professionals to make investment decisions," he said. "Data scientists can paint a picture of a particular issuer by providing macroeconomic information." Hedge funds, Kozinn said, perhaps because they have more of a "culture of entrepreneurship" than more traditional funds, "have shown a willingness to adopt the use of alternative data."

That willingness, however, also exposes hedge funds to more risk from misuse of the data. Questions must be asked of the data provider, including:

  • Is any of the data inside information? Is it material? Is it nonpublic?
  • Was the data obtained in violation of a duty to the sources of the information?
  • Does the data provider have its own compliance program in place?
  • Is the provider willing to enter into a contract with the hedge fund adviser that addresses compliance concerns on MNPI, that policies and procedures are in place to mitigate risk, and more?

"It is important to perform due diligence on the alternative data providers, to have a conversation with them," said Kozinn. A hedge fund CCO most likely will not have the expertise to specialize in alternative data, so he or she will need to train the data scientists used by the adviser to look out for compliance issues as they analyze the data. Among the questions to consider is when you allow the data to come into the advisory firm or hedge fund, he said, adding that advisers should consider embargoing the data until they are certain they know what it contains.

Valuation

Hedge funds may invest in complex instruments, such as derivatives, that cannot be valued with a broker’s quick quote. "Illiquid investments are, by their nature, more difficult to value," said Brown. The adviser’s valuation committee, which should include at least some non-investment personnel as members or observers, such as the CFO or the CCO, should meet on a regular basis, making sure that it keeps good records of how investments were fair valued, he said. "Valuation policies must be disclosed and followed. There must be complete notes and documentation."

Best execution

Hedge funds that specialize in fixed income investments may have more best execution issues than equity shops, said Kozinn. Equity shops typically use an electronic trading system, which provides an immediate record of transactions. Fixed income shops, on the other hand, will use the telephone or services like Bloomberg to make trades. "That raises best execution issues because the trading issues discussed may not be clearly documented," he said.

Best practices here include using the firm’s best execution committee, which also typically includes the CCO, to evaluate how trades have been executed. The committees should engage in a "fulsome discussion process" of best execution, using criteria like the research performed, the time it took for the fund to get out of a position, and the trades themselves, he said.

Personally identifiable information

There are federal, state and international laws involving the handling of PII, which may accidentally enter a hedge fund through a number of ways, including the use of credit card information and other alternative data, said Kozinn. Advisers managing hedge funds should ask themselves how they work with data scientists to scrub the incoming data, whether they properly limit who can view the information to the data teams, and whether they should store the data offsite at either the vendor or some other third party before it goes to the investment team. "Hedge funds are not in the business of caring about PII, but it’s a byproduct of getting alternative data," he said. "If they get it, it’s a compliance issue."

Other compliance issues

Advisers managing hedge funds should also ask themselves if they and their funds are up to speed on compliance on these topics:

  • Liquidity. Funds’ maintaining a proper level of liquidity is something the SEC keeps its eye on. The agency has not prescribed a specific amount of liquidity, but advisers need to have in place procedures that allow for redemptions, and these must be disclosed to clients. "Some firms spell out how redemptions will work in their governing documents," said Brown. "They state that there may be delayed distributions, or they may establish ‘gates’ or other restrictions for how much can be redeemed at any given time."
  • Fees and expenses. As with all funds, the SEC wants to be sure that expenses are properly allocated between the adviser and its funds. "Travel expenses, for instance, that should properly be allocated to the adviser, should not instead be allocated to the funds," Brown said.