50,99 €
Mehr erfahren.
- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance Editions
- Sprache: Englisch
The long-awaited guide for modern hedge fund compliance program development Hedge Fund Compliance + Website provides straightforward, practical guidance toward developing a hedge fund compliance program, drawn from the author's experience training financial regulators, consulting with government entities, and analyzing hedge fund compliance structures across the globe. In-depth explanations of compliance principles are backed by illustrative case studies and examples. Highly in-demand templates of popular hedge fund compliance documentation provide actionable illustrations of key compliance policies. Designed to assist investors, fund managers, service providers, and compliance job seekers directly, this book describes the fundamental building blocks of the hedge fund compliance function. Compliance is one of the fastest growing areas in the hedge fund space. This reference book provides an essential foundation in modern hedge fund compliance, reflecting the recent changes of this dynamic field. * Design and run a hedge fund compliance program * Access templates of core compliance documentation and checklists * Discover how investors can evaluate and monitor compliance programs * Interviews with hedge fund compliance practitioners A steady stream of regulatory changes, combined with the enhanced enforcement efforts of regulators, ensure that hedge funds' compliance-related expenditures will continue to grow. While hedge fund compliance legislation continues to evolve globally, little practical guidance exists for those tasked with the boots-on-the-ground aspects of developing an actual compliance program to comply with best practices and regulatory guidance from leading hedge fund regulators including the US Securities and Exchange Commission, the National Futures Association, the Commodity Futures Trading Commission and the United Kingdom's Financial Conduct Authority. Hedge fund professionals and investors need a fundamental framework for establishing and evaluating an effective program, and when compliance is the issue, trial and error carries too much risk. Hedge Fund Compliance + Website provides clear guidance and practical tools to meet today's compliance professional needs.
Sie lesen das E-Book in den Legimi-Apps auf:
Seitenzahl: 345
Veröffentlichungsjahr: 2016
Ähnliche
Table of Contents
Series Page
Title Page
Copyright
Dedication
Preface
Chapter 1: Introduction to Hedge Fund Compliance
Introduction
Differences in Hedge Fund and Other Alternative Fund Compliance
Hedge Fund Compliance Is Not Specific to One Country
Do Alternative Investments Merit Special Compliance Considerations?
Understanding the Hedge Fund Compliance Framework
Introduction to the Hedge Fund Compliance Function
Distinguishing the Legal and Compliance Departments
Key Players in Compliance
Standard Areas Covered by a Hedge Fund Compliance Function
Compliance Function Roles and Authority
Chapter Summary
Chapter 2: Introduction to Hedge Fund Regulation and Examination
Introduction
Different Types of Regulation for Different Financial Entities
Why Regulation Is Needed
Where Do Compliance Rules Come From?
National and Global Jurisdiction
Common Regulatory Interaction with Hedge Funds
Regulatory Examinations
Chapter Summary
Chapter 3: The Chief Compliance Officer and Regulatory Reporting
Introduction
Introducing the Chief Compliance Officer
Regulatory Reporting
Regulatory Reporting in Multiple Jurisdictions
Common Regulatory Reporting Questions
A Multistep Process
Chapter Summary
Chapter 4: In‐House Compliance Professionals and Hedge Fund Committees
Introduction
Common Compliance Function Tasks
Firm Committees as Compliance Mechanisms
Chapter Summary
Chapter 5: Hedge Fund Compliance Technology
Introduction
Understanding the Hedge Fund Information Technology Function
Primary Compliance Uses of Technology
Compliance Considerations for Use of Electronic Data
Compliance Oversight of Nonelectronic Data
Business Continuity and Disaster Recovery Planning
Chapter Summary
Chapter 6: Compliance Consultants and Other Compliance‐Related Service Providers
Service Provider Compliance
Classification of Compliance Service Providers
Service Provider Compliance Work
Hedge Fund Compliance Consultants
Chapter Summary
Chapter 7: Understanding Key Compliance Documentation
Reasons for Documenting Compliance Policies and Procedures
Understanding the Goals of Compliance Documentation
Jurisdictional Differences in Compliance Documentation
Understanding Boilerplate Documentation
Core Compliance Documentation
Chapter Summary
Chapter 8: Investor Evaluation of Hedge Fund Compliance Functions
Introduction
Compliance Evaluations in Investor Due Diligence
Initial and Ongoing Compliance Analysis
Evaluating Best Practice Compliance
Key Compliance Analysis Areas
Chapter Summary
Chapter 9: Case Studies and Example Scenarios in Hedge Fund Compliance
Introduction
Compliance Scenario 1
Compliance Scenario 2
Case Studies
Chapter Summary
Chapter 10: Common Compliance Pitfalls and How to Avoid Them
Introduction
Pitfall 1: Small Firms Build Large Firm Compliance Infrastructures
Pitfall 2: Underspending on Compliance
Pitfall 3: Lack of Independent Compliance Reporting
Pitfall 4: Outsourcing All Compliance
Pitfall 5: Relying on Technology and Compliance Automation
Pitfall 6: Letting Investor Opinion Drive Compliance Priorities
Chapter Summary
Chapter 11: Interviews with Compliance Service Providers
Introduction
Interview with Kent Wegrzyn (ACA Compliance Group)
Interview with Vinod Paul (Eze Castle Integration)
Chapter Summary
Chapter 12: Trends and Future Developments
Introduction
Chief Compliance Officers Personal Liability Concerns
Increased Senior Manager Regulatory Accountability
Compliance‐Related Insurance
Increasingly Coordinated Hedge Fund Regulation in Europe
Chapter Summary
About the Author
End User License Agreement
Pages
ii
iv
v
xi
xii
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
147
148
149
150
151
152
153
154
155
156
157
158
159
160
161
162
163
164
165
166
167
168
169
170
171
172
173
174
175
176
177
178
179
181
182
185
186
187
188
189
Guide
Table of Contents
Begin Reading
List of Illustrations
Chapter 1: Introduction to Hedge Fund Compliance
Exhibit 1.1 Components of a Common Hedge Fund Compliance Framework
Exhibit 1.2 Example Organizational Structure of a Hedge Fund with a Dedicated Compliance Function
Chapter 4: In‐House Compliance Professionals and Hedge Fund Committees
Exhibit 4.1 Example Structure of Internal and External Hedge Fund Compliance Resources
Exhibit 4.2 Example Compliance Manual Acknowledgment for Hedge Fund Employee
Exhibit 4.3 Example Hedge Fund Committee Structure
Chapter 5: Hedge Fund Compliance Technology
Exhibit 5.1 Representative Structure of a Hedge Fund Information Technology Function
Chapter 8: Investor Evaluation of Hedge Fund Compliance Functions
Exhibit 8.1 Example of How Distinctions May Be Drawn between Different Levels of Hedge Fund Compliance
Chapter 10: Common Compliance Pitfalls and How to Avoid Them
Exhibit 10.1 Comparison of Independent and Indirect Compliance Reporting Structures
Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding.
The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more.
For a list of available titles, visit our Web site at www.WileyFinance.com.
Hedge Fund Compliance
Risks, Regulation, and Management
JASON SCHARFMAN
Copyright © 2017 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.
Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.
Library of Congress Cataloging-in-Publication Data is available
ISBN 978-1-119-24023-5 (Hardcover)
ISBN 978-1-119-24027-3 (ePDF)
ISBN 978-1-119-24026-6 (ePub)
Cover Design: Wiley
Cover Images: (top) © g0d4ather/Shutterstock; (bottom) © Rawpixel.com/Shutterstock
For R, Y, and Z
Preface
Compliance is one of the fastest‐growing areas in the hedge fund industry. Contributing to this change is a seemingly steady drumbeat of new global regulatory activity. In the United States and in Asia, for example, regulators have steadily enhanced their hedge fund compliance enforcement and surveillance activities. In Europe, broad shifts in the laws, such as the Alternative Investment Fund Managers Directive (AIFMD) and the Markets in Financial Instruments Directive (MiFID), have directly influenced the way hedge funds carry out their investment activities.
Today, hedge fund compliance has evolved into more than simply a regulatory exercise. Hedge fund compliance programs are now required to regularly engage compliance risks across a wide variety of operational and investment areas, ranging from cybersecurity and conflict of interest management to trade allocation and increased oversight of the use of investment research. To meet these challenges, hedge funds and their investors and service providers must continually reevaluate the role of the compliance function to ensure that they not only meet these new regulatory requirements but also keep pace with industry best practices. This book is written to assist these groups in embracing this challenge.
Readers of this book will come from different levels of sophistication, ranging from those in an academic setting and new to hedge fund industry to experienced hedge fund compliance professionals working in the compliance field. To assist in highlighting important compliance terminology as you read through each of the chapters, you will find key terms italicized and in boldface. Regardless of your previous compliance experience, this book can also serve as a reference source on specific compliance topics. To facilitate this, the chapters of this book have been organized by key compliance topic area for ease of navigation.
Specifically, this book is structured to provide an understanding of the core concepts of hedge fund compliance across three sections. The first section, Chapters 1 through 4, focuses on topics relating to the structure and duties of a hedge fund's internal compliance function. It begins by providing an introduction to the compliance function and the role of regulators. The Chief Compliance Officer (CCO) role, as well as the responsibilities of other shared and dedicated compliance personnel, are then discussed. This section concludes with an analysis of the function of internal compliance mechanisms, such as fund committees.
The second section of the book, Chapters 5 through 8, focuses on specific topics in compliance as well as the role of third parties in the process. This section begins by addressing the emerging role of technology in compliance management. The use of technology in performing a wide variety of compliance activities, including trade surveillance, archiving, and monitoring employee communications, is also covered. Next, the role of third parties that assist in compliance management, including compliance consultants, is discussed. Examples of key compliance documentation, including the Compliance Manual and Code of Ethics, are then presented. Finally, the process by which prospective and existing investors conduct due diligence on hedge fund compliance functions is addressed with a focus on the analysis of compliance policies regarding employee personal account dealing and material non‐public information (MNPI).
The third and final section of the book, Chapters 9 through 12, applies critical compliance concepts directly to the real world. It begins by focusing on historical case studies and illustrative scenarios as well as common compliance pitfalls. Interviews with third‐party compliance service providers are presented to demonstrate the practical opportunities and challenges facing hedge funds in working with third parties to implement and manage their compliance programs. Finally, the book concludes with a discussion of emerging topics and trends in the compliance space.
Compliance has evolved from a rote exercise of strictly following regulatory rules to one of the most prominent, dynamic, and multidisciplinary areas of hedge fund management. A strong compliance program can improve the overall operating efficiency and level of communication throughout a hedge fund. Similarly, hedge fund investors benefit from the additional oversight and transparency that comprehensive compliance programs can provide. Regardless of your role in the hedge fund industry, as compliance continues to evolve, developing a fundamental understanding of core compliance concepts is now an essential requirement for success.
Jason ScharfmanDecember 2016
CHAPTER 1Introduction to Hedge Fund Compliance
INTRODUCTION
Nearly every profession, whether it is asset management, healthcare, construction, or scientific research, has some areas that require rules and regulations to be followed. At its most basic level, the term compliance refers to the processes and procedures by which an organization adheres to these guidelines. These guidelines may come from a variety of sources. Traditionally, the government is the primary initiator of compliance rules for different industries, but they may come from other sources as well.
Compliance has become a critically important component of investment management and this is particularly true in the hedge fund space. Key questions this book will seek to answer include:
What exactly is hedge fund compliance?
How can hedge funds design and improve their compliance function?
What constitutes best practice compliance?
What role do financial regulators play in implementing and monitoring compliance?
Why should investors care about hedge fund compliance?
What role can third‐party service providers play in compliance?
What global compliance trends are emerging in the hedge fund industry?
DIFFERENCES IN HEDGE FUND AND OTHER ALTERNATIVE FUND COMPLIANCE
Within the sphere of alternative investment fund managers, the lack of homogeneity creates a number of unique compliance challenges. Indeed, separate books could be written about the different compliance frameworks required to address the intricacies of different alternative asset classes, such as real estate and private equity.
Hedge funds, too, are unique from a compliance perspective. In particular, they tend to be one of the more complex fund management entities. Why? For starters, let us clarify what the term hedge fund refers to. Hedge fund is a broad umbrella term used to classify many different types of managers that may be organized under differing fund legal structures. The broad nature of the term is one of the reasons that make the category of fund managers known as hedge funds unique and challenging from a compliance perspective. Other key reasons for the increased complexity of hedge fund compliance include:
Variety of different strategies employed—
Hedge funds utilize a number of different investing strategies. Common hedge fund trading strategies include global macro; long‐short equity; market neutral; event‐driven strategies, including merger arbitrage and special situations; convertible arbitrage; sector funds, including healthcare or energy funds; quantitative strategies; and even multistrategy funds. Although other types of alternative investment categories contain distinctions, the variety of investment strategies employed by hedge funds is relatively large in comparison.
Trading and operating on a global scale—
In many cases, hedge funds may conduct not only trading but also fund‐structuring and asset‐raising activities in multiple jurisdictions around the globe. This global landscape contributes to the complexity of the compliance environment surrounding hedge funds.
Wide range of instrument types traded—
To facilitate both the trading activities of a wide number of strategies, as well as the broad investment flexibility within different strategies, hedge funds often trade a wide variety of instruments. These can include equities; swaps; swaptions; forwards; futures; options; various types of bonds, including treasuries, convertible bonds, and catastrophe bonds; bankruptcy claims; syndicated loans, including bank debt, mortgage‐backed securities, private investments in public equity (PIPES), repos, and reverse repos; commercial mortgage‐backed securities (CMBS); and credit default swaps (CDS). The use of different strategies can‐not only subject hedge funds to the oversight of different financial regulators and exchanges but the combined effect of utilizing multiple instruments also increases the complexity of administering compliance across various security types.
Variety of trading implementation strategies—
To implement trading strategies, hedge funds may employ a wide variety of trading procedures. These may include variations on:
Who is actually deciding to trade? (i.e., a human being, an automated computer trader, or some combination of the two)
The timing of trades—Are they spaced into the market over time or all at once?
The process of executing trades—Hedge funds may provide instructions to counterparties to execute trades in a number of different ways, including over the telephone or through electronic methods, such as instant message or e‐mail. The reasons for this may depend on a number of factors, including the size of the hedge fund, the sophistication of a hedge fund's trading platform, the markets they trade in, and the way they work with trading counterparties. This variety presents a number of unique compliance challenges.
Use of multiple prime brokers and other counterparties—
Prime broker
s are companies that facilitate the implementation of a hedge fund's trading strategy. Companies that provide prime brokerage services are typically referred to as
broker‐dealers
. In their work with hedge funds, they typically offer hedge funds a number of services, including trade clearing, execution, and leverage financing. Today, it is common for hedge funds to utilize multiple prime brokers.
Hedge funds do this for a variety of reasons, including diversifying their exposure across multiple counterparties as opposed to putting all of their eggs in one basket. The risk in using a single prime broker was highlighted after the 2008 failure of Lehman Brothers. There may also be other types of brokers utilized in addition to prime brokers. One example is brokers known as executing brokers. These brokers typically work directly with prime brokers or, in some instances, directly with the funds, in executing trades. Another type of broker is called a futures commission merchant that facilitates trading in futures.
Hedge funds may also utilize a number of other trading counterparties for securities, such as swaps. These swap counterparties are commonly referred to in the industry as ISDA counterparties. This name comes from the standard master agreement often used to implement these arrangements that is provided by the the International Swaps and Derivatives Association (ISDA).
The use of these multiple prime brokers and counterparties often creates unique needs among hedge funds for specific compliance oversight of the ways in which they interact with these groups.
Enhanced research techniques
—From an investment research perspective, hedge funds traditionally employ a relatively wide array of techniques as compared to other fund managers. These avenues may include research activities, such as discussion with industry experts, and the utilization of
expert networks
. Expert networks are for‐profit companies that organize databases of individuals with expertise in particular subjects or with particular companies. Expert networks then coordinate conversations between fund managers and these individuals in order to facilitate the fund manager's research. Accompanying the use of these research avenues are a series of additional layers of compliance oversight that would not otherwise be present in other alternative managers that do not engage in such techniques.
Each item listed above presents a specific set of compliance challenges that we will address in more detail throughout this book. The important takeaway at this stage is that, while there are certain core principles of compliance that can be applied across all asset classes, and within alternative investments in particular, based on the broad trading activities, strategies, and global scope of hedge funds, they present distinct compliance challenges that merit specialized compliance considerations.
HEDGE FUND COMPLIANCE IS NOT SPECIFIC TO ONE COUNTRY
Compliance is a heavily rules‐based exercise. These rules are driven by the laws and regulations of the different countries in which hedge funds operate. Although we will address certain key aspects of different hedge fund regulations in the major countries in which hedge funds operate, this book is meant to provide practical compliance advice on a global basis rather than focus too heavily on the laws of any specific country. There are many other more technical resources that can provide in‐depth specific guidance on the applicable compliance laws in any particular country.
Regional Compliance Expertise Used by Hedge Funds
In practice, many hedge funds engage in business activities in multiple countries. It is not practical for these hedge funds to maintain internal compliance experts who have expertise in all of the countries in which they may operate. To solve this problem, a hedge fund's interpretation and implementation of compliance guidelines in different countries often comes about as a result of consultation with a number of different country‐specific specialists.
To clarify some terminology, individuals or firms that are not employees of the hedge fund but provide services to it are commonly referred to as third parties, third‐party firms, or service providers. Although not every service provider provides compliance‐related services to a hedge fund, many do in one form or another. One of the most common compliance‐focused service providers is known as a compliance consultant. Another type of hedge fund service provider heavily involved in compliance is a law firm, which is also sometimes referred to as a hedge fund's legal counsel. The country‐specific compliance specialists that hedge funds heavily rely on in the compliance area are typically either compliance consultants or legal counsel.
Another reason that many hedge funds utilize third‐party compliance consultants when operating in different countries is because compliance is an evolving subject. As the laws and rules in different countries change, external expertise can often provide valuable insight into trends in compliance practices in specific countries.
Benefits to Developing a Global Understanding of Compliance
When studying the area of hedge fund compliance, there are benefits toward first establishing a general understanding of the subject on a global basis before delving too deeply into the rules of any one country. From the perspective of hedge fund employees, while individuals who are experts in the compliance practices of any single country are, of course, valuable, developing a global understanding of general compliance policies coupled with third‐party country or region‐specific compliance expertise as needed often produces a much more holistic compliance program.
From the perspective of hedge fund investors seeking to evaluate hedge fund compliance protocols, first developing a more general understanding of core hedge fund compliance principles prior to any country‐specific knowledge is also advisable. This is because investors may allocate capital to hedge funds in multiple jurisdictions, which are subject to different compliance regimes. By developing this general compliance foundation first, which is then complemented by country‐specific compliance knowledge, a more universal compliance due diligence program for investors will result.
Keeping both the hedge fund employee and the hedge fund investor perspectives in mind should assist you as you work through the material.
DO ALTERNATIVE INVESTMENTS MERIT SPECIAL COMPLIANCE CONSIDERATIONS?
Hedge funds are commonly grouped into an asset class known as alternative investments. Alternative investments differ from other types of investments, such as long‐only mutual funds, commonly referred to as traditional investments. For reference, a long‐only fund is one that only engages in the purchasing and selling of investments, such as buying or selling equities. These are long‐only investments because the fund's general strategy is to make long‐term predictions that the value of the investments will increase over time. Long‐only funds do not follow a strategy of selecting investments by betting that the value of certain investments will decrease over time.
By contrast, an approach that seeks to profit from the decline in value of a potential investment, such as betting for a decline in the price of the shares of a publicly traded company, is known as short selling. Short selling is typically carried out through the use of equity options. One hedge fund strategy that combined both long‐ and short‐selling techniques is known as a long‐short strategy. In addition, other hedge fund strategies may also typically involve the use of options and other short‐selling techniques. Other common types of alternative investments, often grouped alongside hedge funds in this category, are private equity, real estate, and commodity funds.
Within the area of fund manager compliance, the question may be raised whether alternative investment managers merit special compliance considerations as compared to traditional investment managers. When we refer to a fund manager, unless otherwise stated, we are not referring to a specific individual, such as a portfolio manager, but rather to the management company organization for which an individual known as a fund manager or portfolio manager typically works. Prior to answering the question of whether a special classification category is required for hedge funds, we must first understand the notion of market and regulatory classifications.
Contrasting Regulatory and Market Classifications
Most regulators have big categories by which they categorize similar types of financial entities. This is in contrast to the smaller distinctions among different types of asset managers that may be made in the real‐world marketplace. When it comes to hedge funds, the majority of global financial regulations do not maintain a separate classification for entities that may be classified as a hedge fund, private equity fund, or any other alternative investment vehicle. Instead, within the broad umbrella of regulatory fund manager entities, financial regulations are primarily more driven by the activities of these fund managers. This concept highlights the distinction between what may be referred to as a regulatory classification and a market classification of a fund manager.
Understanding Regulatory Classifications
A regulatory classification is the way a fund manager would be classified based on predetermined regulatory classification requirements. One way to think about regulatory classifications is the way in which a fund manager is viewed from a legal perspective.
For example, in the United States, if a fund manager under the Investment Advisers Act of 1940 (Advisers Act, or Act) and accompanying statutes meets certain specific criteria, then the manager is classified as an entity known as an Investment Adviser. In general, Section 202(a)(11) of the Advisers Act defines an “Investment Adviser” as any person or firm that:
(1) for compensation; (2) is engaged in the business of; (3) providing advice, making recommendations, issuing reports, or furnishing analyses on securities.1
As you can see by these general criteria, the requirements are quite broad. This means that whether an organization is a long‐only mutual fund or a long‐short hedge fund manager, from a regulatory perspective, they are both Investment Advisers.
If an organization does not meet each criterion and isn't exempt for some other reason, then the manager is generally not classified as an Investment Adviser. Why does this classification matter? If a fund manager is not an Investment Adviser, then it would generally not have to register with the U.S. Securities and Exchange Commission (SEC). More specifically, the compliance programs of a registered hedge fund may be distinctively different from an unregistered fund.
Understanding Market Classifications
A market classification is the way a fund chooses to portray itself in the market. Alternatively, it can be the way a fund is classified, typically by investors, based on its actual trading activities. Obviously, it is not in a hedge fund manager's interest to misclassify their activities, but sometimes these two classifications are the same, and in some cases, there may be differences in classification methods, depending on the classification requirements in place.
Market classifications can be contrasted from regulation classification in two primary ways. First, under market classifications, there are no bright‐line criteria determining what constitutes one classification type (i.e., a global macro hedge fund) from another (i.e., an event‐driven hedge fund). For reference, a global macro hedge fund is a fund that follows a strategy of investing in macroeconomic themes, typically utilizing a wide variety of financial instruments on a global basis. An event‐driven hedge fund follows a strategy of investing around the occurrence of certain events, such as corporate mergers or litigation.
Second, there are not necessarily any specific requirements, legal or otherwise, imposed on a manager for labeling themselves, or being labeled, under a market classification. This is in stark contrast to regulatory classification, which can have a material impact on the activities of a fund manager.
Example of Market and Regulatory Classification Differences. To make the distinction between regulatory and market classifications more concrete, let us consider an example. Consider a U.S.‐based fund manager that chooses to promote itself to potential investors as a hedge fund. This would be the market classification from the hedge fund's perspective. A potential investor may take a look at the fund manager's actual, or planned, investment activities and instead classify the fund under a more detailed classification of a global macro hedge fund. This would be an example of how the market classifications can differ, or at least be more specific, between the fund itself and the investor.
As noted earlier, there is no specific regulatory classification for hedge funds, so the fund cannot have the same market and regulatory classification in this case. What would the regulatory classification be? If we focus on just U.S. regulatory classifications, and not any other jurisdictions, and it is a U.S.‐based hedge fund that meets the SEC requirements outlined earlier, then its regulatory classification would be that of an Investment Adviser. As this example demonstrates, a hedge fund, therefore, can be correctly referred to as being in different market or regulatory categories, depending on the specific classification system in place.
When discussing hedge fund compliance, the regulatory classification is typically the driving force over market classifications, as regulatory classifications facilitate the heart of the compliance guidelines that a hedge fund must adhere to. However, it is important to understand the concept of market classification so that the appropriate distinctions can be made between the two classification systems.
Example of multiple regulatory classifications. In the previous example, we alluded to the fact that a hedge fund may have multiple regulatory classifications. One reason for this multiple regulatory classification system is because a hedge fund may be subject to multiple regulatory agencies. To be clear, these classifications may come within the same country or across multiple countries.
In some cases, this oversight is driven by a hedge fund's trading activities. For example, certain hedge funds may engage in the trading of a type of security known as commodity futures. A commodity future is a security that allows a hedge fund to speculate on the future price of commodities, such as lean hogs, coffee, cocoa, and copper. In the United States, if a hedge fund were to engage in futures transactions, they would be regulated by the joint efforts of two different regulators known as the National Futures Association (NFA) and Commodity Futures Trading Commission (CFTC). The NFA is a type of agency known as a self‐regulatory organization (SRO), whereas the CFTC is a federal regulatory agency. SROs will be covered in more detail in Chapter 2.
As part of this oversight by the CFTC and the NFA, a hedge fund may have to register under special regulatory classifications similar to the SEC's Investment Adviser category. Common classifications under the CFTC and NFA regimes are for a fund manager to register as a Commodity Trading Advisor (CTA), a Commodity Pool Operator (CPO), or perhaps as both.
UNDERSTANDING THE HEDGE FUND COMPLIANCE FRAMEWORK
With an understanding of why hedge funds present unique compliance challenges, we can begin to introduce more specifics related to the way compliance is approached in hedge funds. To do this, we will first analyze the makeup of a hedge fund's compliance framework. This will be followed by an introduction of the hedge fund compliance function. Last, the key parties in a hedge fund's compliance framework will be discussed.
A hedge fund's compliance framework is not just the compliance function within the hedge fund itself. This is a common point of confusion among investors in particular. While certainly, the heavy lifting is performed by the compliance function, there are also other elements within the hedge fund that perform compliance‐related functions. Furthermore, outside of the hedge fund, there are a number of service providers and counterparties that also perform compliance‐related functions. This relationship is summarized in Exhibit 1.1.
Exhibit 1.1 Components of a Common Hedge Fund Compliance Framework
Therefore, to fully understand the entire hedge fund compliance playing field, we must look beyond the compliance function within the hedge fund to analyze all of the key compliance stakeholders, both inside and outside the fund.
INTRODUCTION TO THE HEDGE FUND COMPLIANCE FUNCTION
The hedge fund compliance function, or compliance department, refers to a group within the hedge fund whose responsibility is to develop, implement, maintain, and test compliance policies and procedures. The compliance function often sits alongside other operational groups, such as fund accounting or technology.
One structure for a hedge fund compliance department is a dedicated compliance function. Under this structure, the compliance function only focuses on compliance‐related tasks. This is in contrast to a shared compliance function structure, in which the compliance function may be combined with other departments within the hedge funds. A common structure for a hedge fund with a dedicated compliance function is outlined in Exhibit 1.2.
Exhibit 1.2 Example Organizational Structure of a Hedge Fund with a Dedicated Compliance Function
In a perfect world, every hedge fund would have enough resources to devote to developing a stand‐alone dedicated compliance function (see Exhibit ). In practice, for a number of reasons, including resource constraints, this is not always the case.
Employees who work in the compliance function may be shared among different groups and have multiple responsibilities. We will address the pros and cons regarding these different compliance structures in subsequent chapters. For now, the important thing to remember is regardless of whether compliance department employees are shared, there will be individuals within the hedge fund who have a duty, in one form or another, to oversee compliance.
DISTINGUISHING THE LEGAL AND COMPLIANCE DEPARTMENTS
As Exhibit demonstrates, a hedge fund may maintain both a legal and a compliance department. While these two departments may overlap with each other, they generally have different goals.
In other cases, a hedge fund may combine the legal and compliance functions into a single department. Reasons for this can include resource constraints on the hedge fund and a desire to centralize the responsibilities of certain individuals within the hedge fund. The two functions overlap to some extent, and combining them can represent a practical use of hedge fund personnel in certain instances.
The Legal Department Function
As can be expected, the legal function of a hedge fund is traditionally focused around tasks surrounding more legal, as opposed to compliance, matters. These legal tasks can cover a wide area. Common legal tasks performed by hedge funds typically include:
Traditional contract work—
Similar to many other businesses and fund managers, hedge funds engage in legal contracts, including employment contracts with senior personnel, rental agreements for office space, and vendor and service provider contracts. The legal tasks related to these contracts include drafting, reviewing, and negotiating contracts a hedge fund may enter into with a variety of parties.
Litigation management
—Hedge funds may sometimes be involved in lawsuits. These lawsuits may be initiated for a wide variety of reasons, including
Portfolio‐related litigation
—Sometimes a hedge fund will initiate, or participate, in legal proceedings as part of the its investment strategy.
Employment related litigation
—Disputes may arise between a hedge fund and its employees, which includes direct employees of the fund as well as any consultants or other classes or individuals to which a hedge fund may maintain an employment obligation. These types of lawsuits can be broken up into two primary categories. The first category would be suits brought by the fund manager. The second would be those brought by employees.
Third‐party law‐firm management
—Hedge funds often work with third‐party law firms to assist in a variety of legal matters, including those referenced earlier. A common internal legal task at a hedge fund is managing the work of these third‐party firms.
Related but Not Equivalent
The legal and compliance functions of a hedge fund are often thought of as being related departments because a number of similarities exist between the two groups. There are several reasons for this, including
Traditional shared coverage of both functions—The head of the legal function is commonly given the title of
General Counsel
, while the compliance function head is commonly referred to as the
Chief Compliance Officer
. Although not every hedge fund maintains a general counsel, historically the General Counsel at a hedge fund would have also maintained responsibilities for compliance‐related functions. For example, it might not be uncommon for an individual with the title of General Counsel to also hold the title of Chief Compliance Officer.
Shared basis in the law—Compliance and legal functions are both rooted in the law and legal principles; hence, the overlap among the functions.
Complementary functions—The compliance and legal functions may be subject to oversight by each other in certain areas. For example, the activities of a hedge fund's legal department employees are typically subject to compliance oversight. Similarly, the development of compliance materials may require input from those with specialized legal expertise, which may come from the legal department.
So, while the hedge fund's legal and compliance functions overlap to a certain degree, the specific duties and goals are different—they are related but not equivalent.
KEY PLAYERS IN COMPLIANCE
A hedge fund's compliance efforts may be primarily driven by internal personnel. When this is the case, there are various individuals and groups that may be involved in the compliance function including those outlined below:
Chief Compliance Officer (CCO)
—The most prominent compliance professional is the Chief Compliance Officer. In addition to leading the compliance function, the CCO fulfills regulatory requirements. Specifically, many regulators around the world require hedge funds to designate a CCO.
In addition, the CCO typically assists a hedge fund in complying with a number of other regulatory duties, including filing regulatory reports, developing compliance policies and managing daily compliance audit calendars. The CCO position is discussed in more detail in Chapter 3.
Additional compliance personnel
—Similar to the CCO role, other compliance individuals may or may not be dedicated to compliance functions. Although the CCO position is mandated by regulators, other positions are not, and a fund may not have any other additional compliance employees. If this is the case, the CCO may perform all essential compliance functions themselves, or those tasks are outsourced, such as to a compliance consultant.
Shared compliance employee
—A
shared compliance employee
is an individual who performs certain compliance duties in addition to other responsibilities outside of the compliance function.
Consider an example of a compliance department that is made up of six people, five of whom work solely on compliance‐related tasks. The sixth person spends part of their time on compliance duties and the rest on noncompliance tasks, such as fund accounting. Under this structure, the compliance department may be referred to as either dedicated with supporting resources or a mixed compliance department.
Noncompliance personnel
—Noncompliance personnel perform jobs in which compliance matters are not part of their daily activities. These individuals include everyone from investment professionals to fund accounting personnel. This does not mean they ignore the compliance function, but they do not focus on it as part of their regular duties.
Compliance consultants
—Compliance consultants are third‐party firms that provide advice on compliance‐related matters to hedge funds. Their services range from completely running a hedge fund's compliance function to compliance policy development and assisting hedge funds with ongoing compliance management. It is not a requirement for hedge funds to maintain a compliance consultant, and not every hedge fund will have one. The roles of compliance consultants are discussed in more detail in
Chapter 6
.
Other compliance‐related service providers
—Other third‐party service providers can focus more on supporting the infrastructure of the hedge fund, such as information technology consultants and utility companies. Although third‐party service providers are not focused exclusively on compliance, they do perform compliance‐related services. These other service providers are also discussed in more detail in
Chapter 6
.
STANDARD AREAS COVERED BY A HEDGE FUND COMPLIANCE FUNCTION
At this point in the reading, several basic compliance concepts have been introduced, and the structure of compliance departments has been discussed. We can now turn our attention to the key areas covered by compliance.
Standard Areas Covered by a Hedge Fund Compliance Function
At a very basic level, hedge fund compliance can be divided into two coverage areas: investment‐related and non‐investment‐related compliance areas.
Investment‐related compliance areas
. These areas directly relate to the investment management business of the hedge fund organization. Traditionally, this is where the majority of hedge fund compliance efforts are centered.
Take, for example, trade allocation, in which a hedge fund manages two different funds that adhere to primarily the same investment strategy. Each fund has been created to accommodate the tax needs of different types of clients (onshore and offshore). When funds are managed in this structure they are said to be managed in what is known as a pari passu manner.2 One fund is structured for clients who are typically based in the same country as the headquarters of the hedge fund. This is known as the onshore fund. The other fund is for investors based outside of the primary country in which the hedge fund operates. This is known as the
