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Compliance to Take Center Stage if SEC Registration is Required of Hedge Funds


Date: Tuesday, February 3, 2009
Author: Advanced Trading.com

With Congress and the new Obama Administration calling for tighter regulation of hedge funds, compliance is going to be a hot topic in alternative investment circles.

Last Thursday, Republican Sen. Charles Grassley of Iowa, and Sen. Democratic Sen. Carl Levin of Michigan, passed legislation to have the federal government regulate hedge funds. There was an effort to require hedge funds to register with the SEC a few years ago, but that ruling was overturned. Recently, SEC Chairman Mary Schapiro indicated she was in favor of registering hedge funds at her confirmation hearing.

Some hedge funds are already starting to behave as if they were registered with the Securities and Exchange Commission (SEC), according to a compliance expert. "With everything going on in the market, scandals and Bernie Madoff, investors are really hesitant to give money to hedge funds. One of the things they want to see is this compliance infrastructure in place," says Jordan Schwartz, managing director of HedgeOp Compliance, LLC, (now Cordium) a supplier of specialized compliance software and consulting services for alternative asset managers in New York.

Last week, the firm announced it was awarded a U.S. patent on its ComplianceTrak software, a workflow tool that lays out all the steps that fund managers need to follow to meet their compliance requirements. If hedge funds are required to register with the SEC, then the Investment Adviser's Act will become applicable to all hedge fund managers, noted Schwartz. One of the big items in the Investment Act is a code-of-ethics requirement, which spells out that a hedge fund manager should have a written code-of-ethics that monitors its employees' personal trading.

"Obviously they want employees to avoid conflicts of interest and they want to make sure that employees are not trading for their own accounts in the securities that the hedge fund is investing in," said Schwartz. Since the hedge fund manager has a fiduciary responsibility toward investors, they want to make sure that employees are not putting their own interests first or front running trades, he explained. Some hedge funds won't let employees trade any security that the hedge fund is trading in. Others require that anytime an employee wants to trade for their own account, they seek pre-clearance from a compliance officer. "It really depends on how they build out their policies," said Schwartz. In certain cases, pre-clearance of employee trades is only required for limited offerings or IPOs. "If a fund doesn't trade equities, they're not going to require employees to report personal trades in stocks," said Schwartz. However, other managers may require all employees to report everything as a matter of course. All the reporting is submitted to the chief compliance officer (CCO).

Another big rule that will affect SEC-registered hedge funds is SEC-registered is Rule 206.47, which states that investment managers must have a written set of compliance rules and procedures. They must have this manual in place and conduct an annual compliance review of their compliance program once a year, according to Schwartz.

Most managers, even if they are not registered will have a compliance manual in place, said Schwartz. If they become registered, that becomes a requirement. Unfortunately, the SEC doesn't provide much guidance on how to conduct a review, he noted.

Since a lot of hedge funds have lean operations and may not have the staff to handle their own compliance, and tend to hire consultants and outsource their compliance to law firms. But this can be costly, said Schwartz.

The firm is working on a software module that enables managers to handle this code-of-ethics compliance themselves. The product, currently in development, allows the manager to walk through all the steps of performing their annual compliance review. "There could be 20 different steps or phases and depending on their responses to the questions, the software may ask follow up questions as they input the data," outlined Schwartz. Then it gathers all the data they put in and generates a document for them to conduct an annual review process. But many hedge funds aren't aware of the technology options. That is actually the genesis of the software tool. The firm developed the software for its own internal consulting group, but then realized it could be a product.

While ComplianceTrak doesn't have too many competitors out there right now, said Schwartz, there are firms that have software to handle code-of-ethics compliance. "I think a lot of managers don't realize that short of hiring someone or outsourcing, that there are a lot of cost effective ways to use technology," said Schwartz.