Compliance in the Real World Hedge Fund Case Studies

By Maria Trombly | Securities Industry News | January 1, 2006

Hedge funds are among the most varied of investments, pursuing an ever-growing number of strategies even as their assets have multiplied. Hedge funds are also taking different approaches to compliance: some are already registered and just need to get up to speed with newer rules and regulations, such as e-mail archiving. Others are registered abroad, and need to bring their procedures in line with U.S. requirements. Still others, registering for the first time, will have to scramble to finish before the February 2006 Securities and Exchange Commission deadline. Following are case studies of four hedge funds, each representing a different path to compliance Due to restrictive hedge fund communication policies, we regret that we are unable to use their real names.

Case Study Number One:

At Vanilla Hedge Fund, practice makes perfect

Vanilla Hedge Fund came to Kate Dressel, president of Strategic Compliance Solutions, in January of this year. Vanilla's president knew Dressel personally, back when she worked at a hedge fund herself. So when he starting thinking about SEC registration, he called her.

Although the Connecticut fund is not one of her biggest clients--it has only nine employees--Vanilla was in pretty good shape, Dressel says. They were using best practices internally and even had a compliance manual. "They were a little more proactive in addressing the registration issue," she says.

By comparison, some of her other hedge fund customers still hadn't started working on registration documents as of mid-October. She had to call and remind them that they should start no later than Nov. 1 in order to make the deadline.

Despite Vanilla's head start, it still took until August for the fund to file its paperwork. "The compliance manual was a good effort but was not going to be enough to meet the SEC registration requirements," Dressel says. For example, Vanilla didn't have a code of ethics or a set of written supervisory procedures in place. And there were things that the fund was doing right but had never put in writing. "With SEC registration, you have to put everything in writing," she explains.

Dressel was brought in to look at the whole office. She tracked which employee was doing what, and she produced a report about what was missing and what needed to be beefed up. Fortunately, there were no gaping holes.

Only one significant change was needed: Employees would now have to document their actions. "They were a good firm," Dressel says. "They were trying to do it right in the first place."

Vanilla produced anti-money-laundering (AML) policies and procedures and educated its employees about them. It also needed an employee manual to go with the policies and procedures of SEC registration. With the code of ethics and the supervisory procedures in place, the compliance manual was complete. "The thing that was nice, that they approached very well, is that they put a lot of emphasis on training," Dressel says. "With the supervisory procedures, the code of ethics, AML policies and procedures, they did pretty extensive training for employees. The supervisory procedures--things that are required like proxy voting, personal trading by employees, client complaints, conflicts of interest--were written as how-tos so there was no question in anyone's mind about what needed to be done and when."

Since Vanilla is a small fund, procedures were done manually, with the exception of e-mail monitoring, where software from Complinet was used. Employees had checklists and directions to follow in a variety of situations, she says.

"The other smart thing they did is they set their policies and procedures in place and ran through them a couple of times to make sure they worked the bugs out," Dressel adds. "They did that before they clicked submit on their registration form."

The training sessions and dry runs added time to the process, but Vanilla started early so it had time to spare. Vanilla registered in August, well before the deadline. The funds that are starting late won't have the luxury to do dry runs to make sure that everything works right before they submit their registrations.

Using a canned program to generate the compliance manual speeds the process, but Dressel warns against this approach. "I do not recommend canned programs unless there is someone there who has the knowledge base and the time to be able to tailor it appropriately," she said. "Canned programs have their place if you have someone there who has good compliance knowledge and a good understanding of your company. But if you have a person who doesn't have the knowledge and, even worse, doesn't have the time because they're wearing other hats, you're just asking for trouble."

Case Study Number Two: At Billion Dollar Hedge Fund, compliance never ends

The Billion Dollar Hedge Fund has been registered with the SEC for over ten years because they are also an adviser to a mutual fund. They already have a compliance manual in place and won't have to race to submit forms to the SEC ahead of the Feb. 1 deadline

But they still faced a lot of work when the SEC issued its new requirements. Billion Dollar trades in foreign securities and real estate securities, and it had to tighten its policies on disclosing affiliations, fees and side letters with particular clients. The new regulations will also affect the way the fund does its marketing.

"A lot of times investment advisers will use a client list as a reference list," says Janaya Moscony, president of Philadelphia-based SEC Compliance Consultants.

With over $1 billion in assets under management, the fund's 20 employees enjoy a high level of automation. For example, the hedge fund uses a portfolio management system from Boston-based MacGregor Group and AdvisorMail from LiveOffice Corp. for e-mail monitoring and archiving. The only thing the company does manually is check employees' personal trades--and that's because employees aren't allowed to trade in any of the same securities as the hedge fund itself, Moscony says. Instead, there's a quarterly review of personal trades to ensure that all employees comply with the policy.

With the new SEC rules, many of the fund's policies had to be revised, Moscony says. For example, with separate accounts, the hedge fund now has to make sure there's documentation to show that clients were managed according to their objectives and restrictions, she says. There are also some additional custody issues that came up in regard to dispersement of fees, so now the fund requires two signatures instead of one to disperse funds.

To ensure best execution, the fund will tighten its review process to ensure that execution is consistent, and it will take a look back four times a year. It will also have to make sure that any affiliations and conflicts of interest are properly disclosed. Finally, the fund had to make sure it was documenting its prior history with investors so it could prove it wasn't marketing.

And the changes didn't stop there, Moscony says. Every quarter she or someone else from her firm visits the fund and takes a look at new compliance issues. "This is really never ending," she says.

And the new SEC regulations are only part of it. "This company has grown significantly and taken on new business ventures," she says. "In light of that, it requires that we're constantly evaluating the compliance program to make sure it addresses new risks."

Case Study Number Three:

Storm-proofing at Hurricane Hedge Fund

The Hurricane Hedge Fund, located in southern Florida, has already seen two large hurricanes this year. "They wanted to be sure their e-mail data is secure and recoverable at all times," says Ann Davis, director of business development for AdvisorMail at LiveOffice Corp.

They also wanted to get ready for the SEC deadline, she says. Hurricane called LiveOffice in September and explained that they would be "operationally disabled" without their e-mail. Hurricane has 18 staffers whose e-mails need to be archived--too small a number for many vendors, but not an application service provider like LiveOffice, which delivers its product over the Internet.

The fund considered building a solution internally but decided it would be too large a headache. They found six potential vendors through an Internet search, and by attending an industry conference, Davis says, they eventually settled on LiveOffice.

It took them about a week to make a decision and another week to get up and running on AdvisorMail. The fund set its mail server to send a copy of every e-mail to LiveOffice. Hurricane did not need to download or install any software.

An AdvisorMail option allows clients to send all e-mails, not just copies, to LiveOffice so that problematic mail can be quarantined, Davis says, but Hurricane elected not to use it. "It's not a regulatory requirement to pre-review," she says. "We built it just in case someone needs it."

A hedge fund's compliance officer can set AdvisorMail to automatically scan for suspicious words; messages containing those words can be set aside for review. The compliance officer can also randomly pick mail to review, Davis says.

And if a storm hits, employees will be able to use a Web-based e-mail client from LiveOffice until their own system comes back online.

Case Study Number Four:

Start-up Hedge Fund in London readies for U.S. registration

Start-up Hedge Fund was founded in 2003 in London. "Our understanding is that if you have 15 or more U.S. investors, you have to be registered by Feb. 1, 2006," says the fund's chief compliance officer. "We expect that we will fall into that category, so we're currently looking at the related requirements of the SEC and how they're supplemental to the FSA [U.K.'s Financial Service Authority]."

The FSA already regulates hedge funds and has done so for many years. "Suffice it to say they are for the most part similar," says the compliance officer. "But there are some differences, and the differences will require some additional monitoring of certain activities. But we don't regard it, at least here, as being excessive by any means."

This means Start-up won't have to change any of the compliance systems it has in place, he says, including two systems for equity funds: AExeo Technology, from Dublin-based Citco Fund Services, and Boston-based Eze Castle Integration. On the credit fund side, the firm uses Calypso and Reuters Kondor+, provided by the fund's administrator. "Everything we have now, all the systems we currently have are, to our knowledge, more then satisfactory to satisfy any incremental requirements of the SEC," he says.

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