The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

Articles By Topic

By Topic: Internal Controls

  • From Vol. 9 No.19 (May 12, 2016)

    Business Emails Must Be Secure to Avoid SEC Enforcement Action 

    As it continues to enforce appropriate cybersecurity controls, the SEC initiated administrative proceedings against broker-dealer Craig Scott Capital and its principals for failing to protect confidential consumer information by using personal email addresses for business matters. “The enforcement action, including the fines imposed, reflects how seriously the SEC takes the adoption of and compliance with proper policies and procedures,” Anastasia Rockas, a partner at Skadden, told The Hedge Fund Law Report. This enforcement action is particularly relevant to any hedge fund manager that: has an in-house broker-dealer; has high net worth individuals as clients; manages alternative mutual funds and thus has retail investors; or is subject to any look-through of its institutional clients to underlying individual investors. However, all hedge fund managers should pay close attention given that, as Rockas noted, the “SEC has indicated there will be additional enforcement actions in this space and has designated cybersecurity as an examination priority for 2016.” See “OCIE Risk Alert Provides Cybersecurity Guidance to Investment Advisers and Broker-Dealers” (Sep. 24, 2015). For another case involving penalties for inadequate cybersecurity controls, see “Investment Adviser Penalized for Weak Cyber Policies; OCIE Issues Investor Alert” (Oct. 1, 2015).

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  • From Vol. 9 No.15 (Apr. 14, 2016)

    How Do Hedge Fund Managers Legally Penalize Employee Wrongdoing? (Part Two of Two)

    Hedge fund managers may seek to recoup regulatory fines by imposing penalties on employees responsible for violations. However, when imposing such punishments on their employees, managers must take care to ensure they remain in compliance with labor law, while still incentivizing personnel to avoid violations of law, regulation or firm policies and procedures. In an effort to determine industry best practice with respect to imposing fines on employees, The Hedge Fund Law Report spoke with employment counsel and also surveyed 15 general counsels and other “C-level” decision-makers at leading hedge fund managers. We are presenting our findings in a two-part article series. The first part explored the options available to hedge fund managers for imposing penalties on their employees for regulatory violations and examined the limits of those options under employment law. This second part examines how hedge fund managers actually put these options into practice, addressing the prevalence of these remedies in the industry and best practices for hedge fund managers to deploy them. For more on hedge fund manager employment issues, see “Employees of Hedge Fund Managers May Be Liable for Failing to Prevent Fraud” (Jul. 30, 2015); and “Recent Decision Holds That Hedge Fund Managers Have Some Recourse Against Firm Employees That Engage in Insider Trading and Deceive Their Employers Pursuant to the Mandatory Victims Restitution Act” (Apr. 5, 2012).

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  • From Vol. 9 No.14 (Apr. 7, 2016)

    How Can Hedge Fund Managers Legally Penalize Employee Wrongdoing? (Part One of Two)

    As they continue to be scrutinized by the SEC and other regulators, hedge fund managers must ensure that their employees are properly trained and incentivized to avoid regulatory violations. See “Recommended Actions for Hedge Fund Managers in Light of SEC Enforcement Trends” (Oct. 22, 2015). However, despite a manager’s best precautions, an employee’s actions may result in an adverse regulatory action or fine. In such situations, hedge fund managers may seek recourse against the employee responsible for the violation – to recoup losses to the hedge fund manager and to deter similar behavior by other employees. To determine industry best practices with respect to imposing fines on employees, The Hedge Fund Law Report spoke with employment counsel and also surveyed 15 general counsels and other “C-level” decision-makers at leading hedge fund managers. We present our findings in a two-part article series. This first part explores the options available to hedge fund managers for imposing penalties on their employees for regulatory violations and examines the limits of those options under employment law. The second part will examine how these options are put into practice, addressing the prevalence of these remedies in the industry and best practices for deployment. For more on hedge fund manager employment issues, see “New York Federal District Court, Applying ‘Faithless Servant’ Doctrine, Allows Morgan Stanley to Recoup Entire Compensation Paid to a Former Hedge Fund Portfolio Manager Who Admitted to Insider Trading” (Feb. 6, 2014); and our two-part series on “Structuring, Drafting and Enforcement Recommendations for Hedge Fund Managers Considering Employee Compensation Clawbacks”: Part One (Aug. 7, 2013); and Part Two (Aug. 15, 2013).

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  • From Vol. 8 No.9 (Mar. 5, 2015)

    U.K. Financial Conduct Authority Sanctions Aviva Investments for Inadequate Internal Controls over Side-by-Side Management of Hedge Funds and Other Funds

    Side-by-side management of funds presents thorny compliance issues for managers due to the inherent conflicts of interest they present and the temptation to benefit one fund at the expense of another.  Both the SEC and the U.K. Financial Conduct Authority (FCA) are keenly attuned to such issues.  The FCA recently issued a Final Notice imposing a financial penalty of £17.6 million on asset manager Aviva Investors Global Services Limited arising out of conflicts of interest and internal control failures related to its side-by-side management of fixed income hedge funds and long-only funds.  This article summarizes the firm’s internal controls failings, its specific violations of FCA regulations and the FCA’s calculation of the penalty it imposed.  For a recent example of an SEC enforcement action involving improper trade allocations, see “Hedge Fund Adviser Structured Portfolio Management Settles SEC Charges Relating to Improper Trade Allocations and Investor Disclosures,” The Hedge Fund Law Report, Vol. 7, No. 36 (Sep. 25, 2014).  Cherry picking may even lead to federal criminal securities fraud charges.  See “How Can Hedge Fund Managers Avoid Criminal Securities Fraud Charges When Allocating Trades Among Multiple Funds and Accounts?,” The Hedge Fund Law Report, Vol. 4, No. 19 (Jun. 8, 2011).

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  • From Vol. 5 No.11 (Mar. 16, 2012)

    Use of SSAE 16 (SAS 70) Internal Control Reports by Hedge Fund Managers to Credibly Convey the Quality of Internal Controls, Raise Capital and Prepare for Audits

    An “institutional” quality infrastructure is becoming a prerequisite for hedge fund managers looking to raise capital from sophisticated investors.  But institutional is a difficult quality to define with precision in the hedge fund industry, a function of, among other things, the relative youth of the industry, asymmetry in the size and structure of management companies and the reluctance on the part of managers to disclose information.  As used by hedge fund investors, consultants, managers, regulators, service providers and others, institutional is more of a conclusion than a characteristic.  Managers are said to be institutional when they have fund directors with substance, gray hair in key operational roles, best-of-breed technology, brand name service providers, top tier investment talent and high caliber personnel focused on aspects of the business other than investing.  But a manager may be institutional without some of these elements, and even a manager with these elements can have holes in its processes that undermine the veneer of competence.  So how can investors reliably assess the institutional caliber of a manager, and how can managers credibly demonstrate their level of institutionalization?  Along similar lines, how can investors make institutional apples to apples comparisons when hedge fund management businesses are radically different in terms of size, structure, strategy and operations?  One method is to focus on the robustness of a manager’s internal controls, since robust internal controls are a necessary – though not sufficient – element of an institutional quality infrastructure.  Unlike other indicia of institutionalization, the robustness of internal controls can be measured at a single manager and compared across managers.  Such measurement can be accomplished by having an independent auditor conduct an internal control audit and issue an internal control report in accordance with Statement on Standards for Attestation Engagements No. 16 (SSAE 16), which replaced the long-standing Statement on Auditing Standards 70 (SAS 70).  While SSAE 16s have been in use in other industries for some time, they are a relatively new technique in the hedge fund industry.  However, in a climate of heightened regulator and investor scrutiny of non-investment aspects of the hedge fund business, SSAE 16s offer one of the most objective available barometers of institutionalization.  This article provides an introduction to the SSAE 16 audit process as applied to the hedge fund industry, including a description of the SSAE 16 audit and the corresponding internal control report; provides guidance regarding fund service providers a hedge fund manager should request an internal control report from and what should be covered in such internal control reports; outlines the reasons why hedge fund managers may consider obtaining an SSAE 16 audit on themselves, including a discussion of key benefits and costs of obtaining an internal control audit and report; describes the process for hedge fund managers to obtain an internal control audit and report; addresses who should pay for the internal control audit and report; addresses how often a hedge fund manager should obtain an internal control audit and report; identifies the challenges hedge fund managers face in obtaining an internal control audit and report; and explores whether there are any suitable alternatives to the internal control audit and report.

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