Hedge Fund Industry Announces New Guidelines, Including Checklist for Developing Compliance Manual

By James Eccleston

he Managed Funds Association ("MFA") has published new guidelines entitled, "Sound Practices for Hedge Fund Managers." As the hedge fund industry's main trade group, the MFA seeks to raise "the standards across the board" — in all of the principal areas of hedge fund investing, management, operations and compliance. Along those lines, the MFA has prepared a checklist for hedge fund managers to consider in developing a compliance manual. Let's examine the more important aspects of that checklist.

Preliminarily, MFA notes that the contents and specific details of a specific hedge fund manager's policies and procedures will vary depending upon facts and circumstances (including whether the hedge fund manager is registered with the SEC and is subject to the requirements of Rule 206-4(7) of the Investment Advisers Act). MFA divides its guidance into five categories: Applicability and General Provisions; Chief Compliance Officer; Elements of Policies and Procedures; Review and Updating of Policies; and Acknowledgement and Training.

In terms of Applicability and General Provisions, MFA suggests that hedge fund managers identify covered personnel. In explaining what employees, officers and directors are covered, MFA notes that Rule 206-4(7) of the Investment Advisers Act includes all of them to the extent that they provide investment advice on behalf of the investment adviser and are subject to the supervision and control of the investment adviser. MFA recommends that hedge fund managers "set forth policies and procedures that are reasonably designed to prevent violations of such policies and procedures from occurring, and to detect and address violations that have occurred." Finally, MFA suggests that hedge fund managers distribute such policies to all covered personnel and ensure that they know it is their responsibility to understand them.

In terms of the Chief Compliance Officer, MFA recommends appointing this person for "coordinating and supervising compliance with applicable laws and regulations, as well as the internal procedures adopted by the investment adviser." MFA notes that this is required under the Investment Advisers Act for those hedge fund managers registered with the SEC.

Most of MFA's recommendations fall under the third category, Elements of Policies and Procedures. The first of the more important recommendations under this category is that hedge fund managers detail their applicable fiduciary duties. That means detailing that "the adviser must act solely in the best interests of its client and must make full and fair disclosure of all material facts" about the business and business practices. MFA notes that all investment advisers (whether registered or unregistered with the SEC) are subject to the antifraud provisions of the Investment Advisers Act.

Second, MFA recommends that hedge fund managers adopt controls and procedures relating to the fair allocation of investment opportunities among funds and the maintenance of portfolios consistent with the funds' objectives. Regarding the former, an employee or committee should be responsible for enforcing policies and procedures relating to partial fills, de minimis reallocations, deviations from allocation policy and allocations of "New Issues." Likewise, hedge fund managers must fairly allocate aggregated trades among funds, and should establish procedures for when to aggregate trades, how to allocate aggregated trades and how to review adherence to policy.

Third, MFA recommends that hedge fund managers adopt procedures that address various trading activities. These activities include proprietary trading by the hedge fund manager, personal trading activities of supervised persons and insider trading policies. Hedge fund managers should establish "policies to direct that any trading by employees and affiliates will be conducted in a manner that is consistent with the requirements of the policies and in a manner consistent with the applicable fiduciary duties owed by the hedge fund manager."

Fourth, hedge fund managers should "develop disclosure controls and procedures to ensure prompt and accurate disclosure to investors and any applicable regulators, including account statement disclosures." MFA recommends establishing a committee or designating an employee responsible for reviewing required disclosures for accuracy and consistency, as well as for ensuring that they are updated and distributed to investors and regulators on a timely basis. Along those lines, MFA suggests that hedge fund managers include processes to value holdings accurately (and to assess their fees based on those valuations). MFA notes that SEC-registered investment advisers have additional duties associated with updates to their Form ADV and with required reporting of financial and disciplinary information.

The final important recommendation, under the category Elements of Policies and Procedures, is to safeguard client assets. MFA recommends that hedge fund managers develop procedures to protect such assets against conversion or inappropriate use by advisory personnel. Suggestions include limiting authority and access to client accounts to designated employees, and to require approval of the Chief Compliance Officer for deviations from that policy, as well as monitoring the activity of employees with access to client accounts.

The last two categories -- Review and Updating of Policies; and Acknowledgement and Training - are fairly intuitive but some should be emphasized. Specifically, hedge fund managers must establish processes to continually assess whether their compliance policies and procedures remain adequate and effective in their implementation. MFA recommends updating policies and procedures in the event of "significant changes to business or unforeseen market events." Additionally, MFA notes that SEC-registered investment advisers must conduct this review no less frequently than annually.

Hedge fund managers, lawyers counseling them, and hedge fund investors all should benefit from these compliance manual suggestions and from the broader "sound practices" that MFA recommends in its latest publication.

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James Eccleston, an attorney specializing in adviser and broker-dealer issues, is a partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston in Chicago.