by Timothy Mohr, Principal & National Financial Services Advisory leader, BDO Consulting
The hedge fund industry is undergoing a period of immense and rapid change. Capital is rushing in, with inflows in the first half of 2014 reaching $56.9 billion, according to the latest HFR® Global Hedge Fund Industry Report. At the same time, regulatory changes in the aftermath of the financial crisis are placing significant pressure on hedge funds to reevaluate their operational and compliance systems to mitigate the potential impact on their ability to raise and invest capital going forward.
In particular, changes made by the JOBS Act to private placement exemptions have created new opportunities and challenges for hedge fund managers. When the “bad actor” rules – which effectively disqualify securities offerings that involve ‘bad actors’ from relying on exemptions from SEC registration under Rule 506 – first went into effect in September 2013, outstanding interpretative questions remained related to the application of these rules. One year in, however, the SEC has issued several sets of Compliance and Disclosure Interpretations, clarifying the impact of the rules and enabling funds to begin to step up their compliance efforts to mitigate the risk associated with a “bad actor” finding.
What’s more, institutional investors are beginning to take notice of these new rules. Increasingly sophisticated investors are now looking beyond funds’ investment strategies when evaluating new opportunities, pushing for evidence of more rigorous operational and compliance systems, especially as they pertain to monitoring for regulatory and legal troubles that may trip the “bad actor” rules. There is now a higher expectation of transparency and an assumption that any compliance questions can and will be answered quickly.
In the face of these changes, it is more critical than ever that hedge funds have strong compliance and oversight processes in place, and that compliance officers are given the authority to effectively respond to this dynamic marketplace. Not only does their operating success depend on the Rule 506 exemption, but in today’s investment environment, fund managers’ ability to secure new capital commitments often requires them to demonstrate that they can conduct constant vetting for regulatory compliance and maintain the integrity of their fund.
With that in mind, hedge fund managers are beginning to implement systems to monitor their compliance needs on an ongoing basis. A key component of this exercise, particularly as related to the “bad actor” rules, is to continuously monitor for any regulatory or legal troubles that may trigger a disqualification. Putting continuous monitoring systems in place before any issues arise is crucial to hedge funds’ ability to exercise ‘reasonable care’ and establish that they were unaware of disqualifying ‘bad actor’ violations, thereby preventing disqualification in the event that a “bad act” occurs.
But questions remain regarding how to design compliance programs that comply with the “reasonable care” standard. While monitoring processes will vary based on the operating structure of a fund, there are six key steps managers should consider when establishing continuous monitoring programs:
- 1. Develop a “bad actor” assessment and identification procedure to ensure the exercise of ‘reasonable care,’ both immediately and on an ongoing basis.
- 2. Create a list of all covered persons, as well as disqualifying “bad acts” and look-back periods to guide immediate information gathering.
- 3. Develop and distribute questionnaires to all covered persons to ensure sufficient information is collected to conclude with ‘reasonable care’ that no ‘bad acts’ have occurred.
- 4. Undertake due diligence and background checks to ensure the factual accuracy of information collected through questionnaires and affidavits, both immediately and on an ongoing basis.
- 5. Review hiring policies to ensure potential ‘bad actors’ are screened through background checks during the recruitment process and on an ongoing basis.
- 6. Establish agreements with covered persons that operate independently of the fund and its managers to ensure ‘bad actors’ are similarly screened for and flagged on an ongoing basis.
As investors continue to perform more thorough due diligence on hedge funds with respect to the “bad actor” rules, so too will regulators increasingly monitor for disqualifying events. As such, hedge funds should proactively consider revamping their compliance monitoring processes now to ensure they operate in accordance with these regulations. This will allow fund managers to remain focused on raising capital and executing investment strategies. It will also provide a competitive advantage in a market where investors are increasingly looking to invest in funds that already have strong compliance programs in place.
Timothy Mohr is the National Financial Services Advisory leader at BDO Consulting with more than 25 years of experience in financial institution fraud, investigations, investigative due diligence and compliance. He is a Certified Fraud Examiner and a licensed private investigator. Tim leads a range of strategic business advisory, operational and event response offerings for alternative asset management firms, banks and other financial services organizations.
Tim provides domestic and international business intelligence services to financial institutions, private equity firms, hedge funds, fund of funds, endowments, public and private pensions, sovereign wealth funds and family offices. He also performs enhanced due diligence and KYC investigations for clients across industries. Tim’s international experience includes conducting and overseeing investigations globally, including in locations in Europe, Asia, South America and the Middle East. He has testified as a fact witness before grand juries, federal and state courts and in arbitrations on matters involving bank fraud, theft of proprietary information, identity theft, money laundering and regulatory issues.
