Best Practices for Hedge Fund Managers Conducting an Effective Annual Compliance Review (Part Two of Two)

Advisers Act Rule 206(4)-7, commonly known as the Compliance Rule, requires registered investment advisers, including hedge funds, to review their compliance policies and procedures for effectiveness at least annually. The review should not be performed perfunctorily. At a minimum, an evaluation for effectiveness requires making a determination that policies and procedures result in prompt identification of violations and timely collection of the information necessary for managers to correct problems as they are identified; are written in plain language that articulates the goal of compliance and how it is supervised; and are, in fact, adequately supervised by responsible personnel at the firm.

Despite the comprehensive mandate, the Office of Compliance Inspections and Examinations recently found that hedge fund managers’ adherence to the Compliance Rule has been inconsistent at best—Compliance Rule violations were listed among the top five compliance concerns identified in deficiency letters issued to managers. The consequences of violating the rule are almost always some degree of burdensome, ranging from the increased regulatory scrutiny that stems from deficiency letters and enforcement action to adverse impact on a firm’s bottom line should current and potential investors deem a manager’s regulatory issues too risky for investment. (For more on OCIE’s Risk Alert, see ”OCIE Risk Alert Highlights Most Common Compliance Deficiencies for Investment Advisers”)

Accordingly, it is vital that hedge fund managers verify their compliance program meets regulatory guidelines and periodically ascertain whether the compliance program remains effective. This article, the second in a two-part series, addresses the steps hedge fund managers should take if compliance issues are uncovered and how to measure the effectiveness of a compliance review. The first part outlined best practices for hedge fund managers conducting an annual review, including when it should be conducted, how to prepare and who should be involved.

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Rule 206(4)-7 does not specifically require documentation of the annual compliance review. However, the Advisers Act books and records rule, Rule 204-2(a)(17)(ii), requires registered investment advisers to preserve any records documenting the annual review, even if a written report of the review is not made.

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Bao Nguyen, director of risk advisory services at Kaufman Rossin, noted, “The rule itself does not require that a report be generated, but most, if not all managers, who have conducted an annual compliance program review memorialize the review in some way, whether with a detailed report or a simple memo to file.”

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Another mistake is starting too late and not putting in place a plan to frame and contain the review process. “If you wait until the last minute, you’re not likely to generate a meaningful review.” Added Nguyen, “I think one mistake managers can make is having a ‘checklist mentality’ where there is really no major substantive review but instead a ‘check the box’ review of the compliance program. Best practice is to review the written policies and procedures and what’s being done in a practical manner, and then test those areas with a risk-based approach to see if the compliance policies and procedures are being implemented and followed.”

To read the full article, visit the Hedge Fund Legal & Compliance Digest.