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

As registered investment advisers, under Advisers Act Rule 206(4)-7—the “Compliance Rule”—hedge fund managers are required to review their compliance policies and procedures for adequacy at least annually. Despite the Compliance Rule’s requirements to implement, maintain and review policies and procedures designed to prevent violations of federal securities laws, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations recently released a risk alert detailing fairly pervasive non-compliance among advisers. Specifically, OCIE said of compliance review deficiencies, “Annual reviews are not performed or did not address the adequacy of the adviser’s policies and procedures. The staff observed that certain advisers did not conduct annual reviews of their compliance policies and procedures, as required by the Compliance Rule. In addition, the staff identified advisers that conducted annual reviews that did not address the adequacy of the advisers’ policies and procedures and the effectiveness of their implementation. Staff also observed that advisers did not address or correct problems identified in their annual reviews.”

The Compliance Rule infractions OCIE raised in the risk alert effectively serve as forewarning of the deficiencies it will investigate in hedge fund manager examinations this year. Accordingly, this article, the first in a two-part series, outlines best practices for hedge fund managers conducting an annual review, including when it should be conducted, how to prepare and who should be involved. The second article in the series will address the steps hedge fund managers should take if compliance issues are uncovered and how to measure the effectiveness of a compliance review.

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The CCO typically creates a program that details the issues the review should encompass. The weight accorded to each issue typically is based on a risk assessment. Bao Nguyen, director of risk advisory services with Kaufman Rossin, advised, “You should review areas that pose a substantial risk to the firm from both the regulatory perspective and the investor perspective. Areas like fees and expenses need to be reviewed from a robust standpoint because of the potential risk of misallocations to the client and the underlying investors.”

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Third parties, such as compliance firms, administrators and auditors also can credibly perform the annual compliance review for the hedge fund manager. Because third-party firms work with many different types of clients and may specialize in these reviews, they tend to have personnel with knowledge of the review process and industry best practices—which could be a boon for managers. Nguyen explained an ancillary benefit of having an outside service provider conduct the review. “I would equate a CCO trying to conduct the annual review on his or her own to someone trying to proofread their own paper. It’s very difficult because you are so close to everything that you may miss something. You always want a second eye to take a look at what you’ve done, because they can look at things from a different perspective.”

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Nguyen added, “The benefit of having an independent third party review your compliance program is that you’re getting a fresh, objective perspective. When selecting a third party, you want to make sure the firm has expertise in your industry, your business and your strategy. Every fund is run differently, and every back office is different, so a third party should know the risks associated with the manager and the manager’s business from a regulatory compliance standpoint.”