How Much Can Technology and Outsourcing Relieve the Pain?
Can hedge fund managers benefit from outsourcing? What can be outsourced?
In its Final Rule on the registration of hedge fund advisors under the Investment Advisers Act of 1940, in November 2004 the SEC identified a series of important compliance tasks that must now be fulfilled by advisors to hedge funds. See SEC, 17 CFR Parts 275 and 279 [Release No. IA-2333; File No. S7-30-04], RIN 3235-AJ25, “Registration Under the Advisers Act of Certain Hedge Fund Advisers.”
What Compliance Functions Must be Satisfied?
Hedge fund advisors will be required to adopt the following:
- Registration by filing a Form ADV under which hedge fund advisers must to disclose information about their business, affiliates and owners, and disciplinary history.
- Comprehensive compliance procedures.
- Designation of a chief compliance officer.
- Specific procedures governing proxy voting.
- A code of ethics including requirements for personal securities reporting will also be required.
- A commitment to a program of compliance controls combined with SEC’s examinations in order to foster a culture of compliance by advisers.
Registration of Hedge Fund Advisors to Offshore Funds.
The SEC’s rules adopt the look-through approach to both the master and the feeder fund for purposes of determining whether the hedge fund is a “private fund” with 14 or fewer investors. As the SEC concluded in its final rule:
Many offshore hedge funds are organized as master-feeder structures in which an offshore adviser organizes a “master” fund interests in which are purchased by multiple “feeder funds.” The feeder funds seek to achieve their investment objectives solely by investing in the master fund and thus the feeder is a conduit that provides different investors access to the master fund. One feeder fund may be organized as a corporation and offered solely to non-U.S. investors, while another may be organized as a limited partnership in a foreign jurisdiction offering its shares exclusively to more than 14 U.S. investors. See Thomas P. Lemke et al, Hedge Funds and Other Private Funds: Regulation and Compliance (2004-05) at 19. The feeder fund is a private fund under rule 203(b)(3)-1(d); interests in the feeder are sold directly to U.S. investors, and thus the feeder must rely on either section 3(c)(1) or 3(c)(7) to avoid being subject to the Investment Company Act. The adviser to the master fund must look through the master fund as well as the feeder in order to count U.S. investors as clients, so that it is not violating section 208(d) of the Act by doing indirectly through the master what it could not do if it provided its advice directly to the feeder fund. [Footnote 227.]
Determination of the registration requirements thus requires careful attention to the characterization and counting of the individual investors in each fund.
Who Will Be the Chief Compliance Officer?
The SEC noted that not all hedge fund advisors will be fully dedicated to the compliance function:
The rule does not require an adviser to hire new staff, only to designate the person within the firm that is primarily responsible for compliance.
In smaller hedge fund advisers, the designated CCO will likely also fill another function in the firm, and perform additional duties alongside compliance matters. Firms designating a CCO from existing staff may experience costs to the extent the individual is taking on additional compliance responsibilities or giving up other non-compliance responsibilities. These costs may include costs of shifting responsibilities among employees, and might in some cases include additional compensation costs. Some of these firms may need to add compliance capacity to their staffs. Costs will vary from firm to firm, depending on the extent to which firm staff is already performing some or all of the requisite compliance functions, the extent to which the CCO’s non-compliance responsibilities need to be lessened to permit allocation of more time to compliance responsibilities, and the value to the firm of the CCO’s non-compliance responsibilities.
Deadlines.
The implementation of hedge fund compliance procedures is stretched out over a series of deadlines.
| Deadline | Actions Required |
| January 10, 2005 | Comply with amendments to rule 206(4)-2 and Form ADV |
| February 10, 2005 | Comply with new rule 203(b)(3)-2 and amendments to rules 203(b)(3)-1, 203A-3, 204-2, 205-3, and 222-2 |
| February 1, 2006 | Comply with new rule 203(b)(3)-2 and the amendments to rules 203(b)(3)-1, 203A-3, 204-2, 205-3, 206(4)-2, and 222-2, as highlighted below. |
| February 1, 2006 – summary | 1. Registration (Form ADV): register under the new rule (unless the “private advisor” exemption applies, counting only those private investors as of the registration date, not on a 12-month look-back approach), and must have its registration effective
2. Policies and Procedures: must have in place all policies and procedures required under SEC IAA rules, to ensure compliance with the Act and its rules (rule 206(4)-7), including policies to prevent misuse of material nonpublic information (section 204A [15 U.S.C. 80b-4a]) and policies to ensure that (if they vote client securities) client securities are voted in the best interest of the client (Rule 206(4)-6). 3. Code of Ethics: have in place a code of ethics applicable to their supervised persons, which code must require access persons to submit reports of personal securities transactions and holdings (rule 204A-1). 4. Compliance Officer: designate a chief compliance officer. 5. Custody of Client Funds: ensure that they are in compliance with the SEC’s rule for custody of client funds and securities (Rule 206(4)-2). |
| February 1, 2006 | Audit (or Distribution of Quarterly Transaction Statements to Investors):
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Technology and Outsourcing to Support Compliance Functions.
As with other financial services, hedge fund advisors will rely upon technology to support their compliance functions. Some of the compliance functions can be performed by external service providers, as is presently done for general operations that require
- infrastructure support (e.g., telecommunications, computer servers, backup, disaster recovery and business continuity measures),
- ongoing applications development and maintenance for software unique to the business metrics and to conform to the regulatory environment, and
- communications to investors.
The outsourcing of such functions require careful attention to the selection of suitable service providers, the allocation of legal liability (as between the hedge fund advisor and the outsourcing service provider), and ongoing monitoring and oversight by the Chief Compliance Officer of the service provider’s operations.
Legal Contracting Process.
The contractual issues involved in technology licensing and outsourcing of compliance support functions are materially different from those of pure securities law compliance. Negotiations typically require an understanding of legal considerations involving outsourcing, information technology, taxation, human resources and intellectual property law. Efficiency in such negotiations requires the attention and skills of an individual lawyer who understands holistically the life cycle and Darwinian evolution of information technology and technology-enabled services supporting administration, compliance and fiduciary duty of the hedge fund advisors..