Hedge Fund Compliance. Scharfman Jason А.

Although we will address certain key aspects of different hedge fund regulations in the major countries in which hedge funds operate, this book is meant to provide practical compliance advice on a global basis rather than focus too heavily on the laws of any specific country. There are many other more technical resources that can provide in‐depth specific guidance on the applicable compliance laws in any particular country.

       Regional Compliance Expertise Used by Hedge Funds

      In practice, many hedge funds engage in business activities in multiple countries. It is not practical for these hedge funds to maintain internal compliance experts who have expertise in all of the countries in which they may operate. To solve this problem, a hedge fund's interpretation and implementation of compliance guidelines in different countries often comes about as a result of consultation with a number of different country‐specific specialists.

      To clarify some terminology, individuals or firms that are not employees of the hedge fund but provide services to it are commonly referred to as third parties, third‐party firms, or service providers. Although not every service provider provides compliance‐related services to a hedge fund, many do in one form or another. One of the most common compliance‐focused service providers is known as a compliance consultant. Another type of hedge fund service provider heavily involved in compliance is a law firm, which is also sometimes referred to as a hedge fund's legal counsel. The country‐specific compliance specialists that hedge funds heavily rely on in the compliance area are typically either compliance consultants or legal counsel.

      Another reason that many hedge funds utilize third‐party compliance consultants when operating in different countries is because compliance is an evolving subject. As the laws and rules in different countries change, external expertise can often provide valuable insight into trends in compliance practices in specific countries.

       Benefits to Developing a Global Understanding of Compliance

      When studying the area of hedge fund compliance, there are benefits toward first establishing a general understanding of the subject on a global basis before delving too deeply into the rules of any one country. From the perspective of hedge fund employees, while individuals who are experts in the compliance practices of any single country are, of course, valuable, developing a global understanding of general compliance policies coupled with third‐party country or region‐specific compliance expertise as needed often produces a much more holistic compliance program.

      From the perspective of hedge fund investors seeking to evaluate hedge fund compliance protocols, first developing a more general understanding of core hedge fund compliance principles prior to any country‐specific knowledge is also advisable. This is because investors may allocate capital to hedge funds in multiple jurisdictions, which are subject to different compliance regimes. By developing this general compliance foundation first, which is then complemented by country‐specific compliance knowledge, a more universal compliance due diligence program for investors will result.

      Keeping both the hedge fund employee and the hedge fund investor perspectives in mind should assist you as you work through the material.

DO ALTERNATIVE INVESTMENTS MERIT SPECIAL COMPLIANCE CONSIDERATIONS?

      Hedge funds are commonly grouped into an asset class known as alternative investments. Alternative investments differ from other types of investments, such as long‐only mutual funds, commonly referred to as traditional investments. For reference, a long‐only fund is one that only engages in the purchasing and selling of investments, such as buying or selling equities. These are long‐only investments because the fund's general strategy is to make long‐term predictions that the value of the investments will increase over time. Long‐only funds do not follow a strategy of selecting investments by betting that the value of certain investments will decrease over time.

      By contrast, an approach that seeks to profit from the decline in value of a potential investment, such as betting for a decline in the price of the shares of a publicly traded company, is known as short selling. Short selling is typically carried out through the use of equity options. One hedge fund strategy that combined both long‐ and short‐selling techniques is known as a long‐short strategy. In addition, other hedge fund strategies may also typically involve the use of options and other short‐selling techniques. Other common types of alternative investments, often grouped alongside hedge funds in this category, are private equity, real estate, and commodity funds.

      Within the area of fund manager compliance, the question may be raised whether alternative investment managers merit special compliance considerations as compared to traditional investment managers. When we refer to a fund manager, unless otherwise stated, we are not referring to a specific individual, such as a portfolio manager, but rather to the management company organization for which an individual known as a fund manager or portfolio manager typically works. Prior to answering the question of whether a special classification category is required for hedge funds, we must first understand the notion of market and regulatory classifications.

       Contrasting Regulatory and Market Classifications

      Most regulators have big categories by which they categorize similar types of financial entities. This is in contrast to the smaller distinctions among different types of asset managers that may be made in the real‐world marketplace. When it comes to hedge funds, the majority of global financial regulations do not maintain a separate classification for entities that may be classified as a hedge fund, private equity fund, or any other alternative investment vehicle. Instead, within the broad umbrella of regulatory fund manager entities, financial regulations are primarily more driven by the activities of these fund managers. This concept highlights the distinction between what may be referred to as a regulatory classification and a market classification of a fund manager.

       Understanding Regulatory Classifications

      A regulatory classification is the way a fund manager would be classified based on predetermined regulatory classification requirements. One way to think about regulatory classifications is the way in which a fund manager is viewed from a legal perspective.

      For example, in the United States, if a fund manager under the Investment Advisers Act of 1940 (Advisers Act, or Act) and accompanying statutes meets certain specific criteria, then the manager is classified as an entity known as an Investment Adviser. In general, Section 202(a)(11) of the Advisers Act defines an “Investment Adviser” as any person or firm that:

       (1) for compensation; (2) is engaged in the business of; (3) providing advice, making recommendations, issuing reports, or furnishing analyses on securities. 1

      As you can see by these general criteria, the requirements are quite broad. This means that whether an organization is a long‐only mutual fund or a long‐short hedge fund manager, from a regulatory perspective, they are both Investment Advisers.

      If an organization does not meet each criterion and isn't exempt for some other reason, then the manager is generally not classified as an Investment Adviser. Why does this classification matter? If a fund manager is not an Investment Adviser, then it would generally not have to register with the U.S. Securities and Exchange Commission (SEC). More specifically, the compliance programs of a registered hedge fund may be distinctively different from an unregistered fund.

       Understanding Market Classifications

      A market classification is the way a fund chooses to portray itself in the market. Alternatively, it can be the way a fund is classified, typically by investors, based on its actual trading activities. Obviously, it is not in a hedge fund manager's interest to misclassify their activities, but sometimes these two classifications are the same, and in some cases, there may be differences in classification methods, depending on the classification requirements in place.

      Market classifications can be contrasted from regulation

1

U.S. Securities and Exchange Commission. General Information on the Regulation of Investment Advisers, www.sec.gov/divisions/investment/iaregulation/memoia.htm.