Hedge Fund Compliance. Scharfman Jason А.

related to these contracts include drafting, reviewing, and negotiating contracts a hedge fund may enter into with a variety of parties.

      • Litigation management– Hedge funds may sometimes be involved in lawsuits. These lawsuits may be initiated for a wide variety of reasons, including

      a. Portfolio‐related litigation– Sometimes a hedge fund will initiate, or participate, in legal proceedings as part of the its investment strategy.

      b. Employment related litigation– Disputes may arise between a hedge fund and its employees, which includes direct employees of the fund as well as any consultants or other classes or individuals to which a hedge fund may maintain an employment obligation. These types of lawsuits can be broken up into two primary categories. The first category would be suits brought by the fund manager. The second would be those brought by employees.

      • Third‐party law‐firm management– Hedge funds often work with third‐party law firms to assist in a variety of legal matters, including those referenced earlier. A common internal legal task at a hedge fund is managing the work of these third‐party firms.

       Related but Not Equivalent

      The legal and compliance functions of a hedge fund are often thought of as being related departments because a number of similarities exist between the two groups. There are several reasons for this, including

      • Traditional shared coverage of both functions – The head of the legal function is commonly given the title of General Counsel, while the compliance function head is commonly referred to as the Chief Compliance Officer. Although not every hedge fund maintains a general counsel, historically the General Counsel at a hedge fund would have also maintained responsibilities for compliance‐related functions. For example, it might not be uncommon for an individual with the title of General Counsel to also hold the title of Chief Compliance Officer.

      • Shared basis in the law – Compliance and legal functions are both rooted in the law and legal principles; hence, the overlap among the functions.

      • Complementary functions – The compliance and legal functions may be subject to oversight by each other in certain areas. For example, the activities of a hedge fund's legal department employees are typically subject to compliance oversight. Similarly, the development of compliance materials may require input from those with specialized legal expertise, which may come from the legal department.

      So, while the hedge fund's legal and compliance functions overlap to a certain degree, the specific duties and goals are different – they are related but not equivalent.

KEY PLAYERS IN COMPLIANCE

      A hedge fund's compliance efforts may be primarily driven by internal personnel. When this is the case, there are various individuals and groups that may be involved in the compliance function including those outlined below:

      • Chief Compliance Officer (CCO)– The most prominent compliance professional is the Chief Compliance Officer. In addition to leading the compliance function, the CCO fulfills regulatory requirements. Specifically, many regulators around the world require hedge funds to designate a CCO.

      In addition, the CCO typically assists a hedge fund in complying with a number of other regulatory duties, including filing regulatory reports, developing compliance policies and managing daily compliance audit calendars. The CCO position is discussed in more detail in Chapter 3.

      • Additional compliance personnel– Similar to the CCO role, other compliance individuals may or may not be dedicated to compliance functions. Although the CCO position is mandated by regulators, other positions are not, and a fund may not have any other additional compliance employees. If this is the case, the CCO may perform all essential compliance functions themselves, or those tasks are outsourced, such as to a compliance consultant.

      • Shared compliance employee– A shared compliance employee is an individual who performs certain compliance duties in addition to other responsibilities outside of the compliance function.

      Consider an example of a compliance department that is made up of six people, five of whom work solely on compliance‐related tasks. The sixth person spends part of their time on compliance duties and the rest on noncompliance tasks, such as fund accounting. Under this structure, the compliance department may be referred to as either dedicated with supporting resources or a mixed compliance department.

      • Noncompliance personnel– Noncompliance personnel perform jobs in which compliance matters are not part of their daily activities. These individuals include everyone from investment professionals to fund accounting personnel. This does not mean they ignore the compliance function, but they do not focus on it as part of their regular duties.

      • Compliance consultants– Compliance consultants are third‐party firms that provide advice on compliance‐related matters to hedge funds. Their services range from completely running a hedge fund's compliance function to compliance policy development and assisting hedge funds with ongoing compliance management. It is not a requirement for hedge funds to maintain a compliance consultant, and not every hedge fund will have one. The roles of compliance consultants are discussed in more detail in Chapter 6.

      • Other compliance‐related service providers– Other third‐party service providers can focus more on supporting the infrastructure of the hedge fund, such as information technology consultants and utility companies. Although third‐party service providers are not focused exclusively on compliance, they do perform compliance‐related services. These other service providers are also discussed in more detail in Chapter 6.

STANDARD AREAS COVERED BY A HEDGE FUND COMPLIANCE FUNCTION

      At this point in the reading, several basic compliance concepts have been introduced, and the structure of compliance departments has been discussed. We can now turn our attention to the key areas covered by compliance.

       Standard Areas Covered by a Hedge Fund Compliance Function

      At a very basic level, hedge fund compliance can be divided into two coverage areas: investment‐related and non‐investment‐related compliance areas.

      • Investment‐related compliance areas. These areas directly relate to the investment management business of the hedge fund organization. Traditionally, this is where the majority of hedge fund compliance efforts are centered.

      Take, for example, trade allocation, in which a hedge fund manages two different funds that adhere to primarily the same investment strategy. Each fund has been created to accommodate the tax needs of different types of clients (onshore and offshore). When funds are managed in this structure they are said to be managed in what is known as a pari passu manner.2 One fund is structured for clients who are typically based in the same country as the headquarters of the hedge fund. This is known as the onshore fund. The other fund is for investors based outside of the primary country in which the hedge fund operates. This is known as the offshore fund. Funds organized in this manner typically are structured to sit beneath what is known as a master fund that coordinates the underlying funds trading activities. In this structure, the onshore and offshore fund would be referred to as feeder funds, and the entire fund complex would be a master‐feeder structure. Assume that our master fund makes a single purchase of 100 shares of Google stock. Typically, the stock would not remain at the master fund and would need to be allocated between the onshore and offshore feeder funds. But how should this allocation be completed? You might think it would be easiest to split the shares 50–50 among the two funds. Perhaps, however, the onshore fund contributed more of the capital to make the purchase happen and trade should be allocated in a method known as pro‐rata trade allocation, which means that the trades should be allocated proportionally. Or what if the fund manager