The ACA Hedge Fund Update is a new blog series designed to complement our ongoing alerts and formal communications. This series will include insights in areas where we may not have traditionally been your primary trail guide. We hope you find this content informative and insightful.
Diversity and Inclusion Practices in the Spotlight
On August 17, 2020, AIMA and Albourne introduced an enhanced diversity and inclusion questionnaire that was based on the Diversity and Inclusion section of the September 2018 ILPA Due Diligence Questionairre (DDQ). The Wall Street Journal also recently reported that the Yale Investment Office has notified approximately 70 managers that Yale will now measure managers annually on their hiring, training, mentoring and retention of women and minorities on their investment staffs. The Yale Investments Office also plans to report on the progress it makes on the diversity of its own staff annually.
As diversity and inclusion practices continue to be scrutinized by institutional investors, hedge fund managers should ensure their metrics and even unsolicited requests for their diversity and inclusion business practices go through similar quality control processes as other current and prospective investor reporting. In our view, it seems possible that the Office of Compliance Inspections and Examinations (OCIE) may eventually have additional interest in hedge fund manager’s diversity and inclusion claims as these practices continue to evolve and take on heightened significance for institutional allocators.
Fund Administrators Settle with SEC for Causing Fund Advisers' Violations
On September 18, 2020, the Securities and Exchange Commission (SEC) announced that two affiliated fund administrators (“administrator”) agreed to settle charges for their role in causing an investment adviser’s fraud against private funds and their investors.
According to the order, the Administrator’s employees identified, but failed to adequately escalate, concerns regarding the investment adviser, and more specifically, the Administrator permitted the adviser to withdraw money from the private funds without support and followed the investment advisers' instruction to account for these withdrawals as part of a receivable the adviser owed the funds despite having information that should have caused the Administrator to question whether the investment adviser would be able to repay these amounts. The order states that, as a result of this accounting, the Administrator reported materially inflated capital account balances and returns on monthly statements to the private funds' investors. This action, coupled with OCIE’s recent COVID-19 risk alert that references heightened risks on management fee calculations in lieu of pandemic-related financial pressures, suggest that managers may want to review their fee calculation processes and ensure they have adequate due diligence to demonstrate oversight of their third party administrator.
CFTC Orders Firm to Pay Record $920 Million for Spoofing and Manipulation
On September 29, 2020, the Commodity Futures Trading Commission (CFTC) issued an order filing and settling charges against a multinational investment firm and its subsidiaries for manipulative and deceptive conduct and spoofing that allegedly spanned at least eight years and involved hundreds of thousands of spoof orders in precious metals and U.S. Treasury futures contracts on the COMEX, NYMEX, and CBOT. The case was brought in connection with the Division of Enforcement’s Spoofing Task Force. In parallel and related matters, (1) the Department of Justice’s Fraud Section and the United States Attorney’s Office for the District of Connecticut announced entry of a Deferred Prosecution Agreement (DPA) with the firm that includes, among other things, payment of a criminal fine, disgorgement, and restitution; (2) the Securities and Exchange Commission (SEC) announced entry of an order filing and settling charges against a subsidiary of the firm, imposing both disgorgement and a civil monetary penalty; (3) the CFTC has previously issued orders in related matters filing and settling charges of spoofing against two traders and continues to pursue civil litigation against two other traders.
The order finds that from at least 2008 through 2016, the firm, through numerous traders on its precious metals and Treasuries trading desks, including the heads of both desks, placed hundreds of thousands of orders to buy or sell certain gold, silver, platinum, palladium, Treasury note, and Treasury bond futures contracts with the intent to cancel those orders prior to execution. Through these spoof orders, the order states traders intentionally sent false signals of supply or demand designed to deceive market participants into executing against other orders they wanted filled. According to the order, in many instances the firm’s traders acted with the intent to manipulate market prices and ultimately caused artificial prices.
CFTC Chairman Tarbert reminded market participants of the rigor in which the Commission will apply in protecting the integrity of U.S. commodities markets stating, “Attempts to manipulate our markets won’t be tolerated. The CFTC will take all steps necessary to investigate and prosecute illegal activities that could ultimately undermine the integrity of the American free enterprise system.”
As a result of this order, Compliance teams may consider enhancing trade surveillance of order cancellations to ensure order activity does not create a false impression of buying or selling interest with the intent to manipulate market prices. Compliance officers may also consider reviewing this action with internal brokerage or best execution committee meetings in an effort to highlight the type of activity that firm traders should look to escalate to Legal or Compliance in the event they have an inclination a trading partner is attempting to manipulate pricing to the advantage of the firm or otherwise.
CFTC Finalizes Positions Limits Rule
On October 15, 2020 the Commission approved a final rule amending regulations of speculative position limits to conform with certain Dodd-Frank amendments to the Commodity Exchange Act. The Commission has issued five position limits proposals over the past 10 years and, according to Chairman Tarbert, the rule removes a cloud that has hung over both the CFTC and the derivatives markets for a decade. Among other things, the Commission:
- adopted 16 new federal spot month speculative position limits for certain commodity derivatives contracts,
- amended federal spot month position limits for derivatives contracts associated with 25 physical commodities (nine legacy agricultural contracts together with the new 16 non-legacy contracts),
- amended single-month and all-months-combined federal limits for most of the agricultural contracts currently subject to federal position limits. Note under the final rule, federal non-spot month position limits were not extended to the sixteen new non-legacy commodities,
- adopted new and amended definitions for use throughout the position limits regulations, including a revised definition of “bona fide hedging transaction or position” that includes an expanded list of enumerated bona fide hedges and a new definition of “economically equivalent swaps,”
- amended rules governing exchange-set position limit levels and related exchange exemptions; and
- established a new streamlined process for non-enumerated bona fide hedging recognitions for purposes of federal position limits.
The Final Rule imposes a compliance date of January 1, 2022 for purposes of compliance with the federal position limits for the 16 non-legacy core referenced futures contracts that are subject to federal position limits for the first time. The Final Rule provides a compliance date of January 1, 2023 with respect federal position limits for economically equivalent swaps.
Because the nine legacy agricultural contracts are currently subject to federal position limits under the existing federal framework, such limits go into effect on the Effective Date, which is 60 days after publication in the Federal Register. Therefore, as of the Effective Date, market participants will be able to avail themselves of the federal position limits under the Final Rule for the nine legacy agricultural contracts, all of which are higher than the existing federal position limits (except for CBOT Oats, which will maintain the existing federal position limit levels).
The broader federal limits on the legacy agricultural contracts may afford immediate additional capacity for hedge fund managers, which could also change liquidity patterns in these contracts. Although the effective date for the 16 new non-legacy contracts and economically equivalent swaps are years away, hedge fund managers may consider establishing internal teams or working groups responsible for ensuring they have appropriate processes, monitoring tools, and rolling procedures to adequately prepare for the enhanced federal requirements and corresponding operational responsibilities.
Executive Compensation Clawbacks and Supervisory Standards
On October 22, 2020, in one of the largest Foreign Corrupt Practices Act (FCPA) settlements ever, a leading global investment banking, securities, and investment management firm (“global financial services firm”) and its Malaysian subsidiary, admitted to conspiring to violate the FCPA in connection with a scheme to pay over $1 billion in bribes to Malaysian and Abu Dhabi officials to obtain lucrative business. On the same day as the Department of Justice (DOJ) announcement, the global financial services firm released a statement that contained a statement from the Board of Directors.
The Board statement explained, among other things, that in acknowledgement of the firm’s institutional failures, five of the global financial services firm’s former senior executive officers will, to the extent not already paid, forfeit all or the majority of their outstanding Long-Term Performance Incentive Plan Awards that were granted in 2011 and which have a performance period that includes 2012 and 2013 when the underwritings took place, and forfeit a portion of other previously awarded compensation, if applicable. One of these retired senior executives who previously received the 2011 award has voluntarily agreed to return the majority of it. The global financial services firm is in active discussion with another of these retired senior executives, who also already received the 2011 award, about returning the majority of it as well. The amounts for these five individuals represent a portion of the pre-tax value of these awards granted or paid, and total approximately $67 million.
In addition, the current executive leadership team (e.g., the Chief Executive Officer, the Chief Operating Officer and the Chief Financial Officer, as well as the current international CEO) have had their overall compensation reduced by $31 million for 2020. These clawbacks, forfeitures, and compensation reductions will total approximately $174 million in the aggregate.
Although the settlement involves a multi-national public company, it seems plausible that hedge fund managers’ governance structures could potentially be subject to similar executive compensation clawbacks when there is inadequate anti-bribery and anti-corruption controls. When hedge fund compliance programs review their anti-bribery and anti-corruption processes, CCOs may consider citing this case to appropriately sensitize their boards or senior leadership to the risks associated with inadequate FCPA controls and oversight.
SEC Settles with Private Equity Sponsor for Faulty Valuation Write-Down Practices
On October 22, 2020 the SEC announced a settlement with a private equity fund adviser for not making adjustments to quarterly management fee calculations to account for asset write downs. Although the limited partnership agreement (LPA) for the fund afforded for a management fee equal to 1.5% per annum of the total invested capital contributions, the LPA also required that the amount of invested capital on which the 1.5% fee is charged to be reduced as a result of certain triggering events, including write downs of portfolio securities. The SEC alleged that the investment adviser did not make adjustments to quarterly management fee calculations to account for write downs causing the fund, and ultimately its limited partners, to pay over $900,000 more in management fees than they should have.
Many managers to draw down style funds often charge fees on invested capital. However, this enforcement action may be an opportunity for managers to draw down style funds to review their governing documents and valuation processes to address impairments or write downs when asset values fall below cost.
13F Proposal - Status Uncertain
On October 27, 2020 Bloomberg reported that, according to unnamed SEC staffers, the 13F proposal, which received over 2,200 comments, will not be advanced. On July 10, 2020, the SEC proposed increasing the threshold of Section 13(f) securities that triggers a Form 13F filing from $100 million to $3.5 billion which would have eliminated the filing requirement for nearly 90% of existing filers.
DOL Announces Final Rule Related to ESG and Pecuniary Factors
On October 30, 2020, the Department of Labor (DOL) issued its final rule on Financial Factors in Selecting Plan Investments. Unlike the DOL’s June 2020 proposed rule, the final rule contains no specific references to environmental, social, and governance (ESG) or ESG-themed funds. The final rule adds a specific provision to confirm that Employee Retirement Income Security Act (ERISA) fiduciaries must evaluate investments and investment courses of action based solely on pecuniary factors — i.e., factors that the responsible fiduciary prudently determines are expected to have a material effect on risk and/or return of an investment based on appropriate investment horizons consistent with the ERISA plan’s investment objectives and the funding policy. The DOL’s final rule fact sheet also reminded industry firms that the DOL clearly stated in the preamble to the proposal that ESG factors could be pecuniary in nature and that, in such cases, fiduciaries properly could consider the factors as part of their investment analysis. The final rule is effective 60 days following its publication in the Federal Register, though the final rule provides that plans have until April 30, 2022 to make changes as needed to comply with new restricted conditions for a plan’s qualified default investment alternative or QDIA. Hedge fund managers with ESG strategies that are ERISA fiduciaries should review their current processes and update policies and procedures to reflect the final rule while keeping a cautious eye on whether the Biden/Harris administration has an interest in revisiting the final rule or offering clarifying guidance.
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If you have any questions or feedback about the ACA Hedge Fund Update, please contact Chris Ray, Director, US Alternatives Practice, or email our hedge fund practice management team at HFpractice@acacompliancegroup.com.