Originally published by Thomson Reuters
In this article, Gary Allan and Adam Palmer of ACA Compliance (Europe) highlight some of the most common issues they encounter with clients in the alternative asset management sector. Some of these issues may seem straightforward, but if they are missed it can lead to regulatory censure or reputational damage.
1. Anti-market abuse systems and controls
As highlighted in a series of high-profile cases, the Financial Services Authority (FSA) has continued to focus a significant amount of resource into investigating market abuse. Perhaps the most important element in ensuring that the correct culture is adopted is to make sure that staff are trained to be aware what type of behaviour constitutes market abuse, and so that they can identify which issues need to be raised with the compliance and legal teams.
Action: Build market abuse into the firm's compliance monitoring programme, for example, a review of trading activity in issuers at the time of market announcements. Firms should also establish a training programme which includes discussion of recent cases to highlight the main themes of each case and its relevance to the firm.
2. Trade errors
The regulator expects regulated firms to handle trade errors in the best interests of their clients and it is an area which has come under increasing scrutiny during investor due diligence.
Action: Establish (or review) the trade error policy to make sure it is consistent with the principle to look after client interests. Past trade errors should be recorded and periodically reviewed to that ensure necessary procedural changes are fully implemented.
3. Side letters
Despite there being no specific FSA rule, the regulator expects material side letters to be disclosed to other investors. The Alternative Investment Management Association (AIMA)'s guidance note has long been accepted as the industry standard, but disclosure of those letters can be forgotten once the commercial terms have been agreed.
Action: Compliance officers should review all existing side letters and determine whether all material side letters have indeed been disclosed to other investors.
4. Use of dealing commission (softing)
Compliance officers should ensure that dealing commission is only used to purchase permitted goods or services, namely those that relate to execution of trades or research. With the execution of trades, compliance officers should be satisfied the services are linked to the arrangement and conclusion of a specific investment transaction.
With investment research, compliance officers should ensure that the research is capable of adding value to the trading decision, does not repeat or repackage investment research that has been presented before and involves analysis of data to reach meaningful conclusions. Services that cannot be purchased through dealing commissions include computer hardware, travel and publicly available information.
The disclosure obligations in respect of softing are sometimes missed. An investment manager is required to provide each client with an annual statement setting out details of the goods and services that it has received during the preceding year under commission arrangements as well as making its policy clear to clients prior to the provision of services to them.
Action: Goods and services purchased under such arrangements should be periodically reviewed to make sure that they are compliant with the FSA rules and guidance. As well as disclosing the policy to new clients, firms should make sure that all clients are being sent the annual disclosure on the use of dealing commission.
5. Change in control
If there is a change of control at a regulated firm then this may need prior approval from the FSA, in addition to the annual reporting requirement. Control is deemed to be 10 percent or more of voting rights or economic interest in the regulated firm. Any new controllers or existing controllers passing through the 20, 30 or 50 percent thresholds must be pre-approved by the FSA. The control interest may be held directly or indirectly so compliance officers should not forget that changes to ownership structure at group level may also need approval.
Action: Make sure the correct control structure has been notified to the FSA, and if any changes are planned either at the UK regulated firm or group level let those responsible know that FSA approval may be required before the transaction is completed.
6. Transaction reporting
The Markets in Financial Services Directive (MiFID) requires investment managers to report all transactions in relevant financial instruments, including related OTC transactions, to the FSA (or other competent authority). Relevant financial instruments are those admitted to trading on a European market, regardless of whether the transaction was carried out on such a market. The rules permit an investment manager to rely on a third party, such as the executing broker, to make the report to the regulator of their behalf.
Action: A periodic review of internal systems used to generate transaction reports should be undertaken, including a sample check. If the investment manager is relying on other parties to make the reports, compliance officers should ensure that there continue to be reasonable grounds to be satisfied that the third person is indeed making those reports. Has it been built into the terms of business with new counterparties? Are any relevant transactions undertaken with brokers who are not regulated in a MiFID jurisdiction and, if so, who is making those transaction reports?
7. Telephone and electronic communication recording policy
Telephone conversations or electronic communications (communications) that relate to the arrangement or execution of a client order must be recorded and retained for a minimum of six months. Investment managers may rely on an FSA-regulated counterparty to make the recording instead, but if a significant volume of trades is undertaken with brokers not subject to the FSA rule then investment managers need to make arrangements to record and retain those communications. The rule applies equally to company-issued mobile devices.
Action: Compliance officers should ensure that a company policy has been adopted and is understood by the investment team. If recording communications, a periodic check should be made to ensure that the recording system is working and communications are retrievable. Communications on personal mobile devices should be prohibited.
If companies are relying on another party to make the recording, monitoring should be undertaken to evidence that the vast majority of relevant communications are with counterparties subject to the recording rule. Good practice includes notification to compliance of all communications with counterparties not subject to the recording rule so that compliance can monitor the overall volume of such communications.
8. Internal Capital Adequacy Assessment Process (ICAAP)
The FSA requires all hedge fund managers to adopt an ICAAP and to update this document on at least an annual basis. The four crucial elements in any ICAAP are:
- assessment of the risks to which a firm is or might be exposed;
- application of mitigation techniques against the risks;
- stress testing of the firm's capital position and;
- the role of the board of directors and management during the process.
Once completed these elements will provide a firm with how much current and future capital it is necessary to hold to ensure the firm's risks can mitigated, known as Pillar 2 capital.
Action : An outdated ICAAP will hold insufficient information about a firm's risks and capital required. If the FSA requests to review an ICAAP they will not allow time for it to be brought up to date prior to submission. Compliance officers should ensure the ICAAP is updated on at least an annual basis and that the Pillar 3 disclosure statement that summarises the findings of the ICAAP is updated.
The FSA's liquidity rules must also be taken into account, and these are distinct from the ICAAP. The liquidity rules require the investment manager to be able to pay debts as they fall due and to have assessed risks to, and stress-tested, its liquidity position.
9. Remuneration policy statement
The Remuneration Code affects all banks, building societies, asset managers and hedge fund managers.
The FSA allows for a proportionate approach to implementing the Remuneration Code and has divided firms who fall within the Code into four categories (Tiers 1 to 4); the majority of hedge fund managers fall into tier four, the least onerous of the four categories, and therefore only have to meet the minimum requirements.
Action: Compliance officers should be aware which Remuneration Code category their firm falls within, and should ensure that Code staff have been identified and that an appropriate remuneration policy statement (RPS) has been adopted. The compliance officer should also notify Code staff that they have been classified as such (including the implications of such a classification) and update the firm's Pillar 3 disclosure statement to take account of the disclosure requirements that relate to the Remuneration Code.
Make sure that individuals responsible for hiring know what is prohibited under the firm's RPS and the Code, and that your HR function has also reviewed employment contracts and ensured that the contracts comply with the Remuneration Code; for example, proceed with extreme caution regarding any guaranteed bonus payments.
10. If within SEC jurisdiction has the FSA been notified?
The U.S. Securities and Exchange Commission (SEC) has adopted new rules and rule amendments under the Investment Advisers Act of 1940 to implement the provisions of the Dodd-Frank Act. Among other things the Act requires advisers to hedge funds and other private funds to register with the SEC.
Action: Compliance officers should be aware that, if their firm has registered with the SEC in any capacity, then they are also required to notify the FSA. Under Principle 11 "Relations with Regulators" this information is something of which the FSA would reasonably expect notice.