A mutual fund manager agreed to pay over $10 Million to settle charges that it did not observe its own risk management practices, which ultimately resulted in the fund losing 20% of its value. The fund, part of a larger series trust and converted from a private fund in 2013, invested in S&P 500 index futures contracts. The fund’s marketing materials described significant risk management procedures that would limit downside through hedged positions and stop-loss triggers. The SEC alleges that the portfolio manager ignored the risk mitigation limits and that the CEO failed to supervise him. The SEC charges several violations of the Advisers Act including the antifraud provisions. A federal lawsuit continues against the portfolio manager, and the CFTC also settled charges with the respondents.
Don’t allow your portfolio managers to play regulatory Jenga. Very often, former private fund managers have a hard time abiding by the strictures imposed by the Advisers Act and the Investment Company Act. Firms should impose heightened supervision and training to ensure that hedge fund PMs understand the limitations.
The SEC’s Office of Compliance Inspections and Examinations (OCIE) has warned the registered fund industry about rampant regulatory violations involving compliance programs, disclosure, advisory contract approvals, and Codes of Ethics. In a recent Risk Alert detailing common deficiencies and weaknesses uncovered during 300 examinations over the last two years, OCIE chided the industry for weak compliance programs including policies and procedures that failed to prevent violations of investment guidelines or to ensure fulsome disclosure in fund marketing materials; breakdowns in providing the Board with adequate fair valuation information and broker quotes; weak service provider and subadviser oversight; and inadequate annual reviews. OCIE also criticized the information used to approve advisory contracts as well as shareholder disclosure in offering documents. OCIE also warned that funds need to enhance their Codes of Ethics including reporting and how to define “access persons.”
Hire better service providers. Not every lawyer knows the Investment Company Act Board approval, disclosure, and reporting rules. Not every compliance person understands Rule 38a-1 and how to implement fund procedures and testing. Not all administrator/distributors understand the differences between private funds and registered funds. You wouldn’t hire a neurologist to perform surgery. You shouldn’t hire just any lawyer or compliance consultant to implement your registered fund regulatory program.