Compliance: Staying Ahead of New Regulations

Sometime in the near future, small private equity firms and hedge funds may find themselves subject to regulations that only registered advisers had to consider.  With the upcoming Dodd-Frank regulations and the focus on derivatives, clients will – now more than ever before – want to be assured that there are systems and procedures in place to mitigate the risks of transacting in derivative instruments.

The following measures can serve to benefit your overall compliance environment and assist in providing clients with the reassurance of sufficient controls.

If you are not familiar with Rule 206(4)-7, it is probably the best place to start¹. In summary, the rule requires registered investment advisers under Section 203 of the Investment Advisers Act of 1940 to create and implement written policies and procedures reasonably designed to prevent, detect and correct violations and to review them at least annually. It also requires the designation of a supervised person, typically a Compliance Officer, who will be responsible for administering the compliance policies and procedures.

Compliance policies and procedures for smaller firms should be relatively simple compared to the larger advisers, where there may be conflicts of interest due to additional lines of business within their complex and other affiliations.   In creating policies and procedures for a smaller firm, you should assess any conflicts or other risks; and incorporate the appropriate prevention, detection and corrective actions associated with those risks.

Although Rule 206(4)-7 does not specifically list the policies that should be in place, it does state that portfolio management processes, trading practices, proprietary trading, personal trading of supervised persons, accuracy of disclosures, safeguarding of client assets, accuracy of required records, marketing advisory services, client valuation processes and fees, privacy protection of client records/information and business continuity plans should be addressed if applicable to the adviser.

To capture all of your regulatory requirements, internal guidelines and compliance policies/procedures, you should create a Compliance Monitor² which will serve as the framework for a robust compliance program.  A Compliance Monitor should summarize the responsibilities of the Chief Compliance Officer, or designated officer, and should include a comprehensive list of all regulatory requirements, associated compliance policies and tasks and the corresponding systems employed to monitor them.   The monitoring frequency is typically determined by what is deemed reasonable; however, with automation and exception reporting, certain functions can and should be performed on a daily basis.

For example, to address Insider Trading, your Compliance Monitor may include items that are shown in the table below.

Once you have your Compliance Monitor in place, it is a simple matter to incorporate any new regulations.

^1. For more information on Rule 206(4)-7, please visit: http://www.sec.gov/rules/final/ia-2204.htm

^2. The below example, displayed as a simple grid, can easily be converted into a database to log and track issues/remediation and allow the adviser to utilize metrics for analysis and reporting purposes.

  <th>
    <p align="center">
      <strong>Regulatory Requirement</strong>
    </p>
  </th>
  
  <th>
    <p align="center">
      <strong>Compliance Policy</strong>
    </p>
  </th>
  
  <th>
    <p align="center">
      <strong>System</strong>
    </p>
  </th>
  
  <th>
    <p align="center">
      <strong>Compliance Task</strong>
    </p>
  </th>
  
  <th>
    <p align="center">
      <strong>Frequency</strong>
    </p>
  </th>
</tr>

<tr>
  <td valign="top">
    Insider Trading
  </td>
  
  <td valign="top">
    SEC Rule 10b5-1</p> 
    
    <p>
      <a href="http://www.sec.gov/rules/final/33-7881.htm">http://www.sec.gov/rules/final/33-7881.htm</a></td> 
      
      <td valign="top">
        Employee Code of Ethics
      </td>
      
      <td valign="top">
        Trade Capture System
      </td>
      
      <td valign="top">
        Review exception reports for detection of unusual trading activity
      </td>
      
      <td valign="top">
        Daily
      </td></tr> </tbody> </table> </div>