Over the past decade, there has been a marked increase in the number of regulations and reporting requirements present in the financial sector. As a result, having the right compliance framework is now one of the most important aspects of every hedge fund’s daily activities.
As the punishment for failure to meet these requirements can be costly fines or Congressional inquiries, having the right compliance framework is vital. According to the SEC, a record $6.4 billion in fines were issued during Fiscal Year 2022. Of the 760 enforcements issued, 129 were against companies for failing to comply with disclosure filing deadlines, a rate of roughly one every three days.
Let’s first examine some of the regulations with which hedge funds must comply in both the United States and the European Union, then we’ll explore the best practices for making sure these reporting requirements are met.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, commonly referred to as simply “Dodd-Frank”, requires all hedge funds to register with the SEC and file Form PF, which details the level of risk to which managed clients are exposed by the fund’s actions. That same year, Congress also passed the Foreign Account Tax Compliance Act, also known as FATCA, which requires financial institutions located outside the United States to report on financial transactions conducted by US citizens. This ensures that all offshore investment income is properly taxed. The European Union, or EU, enacted its version of the legislation in 2014.
In 2022, Dodd-Frank was updated and reporting times were drastically decreased. For example, under Dodd-Frank, if a hedge fund or private equity firm lost 20% of its valuation over a 10-day period, that information would be filed in a quarterly report. After the change, those institutions must now report that information to the SEC within one business day to remain in compliance. Additionally, new requirements were adopted by the SEC in May 2023 that update the disclosure regulations that hedge funds must follow, specifically with regard to Form PF. The new rules are reportedly aimed at protecting investors from risk by requiring fund advisors to notify regulators of events that might precipitate an economic recession like the Financial Crisis of 2008 and 2009.
The EU has also introduced new reporting requirements over the past few years. The 2014 Network and Information Security Directive, or NIS, requires that every investor’s confidential information be protected on secure networks and that any security breach be reported immediately. There are similar SEC laws in America.
The European Market Infrastructure Regulation, or EMIR, has some similarities with Dodd-Frank, including stricter requirements for investor accounts that trade on margins and a shorter grace period before those investors are subject to margin calls.
Building a Solid Compliance Framework
Although all hedge funds will be familiar with these and other regulations, some of them may have issues keeping up with all of the paperwork involved, the frequency of reports, and other aspects. That is why it is highly recommended that a framework be put into place that helps ensure compliance.
Some funds have a dedicated staff whose entire job is to ensure that the necessary paperwork is completed accurately and submitted to the Securities and Exchange Commission before the deadline. However, this can also be rather time-consuming and expensive, due to the amount of specialized labor required.
Although making sure that paperwork is filed properly and on time is important, there are several other components of a compliance framework that should be addressed as well. Risk management and due diligence must be part of such a framework, as a company operating at too high of a risk level could potentially be violating its fiduciary obligation to the fund’s investors.
For these and other reasons, the role of a compliance manager is very important to hedge fund operations. This comes at a cost. Based on averages from Salary.com, a large hedge fund that requires a team of a manager and four officers could spend nearly half a million dollars every year just to make sure they’re operating within the confines of SEC regulations, not including bonuses, incentives, benefits, or other forms of non-salary compensation.
Compliance Starts at the Core
Compliance reporting cannot simply be outsourced. While it is true there are multiple vendors that offer Form-PF and other compliance submission and filing services, this can only be done if the hedge fund or asset manager is accurately recording each and every transaction and valuation in a way that it can effectively be sliced, diced and categorized into the various reporting buckets required by the regulators. This in turn requires a robust, institutional portfolio risk, reporting, operations and accounting platform at the core of the business.
Fund Studio by Objecutive Inc.
One such option is Fund Studio, offered by the New York Metro-based Objecutive Inc. The platform offers comprehensive reporting, controls and operational support over the full life-cycle of every position held, from its trading, valuation, risk, accounting and reconciliation, across a highly comprehensive set of instrument types. More importantly, Fund Studio provides fine tagging and categorization needed as a foundation for regulatory reporting such as Form-PF.
Objecutive provides a fully outsourced middle-office managed service, or customers can use the cloud-based platform to complete the work themselves, or a combination of the two, depending on what works best for their needs. Ultimately, Fund Studio helps reduce cost, while improving visibility and control, allowing managers to focus on their core strength of driving ROI.