Compliance for Hedge Funds: Regulatory Framework and Trading Regulations

Hedge fund compliance has evolved dramatically since the 2008 financial crisis transformed regulatory oversight of alternative investment managers. What was once a lightly regulated industry operating largely outside traditional securities regulation now faces comprehensive SEC oversight, detailed reporting obligations, restrictions on trading practices, and enhanced scrutiny of marketing communications. The Dodd-Frank Wall Street Reform and Consumer Protection Act eliminated the private adviser exemption that many hedge fund advisers previously relied upon, mandating SEC registration for advisers with $150 million or more in assets under management and creating Form PF reporting requirements designed to enable systemic risk monitoring.

The compliance landscape for hedge funds differs meaningfully from that facing private equity or venture capital funds. While all alternative investment advisers must address core Investment Advisers Act requirements including Form ADV disclosure, compliance programs, and books and records maintenance, hedge fund advisers confront additional obligations stemming from their trading activities. Short selling regulations under Regulation SHO, market manipulation prohibitions, insider trading prevention, best execution requirements, and trade allocation policies create compliance challenges specific to actively traded liquid portfolios. Hedge funds marketing to retail investors through liquid alternative structures face additional Marketing Rule requirements and distribution compliance considerations.

This article examines the comprehensive regulatory framework applicable to hedge fund advisers, addresses trading-specific compliance requirements, and provides practical guidance for implementing effective compliance programs that enable funds to operate successfully while managing regulatory risk.

SEC Registration and the Investment Advisers Act Framework

The Investment Advisers Act of 1940 establishes the foundational regulatory structure governing hedge fund advisers. Understanding registration requirements, exemptions, and the obligations that follow registration provides the starting point for hedge fund compliance.

Registration Thresholds and Requirements

Investment advisers providing advice regarding securities for compensation must register with either the Securities and Exchange Commission or state securities regulators unless they qualify for an exemption. The dividing line between SEC and state registration depends primarily on assets under management. Advisers with at least $100 million in assets under management generally register with the SEC, while smaller advisers register with states. Advisers with $100-150 million in AUM may choose SEC or state registration depending on state law requirements.

For hedge fund advisers, the private fund adviser exemption was eliminated by Dodd-Frank, requiring registration once the adviser crosses the applicable AUM threshold. Advisers managing only venture capital funds may claim the venture capital fund adviser exemption, but this exemption does not apply to hedge fund strategies. The family office exemption excludes certain family offices from registration requirements, but this exemption has specific conditions regarding family client definitions and cannot be relied upon by typical hedge fund structures.

The registration process requires filing Form ADV through the Investment Adviser Registration Depository system. Form ADV Part 1 collects operational information about the adviser's business, while Part 2 provides narrative disclosure serving as the adviser's brochure to clients. The filing process typically takes several weeks from initial submission to approval, as SEC staff review filings for completeness and consistency. Advisers should file well before the date they intend to begin operations as registered advisers.

Form ADV Disclosure Requirements

Form ADV Part 1 requires detailed information about the adviser's business operations. Schedule D collects information about owners, control persons, and certain service providers. Section 7.B, completed by private fund advisers, requests fund-level information for each advised private fund including identification information, fund type classification, assets under management, strategy description, and beneficial ownership information. Hedge fund advisers typically classify funds as "hedge funds" under the Form ADV taxonomy, distinguishing them from private equity funds, real estate funds, and other private fund types.

Form ADV Part 2 requires plain English narrative disclosure about the adviser's business practices. Item 4 addresses advisory business including ownership structure, types of services offered, and assets under management broken down by client type. Hedge fund advisers describe investment strategies employed, including long/short equity, global macro, relative value, event-driven, or other approaches. The description should provide investors with sufficient detail to understand the nature of the strategies without revealing proprietary information.

Items 5 and 6 address fees and performance-based compensation. Hedge fund advisers typically charge management fees of 1-2 percent of assets under management and performance fees of 15-25 percent of investment profits, subject to high-water marks. Form ADV must disclose fee calculation methodologies, timing of fee payments, whether fees are negotiable, and any fee rebates or reductions offered to certain investors. Performance fee disclosure should explain high-water mark mechanics, crystallization periods, and any hurdle rates applied.

Item 8 requires description of methods of analysis, investment strategies, and material risks. This item creates disclosure obligations specific to hedge fund trading activities. Advisers must describe security analysis methodologies, whether fundamental or technical analysis drives decisions, sources of information and research utilized, and material investment risks including leverage risk, short selling risk, derivatives risk, liquidity risk, and counterparty risk. The disclosure should be tailored to actual strategies rather than using generic risk descriptions.

Item 11 addresses code of ethics, participation or interest in client transactions, and personal trading. Hedge fund advisers must describe their codes of ethics governing personal securities transactions by access persons, policies addressing when the adviser or related persons may invest in securities recommended to or purchased for clients, and practices regarding principal or agency cross transactions. Many hedge funds permit portfolio managers and other personnel to maintain personal investment accounts subject to pre-clearance, reporting, and blackout provisions designed to prevent conflicts or unfair advantages.

Form PF: Systemic Risk Reporting for Hedge Funds

Form PF represents one of the most significant post-crisis regulatory innovations affecting hedge funds. The form collects confidential information about private fund operations, exposures, leverage, and liquidity for use by the Financial Stability Oversight Council in monitoring systemic risk. Understanding Form PF requirements and implementing data collection processes to support accurate reporting represents a major compliance undertaking for larger hedge fund advisers.

Filing Thresholds and Timing

Form PF filing obligations depend on an adviser's regulatory assets under management in private funds and hedge funds specifically. All private fund advisers with at least $150 million in private fund AUM must file Form PF, completing at least Section 1 which requests basic information applicable to all filers. Advisers with $1.5 billion or more in hedge fund assets under management qualify as large hedge fund advisers and must also complete Section 2 with substantially more detailed hedge fund information. Large hedge fund advisers file quarterly within 60 days after calendar quarter end, while smaller advisers file annually within 120 days after fiscal year end.

The classification of funds as hedge funds versus other private fund types determines whether Section 2 applies. Form PF defines hedge funds as private funds that can use leverage other than short-term financing, that can sell securities short, or that can enter into derivatives other than for hedging or as substitutes for physical positions. This broad definition encompasses most liquid alternative strategies but excludes traditional long-only private equity and venture capital funds that do not employ these techniques.

Section 1: Basic Reporting for All Filers

Section 1 of Form PF applies to all private fund advisers required to file, requesting information about each private fund advised. Question 6 addresses fund identification and classification, including fund name, identification numbers, strategy classification, and parallel fund relationships. Advisers classify each fund's predominant strategy from categories including long/short equity, global macro, event-driven, relative value, multi-strategy, and other hedge fund strategies. Accurate strategy classification provides regulators with understanding of hedge fund industry composition and strategy trends.

Questions 7 through 16 request financial information about each fund including net asset value, investor flows during the reporting period, fund borrowings and repurchase agreements, investment positions broken down by asset class and geography, derivatives exposures measured by notional amounts and market values, and counterparty exposures. This information provides regulators with visibility into fund size, investor activity, leverage utilization, portfolio composition, and interconnectedness with financial institutions.

Section 2: Enhanced Reporting for Large Hedge Fund Advisers

Section 2 of Form PF applies specifically to large hedge fund advisers with at least $1.5 billion in hedge fund AUM. This section demands substantially more detailed and granular information intended to enable systemic risk assessment. The information is reported both at the aggregate level across all hedge funds advised and for qualifying hedge funds, defined as hedge funds with at least $500 million in net assets.

Question 17 addresses basic information about each qualifying hedge fund including gross and net asset values, investor concentration showing the percentage of NAV represented by the largest beneficial owners, withdrawal rights and liquidity terms available to investors, and gates or other restrictions on withdrawals. This information helps regulators assess whether large hedge funds face potential redemption risks that could necessitate rapid asset liquidations during stress periods.

Questions 18 through 23 focus on exposures, risk metrics, and operational details. Question 18 requests portfolio composition showing long and short exposures broken down by major asset classes including equity, fixed income, commodities, currencies, and derivatives. Question 19 addresses financing arrangements including borrowing amounts from different counterparty types, the value of assets used as collateral, and the types of collateral posted. Question 20 requests exposure to major counterparties including prime brokers, swap dealers, and securities lending counterparties.

Question 21 collects risk metrics including Value at Risk calculations, stress testing results, and exposures to certain risk factors. Advisers report VaR at multiple confidence levels using their internal risk models or standardized approaches. Stress testing shows how portfolios would perform under specified hypothetical scenarios including equity market crashes, credit spread widening, and significant moves in interest rates or currencies. Question 22 addresses trading and clearing through registered entities, providing visibility into hedge funds' use of central clearing and exchange trading.

Data Collection Challenges and Implementation

Form PF reporting creates substantial operational challenges for hedge fund advisers. The granular position-level data required by Section 2 must be aggregated from portfolio management systems, prime broker reports, and fund accounting records. Asset class classifications must map consistently to Form PF categories, which may differ from classifications used in internal systems. Derivatives must be categorized by underlying asset class and notional amounts calculated using Form PF specifications. Collateral values and financing terms must be extracted from prime broker margin statements and derivative collateral arrangements.

Most large hedge fund advisers implement dedicated Form PF reporting infrastructure. This may include data warehouses aggregating position data from multiple sources, transformation logic mapping internal classifications to Form PF categories, calculation engines computing derived fields and aggregations, validation controls identifying potential reporting errors, and workflow systems managing the quarterly reporting process. Technology vendors offer Form PF solutions, but substantial customization is typically required to accommodate specific adviser operations and data sources.

Smaller advisers filing only Section 1 face less intensive data requirements but still must implement processes to collect required information accurately. Many smaller advisers compile Form PF using spreadsheet tools, extracting position data from portfolio management systems and manually aggregating information. The annual filing schedule for smaller advisers provides more time for data collection but requires maintaining institutional knowledge of the reporting process year-over-year despite long gaps between filings.

Short Selling Regulations and Regulation SHO

Short selling represents a core hedge fund strategy enabling managers to profit from securities they expect to decline in value and to hedge long exposures. However, short selling faces specific regulations designed to prevent abusive practices and maintain orderly markets. Regulation SHO, adopted by the SEC in 2005 and amended subsequently, establishes the principal framework governing short sales.

Locate Requirements

Regulation SHO requires broker-dealers to have reasonable grounds to believe that a security can be borrowed so it can be delivered on the settlement date before effecting a short sale. This "locate" requirement prevents naked short selling where shares are sold short without arrangements to borrow them, which can lead to settlement failures. The rule applies to broker-dealers executing short sales, but hedge funds must understand the requirements as they affect ability to establish short positions.

Prime brokers typically handle locates for hedge fund short sales through their stock loan desks. When a hedge fund enters a short sale order, the prime broker's systems check whether shares are available to borrow. If shares are located, the broker approves the short sale. If shares are unavailable or very difficult to borrow, the broker may reject the order or warn the fund about potential difficulties delivering shares at settlement. Hard-to-borrow stocks may be available for shorting but at high borrow costs reflecting scarcity.

Hedge funds must maintain awareness of locate status, particularly for concentrated short positions in small-cap or thinly traded stocks. A stock's locate status can change rapidly based on borrowing demand from other short sellers and lending supply from beneficial owners. If borrows become unavailable and existing borrows are recalled, hedge funds must cover short positions or face mandatory buy-ins when shares cannot be delivered. Compliance personnel should ensure portfolio managers understand borrow markets and adjust position sizing appropriately for hard-to-borrow securities.

Close-Out Requirements

Regulation SHO includes close-out requirements for short positions where settlement fails. If a short sale results in a fail-to-deliver position that persists for 13 consecutive settlement days, the regulation requires the broker to purchase securities to close out the fail position. This close-out requirement prevents persistent fails that could indicate manipulative naked short selling. The requirement applies to the broker-dealer with the fail position, but hedge funds may be affected if their short positions result in fails requiring forced close-outs.

Threshold securities lists identify securities with significant fails to deliver, subjecting them to more stringent restrictions. Securities appearing on the threshold list for five consecutive settlement days become subject to the close-out requirement. Additionally, broker-dealers cannot accept short sale orders in threshold securities from customers unless the customer has borrowed the securities or entered into a bona fide arrangement to borrow. These requirements essentially prevent new short selling in chronically failed securities until fails are resolved.

Short Sale Marking and Reporting

Regulation SHO requires that all sell orders be marked as "long," "short," or "short exempt." This marking enables regulators and markets to monitor short selling activity. Long sales involve selling securities the seller owns. Short sales involve selling securities not owned by the seller. Short exempt sales are short sales exempt from certain restrictions, such as short sales executed by market makers in connection with bona fide market making.

Hedge funds must accurately mark sell orders when transmitting them to brokers. Order management systems typically include marking functionality, but traders and portfolio managers must understand marking requirements and apply them correctly. Mismarking short sales as long can violate Regulation SHO and create regulatory violations for both the fund and the executing broker. Compliance programs should include training on order marking requirements and periodic testing of order marking accuracy.

Volcker Rule: Proprietary Trading and Covered Fund Restrictions

The Volcker Rule, implemented under Section 619 of the Dodd-Frank Act, prohibits banking entities from engaging in proprietary trading and from acquiring ownership interests in or sponsoring hedge funds and private equity funds with certain exceptions. While the Volcker Rule primarily regulates banking entities rather than hedge funds directly, hedge funds with banking entity relationships must understand how the rule affects capital raising, prime brokerage, and service provider arrangements.

Covered Fund Definition and Banking Entity Restrictions

The Volcker Rule defines "covered funds" broadly to include any issuer that would be an investment company under the Investment Company Act but for Section 3(c)(1) or 3(c)(7) exemptions. This definition encompasses most U.S. hedge funds, which typically rely on these exemptions to avoid Investment Company Act registration. Banking entities are generally prohibited from owning interests in covered funds beyond de minimis amounts and from having certain relationships with covered funds they organize and offer.

Banking entities include insured depository institutions, their holding companies, companies treated as bank holding companies, and foreign banking organizations. The prohibition extends to any company controlled by a banking entity. As a result, banks, bank holding companies, and their affiliates generally cannot invest in hedge funds or sponsor hedge fund structures, subject to specific exemptions and transition rules.

Exemptions and Permitted Activities

The Volcker Rule includes several exemptions allowing banking entities to engage in otherwise prohibited activities under specified conditions. The underwriting exemption permits banking entities to acquire and retain ownership interests in connection with underwriting activities where the banking entity makes a good faith commitment to sell the interests. The market-making exemption allows positions taken in connection with market-making-related activities that meet specified requirements. The risk-mitigating hedging exemption permits transactions designed to reduce specific risks arising from individual positions or aggregated positions.

The seeding exemption allows banking entities to invest in covered funds they organize and offer for purposes of establishing a track record, subject to limitations. Banking entities may make seed investments up to certain amounts, but must reduce ownership to below specified percentages within prescribed time periods. The exemption includes conditions regarding investment size, holding period, and the entity's efforts to market and sell interests in the fund to unaffiliated investors.

The asset management exemption permits banking entities to organize and offer hedge funds as asset management services to customers, provided certain conditions are met. These conditions include providing the service to customers, ensuring the banking entity's name does not appear in the fund's name in certain ways, and prohibiting certain transactions and relationships between the banking entity and the covered fund. Even when organizing and offering funds under this exemption, banking entities remain subject to ownership restrictions limiting investment in the funds.

Implications for Hedge Fund Managers

Hedge fund managers without banking entity affiliation generally face limited direct Volcker Rule compliance obligations, as the rule primarily restricts banking entities rather than funds themselves. However, the rule creates practical implications affecting fundraising, prime brokerage, and service provider relationships. Banks and bank-affiliated entities represent significant potential sources of hedge fund capital, but Volcker restrictions limit their ability to invest. Hedge fund managers marketing to bank-affiliated investors must understand Volcker restrictions and available exemptions to structure investments appropriately.

Prime brokerage relationships with bank-affiliated primes may face Volcker implications. Banking entities providing prime brokerage services must ensure arrangements do not constitute prohibited covered fund relationships. Prime brokers cannot guarantee or assume losses of covered funds, creating considerations for margin financing and other arrangements. Hedge fund managers should discuss Volcker compliance with prime brokers to ensure arrangements structure appropriately.

Marketing Rule Compliance for Hedge Funds

The SEC's Marketing Rule, which became effective in 2021, substantially revised the regulatory framework governing investment adviser advertising and testimonials. The rule replaced previous per se prohibitions on testimonials and certain performance presentations with principles-based requirements focused on preventing materially misleading communications. Hedge fund advisers marketing to both institutional and retail investors must understand the rule's requirements and implement compliant marketing practices.

Advertisement Definition and Scope

The Marketing Rule defines "advertisement" broadly to include any direct or indirect communication an investment adviser makes to more than one person offering advisory services or promoting advisory capabilities. This expansive definition encompasses traditional advertisements including print ads, radio and television commercials, and billboard advertising, as well as electronic communications including websites, social media posts, and emails sent to multiple recipients, presentations to groups of potential investors, marketing materials left with prospects, and pitch books distributed to multiple recipients.

One-on-one communications with individual prospective investors generally fall outside the advertisement definition and therefore outside Marketing Rule requirements. However, advisers must carefully analyze communications to determine whether they constitute one-on-one communications or advertisements. Sending the same email to multiple recipients constitutes an advertisement even if sent to each recipient individually rather than as a group email. Posting information on a website accessible to multiple visitors constitutes an advertisement.

General Prohibitions on Misleading Content

The Marketing Rule prohibits advertisements that include any untrue statement of material fact or that are otherwise materially misleading. Whether an advertisement is materially misleading depends on the overall context, considering the sophistication of the intended audience, whether information is presented in a format that obscures or impedes understanding, and whether additional disclosures could eliminate the misleading impression. This principles-based standard requires advisers to evaluate marketing materials holistically rather than checking boxes on specific requirements.

Specific prohibitions address practices the SEC considers inherently misleading. Advertisements cannot include unsubstantiated claims regarding the benefits or features of advisory services, present favorable information without providing fair and balanced treatment of material risks and limitations, include material information in footnotes without prominently disclosing it, or make unsubstantiated claims about the expertise or qualifications of the adviser or its personnel. These prohibitions require hedge fund marketers to present balanced information rather than only highlighting positive aspects while minimizing or obscuring negative information.

Performance Advertising Requirements

Hedge fund performance represents a central element of marketing communications, making performance advertising requirements particularly important. The Marketing Rule permits performance advertising subject to specific conditions designed to ensure performance is presented in a manner that is not misleading. Gross and net performance must both be presented, with net performance calculated after deduction of all fees and expenses. Presenting only gross performance without net performance violates the rule because gross performance overstates returns that investors actually receive.

Performance calculations must be computed using the time-weighted rate of return methodology or internal rate of return methodology appropriate for the fund structure. Time-weighted returns better reflect manager skill by removing the impact of cash flows, making them appropriate for liquid hedge funds with frequent subscriptions and redemptions. Internal rate of return may be more appropriate for certain fund structures but can be affected by contribution and distribution timing. The rule requires disclosure of the calculation methodology used.

Related performance requirements prohibit cherry-picking favorable time periods or portfolios. When presenting performance for any portfolio, the adviser must include performance for all portfolios with substantially similar investment policies, objectives, and strategies throughout the time period shown, subject to limited exceptions. Excluding certain portfolios from performance presentations because they underperformed creates a misleading impression of overall strategy performance. The substantially similar standard focuses on whether portfolios follow comparable strategies that investors would consider equivalent rather than requiring identical portfolios.

Extracted performance showing the performance of a subset of investments drawn from a portfolio rather than the portfolio as a whole faces additional requirements. Extracted performance can be highly misleading if it highlights successful investments while ignoring unsuccessful ones. The rule permits extracted performance only if the adviser maintains records supporting the extraction methodology and can demonstrate that the extracted performance fairly represents the skill of the adviser. Many advisers avoid extracted performance altogether given the compliance burden and potential for challenge.

Testimonials and Endorsements

The Marketing Rule permits testimonials and endorsements but requires specific disclosures and conditions. Testimonials and endorsements include statements about advisory services, performance, or any aspect of the adviser made by current clients, investors, or other persons. When advertisements include testimonials or endorsements, the adviser must disclose that the testimonial was given by a current client or investor if applicable, that cash or non-cash compensation was provided for the testimonial if applicable, and any material conflicts of interest on the part of the person providing the testimonial.

Advisers must have a reasonable basis for believing testimonials and endorsements are not materially misleading. This requires evaluating whether the testimonial or endorsement would lead a reasonable investor to reach conclusions contrary to fact based on the experience of the person providing the statement. Testimonials highlighting exceptional returns during favorable market periods without context about typical results could be misleading if they create unrepresentable impressions about likely future performance.

Compliance and Recordkeeping

The Marketing Rule includes books and records requirements specific to advertisements. Advisers must retain copies of all advertisements disseminated, including the dates of first and last use. For advertisements containing performance results, advisers must maintain the information supporting the performance shown, including underlying calculations and records substantiating statements made. These records must be maintained for five years from the last use of the advertisement, with the first two years in an easily accessible place.

Hedge fund advisers should implement advertisement approval processes ensuring marketing materials receive compliance review before dissemination. Compliance personnel should review materials for compliance with Marketing Rule requirements including balanced presentation, required disclosures, supportable performance claims, and appropriate testimonial disclosures. Maintaining centralized advertisement archives aids recordkeeping compliance and enables consistent review of marketing messages across the organization.

Insider Trading Prevention and Information Barriers

Insider trading represents one of the most serious compliance risks facing hedge funds. Federal securities laws prohibit trading on the basis of material nonpublic information, and violations can result in severe penalties including disgorgement, civil penalties, criminal prosecution, and reputational harm that may be terminal for investment managers. Effective insider trading compliance programs represent essential elements of hedge fund compliance frameworks.

Insider Trading Legal Framework

Section 10(b) of the Securities Exchange Act and Rule 10b-5 prohibit fraudulent conduct in connection with securities purchases or sales. While these provisions do not explicitly mention insider trading, courts have interpreted them to prohibit trading based on material nonpublic information when the trader owes a duty of trust or confidence to the information source. The classical theory of insider trading applies when a corporate insider trades while aware of material nonpublic information about the company whose securities are traded. The misappropriation theory applies when a person trades based on material nonpublic information obtained through breach of duty to the source of the information.

Information is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision. Material information includes information that would likely affect the company's stock price if disclosed publicly. Examples include earnings information before announcement, merger or acquisition discussions, significant contracts or business developments, regulatory actions, and management changes. Information is nonpublic if it has not been effectively communicated to the marketplace in a manner making it available to investors generally.

Expert Network and Research Provider Risks

Hedge funds frequently utilize expert networks, industry consultants, and specialized research providers to gather information about industries, companies, and market developments. These research activities create insider trading risks if experts provide material nonpublic information they obtained through corporate positions or confidential relationships. Several prominent insider trading enforcement actions have involved hedge funds allegedly receiving inside information through expert network consultations.

Compliance programs should address expert network and research provider relationships through several mechanisms. Due diligence on research providers and expert networks should assess their compliance controls and training programs. Consultation agreements should include representations that experts will not disclose material nonpublic information and that information shared was not obtained through breach of confidentiality obligations. Analysts and portfolio managers using expert networks should receive training on insider trading risks and red flags indicating potential receipt of inside information.

When hedge fund personnel receive information that may be material nonpublic information, they should immediately consult with compliance personnel. The fund should implement watch lists and trading restrictions for securities where personnel may possess material nonpublic information. These restrictions prevent trading until the information becomes public or is no longer material. Documentation of the basis for trading decisions provides important evidence that trades were not based on inside information.

Information Barriers and Chinese Walls

Multi-strategy hedge funds or firms operating both hedge funds and other business lines may implement information barriers, sometimes called Chinese walls, to prevent information flows between groups. Information barriers allow different parts of the organization to possess different information and make trading decisions independently. For example, a firm might separate its long/short equity team from its private equity team to prevent sharing of material nonpublic information about companies being considered for private equity transactions.

Effective information barriers require physical and electronic separation, with personnel working in different areas with separate IT systems, communication restrictions preventing discussions between separated groups, different reporting structures with separate management, and trading controls preventing one group from seeing the other group's positions. Information barriers must be carefully designed and consistently maintained, as partial or inconsistent barriers may be ineffective. Compliance should regularly monitor information barrier effectiveness and train personnel on their obligations.

Best Execution and Trade Allocation

Investment advisers owe fiduciary duties to clients including duties to seek best execution of client trades and to allocate investment opportunities fairly among clients. These duties create compliance obligations specific to hedge fund trading operations.

Best Execution Obligations

The duty of best execution requires advisers to seek the most favorable terms reasonably available under the circumstances when executing client securities transactions. Best execution encompasses not only the security price but also the total cost or proceeds of the transaction considering commissions, execution quality, settlement speed, and likelihood of execution. The duty applies both to agency trades where the adviser directs trades to brokers and to principal trades where the adviser trades with clients directly or through affiliates.

Hedge fund advisers should establish best execution policies documenting how the adviser seeks best execution. Factors considered may include commission rates and execution fees, execution quality and price improvement, broker capabilities and service quality, broker research and other services provided, and execution venue liquidity and reliability. The adviser should conduct periodic reviews of execution quality, comparing transaction costs across brokers and evaluating whether selected brokers provide competitive execution.

Commission sharing arrangements and soft dollar practices require particular attention. Section 28(e) of the Securities Exchange Act provides a safe harbor permitting advisers to pay higher commissions in exchange for research and brokerage services that benefit clients. To qualify for the safe harbor, the services received must constitute brokerage or research services, the commissions paid must be reasonable in relation to the services received, and the adviser must make a good faith determination regarding the reasonableness and benefit. Services falling outside the safe harbor such as travel, office equipment, or general business services cannot be paid for with client commissions without violating best execution duties.

Trade Allocation Policies

When hedge fund advisers manage multiple funds or accounts, they must allocate investment opportunities fairly among clients. Trade allocation issues arise when limited investment opportunities exist or when aggregated orders are partially filled. The adviser must establish allocation methodologies that treat clients equitably without systematically favoring certain clients.

Common allocation approaches include pro rata allocation based on client size, rotating allocation giving priority to different clients on a rotating basis, or allocation based on client strategy mandates and objectives. The selected approach should be documented in compliance policies and applied consistently. Deviations from established allocation methodologies require documentation explaining the reasons and demonstrating the allocation was fair under the circumstances.

Portfolio manager personal trading creates potential allocation conflicts if portfolio managers compete with clients for limited investment opportunities or if portfolio managers might structure client trades to benefit personal positions. Compliance programs should address personal trading through pre-clearance requirements for transactions in securities held or being considered for client portfolios, blackout periods preventing trades in securities during specified periods before or after client trades, and reporting requirements enabling compliance monitoring of personal trades. Some advisers prohibit personal trading in individual securities entirely to eliminate potential conflicts.

Custody Rule Compliance

The Investment Advisers Act Custody Rule imposes specific requirements on advisers with custody or possession of client funds or securities. Hedge fund advisers typically have custody under the rule's broad definition, which includes having authority to withdraw client assets or serving as general partner of a limited partnership. The Custody Rule requires annual audits and surprise examinations unless the adviser qualifies for specific exemptions.

Custody Definition and Triggers

Advisers have custody if they hold client funds or securities, have authority to obtain possession of client funds or securities, or have the ability to access client assets. General partners of hedge fund limited partnerships have custody because they can direct fund assets. Advisers with authority to withdraw fees from client accounts have custody. Advisers holding client securities in adviser-named accounts have custody. The definition is intentionally broad to capture arrangements where advisers could access client assets.

Surprise Examination and Audit Requirements

The Custody Rule generally requires advisers with custody to engage an independent public accountant to conduct a surprise examination of client funds and securities at least annually. The accountant verifies that client assets exist and are held in appropriate accounts. Surprise examinations involve unannounced visits to the adviser during which the accountant confirms asset holdings and account details.

Hedge funds audited by independent public accountants in accordance with GAAP audit standards satisfy the surprise examination requirement through the annual fund audit. The audited financial statements must be distributed to limited partners within 120 days after fiscal year end, or within 180 days if the fund is a fund of funds. This audit exemption is the primary basis on which most hedge fund advisers comply with the Custody Rule, as it eliminates the need for separate surprise examinations if the funds receive timely audited financial statements.

Compliance Program Implementation

Rule 206(4)-7 under the Advisers Act requires registered investment advisers to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and rules. The rule also requires advisers to designate a chief compliance officer responsible for administering the compliance program and conducting an annual review of program adequacy and effectiveness.

Core Compliance Program Elements

Effective hedge fund compliance programs address multiple topic areas specific to trading operations. Portfolio management processes should document investment decision making procedures, including research and analysis requirements, portfolio construction guidelines, and position limit frameworks. Trading allocation policies establish how trades are allocated among funds and accounts when multiple clients have similar mandates. Personal securities transaction policies govern employee trading with pre-clearance, blackout, and reporting requirements.

Best execution policies document procedures for seeking favorable trade execution including broker selection criteria, commission management, and execution quality review processes. Valuation policies establish procedures for pricing portfolio securities including pricing source hierarchies, fair valuation methodologies for illiquid securities, and valuation committee procedures. Marketing and performance advertising policies ensure compliance with the Marketing Rule including performance calculation methodologies, required disclosures, and advertisement approval processes.

Books and records policies address Investment Advisers Act recordkeeping requirements including trade documentation, communications retention, and records supporting fee calculations and performance reporting. Privacy and information security policies comply with Regulation S-P and protect client information from unauthorized access or disclosure. Business continuity and disaster recovery planning addresses operational resilience and procedures for maintaining critical operations during disruptions.

Chief Compliance Officer Responsibilities

The chief compliance officer serves as the primary compliance leader responsible for program design, implementation, and oversight. The CCO should be competent and knowledgeable regarding the Advisers Act and relevant regulations, empowered with authority and resources sufficient to execute compliance responsibilities, positioned with appropriate independence from portfolio management to provide objective oversight, and granted access to senior management and boards to escalate issues and report on compliance matters.

Hedge fund CCOs face particular challenges given the pace and complexity of trading operations. The CCO must understand trading strategies and instruments sufficiently to identify compliance risks while maintaining independence from investment decision making. The CCO coordinates with operations, technology, and legal personnel to ensure compliance controls embed effectively in business processes. The CCO also serves as the primary contact for regulatory examinations and inquiries, requiring readiness to respond to SEC requests and explain compliance approaches.

Annual Review and Program Testing

The CCO must conduct an annual review of the compliance program's adequacy and effectiveness, presenting a written report to senior management or the board. The annual review should assess whether policies remain reasonably designed given current business activities and regulatory requirements, evaluate whether the adviser and employees follow established procedures, identify compliance issues or violations that occurred during the year, recommend policy enhancements or additional controls, and consider regulatory developments requiring policy updates.

Testing specific controls provides evidence of program effectiveness. Sample-based testing may examine trade allocation documentation to verify allocations follow stated policies, review personal trading pre-clearance records to ensure employees obtained required approvals, analyze marketing materials to verify compliance with advertising requirements, and test exception reports and monitoring tools to confirm they function as designed. Testing results inform the annual review and identify areas requiring enhanced controls or additional training.

Key Takeaways

• SEC registration triggers comprehensive compliance obligations: Hedge fund advisers with $150 million or more in AUM must register and implement written compliance programs, maintain specified books and records, and submit to SEC examination authority.
• Form PF reporting demands substantial operational infrastructure: Large hedge fund advisers report detailed portfolio, leverage, and risk information quarterly, requiring sophisticated data aggregation and reporting systems to compile required information accurately.
• Short selling regulations affect daily trading operations: Regulation SHO's locate and close-out requirements restrict short selling practices, requiring hedge funds to coordinate with prime brokers on stock loan availability and comply with threshold security restrictions.
• The Volcker Rule limits bank-affiliated capital: Banking entities face restrictions on investing in hedge funds and providing certain services, affecting fundraising from bank-affiliated investors and necessitating compliance coordination with bank-affiliated prime brokers.
• The Marketing Rule requires balanced performance presentation: Hedge fund marketing materials must present both gross and net performance, include related portfolios without cherry-picking, provide required testimonial disclosures, and avoid materially misleading statements.
• Insider trading prevention demands robust policies: Expert network consultations, information barriers, watch lists, and trading restrictions help hedge funds prevent trading based on material nonpublic information and avoid severe enforcement consequences.
• Best execution and allocation obligations require documented policies: Fiduciary duties mandate seeking favorable execution terms and allocating opportunities fairly among clients, with compliance programs documenting methodologies and monitoring adherence.
• The Custody Rule audit exemption facilitates compliance: Annual GAAP audits distributed timely to investors satisfy Custody Rule requirements, eliminating separate surprise examination obligations for most hedge funds.
• Chief compliance officers need trading operations expertise: Effective hedge fund CCOs understand trading strategies, instruments, and operational processes sufficiently to identify compliance risks while maintaining independence from investment decisions.
• Compliance programs must evolve with regulatory developments: Regular monitoring of SEC guidance, examination priorities, and enforcement actions informs program updates ensuring compliance frameworks remain current as requirements change.