“We at the SEC are committed to pulling back the curtain on hedge fund operations and taking a close look at their activity. We are developing a variety of initiatives to do that involving greater specialization and expertise, improved technological tools to track and analyze trading, better coordination among regulators and law enforcement, new legislative initiatives, and other means to address these areas.” - Chairman Schapiro, NASD

Examinations

Sweep examinations of the hedge fund industry have not been commonplace in the past, but more of them are expected, and they will be performed by better-trained SEC staff. One of the SEC’s regional directors, George Canellos, has said staff will “focus on firms with particular profiles that have been determined to pose a greater risk of violating the law,” which means that many more firms like yours will be examined than have been in the past. His comment breaks from the traditional examination process, where cause exams triggered by specific allegations have been the norm.

The regulations

There are a few key regulations that guide how email and other electronic communications must be handled.

SEC 17a-4:

“Store Electronic Records on non-rewritable, non erasable format. Records retention; ability to capture, store and manage correspondence/communications regarding business transactions SEC 17a-4 affects financial services such as brokers, dealers, exchange members. Gives retention periods for securities, broker/dealer records; stipulates requirements if electronic record-keeping systems are used.”

Meaning:

A copy of each electronic record sent and received must be kept in a repository from where it cannot be deleted or altered. This repository must be indexed and searchable, and in addition each record must be date/time stamped.

• An indelible copy of each data record must be stored on non-erasable media.
• This data must be stored offsite, and backup copies maintained.
• Written retention policies must be in place, and it must be clear that they are being enforced.
• Data must be searchable and indexed.

NASD 3010 & NYSE 342:

Requires member organizations to establish and maintain a system of supervision, demonstrate that their system is complete, evaluate it on a regular basis and ensure that it remains effective.

NASD & NYSE affects members of the National Association of Securities Dealers (NASD) and New York Stock Exchange (NYSE). Record keeping requirements are concerning all email communications.

Meaning:

You must have a system and procedure in place to manage these electronic records. This system should supervise and sample the records, and the appointed supervisor must be able to review them for noncompliant language. This supervision itself must be documented and controlled.

Instant Messaging

Mary Schapiro, Chairman, NASD, has been quite clear about the need to track instant messages:

“Firms have to remember that regardless of the informality of instant messaging, it is still subject to the same requirements as e-mail communications and members must ensure that their use of instant messaging is consistent with their basic supervisory and record keeping obligations.”

Insider Trading

There is a belief that insider trading is almost systemic within the hedge fund industry, and the SEC intends to clamp down hard on it. The Galleon case, in which 21 people have been charged, has set the tone for the new SEC.

It is already a requirement that personal and firm trading accounts are monitored, and it is expected that further monitoring of portfolio managers and analysts will be necessary. Moreover, identification of meeting attendees and topics of the conversations will have to be documented. Although regulators will focus on past trades, they will also be monitoring electronic communications for potential problems (such as communications regarding upcoming deals). Firms will be asked to conduct comprehensive training annually, and to keep detailed records of attendance.