Hedge funds grapple with pros and cons of internal ethics hotlines

Hedge funds grapple with pros and cons of internal ethics hotlines
By Kristen Bischoff
Assets are returning in earnest to the hedge fund industry, yet many attempts to bring additional protective measures for investors into fund infrastructures have stalled. In fairness to hedge fund managers, assets may be returning, but certainly they are not returning at the same pace they were prior to the financial crisis, and as of yet they are not returning broadly to many managers, but rather mainly to the largest managers. Additionally, hedge funds are more expensive to run, and will likely only grow more expensive (at least for funds holding over $150m in assets) when regulatory deadlines kick in this summer.

Therefore, it has been difficult for new products that might provide additional protections for both managers and investors to gain traction within the hedge fund industry, especially as the the one-two-punch of the financial crisis and the Madoff fraud fades with distance. One product in particular that has hedge fund managers grappling with pros versus cons, is the internal, ethics hotline (sometimes termed a whistleblower hotline) which Corporate ResolutionsFounder Ken Springer says is a great tool for corporate governance, and allows firms to gather internal information on everything from unsafe work conditions, to harassment problems to suggestions for improvement. While hedge funds have overcome poor performance during the height of the financial crisis with strong returns, and greater transparency during due diligence procedures has reduced the paranoia following the Madoff fraud, the Galleon/insider trading scandal still haunts the industry in daily headlines and Springer also points out that in-house ethics hotlines may be the single best means to deter this type of activity within a firm. “Investors will likely appreciate knowing managers have a mechanism in place to deal with any allegations of impropriety.”

Internal whistleblower hotlines are not a new concept in the business world. “We just had a private equity firm move to renew their contract across 15 companies, they think it is a great compliance tool to be in front of any potentially damaging situation,” Springer told Opalesque.

Firms such as Corporate Resolutions have been running these hotlines for corporate clients for years. In fact many of these firms are currently upset because Sarbanes Oxley required many of them to put the hotlines into place and the Dodd Frank regulation could undermine that by introducing monetary incentives for employees to circumvent internal hotlines and report directly to regulatory agencies. The big push now is for regulation to require employees first exhaust internal compliance systems (such as a corporate ethics hotline) before they can go to regulatory agency hotlines.

But although hedge fund investors have expressed an interest in seeing their managers adopt such a tool, managers themselves have been slow to adopt them.

A recent case in the New York courts (Sullivan v. Harnisch) simultaneously bolsters hedge funds’ ability to push internal reporting ahead of external reporting (allows managers to require compliance officers to internally alert frauds ahead of going to a government regulatory agency), and yet also creates another roadblock by allowing fund managers the ability to fire a compliance officer in retaliation of such a report. (For an in depth analysis of this case which pitted the CCO for billion dollar fund Peconic Partners/Peconic Asset Managers against the fund’s President whom the CCO was investigating for front running fund investors on the sale of Potash Corp stock in 2008, see:Source).

For most funds “airing dirty laundry” is the biggest hurdle to the adoption of an internal ethics hotline, Springer says. Corporate Resolutions’ move to quell these fears includes working with the legal teams of firms in order to maintain information garnered as ‘privileged’, while it is vetted by the firm and counsel in tandem. The former FBI Agent also points to the fact that government agencies have a history of being lenient on businesses that can point to compliance systems meant to deter illegal activity.

He points to leniency the government has had on corporations that have had staff caught violating the Foreign Corrupt Practices Act (a law enacted in 1977 prohibiting bribery of foreign officials). “The Justice Department and the SEC are actually very forgiving to firms that have robust compliance structures in place in order to monitor that type of activity,” he says. “Perhaps hedge funds need to see a similar example in their own industry to realize the benefits of adding this to their infrastructure. After all, the best defense is a strong offense.”