Hedge Fund Compliance Chapter 10: Six Common Compliance Mistakes and How to Avoid Them
Chapter 10 of Scharfman’s book is one of the most practical chapters so far. Instead of explaining rules or regulations, it focuses on six real mistakes hedge funds make with their compliance programs. Let me walk you through all six.
Pitfall 1: Small Funds Trying to Look Like Big Funds
Imagine you launch a small hedge fund. Maybe $25 million in assets, four employees. Your CCO also handles three other jobs because that is all you can afford.
Your investors also invest in billion-dollar funds with entire compliance departments. So you feel pressure to match that. You grab a compliance manual template designed for a large fund. Now your policies say you will review 30% of all employee emails every month. Your CCO starts strong, actually does it for the first couple months. Then reality hits. Other priorities pile up. The email reviews fall behind.
Now you have a real problem. Not just a gap in monitoring, but a violation of your own policies. Regulators care a lot about the gap between what your policies say and what you actually do. Scharfman calls this the “policy/practice gap.”
Most investors understand that a $25 million fund will not have the same compliance setup as a $1 billion fund. What is not fine is pretending you do and then failing to deliver on your own promises.
Pitfall 2: Underspending on Compliance
This is the opposite problem, and it hits both small and large funds.
For large funds, the common version is falling behind on compliance training. A fund raises a lot of money quickly, hires new people across multiple offices, but compliance resources do not grow at the same pace. New hires do not get trained on time. Senior management is focused on putting capital to work and compliance budgets lag.
For smaller funds, underspending often shows up in cybersecurity. Penetration testing means simulating attacks on your systems to find weaknesses. It also includes social engineering tests, where someone tries to trick employees into giving up sensitive information.
Scharfman tells a great story here. In 2013, a fraudster called the CFO of Fortelus Capital Management in London on a Friday afternoon. The caller claimed to be from the fund’s bank, said there was suspicious activity, and asked the CFO to generate security codes to “cancel” 15 fraudulent payments. The CFO did it. The fraudster stole about $1.2 million. The CFO was fired and the fund sued him.
Textbook social engineering. It worked because the fund had not invested enough in training people to recognize these scams.
Pitfall 3: No Independent Compliance Reporting
This one is about organizational structure.
In some hedge funds, the CCO does not report directly to senior management. Instead, the CCO reports to a Chief Operating Officer, who then reports to the top. This creates a filter. Compliance issues can get downplayed or lost before they reach the people who make decisions.
Think of it like a game of telephone. The CCO spots a risk, tells the COO, and the COO decides it is not that serious. The risk goes unaddressed.
The SEC flagged this in a 2015 compliance study. They said the CCO needs enough authority to actually influence how the firm follows its policies. A direct reporting line to senior management is critical for that. Large funds have more layers where issues get stuck. Small funds blur reporting lines because people wear multiple hats. Either way, the CCO needs a clear, direct path to the top.
Pitfall 4: Outsourcing Everything
Hedge funds have access to many third-party compliance services. Consultants, law firms, outsourced CCOs, fund administrators. For a small fund, it is tempting to hand everything to outside providers and move on.
Here is the thing. The SEC has made it clear that hiring an outsourced CCO does not remove the fund’s own compliance obligations. You cannot just check a box and walk away. The fund must actively participate in managing the compliance program.
When funds hand everything off, important things get missed. Outside providers do not see your day-to-day operations. They cannot catch issues they do not know about. When you split compliance across multiple providers, coordination breaks down. Nobody has the full picture. And when something goes wrong, regulators hold the fund responsible, not the consultants.
Pitfall 5: Too Much Trust in Technology
Software can monitor trades, check employee communications, track personal account dealing, and automate training. These tools save time. But here is the problem. Once a fund invests heavily in a compliance system, there is a tendency to trust it completely and stop checking manually.
Scharfman gives a good example. Say a fund gets exposed to material nonpublic information about a specific stock. The compliance team codes a restriction into the trading system so nobody can trade that stock. But what if there was a coding error? The system shows no violations because it does not know the restriction exists. A trader executes a trade in the restricted stock. Now you have a compliance violation nobody detected.
If someone had manually checked whether the restriction was properly entered, the error would have been caught. Technology is a first line of defense, not the only line. Every automated compliance check should have a manual backup somewhere in the process.
Pitfall 6: Letting Investors Decide Your Priorities
This is the most nuanced pitfall in the chapter. Investors have become more educated about compliance. They push funds to go beyond the regulatory minimum. That is generally a good thing. But it can create a mismatch between what the fund actually needs and what investors demand.
Scharfman uses a fictional fund called “Jason Capital Management” to illustrate. This fund just finished a painful manual process of filing regulatory reports with the SEC. They know they need software to make reporting more efficient. That is their real priority.
Then a well-known cyberattack hits a different hedge fund. It gets media attention. Suddenly every investor is asking about cybersecurity. “Are you doing enough penetration testing?” The fund’s own cybersecurity is actually fine. They were not affected. Their policies are solid.
But now the fund faces a choice. Spend the compliance budget on reporting software they actually need? Or redirect it to cybersecurity upgrades they do not need, just to keep investors happy?
Compliance budgets are limited. Rushing into changes they have not properly evaluated could create new problems. The reporting issue, which is the real risk, goes unaddressed.
Funds should listen to investor feedback. But they should not let investor anxiety driven by headlines override their own assessment of what compliance risks actually matter.
Chapter Summary
Chapter 10 is a reality check. The six pitfalls Scharfman describes are not exotic edge cases. They are common, everyday mistakes that funds of all sizes make.
Small funds try to copy big fund compliance programs and cannot keep up. Growing funds forget to grow their compliance teams too. CCOs get buried under layers of management and lose their voice. Funds outsource compliance and stop paying attention. Technology gets trusted more than it should. And investor pressure pushes funds to spend money on the wrong things.
The thread connecting all six is balance. Good compliance is not about doing the most or spending the most. It is about doing the right things for your specific situation, with the right resources, and keeping humans involved at every step.
Other chapters in this series: