The following is Part 1 of a 2-part article from Hedge Fund Legal & Compliance Digest, and features comments from OperationsInc CEO David Lewis. To view the article in its entirety, please click here.
The allocation of a hedge fund’s human resources depends upon a wide range of factors. Larger hedge funds are well-situated to employ a full operational staff, from deep compliance and legal benches to human capital and finance teams. They are also able to—and need to based on the complexity of their staffing—have an in-house human resources function. Given the relatively small size of the average hedge fund, however, a full-bore HR function usually isn’t necessary, and for a substantial number of firms is a luxury they can ill-afford.
Still, someone needs to be responsible for the functions that would normally be within the purview of an in-house HR team, including payroll, benefits management, employee conflict resolution, ensuring compliance with company policies and procedures, hiring and firing, and developing employment contracts and other administrative forms. Some firms will choose to outsource functions such as payroll and benefits management. At other firms, the burden oftentimes falls to the legal and/or compliance executives since performance of certain HR duties is subject to federal and/or state regulations. While this presents a less-expensive option for hedge funds to address HR and employment issues, when the multitasking executive inevitably becomes overextended, HR responsibilities quickly can fall to the bottom of an ever-growing to-do list.
External pressures further increase the stakes of not having a dedicated HR strategy and team in place. Recent enforcement actions demonstrate the regulator’s willingness to sanction firms for violative terms included in employment agreements. And even where the SEC doesn’t get involved, the pressure from investors, both real and perceived, is on hedge funds to ensure that employees expound a positive image, and when they don’t a traditional HR function must deal with the fallout. Additionally, federal, state and municipal laws are constantly evolving in breadth and complexity, as the recent updates to federal trade secrets laws and sick leave mandates in New York City evidence.
This article, the first in a two-part series, examines the HR functions most relevant to hedge fund managers, key laws and regulations that HR operations must contend and comply with and HR-related critical risks hedge fund managers face. The second article will look at how hedge fund managers are currently handling certain HR issues, considerations for determining when and what HR functions to outsource and best practices for hedge fund managers implementing a human resources strategy.
Essential HR Functions for Hedge Funds
Standard human resources functions at a hedge fund that require a dedicated HR professional or team, whether in-house or outsourced, include: hiring; managing and terminating employees; drafting employment and compensation agreements; payroll and benefits administration; communicating performance expectations and conducting annual reviews; setting the tone of, and expounding upon, firm values and culture; implementing and maintaining firm policies and procedures and an employee handbook; and managing employer liability and insurance.
Julie Gottshall, partner and head of Katten Muchin Rosenman’s employment law and litigation practice, explained the human capital issues at play. “HR is responsible for building the organization’s infrastructure for all employee-related issues. They decide how the HR function is going to be handled and put into place the policies that govern the employment relationships. They are responsible for overseeing the drafting of the employment agreements, implementing benefits packages, identifying applicants, interviewing and hiring individuals, managing interpersonal issues, and overseeing any performance issues that arise.”
Federal, State, and Municipal Regulations Hedge Funds Must Reckon With With Developing HR Strategies
Allan Bloom, co-head of the wage and hour practice group at Proskauer Rose and a partner in the firm’s labor and employment law department, explained that employment and HR functions encompass diverse legal issues which hedge fund managers must understand and incorporate into their HR strategy. In fact, compliance with the following laws may form the basis of a fledgling HR strategy:
- Anti-discrimination laws and regulations. Anti-discrimination statutes must be taken into consideration “when recruiting people, hiring them, promoting them or firing them. These laws outline the things you can and cannot take into consideration,” Bloom explained.
- Wage and hour laws. Generally speaking, wage and hour laws govern how to pay people and whether or not they are entitled to overtime, said Bloom. They also help firms determine how frequently, and minimum standards for how much, employees must be paid.
- Tax laws, as they apply to executive compensation. According to Bloom, “If you’re paying people and doing quasi-equity compensation or giving them a piece of the firm’s profits, a carry or something other than a straightforward salary, you need to understand the rules around doing that.”
- Background check and “ban the box” laws. Considered human rights issues, Bloom said these laws govern “what you can ask before you hire someone, and what kind of notice you have to give employees before checking their backgrounds.”
- Leaves of absence and reasonable accommodation. “From time to time, employees will request leaves of absence for health reasons or personal matters, so you need to understand [the Family Medical Leave Act and what it mandates about] what you can and cannot do,” Bloom said.
- Financial whistleblower regulations. These programs outline what firms can and cannot do should an employee report a securities violation, Bloom explained. They also protect employees from retaliation by an employer and constrain the financial terms employers can tie to employment and severance agreements should an employee become a whistleblower.
Of the broad range of federal, state and municipal regulations implicated, and the legal considerations hedge fund managers must take into account, firms should pay particularly close attention to applicability of the Fair Labor Standards Act, the Defend Trade Secrets Act, New York Human Rights laws and the Whistleblower Protection provision in the Dodd-Frank Act.
Fair Labor Standards Act
The Fair Labor Standards Act establishes minimum wage, overtime pay, recordkeeping, and youth employment standards affecting employees in the private sector and in federal, state, and local governments.  Hedge fund managers are subject to FLSA requirements even though hedge fund employees may be compensated through an alternative structure, such as a combination of salary and cash or equity incentives based on various performance factors.
Holly Weiss, a partner at Schulte Roth & Zabel noted, “There are many laws governing compensation, but the most basic issue that comes up is whether people are paid properly and are classified properly. Employees who are not exempt from overtime laws must receive overtime pay for work done in excess of 40 hours in any given work week. Some employers run afoul of these laws, often unintentionally, by assuming that if they pay people a high salary they do not have to pay overtime.” For certain employees, then, an alternative compensation structure does not necessarily discharge hedge fund managers from compliance with FLSA’s requirements.
According to David Lewis, president and CEO of OperationsInc., a human resources outsourcing and consulting firm, “One of the biggest mistakes in the industry is that managers think that if they pay employees well they do not have to pay overtime. That is a false assumption. With that in mind, one of the biggest mistakes we see is a manager not paying an employee appropriately as it relates to the law. That’s not to say the employees are not being paid well, but they should be logging their time, they should be paid time and a half for hours worked beyond eight hours a day or 40 hours a week. Fund managers tend to simply not understand what is required under the FLSA.”
Of particular importance to hedge fund managers, the FLSA has several exemptions for employees who must be paid at least minimum wage and/or overtime. These employees include executive employees ; highly compensated employees ; and outside salespeople . There are also compensation requirements relating to meeting and training time, travel time and for salary and non-salary employees.
Defend Trade Secrets Act
The Defend Trade Secrets Act creates a federal civil cause of action for trade secret misappropriation, granting hedge funds access to a federal forum to seek recourse in the form of actual, unjust enrichment, “reasonable royalty,” or in some cases, exemplary damages against employees for theft of confidential information or trade secrets. (For more on trade secrets see, “New Protections for Trade Secrets Require Fresh Look at Employment Agreements“) Simultaneously, the DTSA includes whistleblower immunity provisions which absolve employees from criminal and civil liability if they provide trade secrets to government officials or confidentially to their attorneys for the same purposes of reporting a suspected theft.
Anne Patin, a partner at Seward & Kissel explained how the DTSA could impact human resources functions. “[The DTSA] gives a federal cause of action for the misuse of trade secrets, and employers need to be aware they should be including a clause in their employment agreements that to the extent trade secrets are used by an employee for whistleblowing or bringing a cause of action, employees have to be notified of their right to do that.” Firms must include language in confidentiality and non-disclosure agreements advising employees of the DTSA’s whistleblower provisions.
New York State and Municipal Human Rights Laws
The New York state Human Rights Law prohibits discrimination on the basis of “age, race, creed, color, national origin, sexual orientation, military status, sex, marital status or disability” in employment, housing, education, credit and access to public accommodations.  New York City has a similar law that additionally includes protections based on lawful occupation, family status and any lawful source of income. It also prohibits retaliation, bias-related harassment, bias-related profiling by law enforcement and discrimination against interns. 
According to Weiss, “There were laws that New York City enacted recently that changed the rules on background checks and affect what can be asked during the course of recruiting or interviewing a potential employee. Employers cannot ask about criminal convictions until after a conditional offer of employment has been extended — a ‘ban the box’ law. There are very tight restrictions on credit checks now in New York City.”
Weiss added, “When you look at changes in the New York City Human Rights Law, for example, a human resources executive at a larger firm may be on a mailing list or simply on top of that issue, whereas a person at a smaller firm wearing multiple hats may not be up on that issue. These smaller firms are looking to outside counsel to keep them apprised of developments in the laws and whom they can call for advice on a wide range of questions and issues.”
Patin further advised, “Employers need to make sure they understand the processes and procedures for obtaining background checks, as they are subject to a conditional offer of employment. Credit checks are limited to employees that meet certain exceptions under the statute and regulations that have been promulgated by the Human Rights Commission in New York City.”
The Dodd-Frank Act amended the Securities Exchange Act of 1934 by, among other things, adding Section 21F, dubbed “Securities Whistleblower Incentives and Protection,” which directs the SEC to award eligible individuals who voluntarily provide original information that leads to successful enforcement actions that result in monetary sanctions over $1 million. (For more on whistleblower programs see, “Best Practices for Promoting Internal Reporting of Compliance Issues Without Violating SEC and CFTC Whistleblower Rules Part One” and “Part Two“)
Bloom explained the thrust of how the SEC’s enforcement of whistleblower protections has affected human resources functions. “The SEC has been active in the last few years in going after companies that the agency believes are limiting the ability of employees to report unlawful activities through language in confidentiality and non-disclosure agreements, settlement agreements, separation agreements and company policies. To the extent any such agreements or policies contain language that could reasonably be viewed as prohibiting or limiting the right of employees from making protected whistleblower complaints or otherwise making certain disclosures to the government—or penalizing them for doing so— they may well raise scrutiny from the SEC. The SEC, just like the EEOC, would expect such agreements and policies to specifically preserve the right of employees to make such disclosures to government agencies and to participate in government investigations.”
Specifically, “There have been three enforcement actions that have been announced by the SEC in this area,” Weiss explained. (For more on the enforcement actions see, “Active August: SEC Approves ADV Changes, New Broker Type; Targets Anti-Whistleblower Provisions, Fee Disclosures“) In 2015, KBR, Inc. was sanctioned for including in its form confidentiality agreement signed by employees participating in internal investigations a provision whistleblowers from discussing their allegations with anyone, absent specific authorization from the company.  Just last month, BlueLinx Holdings and a California health insurer were fined for illegally using severance agreements requiring outgoing employees to waive their ability to obtain monetary awards from the SEC’s whistleblower program. ; 
“Investment managers should ensure that employment, separation and confidentiality agreements do not run afoul of Rule 21F, specifically that they do not discourage whistleblowing activity and do not prevent employees from receiving a bounty or seeking to receive a bounty,” Weiss summarized. Patin added that the recent enforcement actions counsel that employment and separation agreements go one step further and explicitly “notify an employee of their right to use certain information to pursue a whistleblower cause of action or allegation of wrongdoing to government agencies.”
Human Resources-Related Risks for Hedge Fund Managers
Human resources issues are constant and evolving, and an investment firm’s action, or inaction, on issues as myriad as employee performance and termination, healthcare and other benefits administration and the protection of trade secrets, could increase its vulnerability to regulatory censure, civil litigation or investor redemptions. With these risks in mind, hedge fund managers should understand the issues and how to mitigate their risk.
Bloom pointed out, “From an employment standpoint, the biggest risks are complaints of discrimination or harassment. Those can happen at any company, no matter the size, and they attract the attention of lawyers, investors and regulators. Those types of cases can really create reputational harm, and for a lot of hedge funds, your brand and your integrity and reputation are sometimes as important as your track record. If something like this comes up, no matter who is handling your HR function, you need to have outside counsel involved immediately.” In addition, “Any allegation by an employee or former employee of financial impropriety is another risk and red flag and something that should also be immediately elevated to outside counsel.”
Fund managers should also carefully craft offer letters and employment agreements to avoid the risk of unintentionally offering an incentive or promise that they are not prepared or willing to honor. Weiss advised, “An offer letter or a separation agreement is not something that one without experience in this area should take care of because mistakes will be made. The most common mistake I see is the unintentional promise that could be enforceable. If you want to be able to terminate an employee at will, you do not want something in your offer letter that indicates that employment is not at will.”
As a corollary, employment agreements and other employment contracts should clearly outline the terms of employment and compensation arrangements. In particular, hedge fund employment agreements for key employees should clearly differentiate between wages, which are subject to New York state labor laws, and incentives, such as deferred equity-based compensation, which are not, because they are contingent and dependent on continued employment and the financial success of the fund.
Another risk for fund managers is incomplete or inconsistent handling of employee concerns, which Lewis said most commonly involve complaints about supervisors or coworkers. “If you don’t handle these problems appropriately you could turn a small issue into a very large issue.” Similarly, workplace harassment issues routinely arise in the financial services industry, and they need to be dealt with competently and comprehensively, said Lewis. “Employers and employees need to understand what constitutes a hostile work environment and how to adapt and adjust your behavior in the workplace so you minimize your risk there, and that you immediately address any complaints that do come forward.”