As Banks Close Prop Desks and Traders Move to Hedge Funds, Hedge Fund Managers Focus on Permissible Scope of Use of Confidential Information
Hedge Fund Law Report
In recent years, proprietary trading desks (prop desks) have contributed a growing proportion of revenue at the major Wall Street investment banks. As the credit crisis has persisted, however, the idea of a proprietary trading operation housed within a major investment bank has become less and less viable. The freezing of credit markets has severely curtailed leverage, which once enhanced returns. Growing risk aversion has diminished the tolerance among risk management departments for the sorts of trades that generated outsized returns (and that occasionally resulted in large losses). And limits on executive compensation – imposed either by statute or the prospect of public condemnation – have undermined the ability of investment banks, especially those with affiliated commercial banks, to retain trading talent. The result has been a well-publicized wave of closures of prop desks across the Street (and, in the UK, across the City). For hedge funds, this wave of closures has had two primary effects. First, it has decreased competition in certain investment strategies. Second, it had created a surfeit of unemployed trading talent. However, while the closure of prop desks has created a market for talent that is very favorable to hedge fund managers looking to hire, it has also created a scenario rife with legal and compliance pitfalls. Specifically, for the very reasons that a trader would be attractive to a hedge fund manager as a new hire – specific relevant experience; knowledge of specific companies, assets or strategies; relationships with investment target company executives and board members, etc. – the hiring of that trader also creates the opportunity for personnel of the manager to use information possessed by that trader in an unauthorized and potentially illegal manner. In short, while experienced traders often possess valuable information, they do not, as a contractual matter, own that information. Rather, their former employer generally owns that information. That is, much of the information constitutes an asset of the former employer, which subsequent employers are contractually and legally prohibited from using. Think of it as hiring a race car driver: you (the manager) are getting his ability to drive the car, but not the car itself. We detail the confidentiality, non-compete and non-solicitation agreements generally entered into by traders at the inception of employment with investment banks and hedge funds, standard provisions of severance arrangements that bear on confidentiality of information, compliance precautions that hedge fund managers can take, consequences for ongoing confidentiality obligations of closures of prop desks and repercussions of violations of confidentiality obligations.