Sep. 4, 2008

Hedge Funds See Counterparty Risk as a Threat to Global Markets, Expect Another Major Bank Failure

Counterparty risk from credit default swaps (CDS) represents a serious threat to global financial markets, at least in the opinion of 75% of respondents participating in a recent survey conducted by Greenwich Associates, the financial market research and analysis firm. The survey also showed that US respondents were more concerned about the use of CDS, with 85% saying they are a serious threat to global markets. European institutions were slightly more sanguine, with roughly 55% seeing CDS counterparty risk as a significant threat. Moreover, the study also found that following the near collapse of Bear Stearns and its subsequent buyout by JPMorgan Chase & Co., almost 60% of respondents thought another large financial services firm would collapse within the next six months, while 15% believed such a failure would occur within the next 12 months. Only 27% of institutions surveyed think there will not be another Bear Stearns-type collapse. The Hedge Fund Law Report talked to the authors of the survey about their findings, and interviewed leading lawyers about the implications of the survey’s findings for hedge funds.

UK Imposes Strict Rules on Derivatives Disclosure, Perhaps Setting the Stage for More Hedge Fund Regulation in the US

In a policy statement due later this month, the FSA is expected to propose that so-called contracts for difference (CFDs) must be disclosed as if they were common shares. CFDs are equity derivatives that enable traders to obtain exposure to the price performance of a wide variety of assets – including equity shares, indices and commodities – without directly owning the underlying assets. The new UK disclosure regime would be consistent with the recent decision in the US case of CSX v. TCI & 3G (which was covered in the June 19, 2008 issue of the Hedge Fund Law Report). According to the FSA, such a general disclosure regime for long CFD positions will be “the most effective way of addressing concerns in relation to voting rights and corporate influence.” However, hedge fund industry participants have criticized the move as “heavy-handed” and unnecessary. Also, hedge fund professionals have expressed a concern that the new disclosure regime could reduce trading volumes and increase the cost of capital.

Hedge Fund Manager Sues Former Partner for Fraud and Breach of Contract

An ex-partner of New York-based hedge fund group K Squared Capital Advisors L.P. has accused his former partner and the group’s manager of fraud, breach of contract, unjust enrichment, breach of fiduciary duty and bad-faith dealings. In a complaint filed in New York State Supreme Court on August 11, 2008, the plaintiff alleges that the defendants falsely attributed income to the plaintiff, leaving him with a significant tax bill. The plaintiff further alleges that the defendants failed to comply with their contractual obligations and provided the plaintiff with falsely low net asset values for funds under management, thus avoiding their obligation to share a portion of incentive fees with the plaintiff.

Counterparty Risk Management Policy Group III Issues Report on Containing Systemic Risk

In what some are calling a remarkable confession, a panel of prestigious Wall Street executives has issued a report acknowledging the role of the investment banking and brokerage industries in the financial shocks of 2007-2008 and calling for extensive changes in how their businesses operate. The report also contains a notable discussion of hedge funds as an “emerging issue.” The report contains 60 proposals, notably including: requiring banks to account for more assets on their balance sheets; enhancing disclosure requirements and sales standards for complex debt instruments; matching trades on the same day; and increasing risk management and liquidity standards. The report notes that “indirect” supervision of hedge funds via direct regulation of supervised entities that act as investors, creditors and counterparties to hedge funds has worked reasonably well during the past year of financial market turmoil. However, the report also acknowledges that some hedge funds (and private equity funds) contributed to the reach and severity of the recent financial crisis, thus reviving the question of whether direct supervision of hedge funds would be appropriate.