Feb. 25, 2010

What Is Proprietary Trading, and Why Does Its Definition Matter to Hedge Fund Managers?

The so-called Volcker Rule would limit the size and scope of banks and other financial institutions with the goals (according to a White House press release) of “rein[ing] in excessive risk-taking and protect[ing] taxpayers.”  With respect to size, the Rule would seek to limit the market share of liabilities at the largest financial firms.  And with respect to scope, the Rule would impose two prohibitions of note to the hedge fund industry.  First, it would prohibit any bank or bank holding company from owning, investing in or sponsoring a hedge fund or private equity fund.  Second, it would prohibit the same institutions from engaging in “proprietary trading operations.”  See “Senate Banking Committee Hears Testimony from Hedge Fund Industry Experts and Academics on ‘Volcker Rule,’” Hedge Fund Law Report, Vol. 3, No. 6 (Feb. 10, 2010); “Senate Banking Committee Holds Hearings on ‘Volcker Rule’ Designed to Limit Banks’ Ability to Own, Invest In or Sponsor Hedge or Private Equity Funds,” Hedge Fund Law Report, Vol. 3, No. 5 (Feb. 4, 2010).  We plan to explore the potential prohibition on bank sponsorship of hedge funds in an upcoming issue of the Hedge Fund Law Report.  This article focuses on the proposed prohibition of proprietary trading by banks and other financial institutions.  In particular, this article focuses on the threshold issue of defining precisely what proprietary trading is and is not.  This definition bears directly on the likelihood that the proprietary trading ban will become law because one of the chief objections to the ban is impracticability.  That is, opponents object that such a ban is not practicable because proprietary trading cannot be defined in a manner that reflects market practice and enables consistent regulatory enforcement.  (Even if proprietary trading can be defined, opponents argue that the ban may be superfluous, moot or counterproductive: superfluous because capital or liquidity requirements or a systemic risk regulator may better effectuate the same goals; moot because bank proprietary trading desks may be waning in their contributions to bank revenues and in number; and counterproductive because proprietary trading by dealers enhances liquidity in markets required to fund government operations, such as the markets for Treasury and agency bonds.)  The definition of proprietary trading – and its effect on the likelihood of passage of the proprietary trading ban in the Volcker Rule, as well as the shape that any such ban takes – matter greatly to hedge funds because bank proprietary trading desks interact with hedge funds in at least three important ways: as counterparties, competitors and sources of talent.  See “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, Vol. 2, No. 18 (May 7, 2009).  Accordingly, an outright ban of the sort contemplated by the Volcker Rule could be expected to: reduce competition in certain hedge fund strategies (at least in the short term between hedge funds and prop desks, though in the medium term it may increase competition between existing and new hedge funds); increase the supply of investment talent available to hedge fund managers; potentially reduce average hedge fund manager personnel compensation (depending on the elasticity of demand for investment talent); further enhance hedge fund entrepreneurship; increase the number of sales of hedge fund advisory businesses; diminish liquidity in a variety of financial instruments, especially government-issued fixed income securities (in which prop desks currently play a central role); and reduce bank profitability.  On some of the foregoing points, see “How Can Start-Up Hedge Fund Managers Use Past Performance Information to Market New Funds?,” Hedge Fund Law Report, Vol. 2, No. 50 (Dec. 17, 2009) (hedge fund entrepreneurship); “IRS Issues Guidance on Compliance with Section 409A Requirements Applicable to Deferred Compensation Plans of Hedge Fund Managers,” Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010) (hedge fund manager compensation); “For Managers Facing Strong Headwinds, Sales of the Advisory Business Offer a Means of Preserving the Franchise While Avoiding Fund Liquidations,” Hedge Fund Law Report, Vol. 2, No. 11 (Mar. 18, 2009) (hedge fund adviser M&A).  But will such a ban become law?  This article seeks to clarify and deepen the proprietary trading debate as it relates to hedge funds.  In particular, this article: provides background and context of the proposed ban; highlights a provision in the Restoring American Financial Stability Act of 2009 (RAFSA) that may yield a legislative definition of “proprietary trading”; most importantly, discusses the three potential approaches to a viable definition of proprietary trading, while highlighting the shortcomings of each approach; discusses the recent retrenchment among investment banks with respect to proprietary trading; and explains the offsetting potential for “prop creep.”

What Are the Key Elements of a Comprehensive Hedge Fund Adviser Disaster Recovery Plan, and Why Are Such Plans a Business Imperative?

Last week’s issue of the Hedge Fund Law Report included a comprehensive analysis of business continuity plans (BCPs) in the hedge fund context.  See “Key Elements of a Hedge Fund Adviser Business Continuity Plan,” Hedge Fund Law Report, Vol. 3, No. 7 (Feb. 17, 2010).  That analysis enumerated the key elements of such plans, identified the rationale for each element and highlighted various practical considerations (including the increased focus of institutional investors on BCPs during due diligence and the related focus of the SEC on such plans during inspections and examinations).  As the article noted, one of the key elements of any hedge fund adviser BCP is the disaster recovery plan (DRP).  Generally, DRPs are – conceptually and literally – subsets of BCPs, which in turn generally are subsets of a hedge fund adviser’s compliance manual.  BCPs, as the name implies, focus on procedures to enable a hedge fund manager to continue its business operations and investments without interruption in the event of a range of identified risks and events.  Such events may be natural (e.g., hurricanes, earthquakes, pandemics), man-made (e.g., terrorism, theft, other crimes) or technological (e.g., power outages, disruption of exchanges, computer viruses).  DRPs, by contrast, focus on procedures to enable a hedge fund manager to get back to business as quickly as possible following a business interruption occasioned by one of the listed categories of risks and events.  BCPs are about avoiding disasters; DRPs are about recovering from them.  Yet despite the conceptual difference, in practice, they are two sides of the same coin, are often mentioned in the same breath, would both be triggered in many similar circumstances and would call for many of the same actions.  Institutional investors are focusing with renewed vigor on DRPs (as they are on BCPs) in the course of their initial and ongoing due diligence.  (By “ongoing due diligence,” we mean that a savvy current investor may ask to see a robust DRP as a condition of remaining invested.)  There are at least five reasons for this.  First, recently uncovered frauds have demonstrated that man-made “disasters” pose serious investment risks.  See “Federal Judge Approves Settlement Agreements Arising out of Marc Dreier’s Criminal Fraud; Hedge Fund Victims ‘Squabble’ Over Proposed Recovery,” Hedge Fund Law Report, Vol. 3, No. 7 (Feb. 17, 2010).  Second, institutional investors are starting to perceive and prepare for disasters from an insurance perspective, as quintessential “catastrophes” – high magnitude, low probability events against which precautions can be taken.  In this analogy, having a workable DRP is like moving away from beachfront property in a hurricane-prone region.  See “The Hedge Fund Transparency Act and its Unintended Consequences for Cat Bonds,” Hedge Fund Law Report, Vol. 2, No. 20 (May 20, 2009).  Third, as a practical matter, many institutional investors outsource a portion of their due diligence to consultants (such as pension consultants) or operational risk due diligence providers.  If such service providers perceive the benefits of a DRP at one hedge fund manager on who they perform due diligence, they will look for DRPs at other hedge fund managers.  See “How Can Hedge Fund Investors Hone Their Due Diligence in Light of Alarming Rate of  ‘Verification Problems’ Discovered in Recent Study of Hedge Fund Due Diligence Reports?,” Hedge Fund Law Report, Vol. 2, No. 44 (Nov. 5, 2009).  Fourth, many hedge fund managers have grown to rely to an increasing degree on technology.  Such managers can be adversely and more severely impacted by technological interruptions, but by the same token, they generally can recover from such interruptions faster.  Finally, there is the issue of fiduciary duty: a hedge fund manager has a fiduciary duty to its clients (which for most purposes in the hedge fund world means its hedge funds or managed accounts), and no provision in the Investment Advisers Act or at common law provides an exception to that duty during disasters.  Put another way, hedge fund managers are required by their fiduciary duties to prepare for foreseeable adverse events.  See “For Hedge Fund Managers, How Would a Statutory Definition of ‘Fiduciary Duty’ Affect the Scope of the Duty and the Standard for Breach?,” Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009).  In recognition of the practical and marketing imperatives to hedge fund managers of having in place robust and best-of-breed DRPs, this article discusses: a more comprehensive definition of a DRP; the key elements of a hedge fund manager DRP (including recovery point objectives, recovery time objectives and the importance to smaller hedge fund managers of coordinating with service providers); the impact of a hedge fund’s strategy on design of its manager’s DRP; the role played by DRPs in institutional investor due diligence; specific technology issues (including the roles of Blackberries, trading, trade capture and accounting systems, and IT personnel); the potentially paradigm-shifting utility of “cloud computing” in disaster recovery planning; and testing and maintenance of DRPs.

Federal District Judge in Texas Dismisses Former Executives’ Employment Contract Dispute Against Hedge Fund Firm D.B. Zwirn & Co. Over Unpaid Bonuses

Representing a new trend in hedge fund litigation created by the recent financial crisis, various former hedge funds executives have been suing their former employers or partners for unpaid or allegedly unpaid bonuses or other compensation.  See, e.g., “Co-Founder of Hedge Fund Manager Camulos Partners Sues Other Co-Founder for $67 Million in 'Unlawfully Seized' Bonuses and Investments,” Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010); “New York Appellate Division, First Department, Affirms Dismissal of Breach of Employment Contract Claim Against Hedge Fund Manager Stanfield Capital Partners,” Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010); “Minnesota Appeals Court Affirms that Repeated Oral Representations Preclude Limitations Defense in Hedge Fund Manager’s Claim for Unpaid Bonuses,” Hedge Fund Law Report, Vol. 3, No. 2 (Jan. 13, 2010); “Touradji Capital Management Countersues Ex-Hedge Fund Portfolio Managers,” Hedge Fund Law Report, Vol. 2, No. 46 (Nov. 19, 2009); “New York State Supreme Court Upholds Former Portfolio Managers’ Claims Against Hedge Fund Manager Touradji Capital for Breach of Contract and Intentional Infliction of Emotional Distress; Dismisses Remaining Causes of Action,” Hedge Fund Law Report, Vol. 2, No. 39 (Oct. 1, 2009).  In this instance, on February 8, 2010, the United States District Court for the Southern District of Texas summarily dismissed a lawsuit over unpaid bonuses brought by plaintiffs Todd A. Dittmann and Susan Chen against their former employer, defendant hedge fund firm D.B. Zwirn & Co., L.P. (DBZ).  The litigation began in February 2009, when Dittmann, and later Chen, filed complaints against DBZ claiming it had breached their respective contracts for employment compensation, and adding causes of action including, among other things, fraud, quasi-contract and violations of the New York State Labor Law.  In rejecting the lawsuit, the District Court concluded that plaintiffs “worked in a high risk industry with the potential for high rewards[,]” received suitable compensation for several years, and that, in 2007, when “DBZ’s business declined through no apparent fault of the Plaintiffs, DBZ reduced their bonuses and ultimately failed to pay, “all in compliance with the terms of the[ir] employment agreement[s].”  We detail the background of the lawsuit and the court’s legal analysis. 

British Virgin Islands Court Finds that Western Union, which Sought Redemption of its Reserve Fund Shares Prior to a Redemption Freeze, is a Creditor of the Fund and May Appoint a Liquidator, Over Opposition of Hedge Fund Manager Caxton Associates

Respondent Reserve International Liquidity Fund, Ltd. (Fund) is a “money market daily liquidity fund” organized under the laws of the British Virgin Islands (BVI).  Applicant Western Union International Limited (WU) owned approximately 298 million shares of the Fund (i.e., approximately $298 million of holdings).  On September 15, 2008, Lehman Brothers filed for bankruptcy and the 2008 liquidity crisis accelerated.  On that day, WU submitted redemption requests for its entire interest in the Fund, which still had a net asset value of $1 per share.  Days later, the Fund and its affiliate, The Reserve Primary Fund, “broke the buck” and suspended redemptions and the daily calculation of net asset values.  Litigation against the Fund in the United States commenced within weeks by various investors seeking redemptions of their interests and determination of the value of those interests.  WU commenced an action in the BVI seeking liquidation of the Fund under BVI law.  The fundamental issue considered by the court was determining when WU’s redemption of its Fund shares was completed and when, therefore, a shareholder became a creditor of the Fund with respect to the redemption proceeds, which would then entitle the shareholder to apply for the appointment of a liquidator.  WU argued that its redemption was complete on the date of its redemption request, and that it became a creditor of the Fund on that date.  The BVI High Court of Justice agreed, relying heavily on the language contained in the Fund’s Articles of Association.  We summarize the Court’s reasoning and the implications of this decision.

Aite Group Report Examines the “Mini-Prime” Broker Landscape and Projects Slow and Steady Long-Term Growth Outlook for the Hedge Fund Industry

In our September 24, 2009 issue, we discussed the bifurcation in the prime brokerage business created by the financial crisis and the emergence of smaller prime brokers filling the services void left by the focus of larger prime brokers on their larger hedge fund clients.  See “Boutique Prime Brokers are Emerging to Provide Services to Small and Mid-Size Hedge Funds Marginalized by Larger Prime Brokers,” Hedge Fund Law Report, Vol. 2, No. 38 (Sep. 24, 2009).  That article pointed out that certain smaller prime brokers now offer prime brokerage, custody, clearing and financing to smaller clients.  See also “Hedge Funds Turning to Prime Brokerage Trust Affiliates For Added Protection Against Prime Broker Insolvencies,” Hedge Fund Law Report, Vol. 2, No. 25 (Jun. 24, 2009).  Now, a new report by Aite Group, LLC, entitled, “Trends and Firms in the Prime Services Market, 2010,” describes how, over the last five years, this new class of prime services providers, called “mini primes,” has proliferated.  Most notably, some of these firms, not so mini anymore, have steadily moved up the hedge fund totem pole to larger accounts.  Revenues for these providers in the prime services market as of year-end 2009 totaled $278.3 million, with about 2,300 clients, many of them hedge funds.  The Aite Group report examines in detail how some mini primes view their business, relying on interviews with leading providers.  The report also explores how the business of prime brokerage has changed, profiles the interviewed mini primes, and describes the prime services market trends.  Furthermore, the report projects a steady average annual growth in assets under management of 7.4 percent for hedge funds in the upcoming year.  This article details the most salient findings of the report and its implications for the hedge fund industry in 2010.

Interview with Timothy Spangler: Key Legal and Business Considerations when Launching Hedge Funds or Hedge Fund Managers in China

In February 2010, People’s Republic of China (PRC)-based investment management firm Munsun Asset Management Limited and its founder, Li Xianghong, announced the launch of the firm's first China-focused hedge fund, Munsun China Opportunity Investment Fund (Munsun fund).  The investment objective of the Munsun fund is to invest in a portfolio consisting primarily of securities of companies established or operating in the Greater China Region, and of companies listed on stock exchanges in Hong Kong, New York, London and Singapore that do business in or are connected to China.  Timothy Spangler, who advised on the launch, recently spoke with the Hedge Fund Law Report about the launch and structuring of the Munsun fund, and what lessons the launch offers for hedge fund managers and investors that are contemplating launching or investing in hedge funds in or focused on China.  In particular, we spoke to Spangler about: the structure of the Munsun fund and advisory entity; the chief business advantages of organizing a hedge fund adviser or a hedge fund in China; the key legal or regulatory hurdles faced in structuring and marketing the Munsun fund; marketing benefits to organizing a fund or adviser in China; licenses required to manage a hedge fund organized in China; laws governing liquidity of Chinese funds; currency issues; the make-up of the Munsun fund investor base; and tax considerations.  The full transcript of that interview is included in this issue of the Hedge Fund Law Report.  See also “Do Collective Investment Management Schemes Offer a Means for Hedge Fund Managers to Access the Potentially Vast China Market?,” Hedge Fund Law Report, Vol. 2, No. 36 (Sep. 9, 2009).

U.K Financial Services and Markets Tribunal Upholds Findings of Market Abuse Against Individuals for Using Inside Information to Make Spread Bets

In a rare, circumstantial case for the U.K., a London tribunal has found that two close friends colluded in using confidential information to make quick profits from so-called spread betting.  On December 29, 2009, the U.K.’s Financial Services and Markets Tribunal (Tribunal), an executive agency of the U.K. Ministry of Justice which rules on disputes between the Financial Services Authority (FSA) and individuals and firms facing regulatory action, upheld the FSA’s case against Robin Chhabra and Sameer Patel.  In confirming the FSA’s findings, the Tribunal agreed that both Chhabra and Patel had engaged in market abuse under the Financial Services and Markets Act 2000 because Patel placed bets “on the basis of restricted information not generally available which was disclosed to him by Chhabra.”  This article analyzes the Tribunal’s decision including the facts of the civil case, the relevant laws and arguments made by the parties.

Maples and Calder Appoints Jon Fowler as Head of Investment Funds in the Cayman Islands

On February 17, 2010, Maples and Calder announced the appointment of Jon Fowler as the head of its investment funds group in the Cayman Islands.