In the days that followed the collapse of Lehman Brothers, activity within the prime brokerage industry reach fever-pitch: as fear that another broker-dealer would collapse led many jittery fund managers to move their assets to universal banks, the likes of Deutsche Bank, Credit Suisse, Citigroup and JPMorgan were inundated with new client requests. In the chaos, Goldman Sachs and Morgan Stanley, the two behemoths that have long-dominated the prime brokerage industry, suffered unprecedented outflows: in a single week, Morgan Stanley is reported to have lost nearly one-third of its assets to rivals although this has proved to be temporary.
If the collapse of Lehman Brothers has served to starkly underline the importance of diversifying asset allocation, it is also delivering some harsh lessons on the importance of reading the small print: for not only do many of the bank’s hedge fund clients now find themselves undergoing a once-unthinkable ordeal to recover the $44bn, and counting, in client assets held by the bank. But many funds, it has emerged, are now confronting the distinct possibility that they may, due to the provisions governing their prime broker agreements (PBAs), be at risk of losing all their assets in the administration process. This risk relates, primarily, to the way in which UK-regulated prime brokers are able to handle client assets, but also, it transpires, to the regime that governs broker insolvency. Both, it seems, may be in need of some revision.
Unsecured claims
Under UK law, prime brokers may hold client assets in two ways: on a segregated basis, as outlined by the Financial Services Authority’s Client Asset Handbook, meaning the assets fall outside the insolvent estate in the event of the prime broker falling bankrupt; or on a title transfer basis as collateral for financing, under a well-established and critically important prime broker financing practice known as rehypothecation.
| Where assets have already undergone title-transfer, says Bob Penn, a partner at City law firm Allen & Overy, who is acting on behalf of several hedge funds attempting to recoup their assets from Lehman Brothers International Europe (LBIE), the picture is clear: the assets belong to and fall within the estate of the prime broker, who is legally entitled to use them in any way it sees fit. The hedge fund, meanwhile, is left merely with an unsecured claim against those assets, says Mr Penn. |
For those hedge funds whose assets have been rehypothecated as collateral, the collapse of LBIE, or indeed any other prime broker, is extremely problematic but not necessarily disastrous. After all, the hedge fund typically receives stock or cash in return for the rehypothecation of its assets, notwithstanding the haircut – the additional margin by which the fund’s assets are devalued in order to account for a fall in the market. The haircut, legal fees and chronic anxiety aside, however, all is not lost.
But the position of the hedge fund becomes altogether more precarious if its remaining, non-collateralised assets, held in a segregated ‘client securities’ account, are also subject to title-transfer under the original PBA: this is the alarming prospect facing a number of LBIE’s hedge fund clients who originally entered into PBAs which conferred upon LBIE the right to rehypothecate all of the fund’s assets, regardless of its indebtedness to the bank. “This is an enormously important, fundamental issue for hedge funds,” says Mr Penn.
Because LBIE did not historically provide segregated accounts, all assets, at one time, underwent automatic title transfer as standard process, says a source from a major prime broker. In a note on its website, City law firm Herbert Smith suggests that all assets held in LBIE client securities accounts, even under PBAs dating from 2006 onwards, are subject to “a title transfer provision (with an express right of rehypothecation)”. To this extent, says one solicitor, the agreements are “a bit of a joke”.
Limited rights
But LBIE was not alone in this regard: in 2001, when prime brokerage was in its infancy, several players took immediate title of all assets, says another prime broker. In this respect, says Ian Morley, chairman of fund of hedge funds Corazon Capital and founding chairman of The Alternative Investment Management Association (AIMA), the asymmetry of PBAs are typical of the vast majority of counterparty agreements entered into with larger players, which are usually constructed on the presumption that the smaller player is at greatest risk of insolvency. “Then you find yourself in a situation where you haven’t got all your rights protected,” he adds. This is especially true of hedge funds.
Because hedge funds, when first establishing themselves, have very little if any negotiating power most had little choice, says Mr Penn, but to agree, in the first instance, to blanket transfer of asset title. Although LBIE, like many prime brokers, later changed its model, moving away from automatic rehypothecation and providing some form of client asset segregation, it is likely the bank was still operating according to a mixture of agreements, says another source.
Many large, sophisticated and well-advised hedge funds later renegotiated their contracts, ensuring LBIE could only rehypothecate assets in proportion to the fund’s indebtedness, but many other funds did not, says Mr Penn. “The number who did not now find themselves in this extraordinary situation,” he says, whereby assets they believed were safely segregated may in fact have been legitimately rehypothecated under the ongoing PBA. In some cases, 100% of funds’ assets held by LBIE could be at risk, he adds. But this is not the worst of it.
For those funds whose assets are still segregated, but under the original PBA may yet be rehypothecated into the estate, there is a further twist: according to confidential legal advice seen by The Banker, there is a risk that LBIE’s administrators, under their legal duty to reimburse LBIE’s creditors, may exercise LBIE’s right to rehypothecate any assets found in segregated accounts into the LBIE estate, in order to maximise the pools of assets available to creditors. This would leave the hedge fund, in turn, with an unsecured claim against the estate: that is, to effectively transform the hedge fund, which has wrongly believed its assets to be secure, into an LBIE creditor.
Steven Pearson, a partner at PricewaterhouseCoopers, one of four administrators to LBIE, says: “In so far as the company has that right, and it’s consistent with my duty, I have to explore that [course of action].” However, he adds: “I can unequivocally say that we have not done that. I would almost certainly seek the directions of the court if I were to take such action. I would effectively do it with court sanction. I would not do that unilaterally.”
Many hedge funds have nonetheless attempted to terminate their PBAs with LBIE. But having failed, historically, to negotiate suitable termination rights, several now remain locked into their agreements, exposing all the fund’s assets to the potential transfer of title into the insolvent estate.
Confusing rules
To some extent, the question mark hanging over the future of LBIE’s clients’ assets serves to highlight the unfavourable and, as it transpired, incorrect counterparty-risk assumptions upon which PBAs have historically been negotiated – although, as one prime broker claims, many mid-size and larger hedge funds have been in a stronger position to agree more equally weighed contracts in recent years. But perhaps more compellingly, it also serves to highlight the confusion that surrounds the structural and legal status of a so-called segregated account.
According to the current FSA rules, a truly segregated account takes the form of a ‘trust’ held in the name of the client at a nominee bank. But many prime brokers also open client accounts that are held in the name of the broker, wherein the assets are notionally segregated but are ultimately held on the prime broker’s books and records. This does not, it seems, protect assets in the same way as a nominee account.
It is this arrangement that has served to confuse hedge funds, says Corazon Capital’s Mr Morley, regarding the status of their assets. “They think it is in some kind of ‘segregated’ account, but the problem is that it is actually a pooled segregated account, and therefore the word ‘segregated’ in this sense is completely misunderstood.”
The situation does not appear to be much better where cash is concerned. According to Herbert Smith, LBIE is not obliged to keep client monies separate from its own funds because, “through the operation of law and contractual provisions, that cash no longer belongs to the client.” This will no doubt cause considerable alarm among those LBIE clients that have been dutifully stockpiling cash in order to cover anticipated year-end redemptions.
Lehman Brothers’ US-based hedge fund clients are not necessarily immune from the fall-out either. As Martin Cornish, senior partner at law firm Katten Muchin Rosenman Cornish, notes, the US operates a special regime for dealing with the bankruptcies of US brokers, which can result in the faster return of client assets. To this extent, many US funds would have been protected under the US regime. But because UK-based prime brokers are able to extend more leverage than US-based broker dealers, some US-based hedged funds, and their assets, may have been ‘chaperoned’ into the FSA-regulated LBIE entity, says one prime broker. Unlike the US regulations, the UK regime “does not address the protection of customers; it just addresses the protection of creditors”, says another prime broker. (Indeed, it is worth noting that only the football industry enjoys a special insolvency regime in the UK.) As such, UK regulators should consider moving to a US-style insolvency regime for brokers, say some practitioners. The FSA declined to comment.
| If it is clear that rehypothecation is a matter of some controversy, it is equally clear that the practice sits at the heart of the prime brokerage business, not least because, as Alex Ehrlich, global head of prime services at UBS, points out, it allows the vast majority of prime brokerages, under normal circumstances, to operate as self-funding businesses and to secure vital financing for their clients at competitive market rates. |
“Most prime brokerage businesses are self-funding. If they were not, the bank would be drawing down on its capital and the cost of capital would be so high, especially in this environment, that you could not be a competitive prime broker,” he says. In such circumstances the prime broker would have to use its unsecured credit facilities, the cost of which is currently in the region of 225 to 300 basis points above that of secured credit. “It is also a limited resource. So no matter how big and secure you are, you don’t have limitless unsecured credit lines,” he adds.
Stricter regulation
Even so, some fund managers have been sufficiently perturbed by the fallout of LBIE to advocate major restrictions on the practice. In an e-mail, Andrew Baker, deputy chief executive of AIMA, says: “Extensive re-hypothecation is almost certainly not worth the risk in the current environment. There is no free lunch: more [asset] security will mean more expensive funding. We expect prime brokerage agreements to be tightened to exclude or apply strict limits to re-hypothecation.” It seems commercially impossible, not to mention economically undesirable, however, for the practice of rehypothecation to be dramatically curtailed in the long-run.
Rather, the industry will have to revise the processes and documentation that govern the practice, and improve both the visibility and level of choice surrounding the use of assets. The Banker understands, for example, that some prime brokers are already exploring ways in which to periodically adjust the amount of risk a single client takes on in terms of how their assets are held and used, and the associated price they are prepared to pay for financing. This would imply a long list of changes to the way in which accounts are operated, and to this extent significant infrastructural investment too.
Corazon Capital’s Mr Morley also envisages a larger role for custodians, or custody-type services and structures, within the prime brokerage business. Certainly, for those funds that do not require financing, the attraction of a custodian will be strong in the present environment. Take Insparo Asset Management, for example. Because the hedge fund does not use leverage, Mohammed Hanif, the fund’s CEO, has chosen not to enter into any PBAs. “A custody account is always segregated and you have more control over your assets,” he says. Mr Hanif has been approached by many hedge funds seeking advice on how to establish new custody arrangements, he adds.
| It is no secret that custodians have long-coveted the lucrative hedge fund market, and many larger hedge funds do use custody accounts. The Bank of New York Mellon, which is reported to have enjoyed major inflows in recent months, already services a number of the top hedge funds, says BNY Mellon managing director David Aldrich, who regards the custodial role as “complementary to the financing service provided by prime brokers.” |
| But as such, he also underlines the major sticking point: custodians have very limited financing capacity, and they cannot facilitate short-sells. Roy Martins, head of international prime services at Credit Suisse, adds: “If a hedge fund has leverage, one would be obligated to move assets back and forth between the prime broker and custody account. Operationally, it would be challenging.” |
For this reason, some commentators believe it more feasible that prime brokers will move to acquire custodians, or specific custody operations, in order to bolster their service offering. Meanwhile, hedge funds, says financial analyst Celent, may seek out new sources of financing and capital, in order to depend less heavily on their prime brokers in general.
