Prime Broker Insolvency Risk

After the fall: what next?

NOAH MELNICK, GARY BARNETT, STEPHEN CULHANE, STANFORD RENAS & DON MACBEAN, LINKLATERS

The fall of Bear Stearns and Lehman Brothers demonstrates the reality of prime broker insolvency risk. Many hedge funds use just one prime broker, while others employ two or more. The tragic consequences for many hedge funds of not adequately addressing prime broker insolvency risk have become all too public recently. This discussion highlights some of the risks posed to hedge funds by prime broker insolvency as well as potential mitigation techniques.

The defining features of the prime brokerage relationship (and the most important prime brokerage services) are: (1) clearing and settlement; (2) financing; and (3) custody. Clearing and settlement services enable transactions to be executed with multiple executing brokers, while centralising clearing and settlement through a single prime broker. Prime brokers typically provide financing through margin loans, securities loans (e.g. for short sales), repurchase agreements and OTC derivatives (via intermediation and embedded leverage). For convenience and to support access to financing, hedge funds often place assets in the custody of a prime broker.

Utilising prime brokerage services exposes a hedge fund to prime broker insolvency risk; generally, in the amount of that hedge fund’s assets held by and available for rehypothecation by the prime broker (actual exposure can exceed this amount), which grows commensurate with use of prime brokerage services.

For example, to provide financing, a prime broker typically requires a security interest in all of a hedge fund’s assets that it holds and in the case of some OTCderivatives and repurchase agreements, will require the outright transfer of collateral. The more of a hedge fund’s assets a prime broker holds, the more of that hedge fund’s assets that can be caught in insolvency.

Prime brokers also typically demand the right to rehypothecate all assets although some jurisdictions (including the US) impose limits. Rehypothecation exacerbates prime broker insolvency risk by increasing the likelihood that the prime broker will have insufficient assets to satisfy customers’ claims. Hedge funds additionally face the risk of trades not being properly executed or credited immediately preceding and during an insolvency.

The risks posed by a particular prime broker’s insolvency will vary based on: (1) the terms of the prime brokerage documentation; (2) the prime broker’s legal structure, including the applicable regulatory and insolvency regimes, and the involvement of unregulated affiliates; (3) where, how and in whose name assets are registered and held; and (4) the extent to which rehypothecation is permissible.

Successfully mitigating prime broker insolvency risk requires careful consideration of all of these factors in respect of specific prime brokerage relationships, which we address below.

Additionally, attention must be paid to aggregate exposure to prime brokers through the implementation of traditional risk monitoring and controls. Such systems enable proper diversification of exposure and facilitate the kind of constant vigilance necessary to anticipate and avoid potentially devastating situations. Hedge funds aggressively managing specific and aggregate risk are less likely to be caught off-guard in tumultuous market conditions. Some commentators have even suggested that failing to address such risks could support investors’ breach of fiduciary duty claims (although the viability of such claims is questionable).

Other than certain mechanical features articulated in a 1994 SEC No Action Letter, prime brokerage documentation varies both among prime brokers and based on the scope of services to be provided. At the very least, there will be a prime brokerage agreement (PBA) establishing the customer’s primary account. The PBA may also govern the terms on which most financing will be provided although separate agreements for margin lending and securities lending are typical. Usually, an ISDA Master Agreement (Master Agreement), including the schedule (Schedule) and credit support annex (CSA) is executed to enable the hedge fund to transact in OTC derivatives with and through the prime broker.

Fine-tuning the small print
The parties to and the terms of each document greatly affect the scope of a hedge fund’s exposure to prime broker insolvency risk. Limiting the scope of any security interest to specified collateral rather than all of the hedge fund’s assets can help reduce unwarranted claims.

Prohibiting or limiting rehypothecation (eg. in the CSA or PBA), requiring assets and collateral to be segregated (with a third party custodian or, at least, on the prime broker’s books) and/or registered in the hedge fund’s name (rare) rather than in ‘street’ name (common) can provide additional protection. Including mutual ‘adequate assurances’ clauses and termination events based on shareholder equity, book value or rating downgrades in the Schedule can provide early warning signs and termination rights (under the Master Agreement) pre-insolvency. Low initial unadjusted margin requirements and high thresholds for daily exposure-adjusted variation margin in the CSA can reduce exposure by minimising unnecessary posting. Of course, provisions of this nature are routinely rejected and the current credit environment only exacerbates matters. In the OTC context, insolvency risk may be reduced significantly if the efforts of various players (including some hedge funds) to create a central counterparty/clearing organisation(widely supported by regulators) are successful. Until then, master netting arrangements and cross-product master agreements implementing cross-product and cross-affiliate netting can reduce exposure although it is extremely important to note that enforceability varies by jurisdiction.

Such agreements are not without pitfalls and can even increase exposure in some instances depending on the overall mark-to-market value of the portfolio. Requiring prime brokerage documentation to contemplate fully the insolvency of either party should also reduce uncertainty, but may prove difficult in the current environment with prime brokers demanding cross-default provisions with no cure periods or prior notice and significantly increasing initial margin requirements while imposing zero thresholds and low minimum transfer amounts (although some prime brokers are making some concessions).

A prime broker’s legal structure greatly affects the risk its insolvency poses to its customers. US prime brokers are required to register as broker-dealers under the Securities Exchange Act of 1934, as amended (34 Act) and to join, and comply with the rules of, self-regulatory organisations.

For US prime brokers, segregation of customer assets, rehypothecation, securities possession/control and minimum net equity are all regulated under the 34 Act. Customers of US prime brokers holding assets in the US may be protected by the Securities Investor Protection Act of 1979, as amended (SIPA), which established the Securities Investor Protection Corporation (SIPC).

Generally, in a SIPC proceeding, customers of the insolvent party obtain priority over general unsecured creditors to recover from the prime brokers’ pool of customer property on a pro rata basis with other customers. A hedge fund customer would be an unsecured creditor to the extent of any shortfall. Subject to certain restrictions, SIPC covers shortfalls up to US$500,000 per customer. Some US prime brokers maintain additional insurance with the Customer Asset Protection Company (CAPCO) to cover excess shortfalls (also subject to restrictions).

The protections of the US regulatory regime do not generally apply to non-US affiliates of US prime brokers, non-US prime brokers or to assets held outside the United States. US prime brokers commonly rely on such unregulated affiliates for margin lending or securities lending and/or to act as custodians in non-US jurisdictions.

In such instances, the relevant jurisdictions’ laws may provide less protection and impose fewer restrictions than would be the case in the US. For example, many jurisdictions permit rehypothecation in full whereas the US does not.

Hedge funds should accordingly choose prime brokers that hold assets in the US, do not use unregulated affiliates and that have legal structures subjecting them to the US regulatory regime. If unregulated affiliates are involved, a cost-benefit analysis should be performed to ensure proper compensation for the additional risk. Although not strictly a matter of legal structure, choosing prime brokers with strong balance sheets is another good precautionary measure that should not be overlooked.

Beware the prime broker
The recent exodus of prime brokerage customers from even the most blue chip prime brokers suggests that hedge funds are growing increasingly wary of prime broker insolvency risk. One alternative to ‘traditional’ prime brokerage noted by commentators would be to maintain separate custodial accounts for fully paid assets and cash, periodically sweeping credit balances from the prime broker to such accounts. Many hedge funds are also exploring proprietary clearing and settlement systems or outsourcing those services to niche (non-prime broker) providers, while others continue to explore alternative sources of funding. Repurchase agreements executed directly with ‘cash providers’ (e.g. large pension plans) in the market are a good example of an alternative funding source, which benefits hedge funds through counterparty diversification, increased liquidity, lower financing rates, lower margins, the potential to escrow margin as well as potential access to Government liquidity programs. The potential burdens of any alternative should be weighed against any potential benefits pursuant to an overall risk mitigation strategy.

Many of the risk mitigation techniques we have highlighted are not new and in many instances may not be commercially viable. Many hedge funds have tried unsuccessfully for years to negotiate more favourable treatment (or at least greater parity), the ability to effectively segregate or escrow assets and margin, and to restrict rehypothecation.However, disparate bargaining power, dating at least to the fall of Long Term Capital Mangement and probably stemming from the nature of the prime brokerage relationship (i.e. prime broker as lender and hedge fund as borrower), effectively gave rise to a kind of prime broker hegemony, leaving hedge funds aware of, but ultimately unable to address, a very real, and, until recently, seemingly inconsequential risk. Given that context, recent events reiterate the significance of prime broker insolvency risk and may ultimately lead to the balance of power shifting in favour of hedge funds.