The Role of Jurisdiction in Risk Analysis

A closer look at this overlooked aspect of investment risk

ALLISON YACKER AND BLAIR WALLACE, KATTEN MUCHIN ROSENMAN

Jurisdiction is a significant aspect of risk and mitigation analysis that is often overlooked and misunderstood. Now that custodian, broker and fund insolvency are real concerns, investors and fund managers must put a premium on asset protection and legal certainty when making decisions. Complex investments can involve as many as a dozen different jurisdictions and it is critical that risk analysis relating to jurisdiction be performed at the outset of any decision making process. Further, the risks must be examined on both a country-by-country and collective basis. The complicated nature of this analysis requires a sophisticated approach to assessing and mitigating the risks associated with cross-border investing.

Jurisdiction and laws of the custodians
Though it is expected that a hedge fund will use a third-party custodian, investors and fund managers should conduct risk analysis beyond the custodian’s creditworthiness. A hedge fund’s rights and related risks vary greatly depending on the jurisdiction of the custodian. For example, in civil law jurisdictions such as the Netherlands, a custodian’s customer has no legal right to the assets deposited with the custodian. Consequently, a hedge fund customer facing an insolvent custodian in a civil law jurisdiction will have only an unsecured claim for the value of the assets identified in its account. By way of contrast, in a common law jurisdiction such as the US, a fund would maintain a property interest in the assets it deposited with the custodian. As a result, in the case of a US custodian’s insolvency, the fund generally has a right to the return of the actual assets that it deposited in its account. The legal and business risks associated with custodial structures in some jurisdictions may be mitigated by, for example, obtaining a guarantee or a direct pledge of the custodian’s rights with respect to the customer’s assets. Such solutions only present themselves to those who engage in rigorous jurisdiction-specific risk analysis.

Jurisdiction, custody and related trading arrangements
Until recently, trading documents such as prime brokerage agreements were often regarded as “boilerplate” and not worthy of review or subject to negotiation. Accordingly, little to no consideration was given to the jurisdiction-related risks posed by these arrangements or the ways to mitigate those risks. Recent events such as the Lehman bankruptcy have exposed these risks and caught many hedge funds that were account holders at Lehman unprepared. For example, the prime brokerage agreements of Lehman’s US broker-dealer provided that Lehman could, without notice, open accounts for customers with its affiliates in any number of countries and then transfer customer assets to those accounts. Many hedge fund customers that used Lehman as their prime broker were surprised to learn that their assets had been transferred to Lehman’s UK affiliate. Insolvency laws and liquidation procedures in the UK differ materially from the US and most funds are still waiting for the return of their assets from Lehman’s UK affiliate. Some funds have shut down due directly to their inability to recover those assets in a timely manner. Still others continue to face steep losses resulting from their inability to liquidate positions and redeploy assets.

The broad rights afforded to Lehman under its prime brokerage agreements are not uncommon. Most dealers’ form documents contain similar provisions regarding the opening of new accounts and the transfer of customer assets without notice. There may be instances where such provisions are an important tool for prime brokers and their customers by, for example, permitting cross-collateralization of positions in multiple jurisdictions. In any event, it is critical for fund managers and investors to be aware of these issues so they can properly monitor and make informed decisions to manage the related risks.

Jurisdiction and cross-border transactions
Hedge fund managers and investors considering cross-border transactions should scrutinise each jurisdictional component. In jurisdictions that do not have public filing systems that can be searched, there may be no way to accurately determine whether prior liens exist. Further, the requirements to create a “first priority security interest” or a “fixed charge” vary from jurisdiction to jurisdiction and the legal significance of a security interest often varies. It may be impractical or impossible for a fund to execute trades in certain jurisdictions due to legal, operational or administrative limitations. Similarly, it may prove to be prohibitively burdensome from an operational perspective to create an enforceable security interest in certain jurisdictions. Regulatory issues may also arise depending on the nature of the security interest created. Accordingly, structuring hedge fund transactions to provide viable and effective ways to create and enforce a security interest may be a complicated undertaking depending on the relevant jurisdictions and asset classes. Significant structuring and enforcement issues may also arise if the law governing the security document is inconsistent with the law governing custody of the assets subject to the security interest.

Submission to jurisdiction and choice of law
Submission to jurisdiction and choice of law provisions are important considerations as well. Some jurisdictions have a limited body of case law which can lead to unanticipated decisions by courts and legal uncertainty. A party’s submission to jurisdiction does not guarantee that disputes will be resolved in the stated jurisdiction if other factors such as the location of property, service providers or key persons dictates that another court is the proper venue. This was the case when a US bankruptcy court determined that it was the proper forum for insolvency proceedings in respect of Bear Stearns’ failed hedge funds due to the location of assets and managers in New York. Another practical consideration is the limited number of qualified attorneys in certain jurisdictions and the difficulty of retaining counsel that does not have an actual or positional conflict of interest.

Conclusion
Jurisdiction is a fundamental component of comprehensive investment risk analysis. Recent events show that consideration of jurisdiction must play a primary role in investment decisions and structuring. Investors and fund managers that properly perform this analysis before making investment decisions are likely to avoid some of the costly pitfalls that many funds have suffered. The complex nature of these issues underscores the need for expertise to effectively perform this risk analysis. Only then, with such expertise, can managers and investors be sure that they have properly evaluated and structured their investments to mitigate risk, protect assets and provide legal certainty.

Allison Yacker and Blair Wallace are members of Katten Muchin Rosenman’s Financial Services Group and Structured Products Group. They each focus on structured products with an emphasis on OTC derivatives, futures, cross-border financing/asset-based lending and alternative investment strategies, including premium finance and life settlement.