What can law firms do to help a hedge fund avoid or survive a crisis?

John Langan at Withers thinks no matter the cause and nature of the crisis, prevention is often better than cure. He suggests some areas to look into to avoid future problems include initial structuring and ensuring the fund as well as the management/advisory entity has the appropriate structure in the first place.

“Generally, if measures to protect investors are in place and it is clear that investors’ rights will be dealt with consistently and fairly, a fund is more likely to survive a crisis,” he says.

Angela Hayes at Mayer Brown in London says it is a “sad fact that it is often simple and obvious gaps in risk management procedures that are at the heart of crises, such as failures in due diligence and failures in basic risk control like data security.” She believes a law firm experienced in this area can do a lot to help hedge funds avoid a crisis by reviewing and advising on upgrades in internal procedures and training staff.

“When it comes to surviving a crisis, speed is of the essence and steps taken in the first few hours are often critical to the outcome. This can be managed with good, experienced legal advice and also by having a crisis management plan in place and at the ready,” she notes.

Solicitor Nora Bullock and consultant Simon Atiyah at Lovells believe an important aspect of a law firm’s role is to ensure the fund structure and documentation is robust and flexible. They say it is now necessary to foresee and deal with a range of potential issues, including counterparty risk. Also law firms will negotiate key documentation such as prime broker agreements and ensure these are as fair and balanced as possible.

According to Bullock and Atiyah, law firms should aim to cap levels of rights of use or rehypothecation in documentation.

It is likely that in the future as a result of a UK Treasury consultation document on developing effective resolution arrangements for investment banks, there will be a shift in bargaining power so that prime broker agreements will no longer be broadly non-negotiable.

Partner Simon Firth at Kaye Scholer advises that well-drafted documents should furnish the fund’s board with the maximum array of options in the event a crisis develops. “With hindsight it is clear that many funds who encountered a crisis situation in the last year or so were inadequately served by their constitutional and contractual documents, for example being unable to set up side pockets without investor consent,” says Firth.

As boards become increasingly professional and independent, he expects they will involve lawyers early on when problems develop to seek strategic as well as strictly legal counsel.

At Brown Rudnick in London, Sonya Van de Graaff believes law firms can help hedge funds at the formation stage by drafting flexibility into constitutional and investor documents (for example, by including gates and an ability to suspend redemptions) and ensuring the documentation with the funding providers and prime brokers are reasonable by drafting clearly defined financial covenants and not allowing an unlimited discretion to the financier or prime broker to determine net asset value (NAV) and other critical provisions regarding ability to draw on credit or post collateral.

“At the pre-investment stage, legal firms should ensure the hedge fund understands the risks and pressure points of the proposed investment,” she says.

In New York, Ron Geffner at Sadis & Goldberg says the first step in protecting a hedge fund is making certain the business has been formed “most optimally to the circumstances. The terms of the fund should take into consideration the investment strategy including but not limited to inflow and outflow of assets, potential risks associated with the strategy and management of the fund.”

After launch the manager must “contemplate the ramification of entering into side letters,” cautions Geffner.

If a manager has entered into an agreement obliging the fund to only return cash, it presents a dilemma, he notes.

“Advise them not just legally but also based on past experience and provide colour as to what others are doing,” advises Steven Nadel at Seward & Kissel in New York. “Lawyers should do the following: put together a strong compliance manual; review client business to identify major risks and address same and draft offering documents with sufficient flexibility to deal with major crises,” he says.

Henry Bregstein at Katten Muchin Rosenman in New York believes discipline is at the heart of avoiding a crisis. “Assuming a law firm has the requisite expertise to undertake legal risk and how this relates to business risk, the law firm must be able to convince the fund manager that the cost of establishing meaningful, reality-based compliance and due diligence procedures and rigorously maintaining those procedures is not a waste of time and money, but rather a prudent investment,” advises Bregstein.

“Numerous managers have lost significant market cap or have simply disappeared because they didn’t understand that economic proposition. There is a reason people buy insurance,” he adds.

Ingrid Pierce at Walkers in the Cayman Islands believes law firms need to be attuned to the latest market developments and “be able to promote creative solutions and adapt their work product to meet changing demands.”

She says law firms need to work closely with their clients “as they can play a significant role in helping a fund to avoid or survive a crisis provided they are involved at a very early stage in the process. We have seen many cases where a fund fails to instruct counsel until after key decisions have been made.”

Michael Richardson in the Cayman Islands office of Maples and Calder thinks it is important at the structuring stage and during the life of the fund to understand the market in which the fund operates and the potential catalysts of a crisis.

“The law firm’s approach needs to incorporate flexibility, expertise, availability, experience innovation and communication. From a practical point of view, experienced lawyers can help fund manager clients get to grips with the complex relations between the fund, its service providers and shareholders,” advises Richardson.

Partner Gray Smith at Appleby’s Cayman office believes the key is in drafting the documents correctly in the first place. “We have a large fund disputes practice and have been able to see a lot of other firms’ work. The quality has been a little mixed with too great a reliance on precedent. More thought and planning needs to go into offering documents and constitutional documents,” notes Smith.

“Once in a crisis, handling the more aggressive investor responses can help to give managers time to formulate structures which will work for all going forward,” he advises.

In Gibraltar, associate at Isolas Joey Garcia says lawyers and managers should benefit from hindsight in relation to the credit crisis. He thinks they will be much more inclined to place greater emphasis on the planning and risk management aspects of the fund.

“A general rule in most areas of business is to be proactive rather than reactive since a little planning and foresight can go a long way to prevent major problems and disruptions at the later stages,” he says.

In the Isle of Man office of Cains, Daniel Mackelden agrees a properly structured fund is a must. Documents need to contain “the necessary protections and flexibility to match with the fund’s investment aims and investor expectations. There is also an ongoing need to keep the fund up to speed on the latest developments in structuring and make consequential changes.”

Frank Chetcuti Dimech at CDF Advocates in Malta says most of the safeguards need to be built into the offering documents. “Typically these would include designated share classes for illiquid securities, lock-out periods, limitations on redemptions and suspension of dealing,” he says.