What are the most important legal lessons learnt from the financial crisis for hedge funds?

A variety of lessons have come out of the financial crisis. Not only will documentation for hedge funds substantially change in future, transparency will be a key issue for investors. The dangers of counterparty risk, of not performing proper due diligence and much closer attention to detail are all issues that investors will be concerned with in future.

According to Sonya Van de Graaff at Brown Rudnick in London, hedge funds have learnt to engage in active negotiation over funding documentation and prime brokerage documents. “The old bargaining powers have altered. Hedge funds have learnt to focus on counterparty risk, including that of their prime broker and custodian,” she admits.

At Withers, partner John Langan says transparency is the key to hedge funds regaining the trust and improving their relationship with investors and regulators. “Custody agreements and counterparty risk should be assessed on a regular basis,” says Langan.

“A good risk management process is the best way to minimise loss when problems arise, or at least anticipate and avoid potential problems before they arise,” he advises.

When establishing a hedge fund the choice of structure should be one that is robust and can adapt to future changes where necessary, Langan says.

At Lovells, Nora Bullock and Simon Atiyah believe the collapse of Lehman’s was a “wake-up call” exposing the dangers of prime broker relationships and the inadequacy of protections to counterparties. They say many investors were unaware of the nature of the risk.

They also think it is clear that the term ‘hedge fund’ covered a wide range of products, many of which carried little or no hedge to the market turmoil.

The crisis has reinforced the need for more investor due diligence, they believe. Both say investors are no longer content to rely on the blue chip reputations of institutions or individuals.

Finally, the inadequacy of many hedge fund prospectuses and disclosure documents was exposed, they say. Risk disclosures were inadequate, the ability to impose gates and suspend redemptions was inadequately explained and sometimes the criteria were non-existent with inadequate independent oversight, they conclude.

Simon Firth at Kaye Scholer advises investors and funds to read and understand what the legal documents say and assess and monitor legal risk. “Investors are business partners, not friends,” he cautions, adding that they want protection against enforced redemptions.

“After a tumultuous year for the industry that brought transparency and liquidity issues to the forefront of investor concerns, there has been a move by many managers towards managed accounts which offer full ownership and transparency for investors,” notes Joey Garcia at Isolas in Gibraltar. “The challenge for hedge funds is to reduce their total expense ratios in order to be competitive and to return to levels of performance that make them attractive,” he says.

The importance of instructing knowledgeable counsel and taking advice from legal firms with the expertise to deal with specific structures has also been highlighted by the crisis. “Well-drafted legal constituting documents and material agreements can make a considerable difference at times of crisis,” adds Garcia.

“The expertise that fund lawyers can provide to their clients may ultimately prove the difference that ensures the survival of the fund should it run into a situation where investors are panicking and creditors are calling in debts. Whether it is through the inclusion of suspension of redemption provisions, lock-up periods, gates, or side pockets, such measures may prove vital for a fund to remain liquid during difficult times in which it may find itself inundated with redemption requests from anxious investors,” he concludes.

In Malta, Omar Zerafa at Aequitas Legal says the crisis was a test for “subsistence for hedge funds. It clearly demonstrated that those funds in a strong regulatory environment were the most capable of surviving duress. As a result, funds are now seeking jurisdictions with adequate regulation and legislation.”

He believes having an authority supervising the regulatory and disclosure requirements, rather than having such requirements imposed in the fund documents, would help to create a common system for all funds. “Apart from adding to the overall stability of the system, it helps to create legal certainty which would be greatly appreciated by the investors,” he adds.

In New York, Steven Nadel at Seward & Kissel simply advises funds to diversify counterparty exposure and “be careful re liquidity and valuation of investments”.

Another New Yorker, Mitch Nichter at Paul Hastings, suggests funds should “be upfront with investors about potential liquidity constraints and redemption mechanisms and craft more precise and thoughtful fund documents to disclose and implement these constraints and mechanisms and the policies the manager will look to in times of turmoil to meet its obligations to investors.”

At Walkers, Jonathan Tonge’s advice centres on greater scrutiny of all agreements and constitutive documents before the fund launch. “This is principally to ensure that all parties clearly understand the remit of the directors’ authority and the ability of the directors and the manager to manage liquidity. This is true even for funds that are considered to be highly liquid with no need for such measures,” he says.

He adds there has been a much greater understanding of the relevant custody issues, in particular to identify the circumstances in which the fund’s assets may charged or rehypothecated.

Managing liquidity, even if it affects performance, is the issue highlighted by Gray Smith at Appleby in the Cayman Islands. “Legal documents can put you in a robust position when dealing with investors but only keeping them happy is going to make you successful in the long run,” he adds.

At Maples and Calder, Michael Richardson says it is important to consider the level of flexibility required at the structuring stage.

He believes it is crucial to have access to top-tier legal counsel with the ability to gear up during a crisis, survey the available options and implement effective, robust solutions.

“It is important to avoid drift between underlying documents and marketing documents or even oral representations. The fund should be aware of side letters with particular investors and factor in contractual obligations when considering restructuring options, communication and early identification of problems,” advises Richardson.

Tania Dons and Richard Finlay in the Cayman office of Conyers Dill & Pearman say the key lesson for funds and managers is “to get their ducks in a row from day one” by ensuring fund documentation is sufficiently flexible, clearly drafted and provides the tools and mechanisms necessary to deal with potential future problems. Preparation is the key to success, they say.

In the British Virgin Islands office, Robert Briant suggests the most important lesson is the need to structure funds properly. “In good times many persons are not particularly concerned with the detailed language of contracts or the memorandum and articles of association. However, when a crisis occurs, that is when it is necessary to ensure the memorandum and articles of association and contracts are robustly drafted to ensure there is sufficient power to side-pocket assets, impose gates, or suspend redemptions, subject to the requirements of investors to ensure that these powers are not to be exercised too quickly or inappropriately by the hedge fund,” cautions Briant.

In good times no one is particularly concerned about these issues, he says, “but in a crisis these are the issues that come to the forefront”.