By Boris Liberman, Partner, Lowenstein Sandler
After the collapse of Lehman Brothers in 2008, buy-side entities were forced to develop a greater appreciation for the legal fine print that governs trading activity with their sell-side counterparts. The dangerously weakened financial position of banks—and the fire drills that called into question their survival—grabbed investment managers by the lapels and impressed upon them the need to become better stewards and risk managers of their investors’ assets. Investment managers and asset owners finally realized that their strategies were only as good as the certainty required to implement them.
Legal trading documents became more relevant in the shadow of the financial crisis as banks exited or severely curtailed various businesses and client lists and as they became more risk-averse. It wasn’t uncommon for investment managers to receive calls at the end of the day for tens of millions of extra margin to be posted the next day or shortly thereafter across asset classes.
Before the events that triggered the 2008 financial crisis, many investment managers routinely ignored or underappreciated these legal agreements. Few took the time to understand the documents or negotiate their terms. Instead, they viewed them as either secondary to maintaining good relations with their personal contacts at dealers or just plain irrelevant. But the spectacular blow-ups of several hedge funds and the realization that banks can fail made the need to understand legal trading agreements vital.
If investment managers learned their lesson, it appears to have been short-lived. Today, many are again showing less interest in trading agreements than they should or disregarding them altogether. While we have yet to see a repeat of 2008, industry insiders have witnessed dealers paying close attention to their balance sheet, culling their customer lists, and lowering levels of service. Additionally, some dealers are getting out of certain businesses altogether.
These trends will undoubtedly have consequences for counterparties, big and small, requiring them to constantly evaluate their business relationships with banks and their legal rights under trading agreements. If they don’t, investment managers put their funds and clients’ investments at risk.
No investment strategy is invulnerable to disruptive and unforeseen events, especially over a long period. And those events can negatively impact the performance of any fund. Investment managers need to know that dealers can use these events as a justification to terminate trading relationships. The consequences of termination can be severe. It may not only inflict financial damage but also hurt an investment manager’s reputation, making it harder or close to impossible for them to form new relationships with other dealers.
What explains why investment managers disregard legal trading documents? One reason is supreme confidence in the personal relationships fund managers have with their counterparts. Fund managers believe (albeit falsely) that their relationships are so strong that they will always trump the rights and obligations established in underlying legal agreements. In their minds, if the performance of their fund’s investments gives rise to concerns at the dealers, they can simply call up their contact, play some golf, and allay any fears. Problem solved.
A second reason managers will often cite is that banks, with unmatched financial resources, will always do what they want to do no matter what’s in the documents. What’s the use in spending time and resources negotiating an agreement?
A third reason relates to time and money. The owners and principals of investment firms often see their in-house legal teams as cost centers that stand in the way of making money. They want to execute transactions as quickly as possible and not be delayed by considering a long list of hypothetical circumstances or events.
But, as history has shown, all three of these reasons are misguided and wrong. In my twelve years of negotiating with all types of dealers across hundreds of various agreements, before banks decide to end their trading relationship with investment managers of a fund or asset owner, the following questions often figure prominently in their internal deliberations:
- What is the status of the entire investment portfolio the client is trading with us?
- How expensive is the client’s business for us?
- How much information do we have about the client’s investment strategy?
- What level of transparency is there into the internal investment processes of the client? How do they think about risk management?
- How cooperative and forthcoming have they been with us in sharing information about its financial reporting?
- Do we have rights to terminate trading relationship without utilizing events of default or termination provisions specified in the agreements?
- What do we know about the founders?
- Do we have legal rights that give us any immediate opportunities to terminate the relationship if the clients’ investments keep falling in value?
Any sophisticated buy-side entity needs to keep these questions in mind as they negotiate the terms of their legal trading agreements. By better understanding what is important to dealers and the regulatory framework they operate in, buy-side players can better anticipate potential disagreements and protect their rights.
Recently, dealers have been pushing for more stringent terms, pointing to the Archegos fiasco as justification. Nobody wins when failure of a single fund causes billions of losses to exposed dealers, but buy-side entities should understand the rationale for these terms and conditions, some of which could be used to terminate trading relationships even as relevant buy-side investment strategy is performing well. General agreement to more stringent terms would mean greater number of funds being blown up in future. Always remember: dealers do not insist on provisions in the agreements if they don’t intend to utilize them in the future as conditions warrant.
Boris Liberman is a partner in Lowenstein Sandler’s Investment Management Practice, where he advises various buy-side institutions on all aspects of implementing their investment and trading strategy.