The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

Articles By Topic

By Topic: Proprietary Trading

  • From Vol. 9 No.38 (Sep. 29, 2016)

    Seward & Kissel Private Funds Forum Explains How Managers Can Prevent Conflicts of Interest and Foster an Environment of Compliance to Reduce Whistleblowing and Avoid Insider Trading (Part Two of Two) 

    The SEC has recently pursued significant enforcement actions for conflict of interest and insider trading violations, in addition to matters brought via the whistleblower program introduced in 2010 under the Dodd-Frank Act. In response, it is important for fund managers to implement safeguards to avoid becoming subject to SEC scrutiny. These issues, and practical measures that fund managers can adopt accordingly, were among the items addressed by a panel at the second annual Private Funds Forum produced by Seward & Kissel and Bloomberg BNA, held on September 15, 2016. Moderated by Seward & Kissel partner Patricia Poglinco, the panel included Laura Roche, chief operating officer and chief financial officer at Roystone Capital Management; Scott Sherman, general counsel at Tiger Management; and Rita Glavin and Joseph Morrissey, partners at Seward & Kissel. This second article in a two-part series explores the SEC’s targeting of various conflict of interest scenarios, provides an overview of the status of the SEC’s whistleblower program and examines the difficulty of prosecuting insider trading. The first article addressed the inflow and outflow of material nonpublic information, risks related thereto and the ways that fund managers can ensure it is not improperly used. For additional insight from Seward & Kissel attorneys, see “What D&O and E&O Insurance Will and Will Not Cover, and Other Hot Topics in the Hedge Fund Insurance Market” (Jul. 14, 2016); and “The First Steps to Take When Joining the Rush to Offer Registered Liquid Alternative Funds” (Nov. 6, 2014). For commentary from Poglinco, see “How Studying SEC Enforcement Trends Can Help Hedge Fund Managers Prepare for SEC Examinations and Investigations” (Sep. 8, 2016). For more from Sherman, see “RCA Symposium Clarifies Current Market Practice on Side Letters, Conflicts of Interest, Insider Trading Investigations, Whistleblowers, FATCA and Use of Managed Accounts Versus Funds of One (Part One of Two)” (Jun. 13, 2013).

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  • From Vol. 9 No.37 (Sep. 22, 2016)

    Seward & Kissel Private Funds Forum Explores How Managers Can Mitigate Improper Dissemination of Sensitive Information (Part One of Two)

    In the current heightened regulatory environment, the SEC has focused on safeguards that managers employ to prevent the dissemination of sensitive information and to ensure it is not used for improper trading. This was among the critical issues addressed by one of the panels at the second annual Private Funds Forum produced by Seward & Kissel and Bloomberg BNA, held on September 15, 2016. Moderated by Seward & Kissel partner Patricia Poglinco, the panel included Rita Glavin and Joseph Morrissey, partners at Seward & Kissel; Laura Roche, chief operating officer and chief financial officer at Roystone Capital Management; and Scott Sherman, general counsel at Tiger Management. This article, the first in a two-part series, reviews the panel’s discussion about risks associated with the inflow and outflow of material nonpublic information, as well as steps that fund managers can take to prevent its improper use. The second article will discuss the types of conflicts of interest targeted by the SEC, the current progress of the SEC’s whistleblower program and the difficulty of prosecuting insider trading. For coverage of the 2015 Seward & Kissel Private Funds Forum, see “Trends in Hedge Fund Seeding Arrangements and Fee Structures” (Jul. 23, 2015); and “Key Trends in Fund Structures” (Jul. 30, 2015). For additional commentary from Glavin, see “FCPA Compliance Strategies for Hedge Fund and Private Equity Fund Managers” (Jun. 13, 2014). For more from Sherman, see “RCA Asset Manager Panel Offers Insights on Hedge Fund Due Diligence” (Apr. 2, 2015).

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  • From Vol. 3 No.8 (Feb. 25, 2010)

    What Is Proprietary Trading, and Why Does Its Definition Matter to Hedge Fund Managers?

    The so-called Volcker Rule would limit the size and scope of banks and other financial institutions with the goals (according to a White House press release) of “rein[ing] in excessive risk-taking and protect[ing] taxpayers.”  With respect to size, the Rule would seek to limit the market share of liabilities at the largest financial firms.  And with respect to scope, the Rule would impose two prohibitions of note to the hedge fund industry.  First, it would prohibit any bank or bank holding company from owning, investing in or sponsoring a hedge fund or private equity fund.  Second, it would prohibit the same institutions from engaging in “proprietary trading operations.”  See “Senate Banking Committee Hears Testimony from Hedge Fund Industry Experts and Academics on ‘Volcker Rule,’” The Hedge Fund Law Report, Vol. 3, No. 6 (Feb. 10, 2010); “Senate Banking Committee Holds Hearings on ‘Volcker Rule’ Designed to Limit Banks’ Ability to Own, Invest In or Sponsor Hedge or Private Equity Funds,” The Hedge Fund Law Report, Vol. 3, No. 5 (Feb. 4, 2010).  We plan to explore the potential prohibition on bank sponsorship of hedge funds in an upcoming issue of The Hedge Fund Law Report.  This article focuses on the proposed prohibition of proprietary trading by banks and other financial institutions.  In particular, this article focuses on the threshold issue of defining precisely what proprietary trading is and is not.  This definition bears directly on the likelihood that the proprietary trading ban will become law because one of the chief objections to the ban is impracticability.  That is, opponents object that such a ban is not practicable because proprietary trading cannot be defined in a manner that reflects market practice and enables consistent regulatory enforcement.  (Even if proprietary trading can be defined, opponents argue that the ban may be superfluous, moot or counterproductive: superfluous because capital or liquidity requirements or a systemic risk regulator may better effectuate the same goals; moot because bank proprietary trading desks may be waning in their contributions to bank revenues and in number; and counterproductive because proprietary trading by dealers enhances liquidity in markets required to fund government operations, such as the markets for Treasury and agency bonds.)  The definition of proprietary trading – and its effect on the likelihood of passage of the proprietary trading ban in the Volcker Rule, as well as the shape that any such ban takes – matter greatly to hedge funds because bank proprietary trading desks interact with hedge funds in at least three important ways: as counterparties, competitors and sources of talent.  See “As Banks Close Prop Desks and Traders Move to Hedge Funds, Hedge Fund Managers Focus on Permissible Scope of Use of Confidential Information,” The Hedge Fund Law Report, Vol. 2, No. 18 (May 7, 2009).  Accordingly, an outright ban of the sort contemplated by the Volcker Rule could be expected to: reduce competition in certain hedge fund strategies (at least in the short term between hedge funds and prop desks, though in the medium term it may increase competition between existing and new hedge funds); increase the supply of investment talent available to hedge fund managers; potentially reduce average hedge fund manager personnel compensation (depending on the elasticity of demand for investment talent); further enhance hedge fund entrepreneurship; increase the number of sales of hedge fund advisory businesses; diminish liquidity in a variety of financial instruments, especially government-issued fixed income securities (in which prop desks currently play a central role); and reduce bank profitability.  On some of the foregoing points, see “How Can Start-Up Hedge Fund Managers Use Past Performance Information to Market New Funds?,” The Hedge Fund Law Report, Vol. 2, No. 50 (Dec. 17, 2009) (hedge fund entrepreneurship); “IRS Issues Guidance on Compliance with Section 409A Requirements Applicable to Deferred Compensation Plans of Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010) (hedge fund manager compensation); “For Managers Facing Strong Headwinds, Sales of the Advisory Business Offer a Means of Preserving the Franchise While Avoiding Fund Liquidations,” The Hedge Fund Law Report, Vol. 2, No. 11 (Mar. 18, 2009) (hedge fund adviser M&A).  But will such a ban become law?  This article seeks to clarify and deepen the proprietary trading debate as it relates to hedge funds.  In particular, this article: provides background and context of the proposed ban; highlights a provision in the Restoring American Financial Stability Act of 2009 (RAFSA) that may yield a legislative definition of “proprietary trading”; most importantly, discusses the three potential approaches to a viable definition of proprietary trading, while highlighting the shortcomings of each approach; discusses the recent retrenchment among investment banks with respect to proprietary trading; and explains the offsetting potential for “prop creep.”

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  • From Vol. 3 No.6 (Feb. 11, 2010)

    Senate Banking Committee Hears Testimony from Hedge Fund Industry Experts and Academics on “Volcker Rule”

    On February 4, 2010, the U.S. Senate Committee on Banking, Housing and Urban Affairs held a hearing entitled “Implications of the ‘Volcker Rule’ for Financial Stability.”  The hearing followed on the heels of the February 2, 2010 hearing in which Former Federal Reserve Chairman Paul Volcker testified on behalf of the his eponymous rule, which President Barack Obama proposed on January 21, 2010 as a means of curbing commercial banks’ proprietary trading if they also benefit from federal protection of consumer deposits and have access to the Federal Reserve’s discount window.  The proposal would also prevent those institutions from owning, sponsoring or investing in hedge or private equity funds.  For more on the February 2, 2010 hearing, see “Senate Banking Committee Holds Hearing on ‘Volcker Rule’ Designed to Limit Banks’ Ability to Own, Invest In or Sponsor Hedge or Private Equity Funds,” The Hedge Fund Law Report, Vol. 3, No. 5 (Feb. 4, 2010).  At the February 4, 2010 hearing, witnesses included Gerald Corrigan, a Managing Director at Goldman Sachs; Professor Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship, Sloan School of Management, Massachusetts Institute of Technology; John Reed, former Chairman and Chief Executive at Citigroup; Professor Hal Scott, Nomura Professor of International Financial Systems, Harvard Law School; and Barry Zubrow, Chief Risk Officer and Executive Vice President at JPMorgan Chase.  Panelists at the hearing expressed concern regarding the feasibility of enforcing the Volcker Rule as well as its potential impact.  This article details the testimony of lawmakers and panelists at the February 4, 2010 hearing.

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  • From Vol. 2 No.18 (May 7, 2009)

    As Banks Close Prop Desks and Traders Move to Hedge Funds, Hedge Fund Managers Focus on Permissible Scope of Use of Confidential Information

    In recent years, proprietary trading desks (prop desks) have contributed a growing proportion of revenue at the major Wall Street investment banks.  As the credit crisis has persisted, however, the idea of a proprietary trading operation housed within a major investment bank has become less and less viable.  The freezing of credit markets has severely curtailed leverage, which once enhanced returns.  Growing risk aversion has diminished the tolerance among risk management departments for the sorts of trades that generated outsized returns (and that occasionally resulted in large losses).  And limits on executive compensation – imposed either by statute or the prospect of public condemnation – have undermined the ability of investment banks, especially those with affiliated commercial banks, to retain trading talent.  The result has been a well-publicized wave of closures of prop desks across the Street (and, in the UK, across the City).  For hedge funds, this wave of closures has had two primary effects.  First, it has decreased competition in certain investment strategies.  Second, it had created a surfeit of unemployed trading talent.  However, while the closure of prop desks has created a market for talent that is very favorable to hedge fund managers looking to hire, it has also created a scenario rife with legal and compliance pitfalls.  Specifically, for the very reasons that a trader would be attractive to a hedge fund manager as a new hire – specific relevant experience; knowledge of specific companies, assets or strategies; relationships with investment target company executives and board members, etc. – the hiring of that trader also creates the opportunity for personnel of the manager to use information possessed by that trader in an unauthorized and potentially illegal manner.  In short, while experienced traders often possess valuable information, they do not, as a contractual matter, own that information.  Rather, their former employer generally owns that information.  That is, much of the information constitutes an asset of the former employer, which subsequent employers are contractually and legally prohibited from using.  Think of it as hiring a race car driver: you (the manager) are getting his ability to drive the car, but not the car itself.  We detail the confidentiality, non-compete and non-solicitation agreements generally entered into by traders at the inception of employment with investment banks and hedge funds, standard provisions of severance arrangements that bear on confidentiality of information, compliance precautions that hedge fund managers can take, consequences for ongoing confidentiality obligations of closures of prop desks and repercussions of violations of confidentiality obligations.

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