The Hedge Fund Law Report

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

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By Topic: Trade Errors

  • From Vol. 9 No.27 (Jul. 7, 2016)

    Merrill Lynch Settlement Reminds Hedge Fund Managers to Be Aware of How Brokers Are Handling Their Assets

    The 2008 collapse of Lehman Brothers highlighted the significant risk to hedge fund managers from the collapse of a prime broker or significant counterparty. See “Lesson From Lehman Brothers for Hedge Fund Managers: The Effect of a Bankruptcy Filing on the Value of the Debtor’s Derivative Book” (Jul. 12, 2012); and “How Can Hedge Funds Get Their Money Out of Lehman Brothers International Europe?” (Aug. 5, 2009). In theory, client funds in the hands of a broker-dealer should be sacrosanct. Specifically, Rule 15c3-3 under the Securities Exchange Act of 1934 (Exchange Act), commonly known as the Customer Protection Rule (Rule), requires broker-dealers to segregate the net cash owed to their clients and to safeguard client securities. A recent SEC settlement order indicates that two Merrill Lynch entities failed on both counts, engineering riskless “leveraged conversion trades” that artificially created client margin account balances that they could net against the cash they were required to reserve for clients and subjecting tens of billions in client securities to a clearing bank’s lien. Separately, in a move that echoes the SEC’s focus on private fund CCO liability, the SEC has commenced an enforcement action against William Tirrell, the Merrill Lynch executive responsible for compliance with the Rule. See “SEC Enforcement Director Assures CCOs They Need Not Fear SEC Action Absent Wrongdoing” (Nov. 19, 2015). The settlement is a reminder that fund managers must be cognizant of how prime brokers and other counterparties may be using their assets. This article summarizes the key elements of the Merrill Lynch settlement and the related action against Tirrell. See also “Factors to Be Considered by a Hedge Fund Manager When Selecting a Prime Broker” (Dec. 4, 2014). 

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  • From Vol. 8 No.41 (Oct. 22, 2015)

    How Hedge Fund Managers Detect and Bear Responsibility for Trade Errors in Practice (Part Two of Two)

    Hedge fund managers must closely monitor their operations in an attempt to detect any potential trade errors and resolve them as quickly as possible.  However, once a trade error is detected, the question of who bears responsibility for that error remains.  Will the manager reimburse the hedge fund for any losses that it has incurred in light of the trade error?  Or, will the fund have to bear that burden?  Hedge fund managers must also keep in mind other operational considerations including materiality; applicability of trade error policies across multiple funds and accounts; and regulatory concerns.  In an effort to determine industry best practices for addressing trade errors, The Hedge Fund Law Report conducted a survey of hedge fund managers.  This second article in a two-part series presents the results of that survey with respect to detection of and responsibility for trade errors, as well as other operational considerations.  The first article discussed fundamentals of trade error policies and handling trade errors.  For more on trade errors, see “How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part Three of Three),” The Hedge Fund Law Report, Vol. 6, No. 12 (Mar. 21, 2013).

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  • From Vol. 8 No.40 (Oct. 15, 2015)

    How Hedge Fund Managers Define and Handle Trade Errors in Practice (Part One of Two)

    The intricacies of hedge fund trading are rife with opportunities for trade errors to arise.  Hedge fund managers must remain vigilant for situations such as purchases of incorrect amounts of a particular security, inaccurate asset allocations and missed or delayed trades.  Registered investment advisers must also establish a compliance program that includes policies and procedures for addressing trade errors under the Investment Advisers Act of 1940, and the SEC remains interested in trade errors and their resolution when examining hedge fund managers.  However, crafting and executing policies and procedures to address trade errors requires a hedge fund manager to choose from many options.  What should the scope of the policy be?  Who bears responsibility for trade errors and operational procedures under the policy?  These and other questions must be dealt with consistently by the manager.  In an effort to determine industry best practices for addressing trade errors, The Hedge Fund Law Report conducted a survey of hedge fund managers.  This first article in a two-part series presents the results of that survey with respect to the fundamentals of trade error policies and handling trade errors.  The second article will discuss detection of and responsibility for trade errors, as well as other operational considerations.  For more on trade errors, see “Katten Forum Identifies Best Practices for Hedge Fund Managers Regarding Best Execution, Soft Dollars, Principal Trades, Agency Cross Trades, Cross Trades and Trade Errors,” The Hedge Fund Law Report, Vol. 7, No. 10 (Mar. 13, 2014); and “How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part One of Three),” The Hedge Fund Law Report, Vol. 6, No. 10 (Mar. 7, 2013).

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  • From Vol. 7 No.10 (Mar. 13, 2014)

    Katten Forum Identifies Best Practices for Hedge Fund Managers Regarding Best Execution, Soft Dollars, Principal Trades, Agency Cross Trades, Cross Trades and Trade Errors

    At its Investment Adviser Forum on February 20, 2014, partners from law firm Katten Muchin Rosenman LLP addressed a series of legal issues that regularly arise in connection with trading by hedge funds with reasonably liquid strategies.  Those legal issues include fiduciary duty, best execution, soft dollars, principal trades, agency cross trades, cross trades and trade errors.  Forum participants defined these terms as they apply to hedge fund trading strategies and identified legal best practices with respect to each of them.  This article relays the key points from the forum.

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  • From Vol. 6 No.12 (Mar. 21, 2013)

    How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part Three of Three)

    Trade errors can cause substantial harm to hedge fund managers and their investors.  Such errors can, among other adverse consequences, undermine investors’ confidence in a manager’s trade execution capability; cause a manager to miss investment opportunities; and divert investment and operating resources in the course of correcting errors.  As such, managers, investors and regulators are theoretically aligned in their shared interest in avoiding trade errors.  As a practical matter, however, there is no regulatory roadmap to best practices for trade error prevention, detection and remediation.  SEC guidance has been sparse on this topic; and industry practice has largely filled the vacuum left by the dearth of authority.  Accordingly, in the area of trade errors (as in other areas, such as principal transactions), hedge fund managers are left to divine industry practice – and, further, to conform relevant practice to the specifics of their businesses.  How can hedge fund managers do this?  To begin to answer this hard and multifaceted question, The Hedge Fund Law Report has been publishing a three-part series on preventing, detecting, resolving and documenting trade errors.  This third installment in the series discusses the allocation of losses and gains resulting from trade errors among a manager and its clients; limitations on the allocation of trade error losses; documentation of trade errors; whether managers can obtain insurance to cover losses resulting from trade errors; and common mistakes managers make in handling trade errors.  The first article in the series discussed the challenge of defining a trade error; a manager’s legal obligations relating to the handling of trade errors; and the policies and procedures that managers should consider to prevent, detect, resolve and document trade errors.  See “How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part One of Three),” The Hedge Fund Law Report, Vol. 6, No. 10 (Mar. 7, 2013).  The second article in the series outlined various measures to prevent trade errors; detect trade errors after execution; report trade errors once identified; resolve trade errors; and calculate losses resulting from trade errors.  See “How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part Two of Three),” The Hedge Fund Law Report, Vol. 6, No. 11 (Mar. 14, 2013).

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  • From Vol. 6 No.11 (Mar. 14, 2013)

    How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part Two of Three)

    Trade errors can prove to be catastrophic for hedge fund managers, particularly where the firm fails to adopt policies, procedures and controls designed to appropriately identify, prevent, detect and handle such errors.  The task of instituting robust trade error practices has been complicated by the lack of significant guidance in this area.  Nonetheless, regulators and investors remain keenly focused on evaluating how hedge fund managers approach trade errors.  With this backdrop, The Hedge Fund Law Report is publishing this second installment in a three-part article series designed to help hedge fund managers understand and navigate the legal, investment and operational challenges presented by trade errors.  This article outlines measures to: prevent trade errors; detect trade errors after they occur; report trade errors once identified; resolve trade errors; and calculate losses resulting from trade errors.  This article also discusses whether soft dollars can be used to correct trade errors.  The first article in this series discussed the challenge of defining a trade error; a manager’s legal obligations relating to the handling of trade errors; and the policies and procedures that managers should consider to prevent, detect, resolve and document trade errors.  See “How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part One of Three),” The Hedge Fund Law Report, Vol. 6, No. 10 (Mar. 7, 2013).  The third installment in this series will discuss the allocation of losses and gains resulting from trade errors among a manager and its clients; limitations on the allocation of trade error losses; documentation of trade errors; whether managers can obtain insurance to cover losses resulting from trade errors; and common mistakes managers make in handling trade errors.

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  • From Vol. 6 No.10 (Mar. 7, 2013)

    How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part One of Three)

    Trade errors can paralyze even the most seasoned hedge fund managers, both because of the potential magnitude of the financial losses, and because of the urgency with which such errors must be addressed and resolved.  As a result, it is imperative that hedge fund managers adopt a plan as well as policies and procedures designed to prevent, detect, quickly resolve and document trade errors.  Unfortunately, regulatory guidance concerning the handling of trade errors is scant, and hedge fund managers have been challenged to formulate their own measures for addressing trade error issues.  With this in mind, The Hedge Fund Law Report is publishing this three-part series designed to assist hedge fund managers in navigating the myriad legal, investment and operational challenges posed by trade errors.  This first installment discusses the challenge of defining a trade error; a manager’s legal obligations relating to the handling of trade errors; and policies and procedures that managers should implement to prevent, detect, resolve and document trade errors.  The second installment in this series will outline specific strategies to prevent trade errors; detect trade errors after trade execution; report trade errors once identified; resolve trade errors; and calculate losses resulting from trade errors.  The third installment in this series will discuss allocation of losses and gains resulting from trade errors among a manager and its clients; limitations on the allocation of trade error losses; documentation of trade errors; whether managers can obtain insurance to cover losses resulting from trade errors; and common mistakes managers make in handling trade errors.

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