Hedge Fund Documentation - Current Issues and Industry Standards

1. Hedge Fund Documentation - Current Issues and Industry Standards Martin Cornish, Partner, K&L Gates London Terry Minkey, Managing Director, HSBC Prime ServicesPhilip Morgan, Partner, K&L Gates London 13 September 2011

2. Hedge Fund Documentation - Current Issues and Industry Standards Lessons from 2008/9 for single managers and fund of funds Prime broker documentation and custody structures Investor Requirements/Concerns Side Pockets v Closed End Funds and partnership v corporate structures for Illiquid Investments Third party distributor documentation - who is liable for mis-selling?

3. Hedge Fund Documentation - Current Issues and Industry Standards AIFMD - future impact on EU and non-EU funds and managers and fund and other documentation UK Hedge Funds Standards Board Rules - setting de facto industry standards for non-signatories?"

4. Lessons from 2008/9 for single managers and fund of funds • Corporate Governance – Weavering Macro Fixed Income Fund • Clear case of failure to carry out duties • Directors liable for $111m losses • Failure to oversee service providers or make enquiries regarding financial position resulting in breach of investment restrictions, inflation of returns and undisclosed exposure to related entity counterparty • Directors “consciously [chose] not to perform their duties…….. in any meaningful way…….” • Failed to exercise independent judgement, reasonable skill, care and diligence and found guilty of wilful neglect or default and so not entitled to be indemnified by the Fund

5. Lessons from 2008/9 for single managers and fund of funds • Corporate Governance – Weavering Macro Fixed Income Fund • Willful neglect or default • Knowing and intentional breach of duty • Acting recklessly, not caring whether or not the act or omission is a breach of duty (Re: City Equitable Fire Insurance) • Court found directors must undertake a verification exercise and review contracts and satisfy themselves each is appropriate and consistent with industry practice • Directors cannot rely on lawyers/accountants/other service providers to do this for them

6. Lessons from 2008/9 for single managers and fund of funds • Corporate Governance – Weavering Macro Fixed Income Fund • Duty to keep board minutes and record discussions • Duty to make enquiries of administrator, auditor and other service providers • Enhanced obligations following Lehman collapse

7. Lessons from 2008/9 for single managers and fund of funds Can Fund meet its redemption obligations? How liquid is the investment strategy? Can redemption obligations be met – daily, monthly, quarterly, annually? Even if 50%/75%/100% of investors redeem at once? How much notice does the manager really need to go to cash – same day |1 day | 7 days | 30 days | 90 days? Are all investments in truly deep, liquid, tradable markets – history of dislocation; local settlement systems; exchange controls; foreign currency conversion etc.?

8. Lessons from 2008/9 for single managers and fund of funds Gating and other provisions ‘Gates’ limit the number of investors who can redeem on any redemption day – irrespective of ability to calculate NAV Gates imply some level of illiquidity/time needed to go to cash Usually by reference to % of NAV by value – say 20% or more of NAV on any dealing day Pro rating of excess applications by value Outstanding requests usually automatically rolled over – but this can lead to ‘panic’ requests by other investors and an avalanche to ‘join the queue’

9. Lessons from 2008/9 for single managers and fund of funds Assumes serious problems with the Fund portfolio Triggers need to be considered carefully ‘Standard’ provisions cover:- closure of markets on which a substantial portion of Fund’s assets are traded- disposals of a material percentage of the Master Fund’s investments cannot be effected normally for some reason Suspension of calculation of NAV and subscription and redemption provisions

10. Lessons from 2008/9 for single managers and fund of funds breakdown in the means of communication normally employed in determining the price or value of Fund’s investments transfer of funds involved in the realisation or acquisition of investments or payments due on redemption cannot in the opinion of the Directors be effected at normal rates of exchange Suspension of calculation of NAV and subscription and redemption provisions

11. Lessons from 2008/9 for single managers and fund of funds ‘Standard’ provisions do not usually define what is meant by “substantial” or “material” – can cause difficulties Argument for giving Directors wide discretion – e.g. to cover unforeseen events like new short selling rules, imposition of exchange ‘limit up and down’ rules etc. Best practice is to keep very broad in Articles and narrow down in PPM as examples only of when powers may actually be used Suspension of calculation of NAV and subscription and redemption provisions

12. Lessons from 2008/9 for single managers and fund of funds Should allow separate suspension of individual share classes; and subscriptions vs redemptions vs NAV May not be clear whether provisions cover inability to value/deal with individual assets But even if an immaterial or non-substantial portion of assets cannot be valued, can Fund actually calculate an NAV? Solution may be to introduce “Designated Investments” or “Side Pockets” Consider redemptions in kind/provisions allowing hold back of part of redemption monies if doubt about realisation value of assets Suspension of calculation of NAV and subscription and redemption provisions

13. Lessons from 2008/9 for single managers and fund of funds Suspension of calculation of NAV and subscription and redemption provisions Common for funds which are anticipated to have illiquid investments but useful for funds which anticipate being liquid but are affected by unforeseen circumstances - NB Absolute Capital Holding Limited case No performance fees on Designated Investments – query management fees – until disposed of/cease to be Designated Investments If significant illiquids are intended/anticipated, consider closed end funds Or hybrids – partnership feeder into opened ended corporate ‘hedge’ fund and closed end corporate PE partnership

14. Lessons from 2008/9 for single managers and fund of funds Suspension of calculation of NAV and subscription and redemption provisions Fund of Funds – need to consider suspension and other provisions in underlying funds Danger in ‘averaging’ underlying funds’ redemption periods Ability to calculate NAV if one or more underlying funds suspend NAV? Need for Designated Investments and Side Pocket provisions if any underlying funds might suspend NAV

15. Lessons from 2008/9 for single managers and fund of funds • Key Investor Issues • Side letters – danger of providing additional information/rights might prejudice other investors – e.g. information which allows one investor to exit ahead of others • Discussions with key investors about restructurings etc – getting binding commitments

16. Lessons from 2008/9 for single managers and fund of funds Third Party Distributor Documentation – Who Is Liable for Mis-Selling? Usual to have provisions requiring distributor to comply with local laws So contractually distributor is responsible to Fund/Manager Consider indemnity also But local laws/regulations may treat distributor as agent of the Fund/Manager If fund mis-sold, investors may have a free ‘put’ back to the fund – could cause mis-calculation of NAV and retrospective recalculation of all past subscription and redemption prices

17. Lessons from 2008/9 for single managers and fund of funds Third Party Distributor Documentation – Who Is Liable for Mis Selling? Depending on the relationship, consider making clear distributor is independent agent, not engaged by Fund/Manager to act as their agent to raise money for them Rather, just willing to pay for introductions of distributor’s own clients Restrict ability of distributor to create own marketing materials/hold itself out as representing Fund/Manager

18. Hedge Fund Documentation - Current Issues and Industry Standards Who is your counterparty – Lehman language implied contracting with whole Lehman group and on each entities’ terms but not all documents seen or presented Ability of counterparty to set off other group company liabilities Uncertainty of how different group documentation fits together – which ones supersede/danger of overlapping provisions? Borrowing and leverage provisions are not like ‘term’ loans – can be suspended, changed, withdrawn at any time without notice Margin, haircut and other provisions can be similarly changed immediately Prime Broker Documentation

19. Hedge Fund Documentation - Current Issues and Industry Standards Prime Broker Documentation Assets held may not be segregated – typically even where agreements say unencumbered assets will be held in safe custody such provisions are superseded in respect of assets charged in favour of the PB And ALL assets are typically charged unless agreed otherwise So unless you specifically agree otherwise, no assets may be in segregated safe custody accounts Even if in segregated safe custody accounts check whether PB has the right to use those assets and if so whether PB has to put collateral in safe custody

20. Hedge Fund Documentation - Current Issues and Industry Standards Prime Broker Documentation Is PB safe custody account a general account for all customers (trading as well as fund management) and if so is there a greater risk of loss if PB goes under Maladministration as well as credit risk Due diligence on how safe custody aspects work in practice – initial and ongoing FSA Client Assets Sourcebook (Enhancements) Instrument 2010 PBs now required to attach a Disclosure Annex summarising re-hypothecation provisions, including definitions of ‘client indebtedness’ and limits on re-hypothecation (if any)

21. Hedge Fund Documentation - Current Issues and Industry Standards Prime Broker Documentation Daily reporting of positions and use of assets etc 20% limit on PBs holding client money with group banks General liens in custody agreement over all client assets prohibited Liens must be specific to services provided such as intra-day payments, settlement and credit lines Exceptions for central securities depositaries and settlement systems etc

22. Hedge Fund Documentation - Current Issues and Industry Standards Prime Broker Documentation FSA comments on PBs offering ‘bankruptcy remote’ custody structures Some are SPVs, others existing entities offering other custody services SPV structures typically have few permanent staff with transfers of assets taking place automatically Staff transfer on insolvency of PB to SPV with retention incentives to fulfil employment duties - NB. Practical problems contacting anyone at Lehman after administrators appointed

23. Hedge Fund Documentation - Current Issues and Industry Standards Prime Broker Documentation • PBs may retain a charge over SPV safe custody assets in specified events – e.g. insolvency of customer • PB charges should expire on PB insolvency • Structures are complex and require significant legal and other due diligence – and effectiveness untested • Some clients signing up documentation but not using SPVs significantly, treating them as ‘insurance’ in case of market dislocation in the future • Other models – ‘affiliated custodian’ and third party custodian

24. HSBC Prime ServicesProviding end-to-end solutions for hedge fund managersK&L Gates Breakfast SeminarHedge Fund Documentation –Current Issues and Industry StandardsTuesday 13th September 2011

25. Diversification - Multi-prime is recommended and in many cases expected. Due Diligence - Enhanced and deeper due diligence is required on your service providers. Legal Agreements - Understand your Prime Broker legal agreements. Board of Directors - The need for independence and expectations around responsibilities. Lessons learned from 2008/9

26. Lessons learned from 2008/9 • Investors • - The bar has been raised around due diligence, infrastructure and counterparty exposure. • Unencumbered custody solutions and transparency • - Having access to the ‘life-boat’, and understanding how these ‘unencumbered’ structures operate in practice. • Spot the signs and act quickly

27. Financing Financing Collateral Collateral Hedge Fund Prime Broker Custodian Hedge Fund Prime Broker Special Purpose Vehicle Trading data Unencumbered assets Unencumbered assets Trading data Transfer instructions Prime broker custody structures 3rd Party Independent Custodian Special Purpose Vehicle (SPV) • Legal • Multiple legal agreements (Prime Broker and Custodian) • Service levels to be agreed between multiple parties • Legal indemnification between parties for services • Operational • Usually separate billing and reporting from all counterparties, creating additional administrative burden for Hedge Fund • Operationally inefficient due to external sweep of assets and associated costs (both monetary and time costs) • Intra-day exposures • Legal • Legal complexity through Prime Provider requiring separate legal entity (dual employment contracts, untested model) • “bankruptcy remote”? Legally untested • Operational • Potentially quite costly if all assets are held in charged account • Transfer of assets – not simple to transfer assets on a daily basis – used only as Disaster Recovery (DR) • Intra-day exposures

28. Prime Custody Hedge Fund With client consent, assets can be “rehypothecated” HSBC Bank Plc Custody Collateral Financing CustodyAccount ChargedAccount Transfer of title Assets surplus to collateral requirements Trading data The HSBC solution Benefits of HSBC platform • Legal • simple structure of dealing with one legal entity - HSBC Bank plc • essentially a custody agreement • with built in financing, stock lending and margin pooling provisions • Operational • Flexible financing solutions - client chooses the assets it holds in custody, makes available for collateral and/or rehypothecation • Consequently financing rates are determined by client choices • Operationally efficient – instructions to a single entity HSBC Bank Plc (no 3rd parties) • Transparent - client can see which account their assets are in at all times • Asset segregation provided by client custody accounts • Consolidated margining and billing across the platform

29. Liquidity - Portfolio construction - Terms - Managed Accounts Counterparty Risk - Who are your service providers (Prime Brokers/Administrator)? - Are you diversified enough? - Do you have an unencumbered solution in place? Investor requirements and concerns

30. Investor requirements and concerns • Infrastructure and Operations • - How is the business structured? • - Is there any key man risk? • - What is the quality of the systems utilized (Operational processing, Risk etc.)? • Due Diligence • - Expect a longer process and a deeper level of due diligence. • - Be organized and prepared.

31. The impact of AIFMD

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33. AIFMD – Future impact on hedge fund documentation • Offering Document • Agreement(s) delegating AIFM’s functions eg. portfolio management, valuation, regulatory compliance monitoring, marketing etc. • Depository Agreement • Any sub-custody agreements • External valuer contract • Side letters

34. Article 23 – mandatory disclosure to investors (i) before investment and (ii) upon material changes – includes (inter alia) description of investment techniques; types and sources of leverage permitted and associated risks; any collateral and asset re-use arrangements; procedures by which investment strategy/policy may be changed; description of delegations by AIFM and depositary; description of fund’s liquidity risk management (including redemption rights in both “normal” and “extraordinary” situations); description of preferential treatment and the type of investors who receive that treatment • AIFMD – Future impact on hedge fund documentation • Offering Document

35. AIFMD – Future impact on hedge fund documentation • Applies to EU AIFMs for each AIF marketed in the EU with a passport, and to all EU and non-EU AIFMs marketing into the EU using private placement • Level 2 (draft) – Immediate notification of investors when gates or side pockets activated or when redemptions suspended; main features of risk management systems employed to be made available to investors before investment; regular disclosure of a description of leverage measures or ratios and their appropriateness when considered against the AIF’s investment strategy

36. AIFMD – Future impact on hedge fund documentation • Article 20 – AIFM’s liability towards AIF and its investors not affected by delegation • Task which is “critical or important for the proper performance of AIFM’s functions provided to fund” [draft – level 2] – eg portfolio management, valuation, regulatory compliance monitoring, marketing • Agreement(s) delegating AIFM functions

37. AIFMD – Future impact on hedge fund documentation • Contract with delegate should contain certain terms to ensure AIFM discharges its statutory responsibilities, eg [draft – level 2]: • Obligation on delegate to grant rights to AIFM of information, inspection and access etc. Rights of access also to regulator (cf. SYSC ch.8 and A.14 MiFID) • Agreement should allow AIFM “flexible” termination rights • If portfolio management is delegated, delegate should be instructed by the AIFM how to implement the investment policy • Delegate must disclose to the AIFM any development that may have a material impact on its ability to carry out the delegated functions • Delegate must establish a disaster recovery plan • AIFM consent required to sub-delegation

38. AIFMD – Future impact on hedge fund documentation • Article 21 – written contract required; new role • Draft level 2 – UCITS used as starting point for content, but ESMA not providing “model agreement” • Depositary Agreement

39. AIFMD – Future impact on hedge fund documentation • Procedures to be adopted for each type of asset • Types of assets that fall within the scope of depositary’s function • Conditions for delegation of custody functions (NB “objective reasons”) • Information exchange to allow AIFM to do its job • The process by which the depositary will receive information from other parties appointed by the AIF or the AIFM • Draft level 2 – List of 14 elements the contract should contain including:

40. AIFMD – Future impact on hedge fund documentation • When is depositary’s agreement to modifications to fund required? • Provisions dealing with depositary’s rights to enquire into the conduct of the AIFM, and vice versa

41. AIFMD – Future impact on hedge fund documentation • Depositary needs to be able to terminate the agreement as its ultimate recourse if the AIFM is taking excessive custody risks • AIFMD liability provisions and delegation provisions must be hard-wired into Depositary Agreement (Article 21(6)(e)) where the depositary is established outside the EU

42. AIFMD – Future impact on hedge fund documentation • Sub-custodians are treated as delegates of depositary under AIFMD • By contrast the relationship is currently not usually seen as an outsourcing • The contract will need adequately to reflect this change • Any sub-custody agreements

43. AIFMD – Future impact on hedge fund documentation • Has adequate structures and expertise • Is subject to minimum capital standards/prudential supervision (unless no local entity satisfies this) • Segregates its own assets from the depositary’s client assets • Complies with the standard of care required by AIFMD for depositories • (Article 21(11)(d)) Depositary has to ensure on an ongoing basis that the delegate (inter alia):

44. AIFMD – Future impact on hedge fund documentation • Option (see Article 21(13)(b)) of transferring liability for “loss” of financial instruments to sub-custodian in sub-custody agreement if “objective reason” and AIF or AIFM have expressly allowed this by written contract (presumably the Depositary Agreement)

45. AIFMD – Future impact on hedge fund documentation • If EV appointed need written process for exchange of information between the AIFM and the EV to ensure EV has all information it needs to perform the valuation task [Draft level 2]. • Need written valuation policies and procedures which are maintained and reviewed • Valuation a delegated AIFM function, so see previous comments on such delegation contracts. Counterparty can be fund (if internally managed) or AIFM (if externally managed) • External valuer (EV) contract

46. AIFMD – Future impact on hedge fund documentation • “Professional guarantees” from EV – Draft Level 2 says these needs to be written documents signed by EV or its legal representatives which contain evidence of the EV’s qualification and capability – eg. confirmation of sufficient personnel and technical resources • No sub-delegation of valuation function

47. AIFMD – Future impact on hedge fund documentation • Side letters • Article 12(1) – Obligation on AIFM to treat investors fairly. Any preferential treatment must be disclosed in AIF rules or instruments of incorporation. • Draft level 2 – proposed requirement that no investor may obtain a preferential treatment that has an overall material disadvantage to other investors • Not unfair to grant preferential treatment to seed investors – they take additional risk • Could prevent unfair treatment if other investors are informed of preferential treatment and have right to redeem free of costs. (cf. AIMA Guidance – need to disclose existence of side letters that contain “material terms”, and the nature of such terms)

48. UK Hedge Funds Standards Board Rules – setting de facto industry standard for non-signatories? • See www.hfsb.org • HFSB Standards were published in early 2008 • 14 initial signatories; now circa 60 • Founders mostly large hedge fund group; some smaller groups have now signed up • November 2010 – Investor Chapter formed – 30 initial signatories; now 45 • Aim to drive adoption of the Standards

49. UK Hedge Funds Standards Board Rules – setting de facto industry standard for non-signatories? • “The Standards provide a powerful mechanism for promoting transparency, integrity and good governance that maintains a high reputation for the industry, facilitates investor due diligence and minimises the need for restrictive regulation” • Always been a flexible, voluntary “comply or explain” system • But how voluntary? • If something goes wrong courts /regulator may treat as de facto indicator of good/market standard practice • Malta has adopted the standards

50. UK Hedge Funds Standards Board Rules – setting de facto industry standard for non-signatories? • Relevance going forward with AIFMD in the pipeline? • 4 August 2011 – HFSB launched drive to sign up more managers in US and Asia • 1 July 2011 – new Chairman: Dame Amelia Fawcett – former non-executive director Bank of England and vice-Chairman of Morgan Stanley • CP3/2011 – focus on “internationalising” standards; also some hardening of standards