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

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1 hedge LAW REPORT fund law and regulation Trade Errors How Should Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part One of Three) By Jennifer Banzaca 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 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. What Is a Trade Error? The issue of what constitutes a trade error is more complicated that it would appear at first glance. For starters, the SEC has not clearly defined the scope of the term. With this backdrop of uncertainty, hedge fund managers have struggled to formulate their own definition. This task is particularly challenging given the numerous scenarios in which errors can surface, making it difficult for managers to anticipate each situation in which an error can occur. Brad Caswell, special counsel at Schulte Roth & Zabel LLP, explained, What constitutes a trade error for hedge funds is not always clear because hedge funds have so much flexibility in their strategies. It is not like a broker-dealer where you call up and tell them to buy 100 shares of a security, and the broker sells 100 shares. Hedge funds can go long or short, trade derivatives and, depending how flexible the strategy is, have multiple buys and sells as part of a single strategy. Explaining the difficulty of defining a trade error, Elizabeth Shea Fries, a partner at Goodwin Procter LLP, explained, What constitutes a trade error is probably one of the hardest questions that arise for hedge fund managers. Some situations are easily diagnosed as trade errors, including where: (1) a security was purchased/sold instead of being sold/purchased; (2) the wrong security is purchased or sold; (3) the right security was purchased, but for the wrong account; and (4) the wrong number of securities were purchased. Fries commented, I think everyone realizes that

2 when the portfolio manager says buy 1,000 shares of GE, and the trader buys 100 shares or sells 1,000 shares, or buys GM instead of GE, those are all obvious trade errors. However, numerous other situations are not so easily categorized, and different managers may disagree as to whether such situations represent trade errors. Fries explained, Some examples of more difficult scenarios include a situation where the portfolio manager instructs a trader to make the trade, but the trader, who usually trades within minutes, goes to lunch or is otherwise delayed in making the trade and perhaps does not place the trade until the next day. Is that a trade error? The answer is that it depends. I think that there are trades that can constitute mistakes that are not necessarily trade errors. One of the things that managers should be careful about is that, while they should quickly identify trade errors, it may not be appropriate to label every mistake or glitch as a trade error. For example, if there is a delay in making a trade, it may not really be an error, particularly if there is no real impact on the fund as a result, and the delay is within standard practice for the manager in the applicable market context. Managers need to identify possible errors and carefully assess the situation before labeling something a trade error. Practitioners also differ as to whether the failure to execute a trade constitutes a trade error, and that determination may depend on the individual circumstances surrounding the trade. Timothy Selby, a partner at Alston & Bird LLP, expressed the general view that, If someone was supposed to buy 100 shares of IBM and they failed to execute that trade, that is a trade error. Other practitioners may argue that the manager s clients have not suffered actual monetary losses in this situation, and therefore, no trade error has occurred. However, in some situations, the failure to execute a trade can lead to actual losses for a client, including a situation where a manager fails to cover a short sale of a security on behalf of a client. Managers must determine whether a trade error has occurred in such circumstances. These two situations provide a glimpse into the challenge of anticipating all scenarios for the purpose of defining what constitutes a trade error. Some practitioners take the view that trade errors are generally limited to situations involving mistakes during the trade execution process. Therefore, if securities were purchased/ sold in violation of applicable investment restrictions or guidelines for a fund or account, some practitioners would not consider these transactions to be trade errors. Selby explained, I think people look at trade errors as a failure in the execution process. If someone bought IBM but they were not supposed to buy it, I do not think that constitutes a trade error. That may be style drift or a diversion from the strategy, but I do not think it is an error. I think it is an unintended consequence of the management of a portfolio. Selby continued, If you can bust a trade before it gets executed, I do not think you have a trade error. If you can undo it before it hits the portfolio, I would say that is no harm, no foul. Also, who commits the error does not change whether an error occurred. If it is the broker or a trader that commits the error, the real question comes down to liability. If the broker makes the mistake, the broker should be responsible for it. Situations involving the improper allocation of securities among a manager s funds and accounts also raise questions as to whether a trade error has occurred. The determination may depend on the particular circumstances involved. For instance, if a firm has standing instructions for the allocation of orders among funds and accounts; the desired

3 allocation deviates from the standing instructions; and the trade is allocated in accordance with the default allocation instructions, some might argue that a trade error has occurred because the securities have already hit the affected funds and accounts. Others may disagree, noting that there is no error in the actual execution of the trade, only in the allocation of the order after execution has occurred. Situations involving miscommunications among employees at a firm also raise questions as to whether a trade error has occurred. For instance, does the fact that the lack of communications that causes trader A to execute a trade that has already been executed by trader B (unbeknownst to trader A) constitute a trade error? There is no mistake in the actual entry and execution of the order, only in the communication between the traders. Questions also arise as to whether administrative errors constitute trade errors. Caswell noted, There are also administrative errors where something is booked incorrectly. In this situation, the trader places the right trade but when operations keys it into the system, they enter it incorrectly. Administrative mistakes may not be viewed as trade errors. What Legal Obligations Do Managers have with Respect to Trade Errors? Fiduciary Duties The SEC has expressed the general view that investment advisers should bear losses associated with their trade errors as this is consistent with the fiduciary duty of good faith owed by a manager to its clients implicit in the Investment Advisers Act of 1940 (Advisers Act). This position was reflected in a 2005 SEC order settling an enforcement action brought against investment adviser EGM Capital and Michael T. Jackson in which the SEC explained, consistent with industry practice and an investment adviser s fiduciary duty to its clients, losses caused by an investment adviser s own trade error were the responsibility of the adviser and should not be borne by clients. (In the Matter of Michael T. Jackson and EGM Capital, Advisers Act Release No. 2374). Despite this guidance, much uncertainty remains concerning the SEC s views on trade errors. For instance, the SEC has not opined as to whether managers must bear losses for their trade errors in all instances. More specifically, the SEC has not indicated whether managers and their clients are permitted to contract for the clients to bear losses from trade errors in delineated circumstances, including situations where trading losses are immaterial or where the manager s conduct did not evidence a culpable mental state. Additionally, the SEC has not opined as to whether a manager may net losses from trade errors against gains from trade errors over a delineated period. These issues will be discussed in more detail in the third article in this series. Duty to Disclose Trade Errors The SEC has not clearly indicated when a manager must disclose trade errors. Many practitioners take the position that a hedge fund manager does not have an obligation to disclose trade errors unless such information is material to its clients. Kelli Moll, a partner at Akin Gump Strauss Hauer & Feld LLP, commented, If the error is of a magnitude that it has a material effect on the fund, it can trigger a disclosure obligation to investors. Caswell agreed, explaining, Whether a trade error would need to be reported to investors would depend on the facts and circumstances. It would have to reach a level of materiality for it to trigger a disclosure

4 obligation. Fries commented, Clearly, if the error affects the net asset value of the fund, a prompt correction and disclosure are typical. In determining the materiality of the trade error, the magnitude of the error is a key factor, both in terms of the amount of assets involved and the losses suffered. In some cases, an error that reveals a significant gap in the firm s compliance system could also represent a material error. Fries explained, If you have a separately managed account, an error will most likely be disclosed because it will show up on the transaction statements. In the hedge fund space, such statements are not provided to investors, and therefore, it is a little bit more complicated. If there is a material error that has affected the fund s net asset value, you have to tell your investors, and you have to make changes and correct the errors. If the error bespeaks a major compliance issue within the firm, you may need to address it and possibly disclose it. In the ordinary course, there are going to be errors, and not every trade error is material or disclosable. So, you have to make an assessment whether the error is material enough to warrant a disclosure. Kevin Duffy, a partner at Kaufman Dolowich Voluck & Gonzo LLP, added, I would say that you should disclose an error when it is material to the fund or managed account, and the materiality depends on the size of the error. I think that a fat finger error of a small amount relative to the size of the fund is likely not material. I would advise managers to write it up for proper documentation, but investors need not be notified of the trade error. Brian Vahey, Principal at Berkeley Research Group, LLC, added a further cautionary note with respect to disclosing trade errors to investors. If a manager discloses a trade error, it sends up a warning flag. If it is big enough to cause concern and be seen as a material error, disclosing the error is going to have some negative consequences from the investors side. It will probably result in some redemptions. Having a lack of control over certain errors, I think, would cause money to flow out of the fund. Trade Error Policies and Procedures Rule 206(4)-7 under the Advisers Act requires registered hedge fund managers and other registered investment advisers to, among other things, (1) adopt and implement written policies and procedures that are reasonably designed to prevent violations of the Advisers Act and the rules thereunder and (2) evaluate, at least annually, the adequacy of their compliance policies and procedures and the effectiveness of their implementation. See How Managers Should Approach Preparing For, Conducting and Documenting the Annual Compliance Review (Part Two of Two), The Law Report, Vol. 5, No. 13 (Mar. 29, 2012). Although not explicitly stated in the rule, the adopting release makes clear that the SEC expects registered investment advisers to adopt policies and procedures designed to address various risks and conflicts of interest arising out of their trading practices. More specifically, in a document published in May 2006 entitled Questions Advisers Should Ask While Establishing or Reviewing Their Compliance Programs, the SEC explicitly encouraged registered advisers to ask the question, Are trade errors identified at the earliest possible time and resolved in a manner that is consistent with disclosures made to clients and your fiduciary relationship with clients? According to Selby, Any manager who is a registered investment adviser is required to have a trade error policy in

5 its compliance program. Caswell added, The SEC expects advisers to have policies and procedures in place to deal with trade errors; train employees on those policies and procedures; and have a strong compliance program in place to monitor and deal with trade errors. Moll further noted, From a compliance perspective, the SEC certainly expects you to have trade error policies and procedures in place outlining how you handle trade errors; a methodology for tracking those errors; and a process for resolving trade errors. What Policies and Procedures Should Managers Adopt to Address Trade Errors? In developing and implementing a compliance program, managers should include policies and procedures designed to prevent, identify, resolve, and document trade errors, pursuant to Rule 206(4)-7. Robust trade error policies and procedures are critical in establishing that a manager has taken measures to mitigate and manage conflicts of interest associated with trade errors, particularly those related to the allocation of gains and losses resulting from trade errors. In addition, investors are increasingly interested in scrutinizing a manager s trade error policies and procedures to evaluate the manager s approach to reducing trade error risks. Vahey explained, Having the proper policies and procedures in place to deal with trade errors is important because investors want to see less potential for operational risk. There is a lot more housekeeping and data collecting in the trading area now. Such policies and procedures should, among other things: Ensure that the term trade error is clearly defined, as the definition will determine how the manager will respond in handling each individual error. Fries advised, I think a basic trade error policy would start with at least some examples of what constitutes a trade error, which obviously will depend, in part, on what your business is. Caswell commented, The policy should include examples of trade errors and differentiate between trade errors and administrative errors so that employees know the difference. Designate a person responsible for handling trade errors, which will typically be the manager s chief compliance officer (CCO). This person should be endowed with appropriate authority to properly address each situation involving a potential trade error. Include pre-trade controls designed to verify that orders are properly entered and confirmed in accordance with relevant instructions and restrictions. Institute post-trade controls designed to monitor for trade errors. Require employees to report trade errors as soon as practicable to the CCO, recommended Duffy. Caswell agreed, noting, There should be a policy that employees should report any trade errors to the chief compliance officer as soon as possible after the error is discovered. Managers may require employees to fill out forms documenting details of a trade error, including when the trade error occurred, why it occurred, when it was identified and what measures have been taken to address the trade error. Track reported trade errors to ensure that they are properly handled. Akin Gump s Moll explained that from a compliance perspective, there is a general expectation that someone in the compliance department (usually

6 the CCO) is monitoring trade errors. In order for the CCO to monitor errors, there needs to be a reporting mechanism in place within the manager s organization to report those errors. Adopt measures designed to resolve trade errors, including canceling trades, reallocating securities and/or reimbursing accounts for losses/gains from trade errors in accordance with the manager s designated allocation methodology. Specify the method for allocating gains and losses resulting from a manager s trade errors to ensure consistent treatment of losses. Selby advised managers, In setting the policies and procedures, you have to remember that trade errors are just part of the business. You need to determine the attribution of gains and losses, if there is a threshold amount over which the fund will be liable for trade errors. Articulate the responsibilities of the manager so investors are aware of it at the outset. Have as robust a trade error policy in place that you can that talks about the proper price; how frequently it will be done; and whether you will net gains and losses. Document trade errors and the resolution of such trade errors. Keep a log of all trade errors that have occurred and how the firm resolved such trade errors. As Fries noted, You need a reporting and recordkeeping process. The reporting is going to vary significantly by firm. Duffy recommended that managers create a form for trade errors so that the portfolio manager or trader has to document the error and explain what has occurred. This is a simple way for you to have a record of the trade error and what was done about it, he said. Once established, a manager must ensure that employees understand the trade error policies and procedures and diligently monitor employees compliance with such policies and procedures. Caswell explained, It is more than just having a policy. Managers have to make sure they are complying with that policy, that people understand it and that they are implementing it on a daily basis. The traders and analysts need to understand the seriousness of this issue, and they need to be very careful. Because of the numerous situations in which trade errors can surface, managers should strongly consider holding training sessions specifically devoted to the identification and handling of trade errors. Training in handling trade errors can be particularly critical given the time sensitivity of many situations involving trade errors. Without training, employees may panic and respond inappropriately when confronted with a situation involving a trade error. Once established, hedge fund managers should also review trade error policies and procedures at least annually to ensure that they are reasonably designed to prevent, detect and resolve trade errors. Caswell suggested, From a compliance perspective, it is a good idea for the chief compliance officer to monitor and test the compliance policies and procedures, including for trade errors.