How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part Two 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 Two of Three) By Jennifer Banzaca 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 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 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. What Measures Can Managers Take to Prevent Trade Errors? Enterprise-Wide Approach Among other things, hedge fund managers must adopt measures that are reasonably designed to prevent trade errors. Internal controls and technological solutions are powerful tools in a hedge fund manager s arsenal. However, even before implementing any measures to prevent trade errors, those responsible for adopting relevant measures must understand the challenges and risks their firms face. This requires those principally responsible for adopting such measures (often compliance and legal personnel) to dialogue with other employees throughout the firm, including technology, risk and investment personnel, who may be better equipped to understand trading processes, strategies and risks and how to address trading risks. Working together, compliance, legal, technology, risk and investment personnel will be best equipped to institute controls and select technological solutions that will minimize the likelihood of trade errors.

2 Internal Controls For starters, managers should institute controls designed to ensure that orders are properly entered and executed. In many instances, technology may provide the necessary verification. In other instances, firms may have employees other than the executing trader manually verify that the trade has been properly entered. Additionally, managers should institute controls around order limits, investment guidelines or restrictions, risk requirements and compliance requirements to ensure that pending trades are entered and executed in compliance with applicable instructions and do not violate any applicable restrictions. Where orders are aggregated for multiple funds and accounts, firms should institute controls around order allocation to ensure that each order is allocated appropriately, particularly where the desired allocation for a given order deviates from the firm s standing allocation instructions. Elizabeth Fries, a partner at Goodwin Procter LLP, advised that, In part, preventing trade errors comes down to pretrade compliance to make sure you are not buying or selling a security for the wrong client or trading in violation of restrictions or something else that is problematic at the account level. So, pre-trade compliance is important for avoiding something that is a clear error on its face. Some organizations also have a cross-check on the manner in which trades are processed. According to Kevin Duffy, a partner at Kaufman Dolowich Voluck & Gonzo LLP, other measures to prevent trade errors include setting an automatic expiration date for swaps. For issues such as fat finger trades, Duffy explained, I do not think that there is that much you can do, and I do not think that technology will completely take away trade errors. You just have to be careful and follow your procedures. Firms can also institute measures designed to mitigate any impact of any potential trade errors, including limiting employee trading discretion. Brian Vahey, Principal at Berkeley Research Group, LLC, explained, One way you can try to prevent trade errors is to give traders parameters for the types or size of trades they can do. Having a P&L limit is one way to quickly stop anything further from going wrong. If you make a trade error over a certain amount, you are stopped from trading. This allows a hedge fund manager to limit the damage from any one individual trader or strategy. Technology Technology can also be a powerful tool for preventing trade errors, particularly those technologies that expose or eliminate human error. According to Tim Decker, Senior Manager of Global Alliances at Advent Software, While there is tremendous diversity in the technologies to mitigate trade error risk for a hedge fund manager, the tools that are most critical are those that highlight, reduce or eliminate human error in the trading process. Decker explained that there are four critical systems that can facilitate the prevention and detection of trade errors: (1) portfolio accounting systems; (2) order management systems (OMS); (3) compliance systems; and (4) comprehensive trade and post-trade connectivity, which is discussed in the section below. According to Decker, With a tightly integrated portfolio accounting system and OMS, it is simple to ensure that every trade is checked to confirm that the security is set up and approved for trading within the firm; that all trades are constrained to either existing positions or available funds (to

3 address clear errors as well as input mistakes such as trying to sell/buy too many shares); and that all trade scenario modeling is done using the existing asset data from the portfolio accounting system yielding yet another pre-trade check. Decker continued, Next in the risk mitigation chain is a compliance system which performs two key tasks. The first key task is pre-trade checking, which enforces all firm mandates as well as cash or trading thresholds. The second key task falls into the notification and monitoring camp, which uses checks on portfolio holdings to immediately notify traders and the compliance team post-trade of any non-compliance situations. What Post-Trade Measures Can Managers Take to Detect Trade Errors Despite a firm s best efforts, trade errors will almost inevitably occur from time to time. Therefore, firms must adopt measures reasonably designed to detect trade errors after they have occurred. Effective solutions will detect such trade errors as soon as practicable after trade execution to minimize the impact of such trade errors and to facilitate timely resolution. Fries explained, Post-trade monitoring helps to identify trade errors quickly. The amount and type of post-trading monitoring conducted by each firm will depend on, among other things, the firm s investment strategy and operational characteristics. Fries commented, Obviously, if you have a more concentrated portfolio, this is easier to do because you have fewer trades made on any given day. With a quantitative strategy, you are probably running more forensic-type testing on your trading. Manual checking can be an effective tool for detecting trade errors. Brad Caswell, special counsel at Schulte Roth & Zabel LLP, advised, CCOs really need to be reviewing trades on a regular basis. One way to monitor trades in this area is to look for outliers which may indicate there is some type of trade error. If anything jumps out as a red flag, the CCO should follow-up and ask questions about it. Among other things, a daily review of the trade blotter should be conducted to identify trade errors as soon as practicable, Duffy recommended. That is something that the accounting, risk and compliance departments have to go through often to be sure that the correct trades were made. You should be questioning larger positions and looking for anything unusual. Timothy Selby, a partner at Alston & Bird LLP, commented, The CCO sets the policy and educates the staff. Trades get reconciled, and the trade order has to be matched up with the blotter. That is how they check things. Someone s failure to put in a trade does not appear anywhere. So, you are relying on the individual to come out and admit to an error. That is a harder one to recognize. traffic and instant messaging systems may provide a record of what orders should have been placed. You have to match that up with the later confirmation. Ultimately, the chief financial officer is responsible for reconciling trades and should recognize errors. Technology also plays a role in the ongoing monitoring of trades. According to Advent s Decker, A key component in the mitigation, monitoring and reporting process for trade errors is post-trade connectivity, which provides hedge fund managers the ability to perform straight-through processing (trade, settlement and reconciliation) all from within their integrated suite enhancing their ability to quickly identify and monitor trade errors as well as to get a historic view on these processes.

4 Reporting of Trade Errors Despite a firm s best efforts, prevention and detection may not immediately reveal that a trade error has occurred. To facilitate prompt resolution and minimize any harm from trade errors, hedge fund managers must establish policies and procedures designed to require employees to report trade errors immediately to the compliance department or other responsible manager personnel upon discovery. This is particularly critical because many employees may instinctively try to resolve trade errors on their own to avoid revealing that they have made a mistake. However, such impromptu resolution of trade errors may not be consistent with the firm s policies and procedures for handling trade errors. To supplement such policies and procedures, managers should conduct employee training to emphasize the need and reasons for immediate trade error reporting. How Should Managers Handle Trade Errors Once Identified? Compliance personnel must review trade errors to ensure proper handling once identified. Such tasks include investigating the trade error; analyzing the error to choose the appropriate corrective action to be taken in accordance with the firm s policies and procedures; if necessary, calculating gains/losses resulting from trade errors and allocating gains and losses among affected funds and accounts; monitoring the progress of trade error handling; and documenting trade errors once corrective action has been taken. Schulte s Caswell commented, Once you have an issue, what do you do about it from a compliance perspective? You need to analyze it under your policies; make sure you are dealing with the issue consistently with your policies; and document it. What Are the Different Measures That Can Be Taken to Correct a Trade Error? While most trade errors are corrected by allocating gains and losses among the manager and its funds and accounts, other measures may be available. For starters, managers should try to cancel a trade, if possible, to avoid any effects from a trade error. The closer in time to a trade error that it is detected, the more likely it is that a manager will be able to arrange for the cancellation of a trade. Managers may also try to reverse erroneous trades by executing trades in the open market. In some circumstances, managers may also try to reallocate certain securities that should not have been purchased from an affected fund or account to the manager s own account. See When and How Can Managers Engage in Transactions with Their s?, The Law Report, Vol. 4, No. 45 (Dec. 15, 2011). Nonetheless, in both of these scenarios, if there are gains and losses that have occurred prior to the reversal of the trade or the reallocation of the securities, the manager should determine how to allocate those gains and losses among the manager and its clients in accordance with its policies, procedures and fiduciary duty. Nonetheless, managers should recognize that there are regulatory limitations on their ability to resolve trade errors. Among other things, managers may not use soft dollars to cause broker-dealers to absorb losses resulting from trade errors. In providing a safe harbor for the use of soft dollars if certain conditions are satisfied, Section 28(e) of the Securities Exchange Act of 1934 provides: No person... in the exercise of investment discretion with respect to an account shall be deemed... to

5 have breached a fiduciary duty... solely by reason of his having caused the account to pay a member of an exchange, broker, or dealer an amount of commission for effecting a securities transaction in excess of the amount of commission another member of an exchange, broker, or dealer would have charged for effecting that transaction, if such person determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services provided by such member, broker, or dealer.... Under Section 28(e), trade error correction or related services are not considered to be eligible brokerage products or services because they are not related to the initial trade and are deemed to be a separate transaction to correct the manager s error. Thus, Duffy noted, Managers cannot use soft dollars to cover trade error losses. That is the end of the discussion. Soft dollars really should not be used for anything other than research and other covered services. Fries agreed that it is not appropriate to use soft dollars to correct trade errors. Calculating Gains and/or Losses Resulting From a Trade Error As noted above, the most common method for resolution of trade errors is the allocation of the resulting losses or gains. However, before losses or gains can be allocated, a manager must determine the extent of the losses or gains resulting from the trade error. Managers may question whether the losses or gains should be measured from the time that the trade error occurred or from the time that it was discovered. Duffy explained that it is industry practice to calculate losses from the time when the error occurred, not from when it was discovered. Kelli Moll, a partner at Akin Gump Strauss Hauer & Feld LLP, agreed, indicating that in her experience, managers generally calculate trade error gains and losses from when the error occurred until the date that the error is resolved. In some situations, it may be difficult to determine the exact time when a trade error occurred. In such situations, Selby indicated that managers may use the average trading price of a security on the day in question or the closing price on the preceding day in calculating losses and gains.