“Prime Brokerage: The Hidden Dangers”

The ongoing turmoil in the financial markets has sent many hedge funds and other prime brokerage clients scrambling to determine their rights under their prime brokerage agreements in the event their prime broker fails. Can they terminate their prime brokerage agreement? Can they quickly and efficiently move their assets from the prime broker? Can they demand a return of posted collateral? Given the breadth and depth of services provided to hedge funds by prime brokers, it is not surprising that these questions are being asked. Because a hedge fund’s prime brokerage relationship is crucial to the operation of the fund, the failure of a prime broker could have far-reaching implications not only for hedge funds and other clients of the prime broker, but for the financial markets generally. And yet, despite the importance of the prime broker relationship, hedge funds, in the rush to get their businesses operating, sometimes fail to give their prime brokerage agreements the due consideration needed to protect the hedge funds’ interests. In fact, prime brokerage agreements present complex issues for hedge funds – issues that if not carefully addressed, could materially impair a hedge fund’s ability to operate and significantly undermine its ability to survive an unexpected crisis. This article highlights some of the issues that should be considered when negotiating a new agreement or reviewing an existing agreement. The take-home lesson is to address these issues now, not when your prime broker is on the verge of collapse.