Vol 5 (2008) - Issue 1

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The End Game in Insolvency for Hedge Funds: Special Case or No Favoured Treatment? - Part Two

As the international financial crisis regarding sub prime financial instruments seems increasingly unresolved, Part Two (Volume 5, Issue 1) focuses on some of the historical instances of financially distressed firms including hedge funds, and how the current crisis may be resolved. This builds upon Part One’s (Volume 4, Issue 6) focus on the core dimensions of preventing and containing such financial crisis within the context of an international regulatory framework with significant holes as to dealing with hedge fund regulatory and insolvency issues. Part Three (Volume 5, Issue 2) addresses the above credit crisis through 1 September 2007.

V. Hedge funds and regulation: de jure and de facto basis for treatment in the event of large scale insolvency

A. Reasons for concern: old remedies for a new age?
As recent events have shown, the concern about systemic risk is the most critical challenge that regulators face today. Add to that, the desire of many policymakers not to let matters get out of hand, and, the risks posed by derivatives we can quickly see how there are major issues that are of concern. This is especially true given the lack of a carefully integrated systematic crisis resolution framework (as Part I demonstrated).

Indeed, prior to the most recent August Quant 2007 crisis, the current public response of the relevant US and UK officials could be summarised thusly: trust us. Some work behind the scenes has clearly been taking place, as systemic risk was unquestionably an important concern of the relevant high-level officials.

Secretary of the US Treasury, Henry Paulsen has led through an interagency group to look into the issue of crisis co-ordination, in part focussed on hedge funds.Further, as previously mentioned, the Chairman of the US Federal Reserve (Ben Bernanke), the mandarins of the FSA and a special EU working group have reviewed these issues.

Indeed, systemic risk was set forth as a top agenda item in the most recent G8 Summit, reflecting widespread concern, primarily from the European continent, that, these issues require discussion and consensus – before a disaster strikes. However, no coordinated action was taken at the Summit.

Those responsible for policy in relation to the relevant supervisory and regulatory issues have been wrestling with the dilemmas posed by hedge funds as they increasingly take up a larger percentage of financial assets. This upsets the traditional schemes of supervision and regulation for the ‘old age’, as opposed to the new age of hedge funds as well as private equity funds (the latter seeming more and more seem like financial if not operational conglomerates). The enthusiasm for hedge funds is reflected in current and future figures showing asset transfers to hedge funds are increasing, including transfers from more conservative investors as they seek ‘alpha’.

B. Have we been warned? The scope of the challenge
Due to typical redemption options provided to investors, many hedge funds could be vulnerable to insolvency arising from exposure related to the sub-prime August Quant crisis. This will entail the usual cycle of asking for money in excess of assets, and indeed (for many parties) wanting bankruptcy: remember there are many credit default swaps (CDS) out there where the counterparty is expected to fund the loss. This is critical because insolvency is more attractive than a distressed debt discount to avoid bankruptcy. Why take 80% when you can get 100% by collecting on the CDS? Absent liquidity, the question of going concern or enterprise value in the US bankruptcy context becomes fraught: the first lien cannot be refinanced and neither can the second lien, except at huge discount.