The Margin Lock-up Returns to Prime Brokerage
By Karl Cole-Frieman, www.colefrieman.com
In 2009, the problems affecting major banks have also impacted their prime brokerage units, and accordingly there is less appetite to extend credit to hedge funds. As the banking industry recovers, however, credit terms are beginning to loosen up again. As a result, we are beginning to see the return of the margin lock-up for larger prime brokerage clients, who may in fact be in a stronger bargaining position for such agreements than they were a year ago.
What is a Margin Lock-up or Term Commitment?
In the most basic terms, a “margin lock-up” or a “term commitment” is a credit facility extended by a prime broker to a hedge fund or other institutional client. The terms are used interchangeably in the industry. Margin lock-ups prevent the prime broker from changing margin rates, collateral requirements, and often from declining to clear the hedge fund’s trades during the term of the lock-up. For large managers, they are often 90 days, but can range from 30 days to 120 days, and perhaps even longer for the largest hedge fund managers. Practically speaking, the way the arrangement works is that if a prime broker wants to make a change covered by the margin lock-up, they will provide the manager with the requisite notice before doing so.
Margin Lock-ups and Prime Brokerage Agreements
A margin lock-up is negotiated separately from a prime brokerage agreement, but ideally the two agreements are negotiated at the same time. Our experience has been that it is significantly more difficult to negotiate a margin lock-up after the prime brokerage relationship has been established, and that a fund’s greatest negotiating leverage is before signing the prime brokerage agreement.
Negotiating a Margin Lock-up
There are two significant points to negotiate in a margin lock-up: (1) the scope of the commitment (and exclusions), and (2) the termination events. For the scope of the commitment, it is essential that the commitment includes clearing trades. Remember that a prime brokerage arrangement is a demand facility, and the prime broker can normally decide to stop clearing a hedge fund’s trades at any time and for any reason. This is potentially highly disruptive, and could result in significant losses for a fund. If clearing trades are covered by the margin lock-up, the prime broker will have to provide the requisite notice, which will allow time to make alternative arrangements with other counterparties.
Termination Events and Margin Lock-ups
Termination events can be very contentious in a margin lock-up negotiation. The termination events in a margin lock-up give the prime broker the right to terminate the margin lock-up if a certain event occurs. The prime brokers will want to negotiate off of their templates, which will initially have so many termination events it would make the margin lock-up worthless. Managers should be wary of a completely subjective termination event, and such provisions should be negotiated out of the agreement. For example, some prime brokers will try to insist on including a provision that it will be a termination event if the prime broker determines that it would cause the prime broker reputational risk to continue to do business with the fund. More typical termination events include NAV triggers and key person provisions.
Bilateral Termination Events are a Secondary Consideration
Some hedge fund lawyers advocate that the termination events in a margin lock-up should not be completely unilateral, meaning, for example, that the credit rating of the prime broker should be a termination event. We view this as a secondary consideration, and not a point to get bogged down on in the negotiation. If a manager is concerned about the credit rating of the prime broker, they can simply move their balances. They don’t need to terminate the lock-up – leave it in place in case the fund restores balances with that prime broker.
To find out more about margin lock-ups and other topics relating to prime brokerage or custody, please contact Karl Cole-Frieman of Cole-Frieman & Mallon LLP (www.colefrieman.com) at 415-352-2300 or [email protected]
If you are thinking of starting a hedge fund, please contact Mr. Bart Mallon, Esq. at 415-296-8510. Other related hedge fund law and start up articles include: