Vol 5 (2008) - Issue 2

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

As the international financial crisis regarding sub prime financial instruments seems increasingly unresolved, Part Three (Volume 5, Issue 2) focuses on the current crisis and its resolution. This builds upon Part One's (Volume 4, Issue
6) focus on the core dimensions of preventing and containing such financial crisis within the the context of an international regulatory framework with significant holes as to dealing with hedge fund regulatory and insolvency issues. Part Two
(Volume 5, Issue 1) addressed the above credit crisis within a historical framework and discussed available remedies.

'I am firmly convinced that hedge funds provide considerable benefits to financial markets and our economies, but they also can present potential challenges and risks … It is in the US interest to promote a thriving, competitive global hedge fund industry that facilitates price discovery and promotes liquidity in financial markets, while maintaining investor protection and promoting financial stability. Market discipline, focusing on the risk management of regulated counterparties, is the most effective way to address potential systemic risk concerns.'

VIII. The dimensions of the debate about insolvency risk and their implications for hedge funds in the current international financial and regulatory architecture

A. Background

The August Quant crisis has arisen primarily due to the default concerns relating to sub-prime mortgages that have been issued by conduits for originators and purchased by investors. Many of these investors have been hedge funds. In Parts One and Two, the focus of our journey was on how hedge fund restructuring and insolvency would be prevented, contained, and resolved.
Some reference was made in the latter sections of Part Two to current insolvency cases such as In re Sphinx and Bear Stearns High-Grade Structured Credit Strategies Master Fund Ltd., 07-12383, and Bear Stearns High- Grade Structured Credit Strategies Enhanced Leverage Master Fund Ltd., 07-12384, U.S. Bankruptcy
Court, Southern District of New York (Manhattan).

Consideration of which type of insolvency regime was optimal was the focus of Part One given the distinctions between corporate and banking insolvency regimes. Part Two focused on how consideration of mitigating insolvency risk could be undertaken by certain legal reforms, especially given the fact that hedge funds are Highly Leveraged Institutions (HLIs) that are too complex to fail. Part Three now turns to questions of how the August Quant crisis may best be resolved in light of the above background and some specific issues
articulated in greater detail below.

B. The crisis revisited: focus on the informational dimension

The extent of losses from the sub prime market collapse is not clear for the reasons set out below. Specifically,losses are sometimes difficult to determine, and many investors have failed to report such losses, notwithstanding the requirement for firms subject to Sarbanes Oxley that material changes are reported without delay under Section 409.

The uncertainty, related to a real lack of information in some cases, and sometimes a hiding of losses (given human nature and the history of operational risk) has had 'knock-on' effects on funding which banks provide for through private equity transactions, especially bridge loans.