Trade errors: exactly why should the investor pay for a manager's mistakes?

Some while ago we touched on the topic of "prospectus creep", or the habit of hedge fund lawyers to gradually add new clauses, exclusions and indemnifications to hedge fund offering documents.

We thought that we would comment on another example of prospectus creep - trade errors.

A trade error occurs when a hedge fund manager does something they didn't mean to do.  A simple example would be for a trader to buy a security when the portfolio manager wanted to sell.  Alternatively, perhaps the wrong security identifier is entered into an order management system, meaning that the hedge fund buys the wrong instrument.  Or, perhaps there is a reconciliation error meaning that a fund ends up trading from an incorrect holdings list and, as a result, purchases too many stocks to cover a short position.

The question becomes who should assume the cost of that error, being the cost of trading out of the incorrect position and bringing the portfolio back to where it should have been.

Best practice remains for hedge fund managers to reimburse a hedge fund - and make investors whole - if they make a trade error.  This was traditionally the policy applied by virtually all hedge funds and, until a couple of years ago, it was very unusual to find a fund manager who sought to charge the cost of trade errors to the fund.

Indeed, the UK Financial Services Authority ("FSA") touched on the topic of trade errors in their 2005 discussion paper (05/4) "Hedge Funds: A Discussion of Risk and Regulatory Engagement."  In section 3.52 of this document, the FSA noted that:

"There appears to be no common understanding among hedge fund managers on whether trading errors should be borne by the fund manager or the fund. We think that the hedge fund manger, as a matter of law, must bear the costs of any errors for which it is responsible, in dealing with fund assets. To not do so would not only cause reputational damage but could also have regulatory or legal consequences." 

The FSA must have changed their mind, because this policy no longer seems to apply.  The change is to specifically include trade errors within the scope of activities for which the investment manager is indemnified under the terms of the investment management agreement.  In these agreements, the manager is indemnified against losses arising from anything and everything except gross negligence, willful default and fraud (as an aside, the latest trend is to try and exclude even the words "gross negligence", but that is a topic for another day.) 

Our friendly hedge fund lawyers now seek to define trade errors as run of the mill, unavoidable hazards of running an asset management business.  We have seen an increasing trend for offering documents to note that items such as reconciliation errors, "fat finger" errors, inaccurate recording of corporate actions, errors related to margin requirements, other accounting and profit and loss reporting mistakes - and of course trade errors themselves - do not constitute gross negligence.  One well known hedge fund law firm even likes to add the helpful phrase "and shareholders should assume that such errors will occur."

Thanks guys.  

In most areas of business, if you make a mistake, you pay for it.  This all leaves us very puzzled as to why hedge fund lawyers believe that the rules of commerce don't need to apply to fund offering documents.

Which leads us to our final point, which is the particular irony.  All this legal brainpower does not come cheap: it is expensive to think of new ways to constantly tighten hedge fund terms and conditions. Who pays the legal bills for drafting new offering documents with ever more restrictive terms?  

It's the investors, of course, as legal bills are charged to the fund, not paid by the manager.

Comments

[dave]

I respectfully disagree, trade errors as described above occur in the regular course of doing business. The impact belongs on the bottom line. The rate of return and rate of error should lead the investor to evaluate the competency of his manager, and act accordingly.

[WLM]

I have to agree with Dave's comment. I've seen it done both ways (investors absorb costs vs. mgmt company) and I have to say I honestly think investors are better off with #1. When the focus becomes avoiding trade errors at all costs, it can introduce delay and opportunity costs which are harder to measure but often prove to be more expensive to the investor.

[mayes]

Is it true that Asset management firms may have to keep a trade error log following ... Exchange officials said the extension should avoid investor confusion ?

mayes
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[Award Winning Forex Broker]

It is true that mistakes happen, we are at the end of the day only human :) And I do support Dave's suggestion - the managers should not be afraid to trade, and the investor should choose a manager he can trust to work with.

[packaging machine]

there is no logical reason why the investor should pay for the manager's mistake. he should be more responsible.