SEC Looks at Prime Broker-Hedge Fund Relationships

The focus comes as SEC Chairman William Donaldson said in testimony before the Senate Banking Committee that the agency’s investigation has been primarily focused on the implications of this growth for investor protection, according to a Dow Jones report.

In making this statement, Donaldson specifically called out prime brokers as one area of focus, saying the SEC was interested in learning more about services, such as capital introduction, that these firms direct specifically at their hedge fund customers.   “We are looking into these services and the way they are disclosed to investors,” Donaldson said.

The attention comes because prime brokers – those institutions that finance, clear and settle trades for hedge funds and act in the central custodian capacity for all of the securities in a fund’s portfolio – have also been lending a helping hand to hedge funds’ fundraising efforts by steering pension funds, endowments and foundations their way.   Thus, by making these “capital introductions,” the SEC is trying to determine to what extent, if any, prime brokers will be held liable to specific claims:   fund managers that will hold a firm responsible for not raising enough money, or investors blaming the firm for introducing them to a fund whose manager is either fraudulent or incompetent.

Prime brokers contend that they make it clear to investors that they are not advocates for their hedge fund clients. In fact, one unnamed industry executive told Dow Jones his firm will not provide investors with information about a fund’s performance, for example. “Our position is that’s the type of information that should be communicated directly by the hedge fund, and in any case, we have no way to independently verify it,” he said.

Also, prime brokers take certain measures to attempt to match up managers with investors who are most likely to be attracted to their strategy, so as not to waste their clients’ time. “If you burn either side, you never get another chance,” the executive said. “We’re walking a fine line to keep everyone happy.”