Historically, many investment managers have negotiated limited recourse provisions into derivatives trading agreements entered into by the managers on behalf of their clients with banks, broker-dealers, and futures commission merchants (FCMs). In short, these provisions state that only the assets in the specified account under the control of that particular manager can be used to make the other party to the agreement whole for losses and costs that relate to the specified account.
However, recent regulatory pronouncements from two divisions of the Commodity Futures Trading Commission (the “CFTC”) and the Joint Audit Committee (the “JAC”) of several large futures exchanges and the National Futures Association prohibit the use of limited recourse provisions in futures customer agreements. This blog post is Part 1 of a series of posts that will address the impact of these recent regulatory developments on investment managers.
We start with the basics – investment management relationships and the use of limited recourse provisions in derivatives trading documents. Additional posts in this series will address the regulatory pronouncements and how those pronouncements may impact relationships that investment managers have with their clients and the FCMs through which the managers are trading on behalf of their clients.
Part 1: Investment Management Relationships and Limited Recourse Provisions (I Only Control My AUM)
A typical investment management agreement gives an investment manager the discretion to implement a specific investment strategy in respect of a client’s assets (commonly referred to as the “assets under management” or “AUM”). The AUM may represent all or only a portion of a client’s assets.
For example, if a client has only one investment manager, then that manager will have discretion over 100% of that client’s assets. This type of an arrangement is common in the context of a mutual fund complex that has a single investment advisory firm acting as the investment manager to several different mutual funds. However, another client may retain more than one investment manager and allow each of its managers to control a specified account. This type of an arrangement can involve almost any type of an institutional client, including mutual funds, ERISA plans, governmental plans, and corporations.
In these multiple manager arrangements, the client is the beneficial owner of each separate account that is under the control of the different investment managers; each investment manager is only authorized to control (i.e., exercise discretionary authority) over the specified account with respect to which it has been designated as the investment manager. Investment management agreements do not typically authorize the investment manager to encumber or bind assets under the management of another investment manager.
Because of this contractual and commercial reality, many investment managers seek to include provisions in trading agreements with broker-dealers, FCMs and banks that limit recourse of the other party to the assets in the specified account under the control of that particular manager. Such provisions, commonly referred to as “limited recourse” or “nonrecourse” provisions, typically state that only the assets in the specified account under the control of that particular manager can be used to make the other party to the agreement whole for losses and costs that relate to the specified account.
In our experience, these provisions are common in a wide range of trading agreements, including futures customer agreements, ISDA Master Agreements, Master Repurchase Agreements, and Master Securities Forward Trading Agreements. However, recent regulatory pronouncements from two divisions of the CFTC and the JAC prohibit the use of limited recourse provisions in futures customer agreements.
Our next post in this series will explore these pronouncements in greater detail.
Good day. Good to know what is coming, even if it is not all good. DR2