§ 12.02 Prime Brokerage Services

• Jurisdiction: United States
• Publication year: 2022

§ 12.02 Prime Brokerage Services

[1]—In General

Investment funds use prime brokers to facilitate their trading activity. The main services that prime brokers provide to investment funds are custody of their assets, lending and financing of their assets and technological support to monitor their positions. Prime brokers also provide access to trading exchanges, consulting services and capital introduction.

[2]—Leverage

One of the main functions of prime brokers is to provide margin financing to investment funds so they can obtain the leverage needed to implement their trading strategies. When purchasing a security, the investment fund borrows some portion of the purchase price of the security from the prime broker.

[3]—Regulation T, Portfolio Margining and Enhanced Prime Brokerage

[a]—Margin Requirements Generally for New Securities—Regulation T

The margin rules adopted by the Board of Governors of the Federal Reserve System establish limits on the value of stock and other securities that are used as collateral in a transaction.¹ The Federal Reserve's Regulation T ("Reg T") governs the amount of margin that a "creditor"² (e.g., a broker-dealer) may obtain when a customer buys or sells a security, sells a security short, or removes funds or securities from a margin account. Generally, Reg T prohibits a broker-dealer from initially lending to its customers more than 50% of the value of securities or from extending credit in excess of 50% of the value of securities collateral.³ While Reg T imposes margin requirements for new securities transactions and for withdrawals of cash or other collateral, Reg T does not require that additional collateral be provided if the value of a security decreases after it is purchased.⁴

Reg T authorizes the securities self-regulatory organizations to adopt rules governing the amount of margin that must be maintained for open positions.⁵

[b]—Portfolio Margining

Reg T permits broker-dealers to use exchange-approved "portfolio margining" programs to compute their customers' initial and continuing margin requirements if the relevant exchange's portfolio margining rules have been approved by the SEC.⁶

[i]—Eligible Instruments

NYSE Rule 431 permits NYSE member firms to apply a risk-based margin requirement to eligible products—including equity (single stock) options and single stock futures, listed broad-based securities index options, index futures and futures options, and related exchange-traded funds—as an alternative to strategy-based margin requirements, i.e., Reg T.⁷

[ii]—Availability

Portfolio margining is available only to:

• individuals and entities (other than Individual Retirement Accounts) that have or establish, and thereafter maintain, at least $5 million in equity in a portfolio margining account;

• SEC-registered broker-dealers; and

• members of futures exchanges to the extent that listed index options hedge their positions in index futures.

Any such customer must additionally be approved for options transactions, including uncovered short option positions, by the broker-dealer carrying the customer's account.

[c]—Enhanced Prime Brokerage

"Enhanced Prime Brokerage" arrangements allow a hedge fund to borrow amounts in excess of what would otherwise be permitted under Reg T. Enhanced Prime Brokerage arrangements are similar to traditional prime brokerage arrangements except that such arrangements are offered by a non-U.S. financial institution and the prime broker has an enhanced ability to lend to hedge funds under applicable law. But in exchange for the increased leverage, investment funds take on additional legal risk. Generally, there are fewer protections for customers of prime brokers in jurisdictions outside the United States. One major concern for investment funds that use enhanced prime brokerage arrangements is the rehypothecation of assets. Rehypothecation is commonly defined as the right to sell, lend, use or vote a security. The general rule for prime brokers outside the United States is that a prime broker has the right to rehypothecate an investment fund's assets. In contrast, in the United States the prime broker's right to rehypothecate assets is limited.⁸ In other jurisdictions, an investment fund may have difficulty getting back securities that the prime broker has rehypothecated.

[4]—Prime Brokerage Agreements

[a]—In General

There is no industry standard agreement governing prime brokerage. Each prime broker has its own version. One of the main goals of the prime brokerage agreement is to protect the prime broker from the investment fund's insolvency, rather than protecting the investment fund from the prime broker's insolvency. In addition, prime brokerage agreements provide the prime broker with broad discretion to change collateral requirements and margin rates, to terminate lending and to demand repayment. These forms typically expose an investment fund to material business risk if the prime broker becomes insolvent.

[b]—Issues to Negotiate for Investment Funds

[i]—Parties Acting as Prime Broker

In many cases, the prime brokerage agreement will identify the prime broker and all its affiliates as parties to the prime brokerage agreement. For U.S. prime brokerage agreements, this should be permitted only for the purpose of granting the affiliates a security interest in the investment fund's assets held by the prime broker in the prime brokerage account. In UK prime brokerage agreements, an investment fund will transfer its assets to the prime broker and the prime broker's affiliates, rather than grant a security interest in its assets. Ideally, the prime broker should be identified only as the party providing prime broker services to the investment fund under the prime brokerage agreement.

[ii]—Applicability and Scope of Prime Broker Agreement Terms

Some prime brokers want the terms of the prime brokerage agreement to be incorporated into, and otherwise trump, any conflicting terms contained in any other agreement between the investment fund, the prime broker and any of the prime broker's affiliates. This may serve to amend favorable terms existing in trading agreements between the parties (such as an ISDA (International Swaps and Derivatives Association, Inc.) Master Agreement or a repurchase agreement). Ideally, this concept should be deleted in its entirety from the prime brokerage agreement. At a minimum, the prime brokerage agreement should not adversely affect a fund's rights or obligations under the trading agreements in certain key areas, such as collateralization requirements, set-off and netting arrangements and the scope of the fund's indemnification obligation or similar liability in respect of transactions under the trading agreements. For instance, the fund should not be obligated to indemnify an affiliate of the broker under the terms of the prime brokerage agreement for a claim against that affiliate in respect of a transaction between the fund and such affiliate under a trading agreement that does not grant any such indemnification right to the affiliate.

[iii]—Minimum Net Equity

All prime brokers that are U.S. broker-dealers are subject to the letter dated January 25, 1994, from Brandon Becker, Director, SEC, to Jeffrey C. Bernstein, Bear Stearns & Co., Inc. (the "Letter").⁹ The Letter establishes, among other things, minimum net equity requirements for prime brokerage accounts. Currently, the minimum is $500,000 in cash or securities for an investment fund managed by a non-registered investment adviser and $100,000 in cash or securities for an investment fund managed by a registered investment adviser. If an investment fund's minimum net equity falls below the $500,000 or $100,000 threshold, the Letter requires the investment fund to restore such minimum net equity within five business days. Any provisions contained in a prime brokerage agreement with a U.S. prime broker with regard to minimum equity should be consistent with these terms. Some prime brokerage agreements impose minimum net equity requirements as established by the prime broker in its sole discretion. These provisions should be deleted (or at least limited to a specific objective range).

[iv]—Sub-Custodians and Agents

Generally, all investment fund assets should be held, at all times, with the prime broker and not with affiliates of the prime broker. If the investment fund engages in trading activity in jurisdictions with certain legal and/or regulatory restrictions, many prime brokers will either want or be required to use the custody services of foreign entities or affiliates. In provisions addressing the prime broker's appointment of sub-custodians and agents, the prime broker often disclaims liability for any actions of these sub-custodians or agents, so long as they were chosen by the prime broker with reasonable or due care. If the chosen sub-custodian or agent is an affiliate of the prime broker, it is important to maintain the prime broker's liability. Further, once selected, the prime broker should have some duty to monitor the activity of all sub-custodians and agents and determine their suitability on an ongoing basis.

[v]—Timing of Payments

The prime broker may, from time to time, make payment demands from an investment fund. These payment demands may arise from margin calls by the prime broker (e.g., if the value of the collateral declines). The prime broker may also want the ability to transfer the investment fund's assets interchangeably between the investment fund's accounts to meet payment demands. Usually, the prime broker wants the investment fund to transfer collateral immediately after a demand is made. Negotiating a specific cut-off time for same day transfers of collateral is desirable. For example, establishing 10:00 A.M. as a cut-off means that a collateral call made by the prime broker at or before 10:00 A.M. must be satisfied by the investment fund by the close of business on the same day, while a collateral call made after 10:00 A.M...