One of the world’s largest hedge fund operators, MAN GROUP PLC (LON:EMG) (OTCMKTS:MNGPF), has been sued for 20 million pounds ($33 million) over claims that their advice went bad in a “complex” over-the-counter (OTC) derivatives trade.

Man Group

Man Group advised Richard Desmond on investment

MAN GROUP PLC (LON:EMG) (OTCMKTS:MNGPF)’s GLG Partners subsidiary advised Richard Desmond, founder of Northern & Shell Plc media group, on a 50 million pound investment in a product called a Constant Proposition Portfolio Insurance, a type of SWAP investment, according to a GLG claim and a report in Bloomberg.  When Desmond requested that the investment be unwound during the market crash of 2008, he claims in a lawsuit to have lost nearly 20 million pounds and was not informed of all the risk in the investment.

In court documents Desmond lawyers claim the derivative contract was “incomprehensible except to an expert.” Desmond had hired GLG Partners as a consultant into SWAP transactions and later engaged in such a transaction with Credit Suisse.  Desmond has a separate lawsuit against the bank.  In their defense, GLG said they were not a party to the specific transaction between Desmond Investments Ltd (CVE:DLC.P) and Credit Suisse Group AG (NYSE:CS) and that Desmond independently decided to invest.

Complexity by design?

While they have been portrayed as complex, some have accused those who write OTC derivatives contracts as manufacturing this “complexity” by design. At their core derivatives, are a type of insurance against catastrophic loss.  If someone wanted to insure against a significant rise in interest rates, for instance, they would engage in a SWAP transaction with a counterparty, often a large bank. The person would pay the counterparty a premium to purchase the insurance and if such an event were to take place the counterparty is required to pay on the claim.

Think of it like a New Orleans homeowner purchasing hurricane insurance.  So long as the catastrophic event does not take place, either a hurricane or rapidly rising interest rates, the counterparty that sold the insurance collects the premium and is not required to pay out on a claim.  If the catastrophic event occurs, the counterparties that have insured against such losses are required to pay on the claim. The problem is that if a catastrophic event were to take place it could require the counterparty to pay out significantly more in claims than it has in net value.  The economist reports there are nearly $700 trillion in outstanding SWAP derivative insurance contracts, with close to 72% tied to interest rates.  The world economy is valued at $72 trillion.  Many of the banks that are counterparties to these SWAP derivatives transactions have SWAP liabilities that are said to be over four times larger than their net liquidating value.

OTC SWAPs are very different from regulated derivatives traded on an exchange in several important respects. Most significant are the fact that regulated derivatives have common contract standards that are clearly outlined.  Many of the famous unregulated OTC SWAP transactions that have gone badly for investors such as Desmond involve the creation of contracts that are complex and risks not properly explained.  In regulated derivatives, not properly explaining risk to an investor could lead to disbarment from the industry and even criminal charges of fraud, depending on the circumstance.  Unregulated derivatives sold to sophisticated investors face more lax standards, yet there is a move afoot to better regulate the very lucrative OTC SWAP markets that many consider the wild west of derivatives trading and some blame for contributing to the 2008 world stock market collapse.

The GLG lawsuit is the latest in a series of problems MAN GROUP PLC (LON:EMG) (OTCMKTS:MNGPF) has faced.  The hedge fund is primarily involved in trading derivatives contracts using mathematical formulas for what is known as trend following.  Trend following strategies, which performed very well in 2008, have found difficulty as market environments have failed to exhibit market price trends.  After reaching a high of $134.40 in May of 2013, Man Group’s stock was trading near $86.55 on Monday.