Hedge funds may be jeopardised by the collapse of Lehman Brothers. LehmanÆs prime broking operation, whilst not at the magnitude of Morgan Stanley and Goldman Sachs, had a presence in Asia, especially in Japan. Their customers want to know what will happen next.

It appears at this early stage that fully paid securities held in client names are safe. However, assets pledged by a hedge fund as original and variation margin for a loan will go into the pot of the individual Lehman unit, with the hedge fund becoming an unsecured creditor.

If the assets were pledged, they have been re-hypothecated and lent out to somebody else. The prime brokerage has the right to take ownership of these assets, regardless of the hedge fund's own liabilities.

"If the prime brokerage is liquidated, there will be an argument about the status of clients' funds held by Lehman," says a Hong Kong-based lawyer. He says it may be legally possible for Lehman to re-hypothecate assets [that is, transfer them to their own name], but the firm has so far kept them segregated from its own account. That could change if Lehman's own assets prove insufficient to meet the claims of secured creditors.

Cash balances are also endangered, but the situation here is subject to many nuances. If a hedge fund kept its cash at LB International Europe, the UK entity, they may have elected for client money protection under the FSA rules, which would sweep cash into a UK bank nightly. The same, however, does not apply to clients whose prime broking relationship is with Lehman BrothersÆ US entity, and where money may not be segregated.

If a hedge fund didnÆt use Lehman as a prime broker but had another kind of trading relationship, say, an ISDA in place, then that derivatives agreement also results in them being a general creditor or debtor of the firm, depending on the marked-to-market positions of the swaps trades.

It is common practice in the prime broking industry for the PBs to claim the right to deal with hedge fund assets as their own. Hedge funds can, of course, insist this power extend solely to assets held as collateral against funds' own obligations, but this must be put down in writing when accounts are first opened, and prime brokers will insist on getting paid a much higher fee.

One lawyer says that hardly anyone in the hedge-fund world, when drawing up contracts with a prime broker of the size of Lehman Brothers, ever really thought they'd see their counterpart go bankrupt. So it is likely that very few hedge funds are so protected, at least in many Asian jurisdictions.

Will this change? Impossible to say, but lawyers do expect their hedge-fund clients to review all of their counterparty documentation, and see to what extent their funds are exposed. "You can no longer point to any single financial institution and say it is 100% safe," says a lawyer. That said, he does not know if this will herald an entirely new approach to hedge funds' counterparty relationships, such as whether prime brokers will still be able to command higher fees in order to legally segregate client assets from their own.

Japan has served as Lehman's regional hub and most of its client assets are held at Japanese financial institutions. The Financial Supervisory Agency yesterday announced Lehman's failure could not lead to damaging Japanese creditors and investors through the outflow of money from Lehman's assets to overseas affiliated companies.

According to the FSA, Lehman has to retain certain assets within Japan equivalent to all liabilities, including guarantees, to domestically based investors and creditors. The firm has been ordered to tally the precise claims of Japanese investors and their assets held at the firm, ensure these assets are available in Japan, and communicate this with investors.

Industry executives speculate that Japanese authorities are spooked by the notion of more domestic assets exposed directly or indirectly to US subprime mortgages and other toxic securities will vanish. The concept of allowing a large financial counterpart to simply go bust is alien to their experience.

But the move was a prudent one by the FSA to ensure domestic market claims are worked out systematically, argues Christopher Wells, partner at White & Case in Tokyo. The announcement was probably made as a warning, not to Lehman, but to other financial institutions not to conspire in the hasty transfer of assets. Overseas hedge funds that booked contracts with Lehman in Tokyo will have to appeal for their return in Japan. And in Japan, it should be standard for client assets to be booked in their own name.

Simon Osborne contributed to this story.