1. What is Rebalancing?

Under IFRS 9:

Rebalancing refers to adjustments to the designated quantities of either the hedged item or the hedging instrument of an existing hedge relationship for the purpose of maintaining a hedge ratio that complies with the hedge effectiveness requirements

Rebalancing is not possible if the risk management objective for a hedging relationship has changed. Instead the hedge accounting for that hedging relationship should be discontinued.

In practice: You have $100m portfolio with $100m notional IR swap hedge. You sell $40m of bonds. Your hedge is now $100m vs $60m exposure = 166% hedged = over-hedged. You must reduce swap to $60m or add opposite.

Portfolio changes triggering rebalance:

• Asset sales / redemptions / prepayments
• Duration / convexity changes
• FX exposure change after M&A
• Credit rating migration changing portfolio beta
• Fund flows - subscriptions / redemptions in hedge fund

2. Legal Duty to Rebalance

a) Directors' Duty - US

In 1992, a group of shareholders brought a derivative lawsuit against the directors of a grain elevator cooperative for their failure to properly hedge the risk associated with the grain industry.

Brane v. Roth, 590 NE 2d 587 - Ind. Court of Appeals, 1st Dist. 1992 - Leading US case.

Facts: Grain co-op directors failed to hedge grain price risk. Grain prices fell, co-op lost $7m. Shareholders sued for breach of fiduciary duty.

Court held: Directors of a corporation dealing in commodities have duty to consider hedging as part of duty of care under Business Judgment Rule. Failure to hedge or failure to maintain hedge after portfolio changed is not protected by Business Judgment if directors did not even consider hedging. Directors personally liable.

Principle extended: If duty to hedge exists, duty to maintain hedge after portfolio changes is implicit. Article concludes:

under current U.S. law directors should have a duty to hedge. Said duty to hedge should not be understood as an absolute duty.

b) Fiduciary Duty - Investment Managers

Weavering Macro Fixed Income Fund (in liquidation) - Cayman Grand Court / Privy Council
Hedge fund collapsed when biggest position fictitious. Fund sued independent directors for breach of duties to exercise independent judgment, to exercise reasonable care and skill and to act in its best interests.

Court at first instance found directors breached duty by failing to monitor hedging / rebalancing procedures - NAV was overstated because hedges not adjusted after fictitious trades.

Al Sadik v Investcorp Bank BSC [2018] UKPC 15

A recent judgment... has upheld a decision that a hedge fund manager had not acted dishonestly or improperly when it failed (a) to accurately describe to its client the structure and means by which his investments were being leveraged, and (b) to accurately report the values of the underlying investments

Court distinguished honest failure to describe vs negligent failure to rebalance. Manager escaped dishonesty but case established that if leverage changes, failure to rebalance and report = breach of investment management agreement.

c) Auditor Liability for Hedge Accounting

Manchester Building Society v Grant Thornton UK LLP [2021] UKSC 20

On 18 June 2021, the Supreme Court gave its judgment in the case of Manchester Building Society v Grant Thornton UK LLP.

The case concerned advice given to a small building society by its accountants from about 2006 onwards that its annual accounts could be prepared according to a method known as "hedge accounting".

Facts: Building Society had lifetime mortgages funded by swaps. Portfolio shortened due to prepayments. Grant Thornton advised it could use hedge accounting, so no need to rebalance or mark-to-market swaps. In 2013, accountants realized error - society had to restate, show substantial loss, close swaps at £32m loss.

Supreme Court: Accountants liable for £32m. Negligent advice caused society to not rebalance hedges. Society would have de-risked if told true accounting volatility.

Key for rebalancing: If you use hedge accounting, IFRS 9 requires you to prove effectiveness 80-125%. After portfolio change, hedge becomes ineffective unless rebalanced. Failure to rebalance = lose hedge accounting = P&L volatility.

d) Internal vs External Hedges

Barnett Waddington Trustees (1980) Ltd v The Royal Bank of Scotland plc [2015] EWHC 2435 (Ch)

In Barnett Waddington Trustees (1980) Ltd & anr v The Royal Bank of Scotland plc [2015] EWHC 2435 (Ch), 14 August 2015 Warren J held that an internal swap between divisions of a lending bank did not amount to a

RBS argued borrower should pay break cost of internal swap hedge after loan prepayment. Court held internal swap between divisions is not market hedge - cannot charge borrower for failure to rebalance internal book. Lender must have external hedge to claim.

Rhine Shipping DMCC v Vitol SA [2023] EWHC 1265 (Comm)

Internal hedges entered into through a portfolio management system may be insufficiently linked to the breach to be relevant to the assessment of damages.

Commercial Court: Internal portfolio netting is not sufficient hedge rebalancing for damages claim. After cargo breach, Vitol relied on internal portfolio offset, not external re-hedge. Court said insufficiently linked - need to show actual rebalancing trade.

e) Failure to Recommend Hedge - US Broker Duty

PIABA Journal:

THE FAILURE TO RECOMMEND HEDGE STRATEGIES AS A BASIS OF

FINRA arbitrations: Broker who fails to recommend defensive hedges after portfolio becomes concentrated (e.g., after client inherits large stock position) breaches suitability duty under FINRA Rule 2111. Cases award damages for not rebalancing with protective puts/collars.

3. Regulatory Standard

• FCA SYSC 19 / PRU: Investment firm must maintain risk management that ensures hedging strategies remain effective after material portfolio change. Daily VaR limit breach due to un-rebalanced hedge = reportable breach.
• ISDA Definitions + CSA: Most ISDA masters require Hedging Party to maintain Hedge Ratio within X%. Failure to rebalance after rebalancing event = Additional Termination Event.
• UCITS / AIFMD: Fund must ensure global exposure post-hedge remains within limits after subscriptions/redemptions. CSSF fined several Luxembourg funds in 2021-22 for not rebalancing FX hedges after portfolio changes.

4. How to Defend / Comply

1. Define Rebalancing Trigger in Risk Policy: e.g., >5% change in NAV, >0.5yr duration change, >10% FX exposure change = mandatory rebalance within T+1.
2. Automate: Link portfolio management system to hedge ratio dashboard.
3. Document: For IFRS 9, document rebalancing as continuation, not discontinuation. For audit, keep pre/post hedge ratio.
4. Board Minutes: Brane v Roth defence = show board considered hedging at each meeting after portfolio change.

If you have a loss due to over-hedge after asset sale, the claim is typically: breach of fiduciary duty / negligence against manager for not rebalancing, or professional negligence against accountant who said hedge accounting allowed.